Corporate Complexity – Less Is More

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 11th, 2015

Corporate Complexity – Less Is More

  • Isolating corporate complexity as an explanatory factor for valuation is difficult, but performance results over the past 10 years indicate the most complex companies have underperformed versus less complex peers despite roughly equivalent levels of EPS volatility, ROC volatility, and sales growth – Exhibit 1. ()
  • Within sectors we can see several examples of an apparent “complexity penalty” – for companies with similar comps, high complexity names have underperformed low complexity names. Examples include ITW vs. SNA, SEE vs. SLGN, ATR vs. PKG, IIVI vs. RBC, EMN vs. POL, and FLR vs. PWR.
  • Further refining the group into quartiles based on complexity index value reveals that as complexity increases so does management optimism which tends to lead to poor performance and poor returns on capital. See our prior work on the value destruction relationship to management optimism.
  • The concept of complexity as a weight on the multiple is currently evident in EMN (and DOW and DD, as has been well chronicled). Also note the spike GE saw after announcing the sale of its lending and real estate operations.
  • Complex companies with poor performance and overly optimistic managements become ripe for activist interest – DOW and DD have already been targeted – is EMN next?

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Much of our recent research has centered on companies suffering from complexity problems. Both DOW and DD have activists seeking to address this issue, and we believe the discount in EMN is at least in part the result of its highly complex portfolio. Looking at performance data over the past 10 years, there is a generally negative correlation between complexity and share price returns, but while there are winners and losers in the mid-low complexity cohort, it appears that there is an upper bound to the upside for the most complex companies. There are clearly more than a few examples in Exhibit 2 of low complexity stocks that have underperformed but there does appear to be something of a complexity penalty above a certain level. The red demarcating line is arbitrary, but note the limited relative upside to the right of this point. Exhibit 1 showed that even if we split the group evenly in half by complexity value, we see that EPS volatility, ROC volatility and sales growth for each group is virtually identical but on average the performance for the most complex companies is almost half that of less complex peers.

Exhibit 2

Source: Capital IQ, SSR Analysis

The Complexity Index Reviewed

Exhibit 3 shows the components and calculation of our Complexity Index for the 20 most currently complex companies in our coverage. We take a company’s number of reported segments and divide by the percentage of sales in the US. Note that we have excluded companies that use geographical classifications in their segments, as this would lead to a double counting of the non-US sales component.

Exhibit 3

Source: Capital IQ, SSR Analysis

Controlling for Confounding Factors Difficult – Evidence Suggests a Complexity Penalty

We saw in Exhibits 1 and 2 that on average the most complex companies have underperformed relative to less complex peers despite similar levels of growth and volatility. At the stock level, we can find examples within multiple sectors where there appears to be a similar “complexity penalty”– high complexity stocks have underperformed low complexity stocks with similar comps. In the (predominantly US focused) Metals and Transport sectors there is less dispersion in complexity values, and so no clear instances of a potential complexity penalty.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

High Complexity – Where the Optimists Are

If we break our current universe into quartiles, we see that the optimists are noticeably more prevalent at high levels of complexity – Exhibit 10. The cause-effect relationship is less clear. Companies may be optimistic because they are too complex and struggle to gauge their multiple businesses or perhaps the complexity reflects an inherent optimism that businesses can be combined and synergies achieved, leading to the construction of a convoluted portfolio. Either way the result is the same – underperformance. Exhibit 11 shows the composition of the quartiles by stock.

Exhibit 10

Source: Capital IQ, SSR Analysis


Exhibit 11

A Lesson for Eastman?

Our recent work on Eastman (
EMN
) noted the complexity of the company’s portfolio – acquisitions over the past several years have contributed to a sharp increase in the company’s complexity index value and a coincident decline in its relative multiple. Management will need to prove that this complexity creates value for the company’s diverse product offerings, as the market is clearly skeptical at this point.

Exhibit 12

Source: Capital IQ, SSR Analysis

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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