Investors love Elon Musk. A merger of SpaceX and Tesla would test their faith

Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.

Elon Musk is a brilliant engineer and so far, much of what he touches has turned to gold. Just when you think he’s gone too far, or dreamed too big, he delivers.

This week, Mr. Musk was talking about another form of engineering – financial engineering. He announced that the boards of Tesla and SpaceX have struck independent committees to explore whether a merger makes sense.

I’m not an analyst any more and don’t cover any of Musk Corp.’s (my name) business lines – technology, artificial intelligence, autos, robotics, space, power systems or telecommunications – but I do have a historical perspective on what Mr. Musk is doing.

I started my career as a stock analyst covering conglomerates such as Canadian Pacific and Brascan. Ever since, I’ve watched companies expand and diversify, and then reverse course and do the opposite. The conglomerate cycle, as I’ll call it, may be the most predictable cycle I study.

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Rinse and repeat

The cycle starts with credibility. A chief executive and/or management team has success growing a business and builds a sterling reputation with investors. They earn the right to take the business in whatever direction they wish.

At some point, the company announces an acquisition that moves it into an unrelated business area. There are two main justifications – diversification and synergies. Diversifying smooths out the earnings pattern and moderates down periods. Synergies simply means that the combined company will be able to eliminate duplication and reduce costs.

There are likely one or two other reasons lurking in the background. Either growth is slowing in the existing business, or ego is taking over. In the latter case, executives start to believe their press clippings and think they can “add value” to any business they manage. They want a bigger canvas to paint on.

So, where does the cycle come in?

The accumulation trend ends when one or more elements of the business aren’t doing well. Some of the shine comes off management and analysts start digging deeper. The less desirable features of a conglomerate start to bubble to the surface.

Management is spread too thin. Some assets aren’t getting the resources they need. The underperformers are receiving all the investors’ attention and obscuring the good businesses. The organizational structure is too complex. Or there’s not enough cash flow at the holding company level to service debt and pay dividends.

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You get the picture. There are trade-offs, as with any organizational structure.

At some point, management starts complaining about the stock valuation. They feel that analysts aren’t appreciating the true value of the businesses they’ve accumulated, and the stock trades at less than the sum of its parts, or what’s called a holding company discount.

Add a new CEO and/or weak stock price to the frustration and the stage is set for the contraction phase to begin. The narrative changes. Underperforming assets are labelled “nonstrategic.” Divisions are sold off to “surface value.” And investors are offered pure plays on the assets they’re interested in.

And so it goes. Expansion for the sake of synergies and diversification is followed by contraction in the name of focus and value creation. If I sound a tiny bit cynical, it’s for good reason. The pattern is consistent, as are the explanations at every stage along the way.

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Musk Corp.

There may never been a business executive who has garnered such unwavering shareholder loyalty as Mr. Musk. Since Tesla took off, he’s been able to do whatever he wanted. Boards and shareholders have dutifully followed along when he’s changed directions, and there’s hardly been a whimper about lack of focus or weak corporate governance.

The question now is, will the glow around Mr. Musk allow him to deal with the challenges his sprawling conglomerate will face, or will Musk Corp. follow the same well-worn path of other business empires? Will complexity overshadow the fact that the company is the leading auto manufacturer and data centre developer in the world, and that it has a near monopoly on low-Earth orbit satellite communications?

There will be some synergies, but the corporate union won’t change the fact that the Musk empire has generated little profit in its history and has an abysmal governance record. Nor will it change the fact that both sides of the new company operate in asset heavy businesses (autos; data centres) that until Mr. Musk came along, garnered low valuations relative to the rest of the stock market.

Where Musk Corp. goes and how it develops is as unpredictable as its CEO. If history is any indication, however, merging Tesla and SpaceX won’t be the end of corporate restructuring and financial engineering.