Wesfarmers 1, analysts 0: A triumph of conglomerates over specialists

Twelve months ago, perceptions of Wesfarmers’ overcommitment in capital to its Coles acquisition generated headlines declaring “Wesfarmers at the crossroads”.

But this week, Wesfarmers is once again the golden-haired wonder, generating glowing headlines in the business press.

Officially, Wesfarmers – and all conglomerates – justify their structures as “empires” of businesses assets (portfolio managers as opposed to industry specialists) because their diversification can shield the company from the effects of adverse business cycles.

The idea is that if one business in the portfolio falls victim to a downturn, others pick up the slack. It’s the solution to the classic dilemma of the ice-cream vendor who is forced to sit on the sidelines every winter.

One rationale for establishing an empire state is that growth and diversification are inherent in the DNA of the CEO. But big corporations in Australia struggle to reach aggressive growth targets as organic growth is inordinately slow and acquisition opportunities are scarce.

The model works for Wesfarmers, but analysts don’t like it. Although Wesfarmers has excelled for a long period, analysts tend to mark stocks down if they can’t easily get to the gritty details of each business division. Until Orica succeeded in spinning off DuluxGroup, the company was continually undervalued in the market for that reason.

The conglomerate structure turns sour when its managers make a mistake: investing in the wrong industry at the wrong time, or in installing managers in divisional roles who don’t perform as expected. An error at that level is likely to earn the parent company board much more attention than it would an investment fund manager. Clearly Wesfarmers has no problem with that. The appointment of retail veteran Ian McLeod and his cohorts to run Coles has proved to be one investment that keeps on giving.

So what makes a corporate conglomerate like Wesfarmers a success?

According to strategy researchers, the key ingredient for multi-business firms is “relatedness”.

A diversified organisation seeks to grow while increasing shareholder value through three primary options:

Extending further into existing markets

Growing market share is a slow and expensive solution. It involves lowering prices (eg Coles v Woolworths price wars) or spending more (NAB’s “breakup” ad campaign).

Extending market scope

More complicated, this option involves extending a product range into related or neighbouring market segments and geographic areas, or venturing into new lines of business altogether – thereby becoming multi-business firms like Wesfarmers. Rationale for this option quite often hinges on the identification of synergies that will deliver savings.

Controlled autonomy

This is an equally effective option. With a focus on continued expansion into related businesses, the success of the hardware retailer Bunnings would have influenced the Wesfarmers board’s decision to make move on the related industry investment.

The secret to Wesfarmers’ success has been its ability to spawn crops of executives who can successfully deliver results – much more effectively, apparently, than an independent board. This method was also used successfully by transport company Toll, which has a portfolio of independent transport businesses.

Despite the analysts’ distaste for empires, and a global trend that promotes the philosophy of “sticking to the knitting”, Wesfarmers continues to confound convention. Last year the company seemed as though it might slide into decline. This year it has returned to former glory.