Conglomerate Merger

Conglomerate Merger: Consolidation Business Strategy

The conglomerate merger strategy involves the combination of various different businesses with minimal operational overlap.

In simple terms, a conglomerate is defined as a corporate entity comprised of several unrelated companies, each with their own unique business functions and industry classifications.

Conglomerates are formed from conglomerate mergers, the combination of numerous companies that operate in different industries. The merger occurs among businesses unrelated to each other, yet conglomerate mergers can still result in various strategic benefits to the consolidated entity.

Often, the anticipated synergies from such a merger become more apparent in periods of economic slowdowns.

Types of Conglomerate Mergers: Pure vs. Mixed Strategy

In a horizontal merger, companies that perform the same (or closely adjacent) business functions decide to merge, while similar companies with different roles in the supply chain merge in a vertical merger.

In contrast, conglomerate mergers are unique in the sense that the companies involved perform seemingly unrelated business activities.

At a glance, the synergies might be less straightforward, yet such mergers can result in a diversified, less risky overall company.

Conglomerate mergers can be distinguished into two categories:

1. Pure Conglomerate Mergers → The overlap between the companies combined is practically nonexistent, as the commonalities are minimal even from a broad perspective.
2. Mixed Conglomerate Mergers → On the other hand, the mixed strategy involves companies where the functions are still different, but there are still a couple of identifiable aspects and shared interests, such as the expansion of their product offerings.

In the former, the companies post-merger continue to operate independently in their own specific end markets, while in the latter, the companies are different, but still benefit from the extension of their reach and branding, among other benefits.

While the independent nature of the merger might seem like a drawback, it is precisely the objective of the transaction and where the synergies are derived.

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Conglomerate Merger Benefits: Diversification and Risk Management

• Diversification Benefits → The strategic rationale for a conglomerate merger is most often cited to be diversification, wherein the post-merger company becomes less vulnerable to external factors such as cyclicality, seasonality, or secular declines.
• Reduced Risk → Considering there are now multiple lines of businesses operating under a single entity, the conglomerate is less exposed to external threats, because the risk is spread across the companies to avoid over-concentration in one specific part of the company. For instance, one company’s lackluster financial performance could be offset by the strong performance of another company, upholding the financial results of the conglomerate as a whole. Often, the reduced risk in the combined entity is reflected in a lower cost of capital, i.e. WACC.
• More Access to Financing → The lower risk attributed to the post-merger company also provides numerous financial benefits, such as the ability to access more debt capital more easily, under more favorable lending terms. From the perspective of lenders, offering debt financing to a conglomerate is less risky since the borrower is essentially a collection of companies, rather than only one company.
• Branding and Expanded Reach → The conglomerate’s branding (and overall reach in terms of customers) can also be strengthened by holding more companies, especially since each company continues to operate as an independent entity.
• Economies of Scale → The increased size of the conglomerate can contribute to higher profit margins from the benefits of economies of scale, which refers to the incremental decline in the per-unit cost from greater volume output, e.g. business divisions could share facilities, close redundant functions such as sales and marketing, etc.

Conglomerate Merger Drawbacks: Integration Challenges

The primary drawback to conglomerate mergers is that the integration of numerous business entities is not straightforward.

The process can be time-consuming, meaning it can take years before the synergies begin to materialize and positively impact the company’s financial performance.

The combination of two businesses could also lead to friction caused by factors such as cultural differences and an inefficient organizational structure.

The source of the issue is often a leadership team that cannot effectively manage all divisions of a company simultaneously.

Most risks associated with these sorts of mergers are out of the control of the management team, such as the cultural fit between the companies involved, making it even more necessary for each additional integration process to be well-planned, as mistakes can be costly.

Sum of the Parts Valuation (SOTP): Conglomerate Business

In order to estimate the valuation of a conglomerate, the standard approach is a sum-of-the-parts (SOTP) analysis, otherwise known as a “break-up analysis”.

The SOTP valuation is typically performed for companies with numerous operating divisions in unrelated industries, e.g. Berkshire Hathaway (NYSE: BRK.A).

Since each business division of the conglomerate has its own unique risk/return profile, attempting to value the entire company together is impractical. As such, a different discount rate should be used for each segment, and a distinct set of peer groups for each division is used to perform trading and transaction comps.

Completing the valuation on a per-business segment basis tends to result in a more accurate implied value, rather than valuing the company as a whole entity.

The conglomerate is conceptually broken up, and each business unit is valued separately in a SOTP analysis. Once an individual valuation is attached to each piece of the company, the sum of the parts represents the estimated combined worth of the conglomerate.