Understanding Conglomerates: Ownership and Function

Understanding Conglomerates

A conglomerate is a corporation of several different, sometimes unrelated, businesses. In a conglomerate, one company owns a controlling stake in several smaller companies, conducting business separately and independently.

Conglomerates often diversify business risk by participating in many different markets, although some conglomerates elect to participate in a single-sector industry.

The Evolution of Conglomerates

Conglomerates are large parent companies with smaller independent entities that may operate across multiple industries. Each of a conglomerate’s subsidiary businesses runs independently of the other business divisions, but the subsidiaries’ managers report to the senior management of the parent company. Many conglomerates are thus multinational and multi-industry corporations.

A conglomerate boom occurred in the 1960s. Interest rates were low, so leveraged buyouts were easier for managers of big companies to justify because the money came relatively cheap. As long as company profits exceeded the interest paid on loans, the conglomerate received a return on investment (ROI). The synergy grew, with the cross-combining of companies, products, and markets and helped justify mergers and acquisitions. The boom peaked in 1980 as interest rates adjusted to inflation.

Purchased companies sometimes do not improve their performance. Mismanaged and misunderstood by the parent company, they may drag down the entire corporation’s bottom line. In response to falling profits, conglomerates may divest the companies they bought, downsizing and returning to their core businesses or continuing as shell corporations.

Forming a Conglomerate

• Acquisitions: When one company buys another company, it is an acquisition. If a target firm is big enough, it might not become a mere subsidiary; instead, it and the acquiring company might merge, combining their talent, assets, resources, and personnel into one new legal entity. A conglomerate merger occurred when The Walt Disney Company merged with the American Broadcasting Company (ABC) in 1995.
• Expansions: This strategy represents a corporate restructuring and reorganization, and sometimes the creation of a parent company to own various smaller ones. In 2015, Google Inc. restructured. The corporate parent became Alphabet, and Google became a separate subsidiary.
  
• Extensions: Expanding a family business or a historic, one-sector business into new industries or areas. Berkshire Hathaway sprang from two 19th-century Massachusetts cotton mills that merged in 1955. Warren Buffett gained control of it in 1965, making Berkshire Hathaway a holding company to invest in other businesses, rather than manufacture products or provide services.
  

Advantages and Disadvantages

Holding many companies in different industries can be a boon for a conglomerate's bottom line. Poorly performing companies are offset by other sectors. Cyclical companies can be balanced by counter-cyclical or noncyclicals. The parent corporation can reduce costs by utilizing fewer inputs that may be shared across subsidiaries. Companies owned by conglomerates have access to internal capital markets, enabling greater ability to grow as a company. Conglomeration may provide immunity from the takeover of the parent company.

Economists have discovered that the size of conglomerates can hurt the value of their stock, known as the conglomerate discount. The sum of the values of the individual companies held tends to be greater than the value of the conglomerate’s stock up to 15%. Conglomerates can become so vastly diversified and complicated that they grow too challenging to manage efficiently.

The financial health of a conglomerate can be difficult for investors, analysts, and regulators to evaluate. Some economists argue that large and far-flung conglomerates can become inefficient and costly to maintain, eroding shareholder value. Conglomerates that don't succeed reduce the number of businesses under their management to a few choice subsidiaries through divestiture and spinoffs.

Examples

Conglomerates can be found in industries like manufacturing, media, or food. A media conglomerate may own several newspapers, and move to purchase television and radio stations, and book publishing companies. A food conglomerate may start by selling potato chips, diversify by buying a soda company, and expand by purchasing other companies that make different food products. Conglomeration describes the process by which a conglomerate is created when a parent company begins to acquire subsidiaries.

Moët Hennessy Louis Vuitton (LVMUY), commonly referred to as LVMH began as a family business in 1854—a luggage and leather goods maker named after Louis Vuitton, after its founder. LVMH resulted from the merger between Vuitton and wine and spirits company Moët Hennessy. LVMH is the holding company for 75 different subsidiaries in six different sectors, ranging from jewelry (Tiffany & Co.) and cosmetics (Givenchy Parfums) to publications (Le Parisien) and designer clothing (Fendi).

Warren Buffett’s Berkshire Hathaway (BRK.A) has successfully managed companies involved in everything from plane manufacturing and textiles to insurance and real estate. Buffett manages the capital allocation and allows companies near-total discretion when managing their business. Berkshire Hathaway has a majority stake in over 50 companies and minority holdings in dozens more.

Foreign Conglomerates

Japan’s conglomerate is called keiretsu, where companies own small shares in one another and are centered around a core bank. This business structure can be defensive, protecting companies from wild rises and falls in the stock market and hostile takeovers. Mitsubishi is an example of a company engaged in a keiretsu model.

South Korea’s conglomerates are called chaebol, a type of family-owned company where the position of president is inherited by family members, who ultimately have more control over the company than shareholders or board members. Chaebol companies include Samsung, Hyundai, and LG.

The Bottom Line

A conglomerate is a corporation composed of several different businesses. Its structure reflects one company owning a controlling stake in several smaller companies, all of which conduct business separately and independently.