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Like the interior of a black hole, the “conglomerate discount” in finance is widely accepted to exist, but impossible to measure directly. Still, the belief that it is real has inspired corporate break-ups by companies including Honeywell, General Electric and Johnson & Johnson. What causes it? There are two theories: bad markets or bad management. There is room for both.
The bad markets theory is that investors aren’t very good at valuing an apple and an orange at the same time. Think of GE, which used to make gas turbines, jet engines and MRI machines, among other things. This supposedly resulted in confusion and intellectual fatigue, causing investors to throw up their hands and avoid the shares. The company thus decided it would be better to break up.
Under the bad management theory, the problem isn’t investors’ analytical skills. It’s that bosses, being human, struggle to spread capital and their attention effectively across wildly different businesses. Besides, investors who want both apple and orange can just buy them separately. The conglomerate therefore trades at a discount to the value of its parts. Either way, breaking up should, in valuation terms, right the ship. GE, now three separate companies, is the go-to example of this working nicely.
But sometimes, the wonky-valuation problem crops up in other places, and threatens the happy maths of de-conglomeration. Solstice Advanced Materials, which detached from Honeywell last October, announced a merger this week with fellow chemicals maker Element Solutions. The response has been brutal. Solstice’s shares have plunged by nearly a quarter, losing more than half of the gains they had made since escaping the Honeywell sarcophagus. Element’s are down by a tenth.
As with the conglomerate discount that inspired Solstice’s birth, it may be that the market has got it wrong. Based on the $180mn of annual cost savings Solstice and Element predict, Lex reckons the buyer’s shares should have risen by 8 per cent, and the duo should be worth nearly $2bn more than their combined $23bn market capitalisations at the end of last week. Instead, by Tuesday they were worth $4bn less. Fickle hedge funds are an obvious place to point the finger.
Or maybe it’s managers, not markets, that are inefficient. Solstice may have misread its own investors, who perhaps hoped the company would itself get bought at a premium. Becoming bite-sized, after all, is one of the charms of doing the splits. Look at cornflake maker Wm Kellogg, which broke into two parts that were both later acquired. If ever a rival considered bidding for Element, now might be their chance.
In due course, it will become clear whether the response to Solstice’s deal reflects a wonky market or investors’ aversion to the deal itself. That’s because consummating it requires a shareholder vote on both sides. Maybe this week’s rout has helpfully cleared out hedge funds and others who don’t grasp the appeal of a value-creative, tax-efficient union. Given the magnitude of the reaction, only a brave boss would take that for granted.
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