Buffett: Shareholder activist

January 5, 2010

Shareholder activism is a tactic typical of Carl Icahn, not the Oracle of Omaha. Yet Warren Buffett has issued a press release asking other Kraft shareholders to reject Kraft’s proposal to use up to 370 million shares of stock to buy Cadbury.

To state the matter simply, a shareholder voting “yes” today is authorizing a huge transaction without knowing its cost or the means of payment.

What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive “currency” to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more….

Rolfe here. Buffett argues that KFT stock is an “expensive” acquisition currency because he thinks the shares are worth more than $27. He has a special history on this, as I get to below…

Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated….

At this time…we believe no shareholder should vote “yes” when he can’t possibly know what he is voting for.

Buffett is famous for his hands off approach to management. He invests in companies as much for the franchise value as for the folks running the business. That’s because management is often the crucial variable to generating value over the course of the business cycle.

But Buffett REALLY hates to use stock to pay for acquisitions. Here’s an instructive passage from his ’07 shareholder letter:

Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.

For those that don’t follow: 25,203 shares of Class A Berkshire stock are today worth far more than the $433 million they fetched in 1993. In the fullness of time, as BRK stock has risen, the Dexter purchase price has ballooned 10x.

Buying a business with stock that’s going up gives the seller more value over time. It’s tantamount to selling the stock yourself, which doesn’t make sense if you think it’s worth more.

Conversely you have an example like Steve Case, who brilliantly sold all of AOL’s overvalued stock to Gerry Levin in exchange for Time Warner’s great media assets.

On another note: Is Buffett getting sloppy in the credit bubble age? He paid up for Burlington Northern (28x FCF!), even admitting that the price paid was pretty high.  His purchase of Kraft shares also at a high valuation similarly left him with little margin of safety.*

He got lucky on BUD, finding greater fool InBev to pay a premium to the high price he paid for the shares.

Appears that in the age of low rates and overinflated valuations, Buffett has no choice but to chase risk with the rest of us.

By the way, this is not to argue with the fact that Buffett was the 20th century’s best investor. I believe firmly that he was. To me, his value methodology, when properly applied, is the dictionary definition of “investing.”

Trouble is, it seems to me he’s no longer able to apply it in the age of overinflated assets…

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*Buffett bought his KFT shares near the end of 2007 for an average price of about $33.40. Today the stock is near $28. $33 per share implies a $67 billion enterprise value for KFT today. Forward unlevered FCF when Buffett bought his KFT shares (that is, for 2008) ended up at about $3.8 billion, implying a valuation of 18x EV/UFCF. Cheaper than the Burlington deal, but a rich multiple nonetheless.

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