conglomerates

Conglomerates

…are collections of businesses, often with little operational connection with one another, linked together by common ownership.  Outside the US, the controlling entity typically exercises its influence by taking large minority interests in the subsidiary firms;  in the US it’s more common that the controlling entity owns its subsidiaries entirely.

The former structure allows greater reach; the latter makes it easier to dividend cash from one arm to another without incurring tax.

the conglomerate era

Looking back, it’s often strange to see investment suppositions that, to us, are patently crazy but which investors of another era held as gospel.

In particular, there was a conglomerate “era” in the US during the 1960s.  This was a time when Wall Street thought that there is such a thing as “pure” management, which could be applied by expert practitioners to all kinds of businesses, no matter what they were.   So, a management expert could run, say, a movie studio without knowing anything about entertainment, or head a department store chain without knowing anything about fashion or real estate or retailing, or a lead computer chip company without knowing anything about coding or chip fabrication or materials science.

What were these “pure” management skills?  Allocation capital was one.  Your guess is as least as good as mine about any others.

During that period–a decade before I entered the stock market, so I’ve only read about it–conglomerates traded at a premium to the sum of their parts.

Maybe 1950s-style conglomerates made some sense.  I don’t know.  But their executives soon worked out that they could use debt to make acquisitions that would give a (temporary) boost to ep that would get their firm a higher earnings multiple.  So companies like Gulf and Western, ITT, National Student Marketing and Textron turned themselves into M&A machines.  As long as investors believed in the supposed alchemy of management, the worst low-PE dross a conglomerate held its nose and acquired, the greater the gain from multiple expansion when those earnings came under the conglomerate umbrella.

This all ended in tears in the late 1960s, through a combination of higher interest rates, the dead weight of senseless acquisitions,and the inability of conglomerate managers to improve businesses they owned but didn’t know the first thing about, that caused the conglomerates to crater.

today’s view

Today’s view is that conglomerates should trade at a discount to the sum of their parts.  It has its roots–not in the companies per se–but in the idea that investors want to fashion portfolios for themselves, not buy pre-assembled packages.  Off-the-rack conglomerates should be worth less than bespoke portfolios.

One of my favorite examples of this belief (which I think is basically correct) comes from one of the old opium trading companies in Hong Kong, Swire Pacific.  At one time, Swires was a property development company + an airline.  The first component is income-oriented and buttressed by a steady stream of rental payments.  The other is a highly economically-sensitive industrial.

Income-oriented investors, the argument goes, must be compensated through a lower overall PE for having to hold the airline component of Swires they don’t really want.  Similarly, more adventurous investors have to be compensated for being stuck with an income vehicle they don’t want.

Therefore, the parts separated should be worth more than the two together.

In fact, when Swires announced it would seek a separate listing for Cathay Pacific, the stock rose by 40%.

 

Tomorrow, Disney as a conglomerate.

 

 

 

 

Disney (DIS) and ESPN: a lesson in analyzing conglomerates

DIS shares went on a fabulous run after the company acquired Marvel in late 2009, moving from $26 a share to $120 in early 2015.  Since then, however, the stock has been moving sideways to down–despite rising, consensus estimate-beating earnings reports in a stock market that has generally been rising.

What’s going on?

The basic thing to understand about analyzing a conglomerate like DIS is that aggregate earnings and earnings growth matter far less than evaluating each business in the conglomerate by itself and assembling a sum of the parts valuation, including synergies, of course.

In the case of DIS, the company consists of ESPN + television; theme parks; movies; merchandising related mostly to parks and movies; and odds and ends–which analysts typically ignore.

In late 2009, something like 2/3 of the company’s overall earnings and, in my view, 80%+ of the DIS market value came from ESPN.

How so?

At that time, ex Pixar, the movie business was hit and miss; the theme parks, always very sensitive to the business cycle, were at their lows; because of this, merchandise sales were similarly in the doldrums.  ESPN, on the other hand, was a secular growth business, with expanding reach in the global sports world and, consequently, dependably expanding profits.

ESPN profits not only made up the majority of the DIS conglomerate’s earnings, the market also awarded those profits the highest PE multiple among the DIS businesses.

At the time, I thought that if truth in labeling were an issue, the company should rename itself ESPN–although that would probably have detracted from the value of the remaining, Disney-branded, business lines.

Then 2012 rolled around.

More tomorrow.