Investors should seek smarts on sums of the parts

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In most walks of life, two plus two makes four. Not so in the stock market. Here, two plus two routinely equals three. The business in question is “trading below the sum of its parts”, in the jargon.

But what does that damning judgment really mean? And how can investors turn it to their advantage?

Most quoted companies consist of several related businesses bundled into one wrapper. The question for investors is whether these components are worth more in total than the market capitalisation of the parent. If the answer is Yes, there is value to be unlocked by an acquirer or a reforming management.

A sum of the parts valuation is simple in theory, trickier in practice. You price each division first, multiplying its earnings by a figure typical for its specialisation. Then you add up the divisional prices, adjusting for debt and central overheads to get a total comparable with the market worth.

Such valuations are a core skill of buyout companies such as Advent. The US private equity house bought the UK aerospace company Cobham for £4bn in 2020. The deal was controversial because Cobham owned world-beating technology for refuelling warplanes, whose development costs had ultimately been met by UK taxpayers, alongside some mediocre businesses.

Lex correctly prophesied a lucrative break-up would follow. In the latest instalment of this saga, Advent on Wednesday sold Cobham’s AeroComms unit — which makes cockpit communications systems — to French group Thales for $1.1bn. 

That follows a whole host of other disposals. Indeed, a mere year and a half after the deal was inked, Advent had already sold businesses worth more than half its acquisition price. These included the refuelling unit for $2.83bn and an antennas division for $965mn.

It is hard to value the rump of Cobham within Advent. But it is evident the buyout group has made a good return on its dealings.

That should irk former long-term shareholders in Cobham. They may have benefited from a 50 per cent premium on the market cap, but the assets were worth more. It underscores the difficulty that public markets have in valuing companies, especially those that bundle up a lot of disparate businesses. 

There are good reasons for so-called “conglomerate discounts”, where the market capitalisation is far lower than what assets would fetch if valued at similar multiples to peers. 

Investors dislike complexity, on the grounds that management teams might lose focus. Analysts tend to specialise in specific sectors, so companies that straddle more than one can be poorly understood. The market is also suspicious of management claims that diversification reduces risk. As stockpickers, they are perfectly able to diversify their own portfolios. 

This sort of reasoning has led to a broad trend of simplification. General Electric, a favourite of the conglomerate era, is splitting itself up into three. UK pharma group GSK has spun off Haleon on the basis that there is limited overlap between selling Advil and developing HIV vaccines. Investors are urging European telco Vodafone to put assets on the block in order to narrow its discount to the sum of its parts. 

Buying unloved ragbags is not a fail-safe investment strategy, of course. Break-ups can fail to deliver value if fledglings are too small to attract analyst coverage and liquidity. There can be connections between seemingly unrelated businesses, too. Most obviously, corporate costs, procurement and R&D can be shared. And management teams have a privileged viewpoint over broader swaths of the economy, which might help them to spot opportunities.

That said, investors would do well to keep an eye out for companies which trade at a discount to the sum of their parts. Chances are a shake-up is on the way.

Cruise lines: the fickle benefits of ballast

Ships tend to make better speed by jettisoning ballast, not adding to it. But some of the best-performing stocks of 2023 have been large cruise lines, now freighted with debt from pandemic shutdowns.

The likes of Carnival, Royal Caribbean and Norwegian were at risk of running aground in 2020. A lacklustre recovery followed in 2021 and 2022. Holidaymakers appeared reluctant to maroon themselves on floating islands where new and old pathogens can jostle for pre-eminence.

Yet the buffets, entertainment and shuffleboard have proved as irresistible as a siren’s song. The shares of the trio of big cruise operators have each about doubled so far in 2023. Carnival announced record revenue in its most recent quarter. Customer deposits of $7bn were at an all-time high.

Cruise companies feature operating leverage. Ships have heavy fixed costs so each incremental passenger is highly valuable. Hefty financial leverage means slight improvements in operating performance create further bounce.

Still, investors should worry about cruise lines running out of steam. Even after a huge rally, the stock prices of cruise companies are well below pre-pandemic levels. Much of that difference can be explained in the components of value.

At the end of 2019, Carnival had a market value of equity of about $35bn. Today, that is $24bn as the company has issued dilutive stock. More notably, its net debt balance has exploded from $10bn to $30bn. Carnival’s enterprise value today of more than $50bn exceeds the figure from the end of 2019 by about a tenth. This is even as it projects about $4bn of 2023 ebitda, a fifth below the figure it reported in 2019. Operating costs excluding fuel, notably labour, are rising by more than a tenth annually. Carnival’s enterprise value-to-ebitda multiple of more than 12 times is substantially higher than it was pre-pandemic.

Wall Street has moved from worrying about bankruptcy filings to showering cruise ships with ticker tape from the quayside. But given debt levels, these businesses continue to sail through dangerous waters.