George A. Haloulakos, CFA, is a university instructor, author and entrepreneur [DBA Spartan Research and Consulting]. His published works utilize aviation as a teaching tool for Finance, Game Theory, History and Strategy.
Value is the key performance measure in a market economy because it encompasses the long-term interests of all stakeholders in a company. In highly competitive global businesses – especially with diversified companies — it is essential for a firm to be effective in all three phases of managing cash flow — operations, investing and financing – to generate cash at a return exceeding its cost of capital. The concept of stakeholder management has broadened the responsibility of management to include financial stakeholders (i.e., equity owners and creditors) and non-financial stakeholders such as customers, employees and suppliers. This task is magnified for diversified companies whose corporate structure is based on a mix of different types of product or business groups having a variety of financial requirements. Corporate financial strategy for diversified companies based on a portfolio management style may benefit from a stakeholder approach in order to cope with a myriad of challenges including, but not limited to, achieving economy of scale, diversification and growth in difficult or less predictable environments. Two different eras – the “stagflation” period from the mid-1970s to the very early 1980s and the “globalization” decade of the 2000s – provided extremely competitive market conditions where diversified companies achieved mixed results with divergent stock price performance. The case studies reviewed here offer a study in contrast in how the stock market values diversified firms with different corporate financial strategies.
NOTE: The selected case studies for this research article are Bendix (1976 – 1982) plus General Electric (GE), Hitachi and Siemens (2004 – 2008). All of these firms were followed by the author while working as a
Special Situations Analyst (“buy-side” and “sell-side”) and later as a management consultant. As such, insights offered in this paper are based on primary research by the author.
———————————————————————————-This research article is organized as follows: First, we present observations derived from deconstructing the Flow of Funds and/or Earnings results in relation to the equity values for the selected companies. Second is a review of the portfolio management financial strategy model. Finally is a comparison-and-contrast of the diversified companies profiled with attention to the variations in their operating styles and financial results.
* Cash flow from Operations equal or greater than Cash for Investing resulted in higher equity value in a rising market and less downside in a declining market.
* Deleveraging a balance sheet (i.e., net reduction in borrowings) as reflected in Cash for Financing supported higher equity value. Positive cash flow arising from increased Cash from Financing did not produce meaningful or significant increase in equity value.
* Diversification plus added-value acquisitions boosted growth. Raising cash via divestitures strengthened balance sheet while creating flexibility to either pursue attractive investments or return cash to shareholders.
Corporate Financial Strategy and Portfolio Management
Finance explains how capital is employed to create added-value and is the language of business. Strategy explains how a firm mobilizes its resources and leverages to take advantage of market opportunities while remaining ahead of its competitors. A portfolio management style views product groups and/or operating divisions or subsidiary companies as individual investments. The individual product/operating groups are evaluated in terms of how each adds to total portfolio performance with the least risk. Diversification helps to maximize total risk-adjusted cash flows by avoiding dependence upon any one group while lowering volatility [as measured by standard deviation “?”] of cash flows. A balanced corporate business portfolio is comprised of businesses having high relative market share generating surplus cash [sometimes referred to as “cash cows”] that can be used to finance potentially high share / faster growing businesses requiring higher investment.
High growth is associated with either neutral or modestly negative cash flow as high investment is required to maintain competitive position. Low growth is associated with positive or surplus cash generation because a mature business theoretically has lower investment requirements to maintain its competitive position. A higher growth rate indicates correspondingly high demands on investment. The cut-off point between high and low growth is usually 10% per annum.
Higher relative market share implies higher cash generation. As a firm increases its physical output, the higher capacity utilization rate lowers unit costs due to higher absorption rate of fixed overhead. Lower unit costs that arise from economies of scale (i.e., a “learning curve” effect in which accumulated experience translates into increased efficiency) enables earnings to grow faster the higher the share. Market share of a firm’s brand is measured in relation to its largest competitor. Therefore if a brand has a 25% share and its largest competitor has the same, the inferred ratio is 1:1. However, if the largest competitor had a 75% share, the ratio would be 1:3 and this implies a relatively weak position. If the largest competitor had a 5% share, the ratio is 5:1 and this implies the firm’s brand is in a relatively strong position that may be reflected in earnings and cash flow. When used in practice, this scale is logarithmic.
With large, diversified companies (such as those profiled in this article) achieving a balance of growth in net free cash flow and increase in equity value with a portfolio of diverse product groups can prove especially challenging when having to integrate different corporate cultures while addressing worldwide competition! The mixed results and divergent stock price performances for the companies we are profiling affirm this inherent difficulty associated with operating diversified firms.
A “diversified” company differs from a “holding” company because it seeks to integrate these businesses into a networked operation. This is the crucial distinction. A “networked” operation, unlike a “holding” company, is where common processes and tools are leveraged across business lines while allowing autonomy to foster innovation, flexibility and freedom to meet customer needs. The end result is a multi-industry company in which “Return on Invested Capital” (ROIC) is the main financial compass with continued emphasis on cash flow generation and strong balance sheet.
———————————————————————————SIDEBAR: The 2016-2017 financial travails of Toshiba (a Japanese conglomerate founded in 1873) have shown that a diversified corporate business portfolio in and of itself is insufficient to protect a firm from risky investments going awry, strategic missteps or execution difficulties. Toshiba’s $6.3 billion write-down on its nuclear reactor business due to cost overruns and missed deadlines has caused its shareholder equity to become negative. In order to survive, Toshiba is now forced to consider selling a majority stake in its crown jewel: flash memory business that makes chips used in smart phones and solid-state disk drives. This follows earlier sales of its consumer electronics and medical equipment business in the aftermath of a 2015 accounting scandal. Toshiba’s distressed situation provides a sharp contrast to the diversified global companies profiled in this research article – GE, Hitachi and Siemens. While there was divergent stock price performance and mixed results for these three firms, their corporate survival was never in question.
Comparison-and-Contrast: A Tale of Two Eras and Four Companies
The “stagflation” period from the mid-1970s to the very early 1980s proved extremely onerous because high inflation eroded purchasing power and economic gains. Moreover the inflation factor boosted the required rate of return on all capitalized cash flow thereby depressing equity values. In the midst of such adversity Bendix achieved six consecutive years of record earnings via its strategy of complementary acquisitions, diversification and timely divestitures. The acquisitions boosted growth, diversification lowered risk and the divestitures provided additional cash thereby giving the firm increased flexibility via a strong balance sheet. Bendix stock price beat the market averages over the same period – a reflection of investor confidence as higher growth plus a stronger balance sheet combined to increase profits while lowering its required return. This double-play combo was the impetus for higher equity value.
———————————————————————————–SIDEBAR: The 1976-1982 time frame for our Bendix case study is in exact alignment with the “stagflation” period. The term “stagflation” entered into the finance lexicon in 1976 when the “misery index” [unemployment rate plus inflation rate] became a part of the national dialogue concerning the political economy. With fundamental changes arising from the Economic Recovery Act of 1981, the term “disinflation” became pervasive throughout the investment community starting in 1982 as declining inflation and rising employment combined to drive down interest rates, thereby ending stagflation. This is our rationale for studying the 1976 – 1982 period.
———————————————————————————-The “globalization” decade of the 2000s was characterized by very large diversified companies expanding their worldwide presence in both industrial and consumer markets while simultaneously investing in renewable or so-called clean energy as well as implementing sustainability practices across different business lines. The clean energy theme was the centerpiece to all three diversified companies examined in this article but there were differences in terms of emphasis and execution.
_________________________________________________________________________SISIDEBAR: The “globalization” decade of the 2000s in which there was emphasis on clean energy and sustainability reached a heightened level of urgency during 2004-2007 but in 2008 became a lower priority in the aftermath of the worldwide financial crisis and stock market collapse. Our case study of Siemens, GE and Hitachi encompasses 2004-2008 to measure how these firms fared in both good and bad times – especially given the very rapid seismic economic shift that occurred in 2008.
GE and Siemens opted for external, marketing driven strategies aimed at increasing revenues while Hitachi pursued internal improvements to create cost savings. A comparison of the strategies used by the diversified firms from the 2000s profiled in this article illustrates both the similarity but subtle difference in their approaches.
CLEAN ENERGY STRATEGIES FOR DIVERSIFIED COMPANIES
General Electric’s “Ecomagination”: Create added-value for GE customers by providing efficient, environmentally friendly Ecomagination products. Hitachi’s “Monozukuri”: Create internal cost savings by reducing environmental burden of its own products over their entire life cycles. Siemen’s “Cross-sector”: Help customers in industry, energy and healthcare sectors achieve sustainability. For General Electric, the underlying concept for its clean energy strategy was to create added-value for GE customers by providing efficient, environmentally friendly “Ecomagination” products. For Hitachi, the goal was to create internal cost savings by reducing environmental burden of its own products over their entire life cycles. With Siemens, the idea was helping customers in industry, energy and healthcare sectors achieve sustainability.
The differences in how each firm managed their Cash Flow while executing their respective strategies was reflected in their stock price performance during 2004-2008. During the 2004-2007 bull market, Siemens’ stock price gains outpaced the market average while GE and Hitachi were flat. In the 2008 financial collapse, Siemens’ stock price declined less than GE, Hitachi and the overall market when compared against 2004 equity values.
How Bendix Fared During the Stagflation Era
Bendix was an American manufacturing and engineering company that focused on diversification during the late 1970s / early 1980s with expansion into: (a) Automotive Products, (b) Aerospace, (c) Industrial Machinery and (d) Forest Products. Despite a stagnant economy, this successful diversification produced higher sales volume and increased profits – resulting from an upgraded business mix. In addition, the company’s exposure to strategic metals, mining and forest products provided a hedge against the high inflation ravaging the US economy during the same period.
As Bendix was riding the wave of higher sales and profits, its later divestitures helped strengthen its balance sheet by raising large amounts of cash, thereby giving the company greater flexibility if not financial independence. The prevailing high interest rates of the stagflation era (e.g., the prime rate reached 20% in 1980) heightened the importance of financial independence. In sum, Bendix had the right strategy at the right time, and this was affirmed by its excellent bottom line financial results and superior stock price performance.
Superior Financial Results and Stellar Stock Price Performance
(1) Bendix achieved positive revenue and profit growth each year during the stagflation era, (2) Bendix profits grew faster than revenues reflecting shift to higher-margin product mix and (3) divestitures helped sharply elevate profits in 1982. Bendix profit growth outpaced inflation during this period thereby generating real net profit gains. In sum, Bendix increased profits by more than 5-fold during 1976-1982. Over the same period, Bendix stock increased in value by +74.23%, outpacing both the S&P 500 (+30.8%) and the Dow Jones Industrial Average (+4.2%).
A further look at these numbers reveals that Bendix beat the S&P 500 index 4 times in 6 years and beat the DJIA 5 out of 6 years over the same period. Bendix crushed the market averages in terms of sustainable value from start to finish beating the S&P 500 by a factor of 2.4x and beating the DJIA by 17.7x. The broad market averages were in a trading range while Bendix achieved and kept a higher value. Bendix was able to achieve real net profit growth in the stagflation era while creating financial independence on behalf of its shareholders as well as significantly greater capital gains versus market averages.
Bendix was one of the first, if not the first, public company to focus on “shareholder value” in its annual reports (1973, 1974, 1977 and 1981) as it sought to “employ our human, technological, and financial resources in the manner best calculated to bring about a steady increase in shareholder value.” (Source: 1973 Bendix Annual Report) During the 1970s, Bendix was ranked between 61 and 71 on Fortune Magazine’s list of the most valuable industrial firms by revenues. (Source: Fortune 500 Archive). The focus on “shareholder value” provided the foundation to better serve all financial stakeholders for without positive shareholder returns the concept of “stakeholder” management is just a catch phrase or academic exercise.
How GE, Hitachi and Siemens Fared (2004 – 2008)
During the 2000s GE, Hitachi and Siemens sought to further expand their global presence via renewable or clean energy as well as striving to implement sustainability practices in their diversified business portfolios. GE opted for significantly higher debt/leverage while creating stand-alone renewable or clean energy product groups and was unable to internally finance its aggressive capital investment. Hitachi delevered its balance sheet (i.e., reducing debt) while internally financing its capital investment and using renewable or clean energy as well as sustainability practices to reduce costs.
Siemens opted for an external marketing approach but differed from GE’s strategy because it incorporated renewable or clean energy products into its existing product groups along with sustainability practices to help customers in its target end-user markets achieve efficiency and sustainability. Siemens significantly de-levered its balance sheet while being able to internally finance its capital investment.
Flow of Funds Analysis
General Electric: Positive Net Free Cash Flow 4 out of 5 years, but Op Cash Flow exceeded Inv Cash Flow just once. Financing made up the difference. Therefore “quality” of Cash Flow without Financing is mediocre to poor. In this 5-year period, Financing increased by a cumulative $74,725 million (i.e., higher debt/leverage) which implies increased “financial risk.”
Hitachi: Positive Net Free Cash Flow 1 time out of 5 years, but Op Cash Flow exceeded Inv Cash Flow 4 out of 5 years. Therefore “quality” of Cash Flow without Financing is good to very good. In this 5-year period, Financing decreased by a cumulative $1,068 million (i.e., lower debt/leverage) which implies lower “financial risk.”
Siemens: Positive Net Free Cash Flow 4 out of 5 years with Op Cash Flow exceeding Inv Cash Flow twice. In two of the years, Op Cash Flow was just 2.5% below Inv Cash Flow once while falling short by under 7% in yet another. Therefore “quality” of Cash Flow without Financing is fair to good. In this 5-year period, Financing decreased by a cumulative $6,113 million (i.e., lower debt/leverage) which implies noticeably lower “financial risk.”
Both Hitachi and Siemens achieved superior “quality” of Cash Flow versus GE during 2004-2008. GE’s cumulative Op Cash Flow fell short of Inv Cash Flow by $67,322 million while levering its balance sheet with $74,725 million in debt to make up the deficit. Deconstructing the numbers further illustrates that Siemens cumulative Op Cash Flow exceeded Inv Cash Flow by $1,792 million while Hitachi’s Op Cash Flow outpaced its Inv Cash Flow by $2,163. Advantage: Hitachi. However, Siemens delevered its balance sheet by a factor of 6-times greater versus Hitachi arguably making its overall “quality” of Cash Flow better than Hitachi. Advantage: Siemens.
In sum, Siemens achieved better quality cash flow AND lower financial risk while successfully building its “sustainability” brand worldwide via its “cross-sector” renewable or clean energy presence in its key end-user markets. Siemens outpaced GE, Hitachi and the S&P 500 market index during the bull and bear periods of 2004-2008.
STOCK MARKET PERFORMANCE
(1) During 2004 – 2008, GE lagged the market index each year. Hitachi beat S&P 500 once. Siemens beat the market twice. (2) From start to finish, Siemens outperformed GE, Hitachi and S&P 500. (3) Siemens outperformed GE, Hitachi and S&P 500 in both bear and bull markets. Overall, while all three company stock prices and the market declined from 2004-2008, Siemens stock price fared best, as it declined by -15.52%. Hitachi’s stock price fell -45% and GE was the worst with a -56% decline. The S&P 500 declined 28%. Clearly Siemens was best in both a bull and bear market!
GE and Hitachi had catchier, clever sounding business concepts – “Ecomagination” and “Monozukuri” versus Siemens “Cross-sector.”
However, Siemens executed its strategy more efficiently while significantly deleveraging its balance sheet, thereby reducing its financial risk. For these reasons, Siemens outperformed its global rivals as well as the market average in both bull and bear markets.
Lessons Learned From These Case Studies
* Diversification in and of itself does not assure financial success, much less financial safety. Corporate financial strategy for the diversified firm that creates sustainable added-value must be crafted and executed so that the resulting revenue and profit growth translates into high quality Net Free Cash Flow. This will help to strengthen its balance sheet, reduce risk and achieve higher equity value. Among the companies addressed in this article, Bendix and Siemens were the ones best able to fulfill these goals on a relative and absolute basis.
* Bendix (1976 – 1982) showed how a company could mitigate the effects of a stagnant economy, runaway inflation and high interest rates by driving revenue and profit growth through diversification and acquisitions. This enabled Bendix to achieve real, sustainable net profit gains that resulted in superior stock price performance versus market averages.
* Siemens outpaced General Electric and Hitachi by generating Operating Cash Flow matching or exceeding Cash for Investment while deleveraging its balance sheet at the same time. Siemens integrated its clean energy strategy into its overall corporate business portfolio (“cross-sector”) instead of a specialized product group (like GE) thereby generating profitable revenue growth.
* Internal cost savings, while beneficial in achieving financial stability, does not create sustainable Net Free Cash Flow. In other words, addition-by-subtraction yields short-term benefits but is insufficient by itself in fueling corporate growth. Hitachi remained stable in financial and market value terms with its internal focus and reducing its debt position over time.
Based on nearly four decades of research and analysis, I have learned that corporate financial strategy and valuation for diversified companies is often an exercise in intricate simplicity. As an independent analyst one must avoid the temptation to become trapped in a maze of seemingly endless detail and minutiae when deconstructing the numbers. This is because you will never have enough information as would a corporate insider, and having such information does not necessarily translate into optimal financial assessments. Instead it is wiser to focus on basic, usually unshakeable principles of Finance and Strategy while conforming to the universal importance of profitability and quality of cash flow.
AUTHOR NOTE: The focus on profits for Bendix (1976-1982) in contrast to the emphasis on cash flow for GE, Hitachi and Siemens (2004-2008) for this research article was based on having done the same when following these companies as an analyst and later as a management consultant.
As a practical matter, profits were the focal point when evaluating US companies while cash flow was used for analyzing international or global diversified companies. Evidence-based research and best practices utilized by my employers were the guidelines in following this dual-tracking approach.
If you would like copies of detailed year-by-year financial and stock price results for the companies analyzed in this article and also a set of Power Point slides, please contact me via e-mail and I will send you the statistical tables. My e-mail address is: Haloulakos@gmail.com
Bendix. Various public company documents. 1973-1983.
Fortune Magazine. Fortune 500 Archive. 1970-1980.
General Electric. Various public company documents. 2003-2009.
George A. Haloulakos, CFA. (Subject Expert: Finance) DBA Spartan Research. Industry and Financial Research files. 1979-to date.
Hitachi. Various public company documents. 2003-2009.
Siemens. Various public company documents. 2003-2009.
Securities & Exchange Commission (SEC) – 10 K Reports.
Wharton Research Data Service.
Megha Kumari. Financial Research/Data Mining. University of California at San Diego – Extension Division. Graduate Student – Finance Certificate.