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Using the Value Line Page: Looking at Conglomerates General Electric, 3M, and United Technologies – February 4, 2011
Well-known conglomerates Sara Lee (SLE), Fortune Brands (FO), and ITT (ITT) are all breaking apart their somewhat-disparate businesses. As an example of extreme diversification, Fortune Brands, in its current form, owns products ranging from golf balls to alcohol. At first blush, it is hard to see the connection between such different products, unless you are watering yourself at the 19th hole (a bar, for those not into golf jokes). However, in Fortune Brands’ case, the connection is that the brands it owns are leaders in their respective spaces. Thus, the rationale for owning disparate businesses is the marketing advantage of selling highly regarded products. (Read more about Fortune Brands’ breakup.)
The connection between the three breakups is that shareholders pushed for each of these companies to “unlock” value. Cutting up a conglomerate is thought to yield higher valuations for the resulting, more focused companies, and thus greater returns for shareholders. But often, the deconsolidation trend is simply a fad on Wall Street—sometimes Wall Street likes conglomerates and sometimes it doesn’t.
Still, some conglomerates work better than others. United Technologies (UTX – Free Value Line Research Report) and 3M Company (MMM – Free Value Line Research Report) come to mind as two companies with disparate operations that have, historically, performed well as a whole. General Electric (GE – Free Value Line Research Report) is an example of a conglomerate that has recently stumbled, but looks to be in the process of righting itself.
Understanding a conglomerate’s investment merits requires taking special notice of certain factors. To get a handle on what a company does and where its revenues are derived, it is important to read the Business Description that appears on every Value Line research report. This is vital information when looking at a company that has multiple and often varied divisions. In the case of United Technologies, the business description highlights the company’s six primary business segments (including such diverse areas as aircraft engines and elevators) and the percent of revenues that were derived from each. GE and 3M, meanwhile, outline five and seven divisions, respectively. (Note that GE’s move to divest control, though not total ownership, of its media business may result in one division being eliminated.
The percentage of income earned from foreign operations is another aspect of the Business Description that should be considered. One of the benefits associated with conglomerates is the diversification of their businesses. Extensive foreign operations create geographic and market diversity to complement product diversity. For this trio, 3M derives the most income from foreign locales (67% of 2009 revenues), GE is next with 54%, and United Technologies has the lowest level at a still substantial 46%. For investors seeking a lower-risk way to invest in the projected growth in foreign markets, particularly within emerging economies, a U.S. multinational conglomerate might be the safest option.
Of course, diversification can also be a negative, as weak units can drag down overall results even when other units are performing quite well. United Technologies’ fourth quarter (read Value Line’s analysis of United Technologies’ fourth-quarter results) provides an example, as four of the company’s six main operating segments performed well in the period, while two large divisions experienced revenue declines. Overall, however, the company was still able to beat expectations and register year-over-year growth.
The benefits of diversification can be undone quickly, however, if too much of a good thing leads to one division representing too large a portion of a company’s operations. This was one of the issues that besieged GE in the long and deep recession that ended in mid-2009 (recessions are shown by the shaded bars in the Graph section of the Value Line report). The company’s revenues were derived disproportionately from its financial arm. When the financial markets froze, the company’s recovery potential was questioned, driving its share price down from $42 in late 2007 to a low of about $6 in early 2009. Annual monthly high and low prices are shown at the top of the Graph.
Clearly management allowed the stellar performance of one unit to blind it to the risks it was taking. As the Quarterly Earnings box displays, earnings fell from $2.20 per share in 2007 to about $1.00 in 2009. This fall was accompanied by a dividend cut, shown in the Quarterly Dividends box right below the Quarterly Earnings box, in mid 2009, taking the quarterly payout from $0.31 per share to just $0.10 per share. Note that GE’s finance arm still accounted for a third of the company’s revenues is 2009.
When looking at conglomerates, it is also important to examine their debt levels. Most conglomerates use debt financed acquisitions as a means to expand existing businesses and as a way to diversify into new business lines. Debt, then, is a material issue. Borrowings can be added quickly if management is taking aggressive steps to expand, but servicing that debt can be onerous if it is isn’t properly managed. A company’s debt level can be found in the Capital Structure box. Moreover, for companies that make frequent acquisitions, small or large, having some balance-sheet flexibility can be very important. United Technologies and 3M both have management debt loads of less than 33% of the capital structure. GE’s financial arm, meanwhile, bloats that company’s leverage, placing it near three quarters of the capital structure.
The relatively low levels of debt carried by 3M and United Technologies underpin their high scores for Safety, a proprietary Value Line measure, found in the Ranks box at the top left of their research reports. The Safety score is also supported by impressive Financial Strength, Stock Price Stability, and Earnings Predictability scores, all of which can be found in the Ratings box at the bottom right of their reports. General Electric’s high debt load and recent troubles have led to a middling Safety rank and a more pedestrian Financial Strength rating.
Debt is such an important issue for conglomerates that, in addition to current levels, it is important to examine the historical trend, as well. For this, one should review the historical portion of the Statistical Array. Management’s actions in taking on debt and paying off debt should be looked at. Another issue to consider is how well the debt is utilized. To get a rough estimate of this, one can examine the return on total capital and return on shareholder equity lines in the Statistical Array. These measures show how much a company is earning for its shareholders—the higher the numbers, the better.
Also note that a company that makes good use of debt will generally experience greater growth in return on shareholder equity percentages than return on total capital as debt is added to the balance sheet. This shows that the leverage is working to shareholders’ advantage. (Read more about return on shareholder equity and return on total capital.)
Although the noted factors are important for conglomerates and non-conglomerates alike, it is key to think about how the business model of a conglomerate differs from a company with just one business line. Although there are other factors to consider for each of the conglomerates discussed above, 3M and United Technologies stand out as broadly diversified and well-run companies that would be appropriate for conservative investors. General Electric, however, is a riskier investment. Although it has large upside potential, conservative investors may not want to take on the elevated risk.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.