Complexity – A Drag on Performance and Constraint on “Self-Awareness”

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 15th, 2017

Complexity – A Drag on Performance and Constraint on “Self-Awareness”

“What’s most important, ultimately, for everybody is where do we go with the company in the future. This is all really in the context of making us simpler and easier to operate. Complexity hurts us. Complexity has hurt us.”

-John Flannery, GE Business Review, November 13, 2017

  • Complex companies underperform their easier to understand/model counterparts and our empirical analysis sheds light on the extent of the underperformance and the higher degree of skepticism (lower multiple) bestowed upon them – Exhibit 1.
    • Complexity is a contributor to a well-run versus less well-run company as identified in research published last week. So, while complex companies might be harder to model, they are also on average poor capital allocators and have disappointing returns as a consequence.
    • As an investor, you are at risk of buying a company that warrants a lower multiple by virtue of its complexity and then disappoints versus its own objectives.
  • GE has correctly identified that it is too complex – but has not suggested a strategy to address it adequately – if GE divests Transports, Lighting and Energy, it will not do enough to move out of the most complex group we define in Exhibit 1.
    • A more significant break-up is needed – though the company could help itself by disbanding GE capital and placing the appropriate assets and liabilities back on the operating businesses, and selling, giving away or paying someone to take the stub.
  • By contrast – Dow and DuPont, long-term members of the complex group, should create three companies that sit in the middle group in Exhibit 1, if we assume that the reporting structure used in the Q3 earnings release is the way each business will be managed.

Exhibit 1

Source: Capital IQ and SSR Analysis

Methodology

Our definition of complexity is simplistic, but it can be applied to all companies and it drives some very interesting results as summarized in Exhibit 1. We calculate a complexity index by dividing the number of reported business segments by the proportion of business than constitutes domestic sales. The more segments the more complex and the more geographically diverse, the more complex. We show the data behind the averages in Exhibit 1 by company in Exhibit 2. The correlation is far from perfect but it is illustrative.

Exhibit 2

Source: Capital IQ and SSR Analysis

If we look at the performance of the three groups from 2010 we can see the distinct lag in the complex group. However simplistic our definition may be – it yields interesting results.

Exhibit 3

Source: Capital IQ and SSR Analysis

GE – Not Enough

To make it into the middle group you need a complexity index below 14. As shown below in Exhibit 4, in an approximate analysis for GE, the suggested divestments – including energy – are not enough. Clearly any reduction in complexity is good, but even if GE does what has been suggested, the conglomerate will still be hard to model and it is likely to be too complex to manage effectively – leading to the issues of capital deployment that we mentioned last week.

Exhibit 4

Source: Capital IQ and SSR Analysis

DWDP – Doing It Right

Exhibit 5 is an estimate of what we think the DWDP splits will look like from a complexity perspective – moving from the more complex group to the middle group – so a major step in the right direction.

Exhibit 5

Source: Capital IQ and SSR Analysis

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