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The conglomerate discount: Why Smiths is spinning off its medical division

The value of a conglomerate is almost always less than the combined value of its subsidiaries, which is why firms such as Smiths and Whitbread are spinning off some of their assets
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Investors aren’t convinced that big conglomerates get the most out of their subsidiaries

Conglomerates were all the rage back in the 1980s, but their popularity has been waning of late, with investors preferring instead to opt for simpler pure-play companies.

Smiths Group PLC (LON:SMIN) has become the latest firm to spin off an asset in a bid to maximise its value, following in the footsteps of Premier Inn owner Whitbread PLC (LON:WTB), which sold off its Costa Coffee chain to Coca Cola Co (NYSE:KO) for £3.9bn.

READ: Whitbread agrees to sell Costa for £3.9bn

That was amid pressure from activist investors who had long argued that there were no synergies to be gained from having a hotel chain and coffee business under the same roof.

Similar criticisms have been levelled at Smiths, which said today (Friday) that it will demerge its medical business and list it as a separate company in London.

“The decision to separate out the medical division shouldn’t come as a surprise,” said AJ Bell investment director Russ Mould back in November, when news of a separation first broke.

“It didn’t really fit with the rest of the engineering group whose interests range from airport security scanners to components for the aerospace and construction industries.”

Lack of synergies

Where markets see little benefit in having different businesses under one roof, they will generally apply what’s known as a conglomerate discount.

To get the theoretical value per share of a company which own several businesses, you would up the value of each division and divide by the number of shares.

“You can pretty much guarantee that your conglomerate will trade at a discount to that figure,” explained Mould.

There could be several reasons for this, although most will point to management in one way or another.

Difficult to manage

Firstly, investors often question management’s ability to efficiently run a group of companies. It can be hard enough trying to lead one, let alone a handful.

In order to combat this, the top bosses might opt to bring in a layer of management beneath them who look after the individual businesses, which creates issues of its own.

Each subsidiary ends up being led by different people who possibly have different values and visions that don’t necessarily chime with the larger conglomerate.

BT Group PLC (LON:BT.A) is a prime example of both of those points. Bosses were seemingly unable to keep tabs on the Italian office, where managers had, shall we say, a different way of running things.

Congloms out of fashion

Away from management, there’s always fashion, too. Investors loved conglomerates back in the eighties, given the diversification they offered within one holding, where issues at an underperforming business could be offset by strong performances elsewhere.

But as evidence began to mount that portfolio companies in conglomerates performed no better than standalone entities, the market became more suspicious.

The downfall of UK conglomerate Polly Peck in the early nineties after rapid expansion in the years before didn’t help sentiment either.

“Over time, shareholders realised that if they wanted diversification, they could do it themselves,” said Mould.

This distaste for conglomerates still largely exists today. Whitbread gave in to shareholder pressure when it let Costa go, while City analysts have been calling on Associated British Foods PLC (LON:ABF) to do the same with its Primark clothes retailer.

Even Berkshire Hathaway, arguably the world’s most famous conglomerate, trades at a discount to its net asset value, despite benefitting from the so-called ‘Warren Buffet premium’.

Spin-offs almost always do better

So if companies are undervalued when they are part of a conglomerate, what happens when they are ‘set free’?

Renowned hedge fund manager Joel Greenblatt noted in his popular investment book, The little book that beats the market, that spin-offs tend to produce superior returns.

Analysts will typically say this outperformance can be traced to the closing of the conglomerate discount which is embedded in the spin-off’s initial valuation.

It might also be down to a more ‘optimal’ management structure where bosses are held directly to account by shareholders.

Whatever the case may be, Smiths will be hoping its decision will maximise the value of an asset that doesn’t quite fit in with the overall business.

Given that shares are up 10% since November when Smiths first announced some form of demerger or sale, it would seem the market is already closing some of the conglomerate discount.

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