GE's Changing Corporate Strategy

General Electric announced this week that it would divest nearly all of GE Capital, the financial business that had been a major profit generator in the past.  The latest strategic shift at GE marks the continued move away from the firm's historic strategy of unrelated diversification.  Few true conglomerates (i.e. unrelated diversifiers) remain in the United States.  Investors can diversify risk more efficiently than corporate executives.  Without true economies of scope, conglomerates could not justify their existence.  The argument that governance economies existed did not hold water in many cases, i.e. corporate parents could not argue that they simply had better many management systems through which they added value to each of the business units.  For this reason, many conglomerates have broken up over the past two decades.  GE remained an exception to the rule for many years.  Investors did not push for a breakup when the company routinely outperformed competitors for each of its major business units.  The whole seemed clearly greater than the sum of the parts.  Governance economies did seem to exist.   People raved about the quality of the management systems and the leadership talent at GE.  A lagging stock price in the past decade shifted the conversation.  Investors begin to ask a question that once seemed unthinkable to ask: Should GE break up?   Could the whole no longer be worth more than the sum of the parts?  

The divestiture of GE Capital does not end this conversation though.  GE has returned to its industrial roots in many ways.  It no longer owns a television network or a major financial business.  However, it still owns quite a wide array of industrial businesses.  Investors will continue to ask the question:  Are these businesses worth more together than apart?  They will continue to ask:  Where are the economies of scope (i.e. the synergies)?   Are the governance economies sufficient to justify keeping all the units together?  Yes, these businesses are more similar than the portfolio was in the past.  However, we still aren't talking about the type of relatedness that we see at a company such as Disney.  If performance lags, the questions will continue.  GE has moved in the right direction, but the strategy will likely continue to evolve. 

Breaking Up Isn't So Hard to Do

HP announced yesterday that it would be splitting into two companies.  One will focus on personal computers and printers, while the other will focus on computer hardware, software, and services.  Interestingly, this breakup represents the second split for HP in its history.  In 1999, HP spun off its measurement instruments business as Agilent Technologies.  Could the deal increase shareholder value?  Perhaps, as it has become increasingly difficult to argue that the synergies between the two sides of HP are significant enough to outweigh the costs associated with managing and integrating such a large, bureaucratic, and highly complex organization.  Of course, the deal also opens up the possibility that one or both of the new entities could be takeover targets.  Here in Massachusetts, we have been reading rumors about EMC exploring talks with HP about a merger.  The breakup at HP probably makes such a deal more likely.   Of course, it's not entirely clear why or how a merger would be beneficial.  While some synergies might exist, again the key question is whether the benefits outweigh the costs associated with integrating such large, complex organizations. 

Beyond this particular deal, the Wall Street Journal reports that, "Corporations around the world have sold or spun off $1.6 trillion worth of subsidiaries and business lines so far this year, just behind 2007’s record-setting pace, according to data provider Dealogic."   We have seen some high-profile moves by diversified firms to become more focused.    GE sold its appliance business.   Gannett announced  a split into two entities, one focused on newspaper publishing and the other on television broadcasting.  Other firms, such as Pepsi, face pressure from activist investors to break up.  What's behind these moves?  The Wall Street Journal cites research showing that U.S. conglomerates tend to under-perform more focused firms:  "Shares of North American conglomerates underperformed their more focused rivals by 11.4% on average from 2000 to 2010, according to a study from Anil Shivdasani, a finance professor at the University of North Carolina Kenan-Flagler Business School... Professor Shivdasani said Monday the data remained similar through the end of last year."

This research has been well known for many years though. Why the pickup in breakups lately?  I think several reasons may exist.  First, economic growth has been very low in this "recovery."  As a result, many firms have businesses in mature markets that are struggling to find ways to grow revenue.   Without sales growth to help drive share prices upward, they are looking for other ways to create value for investors.  Second, a new class of activist investors has become very vocal and has challenged the diversification strategies of many of these large firms.   Third, more investors have begun to question the economies of scale and scope rationale behind these large firms.  They are wondering if, in fact, these organizations are experiencing significant diseconomies of scale and scope. Finally, investors have become quite concerned that CEOs are cross-subsidizing extensively, milking cash cows to fund other initiatives.  Such practices used to be quite commonplace and accepted, but increasingly, they are being challenged.  These investors would rather see the CEOs return cash to shareholders from mature units, and let the newer, higher growth entities seek capital directly from the markets.