Is a GE breakup, the end of Conglomerate business model

GE breakup

In this blog, we shall discuss on the GE breakup, why companies operating in multi businesses are performing badly and are no longer preferred by the shareholders.Conglomerates businesses are facing high pressure from activist investors to exit businesses that are no longer their core competency.
Most of the Conglomerates are asset heavy and due to the digital disruption, their current business models are no longer relevant.
To substantiate the decline of Conglomerates, we shall take the case study of GE and how one of the globally best run managed companies finds itself in the verge of filing for bankruptcy.

GE breakup overview

• GE is one of the oldest companies started in 1878 by none other than famous scientist – Thomas Alva Edison.
• The company started with manufacturing of light bulbs and scanning machines, but later moved to appliances market.Most of the US households were using GE appliances.The company was stable and was growing at double digits with high margins.
• As GE was operating in an industry which had lower scope for growth, it understood that only way to grow was to expand through acquisitions.
• The company took a decision to enter to other industries.This happened during the period of Jack Welch era, where companies resorted to acquisitions to enter into newer businesses.
• Welch acquisition strategy was to acquire companies that are market leaders in the respective industry.He was not interested in doing roll ups or bolt-on acquisitions.Once the company was acquired, GE incorporated their superior management structures and capabilities in order to better able to integrate the companies and realize value.
• When Welch retired in 2001, GE had the highest market capitalisation.The company growth continued under Jelf Immelt who pursued Welch acquisition strategy to grow GE revenues.
• Things went on well until recession in 2008, when GE financial arm was affected by the loan defaults and freeze in capital markets access.
• GE had complex financials and dubious financial reporting standard which was able to hide their bad acquisitions bets and heavy debt in their balance sheet.
• GE was not able to compete in the digital era as it was holding many businesses which are no longer relevant.Further high debt taken reduces their earning which impacts the shareholders returns.This has seen GE stockprice plummet and for the first time finds itself removed from Dow Jones listing.

GE breakup reason 1 – Weakness in GE Acquisition Strategy

• GE acquisition strategy worked well when it was able to buy companies at the right price.As GE was a behemoth, it had access to cash and capital compared to other bidders which helped it to buy companies.Due to its strong management structures and leadership capability, it was able to add value to the acquired companies.The target management were also happy to be part of GE brand due to GE reputation and credibility.
• This strategy of acquiring companies was soon replicated by Private equity firms who were able to raise capital from investors through their buyout funds.Further in the current environment, where access to capital is very cheap, GE finds itself with more bidders vying for the same asset. This increased competition inflated the asset prices which led to GE overpaying for many targets.
• GE had to raise debt to fund its acquisitions.As majority of the acquisitions did not do well, GE had to impair these acquisitions which left it with huge interest payments for its acquisitions.

GE breakup reason 2 – Decline of GE capital

• Jack Welch wanted to diversify from GE capital intensive business to grow the company and deliver higher shareholder returns.
• Welch decided to venture into Financial services business as he felt that this business requires less investment and had more scope for higher profits.
• GE capital which started as internal lender to buying equipments became an NBFC firm that lend money to borrowers in Industrial equipments sector.The business did not have any unique differentiation.Hence the business was affected due to recession when majority of its borrowers defaulted.
• High defaults left its balance sheet with higher NPA.Currently the outstanding debt for GE capital far outstrips its revenues which leaves the firm with high exposure to debt.

What is the future for GE and other conglomerates?

• When we look at GE or any other conglomerates, one needs to closely analyze it’s current business mix.
• In case of GE, it currently operates in aviation, Healthcare and Transportation.Further it also has presence in Energy business which includes renewable energy, Power and Oil.Other business like water are divested, its investments in NBC Universal is sold to Comcast and its appliances businesses are sold to Haier.
• Conglomerates have high corporate expenses that runs to billions of dollars annually which highly impact the profitability. When Conglomerates decides to divest, many of these corporate expenses are reduced.

Hence futures for Conglomerates would be:
Breaking up the business

• Conglomerates would be spinning off their business going forward. They need to seperate these business so that there is no dependency on the parent business structure.
• Then they need to find a suitable buyer for these assets and price the assets in such a way that the buyer is able to get more value through additional synergies.

Retrench and Refine the business

• Conglomerate business can also redefine their strategy and change their business models.Most of these conglomerates are at matured and declining phases in the Corporate life cycle.
• Hence they would do better by accepting that they are matured companies and decide to operate in low growth high margin business which helps their shareholders to get a stable returns from their investments.
• They can decide to exit all low margin businesses and raise capital which would reduce their outstanding debts.

Reinvest and move to new business

• Conglomerates can also decide to take a plunge to move to new markets and businesses like digital.
• They can reinvest their earnings or take additional debts to resort to acquisitions which would enable them to access new capabilities.
• This decision can backfire as already most of these Conglomerates are already facing high debt exposure and taking additional debt will affect their credit rating that would inturn crash the stock price.

Conclusion

• GE breakup is a reminder that conglomerate business are facing pressure from activist investors and their shareholders to divest their existing business that are either low margins or where the parent companies do not have any competency. Companies are expected to focus only on those businesses where they have high competency.
• Most of the financials of the Conglomerates are highly complex and risky.They are highly vulnerable to scrutiny.GE recently is facing an allegation of accounting fraud as it was able to hide lot of its irregularities and bad acquisitions bets in these complex financials.
• Conglomerates businesses are similar to Private Equity firms with only difference being that Conglomerates hold their business for a longer time than PE firms who know when to time their exits.As Conglomerates take a long time to exit, most of the divestitures are sold at discount which further impacts the return on assets.Conglomerates businesses need to divest their businesses far regularly and should be able to leverage the favorable market conditions to get a higher return on their assets.