Acquiring companies with stock

By Felix Salmon
January 27, 2010
John Gapper and Nadav Manham have both picked up on Warren Buffett's explanation of how he thinks about M&A, especially when a company is paying with stock:

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John Gapper and Nadav Manham have both picked up on Warren Buffett’s explanation of how he thinks about M&A, especially when a company is paying with stock:

Kraft, in my judgment, well just in the past two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said they got $3.7 billion for it. But, because it had practically no tax basis, they really got about $2.5 billion. They sold a business for $2.5 billion that Nestle is willing to pay $3.7 billion. Now can Nestle run it that much better than Kraft? I doubt it. But that business that was sold for $2.5 billion earned $280 million pre-tax last year. But they sold that at less, right around nine times pre-tax earnings in terms of their own figure.

Now they mentioned paying 13 times EBITDA for Cadbury, but they’re paying more than that. For one thing, EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that, they’ve got a billion-three they’re going to spend of various rearrangements of Cadbury. They’ve got $390 million of deal expenses. They are using their own stock, 260 million shares or something like that, that their own directors say is significantly undervalued. And when they calculate that 13, they’re calculating Kraft at market price, not at what their own directors think the stock is worth. So, the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17 and they sold earnings at nine times. So, it’s hard to get rich doing that.

There’s a lot of very smart analysis packed into this extemporizing (Buffett was talking on TV). Kraft is selling a business for $2.5 billion, after taxes, which throws off $280 million a year. Yet it’s buying Cadbury at a much higher multiple than that, and it’s paying in undervalued stock.

In general, you see many more stock-based acquisitions when companies are overvalued than when they’re undervalued. (Think of AOL buying Time Warner, or for that matter just about any acquisition by WorldCom.) It’s even possible to use stock-based acquisitions as an indication that a company thinks its shares are trading at too high a level. But sometimes, as Buffett notes, companies will use their stock even when it’s undervalued. And that can be very bad for existing shareholders.

All of which raises the question: what are we to make of the fact that Bufffett himself is using Berkshire Hathaway stock to buy Burlington Northern? Does it mean he thinks that his stock is overvalued? Or, if he thinks BRK is undervalued, does that mean he’s making a similar mistake to that which he deplores at Kraft? Either way, there seems to be an implicit “sell” signal here. Or is there something I’m missing?

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