Specialization-1 vs. Diversification-0

There is an ongoing debate in the business world between specialization and diversification. Companies like Fitbit and Lululemon benefit from their expertise and innovation in niche markets, whereas companies like PepsiCo and Koch Industries benefit from their diverse product and service lines that appeal to a wide variety of customers in several unrelated markets. So which business strategy is more effective in creating value for the company and its shareholders? While this question is not entirely answered by a quantitative analysis, given that businesses are dictated by more than the numbers, this research report addresses the underlying question by analyzing the conglomerate discount using ten company examples.
The Conglomerate Discount
The general idea behind the conglomerate discount is that companies with multiple unrelated business segments are unfairly valued in the market place as a result of rolling up the various divisions under one, larger parent company. Proponents of the conglomerate discount theory argue that the market essentially penalizes companies that diversify their portfolio of businesses by valuing the conglomerate company at a market value that is less than what the sum of the values of unrelated segments would imply. Because the operations of the business units vary tremendously, an investor that wants to generate a return on one division of the conglomerate must also invest in the multiple other unrelated segments that may not be well aligned with the underlying investment thesis, thus causing that investor to look elsewhere. Opponents of the conglomerate discount theory argue that diversification acts as a hedge to retain value in a company should something run astray in individual markets. Some even go so far as to argue that there is a conglomerate premium and that companies like General Electric and Berkshire Hathaway benefit from intangibles like brand recognition and brand loyalty, and thus should be valued at a premium.
To address this debate, this analysis focuses on ten different conglomerates in various industries with at least three unrelated business segments. The goal of the analysis is to create a clearer picture of whether or not there is a conglomerate discount or premium, and if so, what the size of that deviation from the actual value of the company may be.
The Analysis At its core, the analysis consists of comparing implied market values of ten different companies that were generated using a sum-of-the-parts valuation methodology with the current market caps of the respective companies. The analysis focuses on conglomerates in a number of different industries with market values that range from $64B to $283B. The ten companies were selected to specifically create a diverse landscape of companies that could yield a notable conclusion. Conglomerates were excluded that operate financial institutions like GE Capital since the valuation metrics for those companies vary tremendously and debt is not viewed in the same light as other institutions. Behemoth conglomerate companies, like Berkshire Hathaway for example, were also excluded because they operate more like hedge funds with over 50 subdivisions. Figure-1 below provides the list of companies included in this analysis. Company | Market Cap (B) | Johnson & Johnson | $282.7 | The Walt Disney Company | $184.3 | Comcast Corporation | $143.6 | The Boeing Company | $96.6 | 3M Company | $96.1 | United Technologies Corporation | $83.5 | Honeywell International Inc. | $78.6 | The Dow Chemical Company | $66.2 | DuPont | $65.3 | Danaher Corporation | $64.7 | Figure-1 | |

To conduct the sum-of-the-parts (SOTP) analysis, relevant financial performance data was sourced from each company’s most recent 10-K SEC filing where financials are broken down by business segments. Segmented financials are oftentimes not broken down into full income statements, and the divisions may only report financials down to operating income (EBIT). For that reason, the most relevant measurements of performance that were readily available in the annual reports for each company were used. Figure-2 below shows which performance metrics were used for each company. Company | Performance Metric | Johnson & Johnson | Revenue | The Walt Disney Company | EBIT | Comcast Corporation | Revenue | The Boeing Company | EBIT | 3M Company | EBIT | United Technologies Corporation | EBIT | Honeywell International Inc. | EBIT | The Dow Chemical Company | EBITDA | DuPont | EBIT | Danaher Corporation | EBIT | Figure-2 | |

In order to accurately value each segment of the conglomerate companies, the measure of performance from Figure-2 for each business segment was considered, and a relevant financial multiple was established depending on the industry that the division operates in. In the 10K filing, each business segment has a comprehensive description of the industry in which it operates and provides a summary of products or services offered within that division. Because each industry varies when it comes to the appropriate multiple to apply to the relevant performance metric, it was important to choose multiples that would accurately determine value for the different divisions of each conglomerate. The method used for this was to select pure-play companies that fit the description of the business segment of the conglomerate, and then a quick-and-dirty comparable companies analysis was conducted on Capital IQ to determine a median multiple for that industry. For example, when valuing the Electronics and Energy segment of 3M, a 15x EBIT multiple was applied which was the median EV/EBIT multiple from the comp set of Texas Instruments which has very similar operations to the Electronics and Energy division of 3M. This methodology was applied to each business segment, and then an enterprise value for each conglomerate company was determined by summing up those values. In order to make a fair comparison, net debt was subtracted from each enterprise value so that the implied market value could be compared to what the market is currently valuing that respective company at. This comparison is at the heart of the analysis, since it allows a determination of whether or not the conglomerates are fairly valued in the market place.
The Findings

Number | Company | Number | Company | 1 | 3M Company | 6 | The Walt Disney Company | 2 | The Dow Chemical Company | 7 | United Technologies Corporation | 3 | Honeywell International Inc. | 8 | Danaher Corporation | 4 | Johnson & Johnson | 9 | DuPont | 5 | The Boeing Company | 10 | Comcast Corporation | Figure-3

As Figure-3 indicates, eight out of the ten companies valued that have multiple unrelated business segments are currently trading at a discount relative to their implied market values, with some trading at deeper discounts than others. The blue dotted line represents the average discount of 12%. To put it in perspective, given an average of a 12% discount, a $50B conglomerate company is expected to currently be trading at a $6B discount. The other two companies in the green (3M Company and Danaher Corporation) are trading at right around a 20% premium to their implied market values from the SOTP analysis. Figure-4 below provides a complete list of market values and implied market values as determined by the SOTP analyses. Company | Market Value | Implied Market Value | Premium/Discount | 3M Company | $96.1 | $79.5 | 21% | The Dow Chemical Company | $66.2 | $77.4 | -14% | Honeywell International Inc. | $78.6 | $113.7 | -31% | Johnson & Johnson | $282.7 | $322.9 | -12% | The Boeing Company | $96.6 | $121.4 | -20% | The Walt Disney Company | $184.3 | $192.7 | -4% | United Technologies Corporation | $83.5 | $128.9 | -35% | Danaher Corporation | $64.7 | $52.5 | 23% | DuPont | $65.3 | $98.7 | -34% | Comcast Corporation | $143.6 | $161.3 | -11% | Figure-4
Analyst Commentary
The analysis of these ten companies suggests that, for this limited data set, it is reasonable to assume that there is such thing as a conglomerate discount. However, it should not be inferred that all conglomerate companies will trade at discounts or that they will trade at the same discount percentages. It is important to note that two of the companies are not only trading at premiums, but are trading at a significant percentage over their implied market values. While it is difficult to determine the exact reasoning behind this premium, it is likely that it comes as a result of intangibles like brand loyalty, brand recognition, and market share. These qualitative factors can improve market sentiment towards those companies or business segments, and thus contribute to the market valuing them at premiums relative to what their respective peer groups would suggest.
While this report focuses strictly on the valuation behind the conglomerate discount, it is also important to note what is being done to unlock that average 12% value for a conglomerate company and its shareholders. Activist investing has become an increasingly popular topic as it relates to corporate spinoffs and opening up value for companies with unrelated segments. By spinning off dissimilar divisions into separate entities, each part can be valued independently and should result in a creation of value, and thus a generation of wealth for all shareholders, including the activist investor. Additionally, these conglomerate spinoffs offer an opportunity to enhance company performance by improving focus of each segment’s management team on their individual operations. This allows management to do what they do best, while also giving investors the opportunity to essentially invest in one segment of a larger company. It is likely that the opposite would be true for conglomerates trading at premiums, and that separating the components of the business would lead to a destruction of value, so we could expect these companies to remain as consolidated entities.
Key Assumptions/Risks to the Analysis
While this analysis offers strong evidence to conclude that there is such a thing as a conglomerate discount, there are a few key assumptions and risks that should be considered. The mains risks to the analysis are as follows: * Sample size of 10 for conglomerate companies was limited and may not be representative of the entire landscape of conglomerate companies * Performance metrics used for individual segments were pulled from what was available in the SEC filing, and may not be the most accurate performance metric for that industry * Financial performance metrics used were original numbers as reported in the 10K, and were not adjusted or scrubbed for any material and/or nonrecurring items * Pure-play companies used for finding relevant multiples may not have exact operations of the conglomerate segment and may be in different stages of the business cycle * Multiples were found using the median multiple of a quick-and-dirty Capital IQ comp set of the similar pure-play company

Conclusion
Based on the findings of the analysis, it is important that management teams understand the relevance of the conglomerate discount, and that diversification may not always be in the best interest of the company and its shareholders. Overall, the analysis indicates that the market puts an emphasis on specialization when it comes to maximizing value. While management teams of conglomerates may not agree with this financial theory, the sheer increase in number of activist-influenced corporate spinoffs over the last few years should be a strong indication that the market values conglomerate companies at a value that is less than the sum of the parts of the individual business segments. Unless conglomerates can find a way to create value as a consolidated entity to a point where they trade in line with their implied market values or at a premium to their implied market values (like 3m Company and Danaher Corporation), the score will remain at Specialization-1 vs. Diversification-0.