Management Lessons of Premium Conglomerates. Discussion Paper

Transcription

1 Management Lessons of Premium Conglomerates Discussion Paper

2 Management Lessons of Premium Conglomerates Larry Shulman December

3 About the Authors Larry Shulman is a senior vice president in the Chicago office of The Boston Consulting Group and global coleader of the firm s Strategy practice. Acknowledgments The author would like to acknowledge the following BCG colleagues for their contributions to the firm s thinking about premium conglomerates: Gerry Hansell (Chicago), Dieter Heuskel (Düsseldorf), Robert Howard (Boston), Mark Joiner (New York), Tom Lewis (Hong Kong), George Stalk (Toronto), and Carl Stern (Chicago). For Further Contact This paper is a work in progress representing the evolving perspectives and analyses of individuals within The Boston Consulting Group. Its purpose is to stimulate discussion rather than to claim a definitive point of view or draw a final conclusion. The author welcomes your feedback. He can be reached at shulman.larry@bcg.com. The Boston Consulting Group, Inc b Premium Conglomerate Discussion Paper

4 Management Lessons of Premium Conglomerates Much of the debate about the value of highly diversified companies, or conglomerates, centers on theoretical views of diversification, risk, and investor portfolio profiles. Some analysts have used observed differences in the priceto-earnings (P/E) ratios of conglomerates (when compared with those of more focused companies) to posit the existence of a so-called conglomerate discount. Others have tried to estimate theoretical break-up values, arguing that if the multiple businesses of a conglomerate were floated on the market as independent companies, the sum of their value would be greater than the value of the conglomerate itself. When the actual performance of real-world companies is factored into the debate, however, such claims often appear irrelevant or extremely difficult to verify. Comparing relative P/E ratios may provide a useful one-time snapshot of a company s valuation, but it says little about the company s ability to create additional value over time. And estimates of break-up values are notoriously variable. Short of an actual transaction, it is impossible to know with any certainty what the break-up value of a specific company will be. Empirical evidence demonstrates that roughly half of demergers have actually destroyed value rather than created it (see Exhibit 1). In an effort to take a more pragmatic and action-oriented approach to the issue of conglomerate performance, The Boston Consulting Group recently Premium Conglomerates Discussion Paper 1

5 conducted a study of the market performance of conglomerates during the ten-year period from 1988 to Our sample consisted of the 500 large, publicly traded U.S. companies listed on the S&P 500. Instead of focusing on P/E ratios or theoretical break-up values, we concentrated on total shareholder return (TSR), the best metric for long-term value creation. And we not only compared the performance of diversified companies with that of more focused companies but also investigated variations in performance across all the diversified companies in the sample. We came to four basic conclusions: On average, conglomerates perform in line with stock market averages. Indeed, during the 1988 to 1997 period, they performed somewhat better than average. Whereas the S&P 500 delivered an average annual TSR of 17.6 percent, the Value Line index of diversified companies delivered an annual TSR of 18.6 percent (see Exhibit 2). There is no correlation between a company s degree of focus and its shareholder return. Focused and diversified companies display similar degrees of variation in performance around the market average. Exhibit 3 measures Exhibit 1 Value Creation Before and After Demerger, Annualized 30 weighted relative total shareholder return of the 20 demerged companies (%) 10 Market 10 AMAX Marriott 7 1 Union Carbide Amex Eastman Kodak ICI Litton Morton Thiokol Racal Electronics Ethyl Pacific Telesis1 SKB BAT Baxter Teledyne Courtaulds Santa Fe Pac Market Relative total shareholder return as conglomerate predemerger (%) Premiums Underperformers 1 Pacific Corp. Holding took over Pac Telecom on September, Burlington Northern took over Santa Fe Pacific in September, SOURCE: BCG database. 2 Premium Conglomerates Discussion Paper

6 Exhibit 2 On Average, Diversified Companies Perform at Market Averages Average annual total shareholder return, (%) S&P 500 Value Line Diversified Companies Exhibit 3 Total Shareholder Return by Degree of Diversification, Total shareholder return relative to stock market average, (%) Diversification of businesses (number of two-digit SIC codes) Premium Conglomerates Discussion Paper 3

7 diversification by the number of Standard Industrial Classifications, or SIC codes, represented at a given company. The chart indicates similar variations in performance for highly diversified companies participating in five or more businesses and for more focused companies participating in only one or two. Some conglomerates systematically outperform relevant stock-market indices. We identified a subset of 50 diversified companies that significantly outperformed market averages from 1988 to 1997 (see Exhibit 4). An investment in this group of premium conglomerates in 1988 would have yielded an annual growth in TSR of 27 percent over the subsequent ten years roughly ten points more than the S&P average. By contrast, another group of 50 highly diversified companies consistently underperformed the market during this period. These underperforming conglomerates managed to destroy absolute shareholder value during the greatest bull market of all time. The TSR for this group was negative 1 percent per year during the 1988 to 1997 period (see Exhibit 5). Exhibit 4 U.S. Premium Conglomerates, Number ten-year of two-digit Rank 1 Company Name relative TSR SIC codes 1 Gillette Co Safeguard Scientific, Inc Pfizer, Inc Berkshire Hathaway Crompton & Knowles Corp Clayton Homes, Inc Thermo Electron Corp Kansas City Southern Inds Lancaster Colony Corp Williams Cos., Inc Premark International, Inc Volt Info Sciences, Inc Leggett & Platt, Inc Philip Morris Cos., Inc Procter & Gamble Co Lennar Corp General Electric Co Tyco International Ltd PepsiCo, Inc ABM Industries, Inc Centex Corp Sara Lee Corp Oneok, Inc Federal Signal Corp Carlisle Cos., Inc Number ten-year of two-digit Rank 1 Company Name relative TSR SIC codes 26 Crane Co Allied Signal, Inc Monsanto Co Textron, Inc ConAgra, Inc Walt Disney Co Equifax, Inc General Dynamics Corp Cincinnati Bell, Inc Bestfoods Honeywell, Inc Paccar, Inc Deere & Co Bristol-Myers Squibb Lockheed Martin Corp Fleetwood Enterprises Royal Dutch Petroleum Service Corp International American Home Products Corp ALLTEL Corp Enron Corp Chevron Corp Teleflex, Inc DuPont United Technologies Corp Rank order based on ten-year relative total shareholder return. SOURCES: Compustat; BCG database; BCG analysis. 4 Premium Conglomerates Discussion Paper

8 Premium conglomerates are managed to a specific set of rules. The group of premium conglomerates includes many different kinds of companies. Some are operating companies, others are holding companies. Some are industrial conglomerates, others focus on consumer goods. In some premium conglomerates, the linkages across businesses are obvious; in others, linkages are difficult to identify. However, these companies all have a few things in common when it comes to the way they are managed. Premium conglomerates differ from their averageperforming and underperforming counterparts on four key dimensions: They regularly shrink and even exit from low-return businesses and invest aggressively in high-return businesses. They emphasize performance and accountability in their management practices. They shape their business portfolios according to a distinctive strategic logic. They manage their reported earnings consistently and predictably. Exhibit 5 Performance of Premium Versus Underperforming Conglomerates, Share price index 6 5 Premiums Average annual shareholder return S&P Underperformers Premium Conglomerates Discussion Paper 5

9 These findings suggest that the debate about conglomerate performance should not focus on diversification per se. Rather, it should emphasize how successful conglomerates actually manage themselves. The lessons that emerge are of value to diversified and focused companies alike. Managing Capital Allocation: Aggressive Investment in High-Return Businesses Premium conglomerates have a distinctive approach to capital allocation. They aggressively manage it in a way that allows them to routinely shift capital from businesses that have low or erratic returns to businesses that provide high returns. Underperforming conglomerates, by contrast, tend to have a more passive approach to capital allocation. They spread their investments more broadly over the full range of their businesses whether those businesses are performing well or not. 1. Historical changes in the definition and composition of the businesses in each conglomerate s portfolio made it impossible to track investment patterns over the entire ten-year period of the study. Exhibit 6 compares the investment practices of premium and underperforming conglomerates from 1991 to At the beginning of the period, both types of conglomerates had about equal proportions of their assets invested in positive- and negative-spread businesses. Over the next five years, however, the premium conglomerates used their new capital to expand their higher-return business positions significantly. By contrast, underperforming conglomerates tended to invest more of their capital in businesses that either performed erratically (with some good years and some bad) or actually destroyed value. In fact, they invested three-and-ahalf times more capital in negative-spread businesses than they did in positivespread businesses. And they invested the bulk of their new investment capital, almost 75 percent, in those businesses that, on average, were earning just about the cost of capital. Although in some cases the premium conglomerates turned around poorly performing businesses, the primary way they expanded their high-return positions was to withdraw capital from their low-return businesses and deploy it elsewhere. In fact, premium conglomerates generally shrank their negativespread businesses by exiting from them often absorbing a book loss. The 6 Premium Conglomerates Discussion Paper

10 underperforming conglomerates, by contrast, invested much more democratically. They did not reshape their portfolios and, therefore, did not improve their ability to clear the cost of capital consistently. Although both groups made acquisitions, the premiums managed these transactions to reshape their portfolios by funneling capital to positive-return businesses. They tended to make many more acquisitions and smaller ones in a process of fine-tuning existing businesses rather than moving into entirely new businesses. In conclusion, premium diversified companies invested shareholder capital in high-return businesses capable of consistently earning in excess of the cost of capital. Underperforming conglomerates dispersed shareholder capital into businesses with varying profitability profiles and were unable to consistently earn above the cost of capital on new investments. Exhibit 6 Conglomerate Investment by Business ROI, Business-unit historical ROI Premium conglomerates Underperforming conglomerates Positive spread, greater than hurdle rate Neutral or erratic spread Negative spread, lower than hurdle rate (%) (%) Premium Conglomerates Discussion Paper 7

11 Management Practices: Insisting on Performance and Accountability Premium conglomerates heavily emphasize performance and accountability. Although external discontinuities may be accepted as an explanation for missing one period s earnings, they never become an excuse to reset future requirements for financial returns. The consistent message is that if the numbers cannot be made, operating managers must change their business paradigm and quickly. Premium diversified companies are generally known for being tough organizations. Companies like ConAgra, Berkshire Hathaway, Textron, and Allied Signal have built reputations as organizations that demand performance. Underperformers whether businesses or individuals are not tolerated. Premium conglomerates also share a common approach to incentive compensation: it is always tied to overall business performance. The philosophy is, You make your numbers, you get your bonus. There are seldom partial bonus payouts; there are often large stock-option awards. By contrast, underperforming conglomerates do not stress accountability for performance and earnings, and they consistently reset performance goals to allow for partial bonus payouts to key managers. The premiums perform rigorous strategic reviews for all their key businesses. They assume that change is inevitable and that the response to it must be swift. They tend to leave management teams in place for sustained periods, and these teams continually alter their strategies and responses as environments and competitors change. Conversely, underperforming conglomerates tend to assume that the environment is relatively stable. Instead of being a part of the formal business process, strategic reviews and investigations are episodic and driven by crises. Moreover, the underperformers tend to continually change and reshuffle management teams at key businesses. As a result, executives lack the necessary experience to reorient a business rapidly when the need arises. Interestingly, managers at both successful and unsuccessful conglomerates readily recognize these differences. International Survey Research (ISR), a global leader in employee opinion surveys, conducts annual surveys at many 8 Premium Conglomerates Discussion Paper

12 large U.S. corporations. BCG asked ISR to create composite data for its two groups of conglomerates. Exhibit 7 illustrates that managers at premium conglomerates know that their companies are well run, that their performance matters, and that poor performance will be penalized. Managers at underperforming conglomerates are much less certain that their companies are well run, that individual performance matters, and that competency drives performance. The fact that managers at both premium and underperforming conglomerates can describe the differences in the management philosophies of their companies suggests that these differences are real to them and measurable. Strategic Business Types: How Premium Conglomerates Maintain Focus Premium conglomerates manage the diversification of their corporations in a way that allows managers to focus on a broad set of strategic issues across the Exhibit 7 U.S. Conglomerate Employee Opinions About Management Premium conglomerates Underperforming conglomerates In my judgment, the company as a whole is well managed. 67% 49% The company does a good job of promoting the most competent people. 49% 42% The company is too lenient with employees who perform poorly. 52% 59% SOURCE: Composite derived from employee survey data collected by International Survey Research over a period of five years. Premium Conglomerates Discussion Paper 9

13 portfolio. Although they operate in many different businesses, premium conglomerates opt for a particular style of competition that unifies and focuses senior management. The result is a distinctive and clearly understood set of strategic screens that explain the inherent logic of the company and define the needed capabilities of senior management. A classic example of how premium conglomerates use such screens is General Electric. Over the course of Jack Welch s tenure as CEO, the company has progressively focused on two strategic screens. The initial screen was for a particular type of product business. Typically, these businesses: manufacture capital goods that require substantial new investments (in the neighborhood of $250 million or more) in product development, facilities, or design; have few worldwide competitors (generally no more than four or five); have relatively long-lived technology bases (lasting roughly 10 to 15 years); and are periodically transformed by new game-changing technologies that require investments of a billion dollars or more. Understood at this level of abstraction, the different product businesses of GE are remarkably similar. The strategic positioning and competitive framework required to succeed at aircraft engines are no different from those required for power systems or medical systems or locomotives. In fact, this similarity explains how GE can use the same strategic review and planning process for the vast majority of its businesses. Knowing where and how to compete and where and how not to is one of the great strengths of premium conglomerates. Jack Welch has said that General Electric would be at a potential disadvantage if it chose to compete in consumer goods or consumer electronics businesses. These businesses are too fast for General Electric in other words, they evolve too quickly. They don t grant GE the advantages of size, scale, and available capital that make the company such a powerful competitor in its core businesses. In the past decade, General Electric has complemented this initial productbusiness screen with a separate strategic screen for the service businesses gath- 10 Premium Conglomerates Discussion Paper

14 ered together in the company s GE Capital Services unit. Whereas the company s product businesses focus mainly on profit improvement, the company s service businesses focus primarily on growth. GE strives for high share in very narrow niche markets that require large, scale-sensitive investments in infrastructure. The company strives to grow the business by leveraging these infrastructure investments. For example, General Electric is one of the largest car-leasing companies in the world, with major investments in the information systems necessary to coordinate leases for corporate fleets. The company is one of only three global lessors of shipping containers a business that requires massive investments in inventory to ensure adequate coverage in the major ports of the world. In addition, the company s capital leasing business is one of the few that can take on a lease without syndicating it to others. GE s massive financial resources and its capacity to absorb the entire risk of a lease are distinctive competitive advantages. 2. The dominant screen, however, can shift over time. GE, for example, is probably in the midst of a shift in emphasis from the product-business screen to the service-business screen. The use of a limited number of clearly defined strategic screens allows managers of premium conglomerates to clarify their management processes. Like GE, premium conglomerates are usually involved in no more than two strategic business types. The dominant business type generally comprises about 70 percent of the corporation. 2 Conversely, underperforming conglomerates tend to be involved in three strategic business types on average, with the dominant type comprising only 50 percent of the corporation (see Exhibit 8). There is a big difference between managing a diversified company in two major types of businesses, with one clearly dominant type, and managing a diversified company in three or more types of businesses, where no one type dominates. Focusing on a limited number of strategic screens allows premium conglomerates to break the compromise between diversity and focus. They combine the diversity of multiple markets and products with the focus that comes from choosing the type of competition in which they will engage. Premium Conglomerates Discussion Paper 11

15 Managing Earnings: The Imperative of Consistency and Predictability Sophisticated institutional investors in the United States have high levels of discomfort when it comes to conglomerates. They often privately refer to them as black boxes. They see the corporate management of a conglomerate as an extra layer of diversification that is outside their control. They are unable to calibrate how specific external events will affect a company s value or to fully understand (let alone predict) earnings and performance swings. As a result, institutional investors insist that conglomerates do the only thing that, in the opinion of these investors, conglomerates can do: perform as predicted. Premium conglomerates seem to understand that attitude. Rather than rail against Wall Street s supposed lack of insight, they manage results so that Wall Street has little to complain about. Because of their diversity, premium conglomerates understand they can afford few earnings surprises. They must perform on schedule and as expected. As a result, they manage their earnings much more consistently than underperforming conglomerates do. Exhibit 8 Strategic Screens at U.S. Conglomerates Premium conglomerates Underperforming conglomerates Average number of strategic business types 2 3 Percentage of corporation in dominant business type 71% 51% 12 Premium Conglomerates Discussion Paper

16 Premium conglomerates grow same-quarter earnings per share (EPS) in an extremely consistent pattern. The premiums in our sample delivered quarterly EPS growth a remarkable 98 percent of the time. The underperformers, by contrast, achieved quarterly EPS growth only two-thirds of the time. Premium conglomerates also made or exceeded quarterly earnings estimates almost 70 percent of the time. The underperformers did so only 37 percent of the time (see Exhibit 9). There is a clear link between earnings consistency and the performance-based management practices of premium conglomerates. These companies demand performance and results at the business-unit level because the stock market demands them at the corporate level. Management systems reward making the plan, or else, because the company must make its quarterly earnings estimates, or else. What s more, the focus provided by a dominant strategic screen creates an internal consistency that also contributes to predictable earnings performance. This internal consistency is what makes premium conglomerates a uniquely high-performing set of companies. Exhibit 9 Managing Earnings Consistently and Predictably Premium conglomerates consistently grow earnings......and avoid financial surprises Percentage 100 of quarters reporting year-to-year earnings 1 growth Percentage 100 of quarters in which company earnings estimate 75 was met 1 or exceeded Premiums Underperformers 0 Premiums Underperformers 1 Time frame ranges from 15 to 30 quarters per company within groups. SOURCES: Annual reports; First Call; Zacks; BCG analysis. Premium Conglomerates Discussion Paper 13

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