Conglomerates : Governance and Strategic Issues

- related to P1 and P3 ACCA Candidates

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Pic 01: Humble machine that destroyed Xerox?

I have the bitter-sweet experience having John Zinski, CEO of of Securities Industry Development Corp - the training and development arm of the Securities Commission, as my facilitator when I pursued my Master of Science postgraduate studies in Nottingham (U.K) University. We didn’t quite meet eye to eye on my research analysis on “Why Xerox failed?” My supposition was that its Board was short termistic in relations to EPS (Earnings Per Share) zealously cutting costs and outsourcing its primary activities.

Its strategic collaboration with Fuji (Japan) Limited saw the gradual loss of its core competencies pertaining to knowledge on developing low end photocopiers. Xerox didn’t mind that Fuji Limited was sending over 1,000 engineers to swarm all over its factories including the Research and Development division. These keen engineers would bring back valuable knowledge for analysis and further development on their then shallow grasp of the photocopiers’ technology. In the end Fuji Limited gained significant market share in Asia under the brand name Fuji-Xerox. In time Ricoh machines penetrated USA market and hurt Xerox market share.

Fuji offered a defensive strategy that Xerox could sell its machines in USA, confident it will succeed since Fuji’s technology was superior to Ricoh in Japan. However this collaboration turned in favour to Fuji with it now insisting on intellectual fees. As a result, Xerox lost out on competitiveness and profitability as it becomes a mere brand on the outside but possess no real competencies on inside.

John enthusiastically challenged my research findings arguing that Xerox was hugely successful and merely relegate low end photocopiers market segment to a non-threatening partner. But I defended that the numbers don’t lie in that Xerox revenues fell double digits and was a brink of corporate insolvency. Insisting he was ‘right’ being a senior manager of the company for over 10 years, he brushed aside my arguments. Well, I could only say both of us were right as we looked at the same case study from ‘different eye’.

Still this was an enriching experience of research and intellectual exercise.

Now his article on the “Good and Bad of Conglomerates” certainly a very good one for P1 and P3 candidates.





































Pictures above: Which of the above businesses would you think an Asian Firm and Western be keen? Would it be investing big budget movies like the US$500 million Matrix trilogy, US$200 million Titanic or dull business like properties development in Kuala Lumpur?

What is Conglomerate?
A simple definition is a firm that has large number of businesses, which often are unrelated to each other. Sime Darby Berhad, GE (USA) Limited and Cheung Kong (Hong Kong) Limited are prime examples.

P1 Perspective
Conglomerate places overwhelming pressure on Board of Directors to supervise, devise and execute effective strategies. Unfortunately one cannot find supervisory and advisory committees comprising of independent Non Executive Directors to be an expert in every business fields. A “Jack of all trades and Master of none”scenario.

Board that gives green lightand offer no real meaningful advise to Executive Directors on strategies without real understanding of the business certainly exposes firm to higher risks.

Institutional shareholders would have conflicting view on conglomerate’s performance witnessing certain ‘star’ industries rising in growth and contribution while uncertain of the lackluster performance on the rest of conglomerate. They thus decidedly value the shares at a discount viewing it as an uncertainty on its potential.

Insider dominated firms i.e. firms with families as major shareholding controls, opportunistically seek to expand to other businesses believing they are spreading the risks in a few basket. Disregarding share price performance as it means nothing more than a paper loss as they have no intention to sell out their shares, they select strategies that fit their risk appetite. Generally, Asian conglomerates prefer the stable returns form low to moderate risk businesses. Hence it comes as no surprise to witness so many listed companies are involved in mature industries like construction, infrastructure, manufacturing and automobiles while shying away from infant volatile industries like R&D for new pharmaceutical drugs, fashion design or mega bucks movie production.

Executive directors in subsidiaries have agency problem of being territorial and empire building resulting in mediocre contributions to the detriment of shareholders. The Board would fail in giving sufficient supervision on individual businesses in a conglomerate.

P3 Perspective
Porter argued that “Diversification destroys shareholders’ value” (Remember to use this phrase in exams). Empirical research gave overwhelming proof that post- Mergers and Acquisition actually delivers less market capitalization values compared to pre –acquisition. Put it simply, a 2+2=3 scenario.

He argued that Board lacks the parenting skills to guide and add value to individual business units. Having spread out thinly and stretching management talents, business units are either starved of cash or misguided in strategies.

Malaysian Stock Marker regulator views on Conglomerate?
Well, John of Securities Commission, has done quite a good job on why conglomerates fare badly in open economies while thrive somewhat in protectionists (governments that protect local companies from foreign competitors using licensing, import duties or quota) economies.

I post the article below for your reading pleasure and see if you could decipher and differentiate both P1 and P3 contents.

Happy reading.

ARTICLE: Are conglomerates good or bad?
IN most developed capital markets, conglomerates trade at a discount. Yet this does not appear to be the case in many Asian markets, despite the fact that conglomerates are more difficult for boards to govern than other forms of organisations.

Although the reasons for the discount exist in Asian markets, perhaps the fact that some conglomerates may attract better talent than single line-of-business companies or are better connected is enough to compensate for the inherent governance disadvantages conglomerates face. What this does is to put even more pressure on the boards of conglomerates to really understand what is going on under their watch, making an already challenging job even more difficult.

The case against conglomerates
In developed capital markets where there are deep pools of capital and many highly liquid stocks, conglomerates typically trade at a discount to the market. There are three reasons for this.

The first reason is that investors believe that they can diversify their risks better than the managers in the conglomerate can. They literally have the entire market to choose from and they are not limited to equities, but can choose to invest in fixed income, derivatives, property and commodities. As a result the argument that a conglomerate represents a better spread of risk than a single product business, whilst correct, does not appeal, because investors can build their own portfolios to match their risk appetites exactly, whereas managers can only guess what their shareholders want.

The second and perhaps more important reason is that conglomerates risk losing focus. They risk being moderately good at most things and not outstanding at any one thing. In a rapidly changing and hypercompetitive world this is a critical weakness. Focussed competitors have the advantage in competitive battles for markets. They have no alternative businesses to depend on if the going gets rough. They will therefore fight harder to maintain share; invest more in relevant R&D to stay competitive. Their boards will also know exactly what is going on and will not be able to be bamboozled so easily, because they only have one industry to understand instead of many.

The third and perhaps most important reason is the difficulty to manage talent and develop appropriate succession planning in conglomerates. Whilst it is true that conglomerates offer a rich diversity of experience, the problem is to know which of the many experiences are the ones that matter most in the board and in the CEO at any time when the strategic priorities or direction are forced to change as a result of changes in technology, competition or economic circumstances.

Thus even a vertically integrated conglomerate like Unilever decided a long time ago that skills in oil plantations and mills (the source of key raw materials), or in shipping and distribution (to get raw materials to factories and finished products from factories to retail stores), or in running the stores themselves to capture the last margin in the value chain did not help their core skills of creating fast moving branded consumer goods for everyday use. Even though they were leaders in their field, they sold their plantations and oil mills, their shipping line and their logistics business. They sold their supermarkets and their specialty chemicals businesses as well as their upmarket cosmetics and invested the money and effort in building brands for everyday use.

Even so there are commentators who argue that they are still too diversified because they are in foods, detergents and household cleaners as well as health and beauty products, competing with more focused companies like Procter and Gamble, Nestle and Danone which can outcompete in their chosen narrower fields.
The case for conglomerates

So why are there so many conglomerates in Asia?
Investors may still see them as the BCG matrix theory operating in practice, where different divisions operate in different markets with different risk profiles, different business cycles and different competitors, throwing off or consuming cash to the greater good of the organisation as a whole. Unlike in developed markets it may make sense to argue that companies can diversify risk better than individual investors because the capital markets do not offer the same range of asset classes for investors to hold on their own as part of a diversified portfolio.

In addition because the local markets are smaller, there are fewer focused first rate competitors fighting for share. This means that hoarding talent and spreading it across lines of business in markets like Hong Kong, Indonesia, Singapore or Malaysia where the talent pool of skilled managers and directors is small may still make sense. Spread good managers with proven track records across the different businesses and the company will do well, capturing the opportunities for economic rent in each line of business because the competition is seriously short of deployable talent. In semi-free or protected markets where level-playing fields do not exist, this argument has even more force. It has created dominant local players in Hong Kong, Singapore, Indonesia and the Philippines and spectacular world-beating chaebols from Korea, following in the footsteps of Japan’s keiretsu. Thus, in markets where the leading players are all equally unfocused, there is little competitive disadvantage in choosing the conglomerate model.

Finally in markets where technical “know-who” is more important than technical know-how, it may not matter so much from a talent management and succession-planning perspective who is promoted as long as they have a basic minimum level of competence and a great network of connections to leverage.

Going abroad changes the conglomerate equation
What boards of successful local conglomerates must think about is what happens when the company ventures abroad into bigger markets where there is either a level competitive playing field, or if it is not level, it is tilted in ways the local company no longer understands.

If the field is level, and the market large enough to warrant focused competition, the focused competitors will do better in the industries of their choice. If the field is tilted, but senior managers no longer have the right technical “know-who” to win business on attractive terms, then again the conglomerate model brings no benefit and may create serious risks because the board only understands too late what has gone wrong because errors of judgment or strategy can go unnoticed or be hidden by senior managers in the forlorn hope that things will get better, given time. If the field is tilted and the market is large enough to warrant focused competition, as might be the case in Brazil, China, the Gulf or India, then a model that works well for the smaller Asean markets might cause grief when it is exported without sufficient regard being given to the different conditions in such markets.

SOURCE : John Zinski, 2010, The Star, Are conglomerates good or bad?, July 23