The New Conglomerates

by: Carlton Getz, CFA


Conglomerates were one though to be a largely past phenomenon.

Technology companies, with their abundant cash flows, have become a new version of the conglomerate, investing in research & development sometimes far afield of their core competencies.

It's worth asking the question: when the core businesses ultimately slow, will the billions in shareholder funds have been wisely spent?

The more things change, the more they stay the same.

In the minds of most investors, conglomerates are an anachronism of the past, a corporate structure that rose to popularity in the 1960s under the guise of diversification, efficient capital allocation, or any of a number of other management axioms of the time. Indeed, the names are legendary. ITT, the telephone company that eventually grew into a business so diversified that a consumer could eat bread, buy insurance, rent a car, book a hotel, get a technical education, and buy auto parts and cosmetics (and more) all from the same parent company. Litton. Textron. Teledyne. In the end, many were eventually consigned to the dustbin of financial history (or surviving as well-focused remnants of their original selves) through sales, spin-offs, and other corporate divestitures as investors shifted away from internal diversification and demanded ever more focus on core operating businesses. Indeed, the relatively few true conglomerates that remain face frequent pressure to break up their varied businesses to improve results and separate relatively poorly performing businesses from better ones, and the process continues today.

Yet... not everywhere. The conglomerate phenomenon is stealthily reappearing in a rather unusual space - technology. The contours are a little different, the method is a little different, but the results are similar in many respects. The emerging conglomerates of this new age are not solely the rampant acquirers of other businesses in the name of consolidation, but they use the same fuel that propelled their predecessors some fifty years ago: cheap and easy cash. Indeed, it’s increasingly apparent that technology companies flush with cash (usually from businesses that are anything but innovative at their core) are willing to spend that cash not simply on acquisitions but also on projects ranging far and wide, even to the point of being, at best, tangential and, at worst, wholly irrelevant to the core business. The move is newer, flashier, with better special effects, but the plot is fundamentally familiar. We believe the end ultimately be the same.

In many ways, being a "technology" company has become an excuse for doing a lot of different things without acknowledging that these activities are increasingly beyond the company's core business and, indeed, its core competence.

We briefly explore and critique this trend with a consideration for the question: when the cheap and easy cash which propels the process begins to run thin and the returns on investment begin to decline, just as it did in the earlier iteration, what then? In the process, we make some statements that are sure to be controversial, but this is the intent - to reset the viewpoint, so to speak, if only for a moment to perceive some of these companies in a slightly different light.

The New Conglomerates

In most cases, when people thing about companies such as Alphabet (GOOG, GOOGL), Amazon (NASDAQ: AMZN), Netflix (NASDAQ: NFLX), and Tesla (NASDAQ: TSLA), thoughts usually turn to the products or services that each is best known for within the general population. Search engines. Online retailing. Video Streaming. Electric Cars. Yet, in each case, the common perception is increasingly become obscured in reality by the ever-expanding interests of the underlying companies. Alphabet, recognizing this trend more publicly than the others through its name change from Google, is still an advertising company, but has branched out into a variety of other marginally or unrelated industries, notably media delivery, self-driving cars, and wearable technology. Amazon is an online retailer, but also a media production company and major web services provider, with speculation that it may even become a delivery company. Netflix is largely a content provider, but is also a content developer and owner. Tesla manufactures electric cards, but also batteries, solar panels, and various related products.

In some cases, the association of products at least have a common thread. Tesla is dealing in electrical power technology, but this does not in itself justify the combination of industries, which have relatively little in a practical sense to do with each other into a single company and more than it does for General Electric (NYSE: GE), despite the potential long-term rationale. The pursuit of original content by Netflix has some merits, not the least of which is a greater incentive to pursue original content. Amazon’s web services division is a direct outgrowth of the company’s focus on online retail, but is still a vastly different operation than the core function of the company. In other words, in some cases, there is a tangential aspect to the conglomeration of businesses under each umbrella, but in many cases, the connection is exceptionally tangential or outright irrelevant. The connection doesn’t necessarily translate into significant cost savings opportunities or cross-marketing opportunities - just as with the conglomerates of yesteryear.

So, while the new conglomerate is different than the conglomerates of yesteryear insofar as they operate in business that are at least vaguely related in some way, it still begs a similar question: just as one wasn’t quite sure what ITT was, featuring everything from telecommunications to hotels, valves, etc., the same can be said for Amazon. What exactly is Amazon? Is it a retailer? A subscription service? Is it a media producer? Is it a device creator? Is it a web services company? Is it a freight delivery company? A grocery store? Or is it something else entirely?

In other cases, vertical integration carries the whiff of a bygone era when large industrial companies owned the supply chain from beginning to end. Ford (NYSE: F), at one point, owned everything from the iron ore and coal mines through to the assembly plant, and while largely successful in that instance, it eventually provide to be too unwieldy to sustain as an organizational practice. The suggestion that Amazon will move into the delivery business, for example, smacks of the kind of vertical integration that makes some degree of sense on paper until you ask: what does Amazon know about running and airline? It could partner with a firm that specialized in air transport, as is the case with Atlas Air Worldwide Holdings (NASDAQ: AAWW), but that isn’t truly vertical integration so much as a contract operation. However, the fundamental design remains: to control the delivery process from beginning to end.

Illusive Innovation

The other differentiator, despite each using their copious cash for more than a few outright acquisitions, is that the conglomeration is more focused on developing products and technologies internally rather than simply acquiring them from others, somewhat similarly to how IBM Corp. (NYSE: IBM) and Xerox (NYSE: XRX) progressed in prior years. The question is: will the innovation prove illusive?

The trend towards conglomeration through development is somewhat curious, given that many of the companies doing the work haven’t really developed anything that novel. The reality is that in the broader technology world, there is precious little that is truly new under the sun outside, perhaps, of developments from Apple (NASDAQ: AAPL) over the last two decades. Amazon, at its core, is little more than a bigger, faster, cheaper version of the ubiquitous Sears (NYSE: SHLD) catalog with a highly profitable appendage in Amazon Web Services, which could be looked at as, in essence, a digital printing press. Google, at its core, is little more than a bigger, better, cooler encyclopedia and phone book. Tesla builds cars with a different engine. Facebook (NASDAQ: FB) is a bigger, better, cooler, continuously updated year book. Twitter (NYSE: TWTR) is an instantaneous broadcast electronic postcard that allows people to express their thoughts and their ignorance in equal measure, and so on. Facebook may be one of the few major technology companies which hasn’t (yet) run off the rails into conglomerate status, although the development of virtual reality tours of disaster areas still smacks of having too much money to spend on questionable development.

The details, of course, are more far more complicated than such a summary would imply. It’s easy, of course, to diminish the foresight of others, especially when what may appear to be obvious ideas in retrospect didn’t first occur to oneself. However, whatever one thinks of the novelty of the format or process, it remains necessary to take a clear look at exactly what the inventor has done, especially when using shareholder resources to fund new projects. A company which has successfully translated the manual mousetrap into an automatic one may be successful at translating something manual to being automatic, but that doesn’t mean it has the skills or vision to develop, identify, and be successful with something completely new. Indeed, business history is filled with examples of excellent companies that invented the future, yet didn’t know what to do with it.

Thus, the statements above are not meant to diminish the foresight or success of any of the companies, but to encourage taking a moment to consider exactly what these companies have done in the larger sense of progress and technology. In particular, how it relates to their present diversification activities. Inevitably, others will have differing views on exactly how revolutionary some of the industries developed by these companies are, yet in most cases, we’re not talking about an Edison or Westinghouse driving forward a revolutionary technology that changes the fundamental function of the world. These are not McCormicks or James Watts. Amazon, Google, and Netflix all represent incremental improvements on age-old processes - made possible by those fundamental advances such as electricity, fiber optics, etc. Henry Ford didn’t invent mass production or standardization, but refined and used these concepts to build a better process. In other words, these companies built better mousetraps, which is inherently valuable, but none invented one.

After all, whatever happen to the phenomenon of Google Glass? How are autonomous cars related to web search and that which supports it, the age-old business of advertising? Indeed, even if Google does successfully develop a self-driving car, all the company will have achieved is a way to improve on a machine that pollutes the environment and has contributed untold frustration and aggravation to billions of woe-bound commuters stuck in traffic around the world.


Reverse Case

It’s also worth drawing into question why the new conglomerates have been given license to pursue projects in some cases wholly unrelated to their core businesses. In many cases, the argument comes down to a vague notion that a highly successful and innovative company will continue to be highly successful and innovated, not just in its own industry but in other industries. It’s the exact opposite of the focus over the last two decades on companies which specialize in their industry without the distraction of ancillary or unrelated businesses.

Indeed, consider for a moment the market reaction if the reverse were the case. The market would howl with laughter if J.C. Penney (NYSE: JCP) announced that it was going to diversify into cloud computing and software services by acquiring Oracle (NYSE:ORCL) - beyond the fact that it would be financially improbable. A similar reaction would meet the acquisition by Ford of a collection of toll roads or, better, yet, automated tolling technology, or General Motors acquiring Yahoo. In each case, investors would ask valid questions: what are you doing, and why? The same skepticism is not often applied in the other direction.

The value, instead, is elsewhere, whether in the perception of infallibility, limitless growth, management expertise, etc. Indeed, if investors were really beating down the doors to buy shares in marginally profitable retailers, retail would be having a great year. Instead, what investors are buying is growth - or the prospect of it - at whatever price, and blast the profits! Amazon may be losing a penny on every sale, but it’ll surely make it up on volume, and besides, it has a highly profitable cloud business.

The Denouement

The adventures (and misadventures) of the emerging technology conglomerates are the result of an all-too-familiar problem for successful companies - a surplus of available cash, and a lack of knowledge of what exactly to do with it. A combination of factors have allowed the new tech conglomerates to get away with this activity: a combination of strong growth, ample profits (and free cash flows), and the license given to all companies whose shares appear on an inevitable and irreversible path to the moon. Capital gains can salve a lot of misgivings and non-performance, and so long as there is plenty of gravy, the train will keep on rolling. Yet, it’s worth asking - what if all that money is spent for naught? A handful of research flameouts, and it’s not difficult to imagine burned investors wanting their billions back.

At some point, the revenue party is likely to end. We’re sure there are true believers in the world that imagine Amazon will indeed kill every other retail business and take over the retail landscape, but just as Wal-Mart (NYSE:WMT) was supposed to put everyone else out of business, Amazon will fail to fulfill these expectations. It may be a great company, and it’s certainly fast-growing, largely due to convenience and the ability to price goods at virtually no profit and thus capture market share, while earning virtually nothing for shareholders. However, even Amazon is not unique from an historical perspective, and there will come a time when revenue growth begins to decline and profits will become the driving force for valuation. It’s true that the beginning of the end of rapid revenue growth may still be years away, but at the current valuation, it’s also possible that significantly all of that growth is already incorporated into the valuation - a redux of the experience of Wal-Mart investors from 1999 to 2012.

On the other hand, and to their credit, many of these companies appear more flexible than their historical peers, or at least such is the hope of their shareholders. It’s possible that one or a few will use their hoards of shareholder cash to discover a true breakthrough - something beyond the proverbial mousetrap - that actually revolutionizes the world rather than simply contributes to incremental improvement of age-old products and services. Perhaps. Yet institutions, no matter how flexible, have their inherent limitations, and it behooves investors to wonder whether it’s just as likely that many wind up like Xerox with the Xerox Star - with a limited vision of what to do with it and, possibly worse yet, so far ahead of the market that they ultimately fail to be the ones who successfully commercialize the product.

The Long View

Ultimately, the question is: how long can it last? The time will come when revenue growth begins to slow (indeed, for some it already has), at which point shareholder restlessness will return as the sometimes extravagant valuations assigned largely on the basis of limitless revenue growth will begin to erode. Realistically, who among Amazon shareholders really wants to be invested in a near-zero margin retail business? Is this the promise of Amazon?

Ironically, the “safest” part of the technology spectrum may, in some sense, be the one faring the worst: the part populated by companies with marginal business models that inherently limit the ability to become conglomerates, such as Twitter.

We’re not perennial skeptics, but we do take a skeptical view whenever the consensus is that it’s different this time. We provide this perspective as food for thought - a moment to pause and view the landscape from a different perspective. However, our sense is that relatively little of great value will come out of the development efforts funded by technology behemoths flush with cash relative to the creations of new companies focused on their core industries. The corporate world does not have an extensive list of companies that have transformed themselves out of maturing industries, and whatever the consensus of endless growth, the present industries will mature.

In the meantime, the question go-go technology investors (to use the term loosely) should ask themselves is: exactly what am I investing in, and why?

Disclosure: I am/we are long GE, XRX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We may adjust our position in XRX within the next 72 hours.