Sometimes, if you're lucky, the stock market just makes you a winner. That's how shareholders in telecom-equipment 3Com have to be feeling today, after the company's shares tacked another 7 percent in anticipation of tomorrow's spinoff of 3Com's Palm Computing division (the makers of the now omnipresent Palm III, V, and VII). 3Com's shares have doubled in the past month, almost entirely in anticipation of tomorrow's IPO, in which 3Com will be selling 4 percent of Palm to the public.
The thinking here is obvious enough. The Palm IPO should be one of the hottest offerings in recent memory, which is to say one of the hottest offerings in history. And since after the IPO 3Com is going to own 96 percent of the company, 3Com is much more valuable than it was before the spin-off was announced.
Or is it? There is something odd, after all, about the idea that even though the actual business that Palm does has not--and will not--change at all, its value to 3Com has suddenly skyrocketed. The now-familiar idea is that if you spin off a high-profile division, as GM has done with its Hughes satellite division and as 3Com is doing, you unlock shareholder value. But this only makes real sense if keeping the spun-off division within the company would somehow have hurt it from a business angle. And even if 3Com has not done the best job of competing in the telecom-equipment market over the past few years, no one's suggested that the Palm business has suffered. So if Palm by itself is worth X, then 3Com should be worth some multiple--even if only a small multiple--of X.
Of course, that's precisely what's happened as a result of the impending IPO. Even though Palm accounts for just 20 percent of 3Com's revenue, the company's stake in Palm now accounts--depending on what estimates you use--for something like 80 percent of 3Com's market cap. But the important point is that this happened only after the spin-off was announced. In other words, it was the prospect of the chance to invest in Palm by itself that made investors willing to invest in 3Com. This makes a certain kind of sense, but it's a twisted sense.
The problems here are twofold. In the first place, investing in this way forces you not only to try to evaluate the underlying businesses of both 3Com and Palm but also to try to evaluate just what value the stock market is going to place on Palm, because investors are now placing a huge value on the revenue 3Com will reap when it eventually divests itself of the rest of its stake in Palm. (And the more valuable Palm is, the more valuable that stake will be.) At the same time, it creates a strange situation for 3Com: Palm is its fastest-growing and most valuable division, and if it stayed part of 3Com, it would have an important impact on the company's bottom line for a long time to come. Spun off, it will immediately contribute billions to the company's potential future revenue (since investors can always say, "When 3Com sells its stake, that'll be a huge windfall"). But while Palm's contributions to the bottom line are predictable and recurring, any windfall gain will be a one-time event. And after it's gone, what will 3Com really be?
This is an extreme version of a question that a host of other companies are confronting, since we've seen an explosion of cross-investments in recent years, in addition to the development of so-called Internet incubators, whose only real sources of revenue are the investments they have in other companies. There's nothing inherently wrong with these models. But when investors value a company primarily on the basis of how other investors are valuing that company's investments, we're not really talking about an allocation of capital toward the kinds of things that will enhance productivity or foster technological innovation. We're talking instead about an investing circle that is virtuous for the moment but that has tremendous potential to become vicious somewhere down the line.