Economics of Breakups - Conglomerate Discounts and Premiums

Breaking up is back in favor. Recent examples in the US include ITT, Motorola, Fortune Brands, Marathon Oil, Genworth, Sara Lee and just recently, El Paso. The results have generally been quite positive. For example, ITT’s shares jumped 11% on the breakup announcement, creating roughly $1B in value. This leads to two interesting questions:

• Do pure plays really outperform diversified companies over time?
• Why did the market value of the same ITT people, assets, products and customers increase by $1B simply by announcing the breakup of the company?

To answer the first question, Marakon recently analyzed the S&P 500 to compare historical and expected performance of pure plays to diversified companies. To identify pure plays, we created a diversification index based on the North American Industry Classification System (NAICS). A company with revenue 100% concentrated in the first 4 digits of the code was defined as a pure play, while companies with revenue in two or more segments were classified as diversified. Somewhat to our surprise, 283 of the 500 companies were pure plays, 57% of the total. The remaining 43% were classified as diversified companies with roughly 18% having minimal diversification, mostly into one related industry, while 25% had diversified into multiple industries.

To see how the two groups fared historically, we compared the total shareholder returns (TSR) of the pure plays and diversified companies over the last year, the previous two five-year periods and the last 10 years. As can be seen in the left side of Exhibit 1, the diversified companies posted better TSRs in the past one and five years (probably due to their reduced risk profile during the recession) while the pure plays outperformed in the 2001-2006 period when growth was valued more highly than risk; over the 10-year period, the performance was nearly identical.

We then calculated price/earnings (P/E) using 2012 analyst estimates of earnings and market/book ratios for the two groups to get a sense of how investors expect the two groups to perform. As can be seen on the right side of Exhibit 1, the results are mixed: pure plays trade at a 10% higher P/E ratio and at a 10% lower market/book ratio. Since P/E ratios are more sensitive to growth than market/book ratios, this makes sense given the recovery in the world economy. In summary, the answer to the first question appears to be no – the data doesn’t show pure plays outperforming diversified companies over time.

The conventional answer to the second question is that ITT’s stock was subject to a conglomerate discount that was eliminated by the breakup. The size of a conglomerate discount can be measured by comparing the market value of the company (the whole) to the value of its businesses (sum of the parts). While the former is observable, the latter must be estimated, usually using comparable multiples. We did this by using the average P/E multiple for each segment in which a diversified company participated to estimate the sum of the parts and divided it by the value of the whole company. As can be seen in Exhibit 2, simply looking at the averages in Exhibit 1 hides a very important message: there is a very large variation in whole vs. sum of the parts. On average, diversified companies trade at a 6% discount to the sum of the parts, not too different than the 10% differential in P/E ratios noted in Exhibit 1. However, roughly one-third of the companies command a “conglomerate premium” of up to 40% while the other two-thirds trade at a discount to the sum-of-parts valuation that also ranges up to 40%.

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May 2011

Jim McTaggart, Ron Langford

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