The 60's Conglomerate Boom and Today's Growth Companies

The Conglomerate Boom of the 60's, like all bubbles, sounds ridiculous in hindsight. From 1965 through 1969, the market was obsessed with rising earnings and investors didn't seem to care if the earnings came from new business or from buying other business. As long as earnings growth was up the company would keep its high valuation multiple.

The basic formula was that a fast growing company valued favorably by the market would use their stock to purchase low growth companies - and the earnings of the combined company would have the same multiple as the fast growing company. 

Investors didn't seem to realize that the low growth company's earnings wouldn't magically start growing just because it was bought by a company with a high multiple. The total valuation of the combined company would be higher than the prior valuation of the separate companies. The market's irrational behavior created incentives for unnecessary mergers. This lasted as long as the credit financing mergers was cheap (Conglomerates didn't have to properly account for convertible debt until 1969) and the market was willing to give high valuations to companies that produced earnings growth through the acquisition of other companies.

We might be seeing the start of similar incentives in today's private early growth stage companies. Most of the new start up companies are seen as competitors with the potential to disrupt whole industries. They are judged more on revenue than on earnings since the logic is that revenue will be more easily turned into earnings after the competition is decimated. Winning is what matters.

Whenever there are successful companies attracting capital and getting high valuations, there are less successful companies who will only succeed in mimicking the visible traits of successful companies. This creates some perverse incentives. The valuation given to successful growth companies is anywhere from five to ten times revenue - or higher. Meanwhile, the average company in the S&P 500 is trading at 1.7 times sales and the smaller companies in the Russell 2000 are trading around 1.2 times sales. Right now, it should be very tempting for a variety of early growth companies with high valuation multiples to go out and use their stock to buy companies with old economy valuations, point to total revenue growth, and hope that investors don't significantly change their valuation multiples.

Lending Club's $140 million cash and stock acquisition of Springstone Financial LLC looks like a good example of the conglomerate boom dynamic resurfacing in the current market. Lending Club is currently valued at 40 times its 2013 revenue, which appears to be significantly more than Spingstone Financial was valued. If the market mistakes the additional revenue from Springstone as indistinguishable from growth in Lending Club's core business then the acquisition will push up the market value of Lending Club's future IPO. This could happen regardless of whether or not the move into financing private education and elective medical procedures works out for the company in the long run.

For those looking to make long term investments in growth stage companies, it's important to make sure that the revenue these companies are valued against is the type of revenue that can scale and not revenue gained from the acquisition of businesses. Nostalgia for the 60's should have its limits.