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?

15 comments

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Buffet and BN agree on the actual value of BN; BRK and BN think BRK is undervalued; BN thinks BRK’s actual value is higher than Buffett. So Buffett can pay BN for the agreed upon BN value with a currency that BN values more than Buffett.

Posted by Zdneal | Report as abusive

The way I see it, Buffett saw an extraordinary risk that someone could come in after he is gone and do stupid stuff with Berkshire and destroy its value. Over an extended period of time and with Warren B no longer overseeing things, the compounded risk of something bad happening at Berkshire becomes very high. If every year after Buffett their is a 5% chance of a stupid, value-destroying disaster, the chance of such a thing happening is 2/3 in just twenty years.

What is the best way to protect Berkshire’s value? Chain it to a business that is sure to be around in 50 and 100 years, and is sure to grow with the economy.

Posted by DanHess | Report as abusive

Yeah, Buffett stated explicitly he thinks Berkshire is undervalued, which I believe is the first time he’s done that since early Spring of 2000 (which was clearly true in hindsight).
http://www.bloomberg.com/apps/news?pid=2 0601087&sid=a8vpgW1B0jlg&pos=5

I also agree with DanHess that this constitutes buying a long-term asset that both matches up well to the insurance book of business (kicks of consistent earnings for a long period of time to pay off the expected stream of future insurance liabilities) and ties the hands of future CEOs who might be inclined to make poor investments.

It also has the benefit of being capital intensive, which is a bad thing for most companies, but good for Berkshire. A huge problem that Berkshire has is reinvestment opportunities. With so much cash coming in each year (float from insurance plus subsidiary earnings), a business with a reasonable return and huge opportunity to invest at that return is preferable to a high-profitability business with no reinvestment opportunities. So in the Berkshire stable, utility companies are “better” than See’s Candy, even though See’s is more profitable.

Posted by Beer_numbers | Report as abusive

Yeah, Buffett just recently came out and said that he thinks Berkshire is undervalued: http://www.businessweek.com/news/2010-01 -21/berkshire-jumps-after-buffett-says-s tock-undervalued-update2-.html

But if it really was THAT undervalued and there was no way to do the deal without paying with stock, it seems that Buffett’s natural reaction should have been “Ok, then we don’t do the deal.” I agree with the commenter above that Buffett is basically diversifying away from himself. But I don’t think that would overpower Buffett’s value bent. He probably thinks Berkshire is at about fair value.

Posted by PopEconomics | Report as abusive

Of course Warren is going to say that BN is undervalued, the stock market is picking up, and the recession’s over.

He has a derivatives bet the size of his entire company’s present value.. which requires the NYSE to remain elevated. Stock market falls? BRK goes BK.

He is a market mouthpiece, nothing more.

Posted by Unsympathetic | Report as abusive

Buffet didn’t go for an all-cash deal because he couldn’t afford it. The deal was worth some $26 billion; by the end of September, Berkshire’s cash reserves were down to about $23 billion. He has to come up with $16 billion in cash to pay for the deal, and he’s going to borrow half of it, which has costs of its own. Berkshire’s AAA credit rating is incredibly important to its ongoing operations, particularly in insurance. Buffet’s not about to jeopardize that. Even depleting cash reserves by $8 billion was enough to prompt the agencies to announce a review. Borrowing enough cash to make this deal work probably would have sparked a downgrade.

So once you rule out an all-cash deal, the question Buffet has to answer is this: if both stocks are undervalued, which of the two stocks is more greatly undervalued at present, compared to its longterm earnings potential? He clearly decided that the answer was Great Northern.

Posted by Cynic | Report as abusive

Unsympathetic,
1. We’re pointing out that he said BRK was undervalued, not BNI.

2. I have no idea how you’re measuring the derivative bet, but you’re giving a bad connotation. As described in the 2008 annual report, the put contracts totaled $37.1 billion (at then-current exchange rates). If the 4 indices (S&P 500, FTSE 100, Euro Stoxx 50, Nikkei 500) each fell to 0, the company would lose $37.1 billion.

I think most people would agree with the incredibly unlikely probability of those 4 indices going to 0. Further, if they did all go to 0, I have a hard time imagining who would care whether Berkshire was bankrupt – every company on the planet would be bankrupt at that point.

A more realistic scenario described was if the 4 indices dropped by 25% from inception, BRK would owe $9 billion. Large, but not life-threatening.

At any rate, the equity puts were subsequently restructured to have a lower strike price and shorter maturity. The most recent 10-Q reports a net liability of $10.3 billion related to financial products (including equity index puts and and CDOs).

If you’re talking about the notional value (i.e., undiscounted maximum loss), it is $64.1 billion, which assumes maximum loss on all contracts. Still far less than BRKs current market value, and fairly irrelevant since the bulk of that ($38.592 billion) occurs in a state of the world in which everyone is bankrupt.

So I think you might be less informed than other commenters here.

Posted by Beer_numbers | Report as abusive

Beer_numbers: How, exactly, does a detailed discussion about BRK’s multi-billion dollar exposure not make Buffett a market mouthpiece?

In your urge to correct, you made my point. Congratulations!

Buffett has billions of reasons to say whatever’s needed to inspire belief that the market is undervalued.

Posted by Unsympathetic | Report as abusive

The comment I made wasn’t meant to deny that Buffett was a market mouthpiece. It was meant to point out that your statement (He has a derivatives bet the size of his entire company’s present value.. which requires the NYSE to remain elevated. Stock market falls? BRK goes BK.) was ridiculous.

If I wanted to deny the fact that Buffett was a market mouthpiece, I’d point to the 1999 Fortune article where he laid out very clearly why he viewed the stock market as extremely overvalued (while Berkshire had enormous market exposure): http://money.cnn.com/magazines/fortune/f ortune_archive/1999/11/22/269071/index.h tm.

If I wanted to point out that he’s fine pointing out when even Berkshire is overvalued, I’d point out that he said Berkshire was overvalued when the company issued its B class shares. (He said he wouldn’t buy the shares at that price, but I can’t find a convenient link.)

So given that Buffett has made public proclamations over the past 40 years that the market was overvalued and that the market is undervalued, it’s easier for me to believe that he’s simply giving his opinion than talking his book.

Posted by Beer_numbers | Report as abusive

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