Warren Buffett’s Berkshire Hathaway Inc. on Tuesday agreed to buy Burlington Northern Santa Fe Corp., a $34 billion acquisition that if approved will be the biggest in Berkshire’s history. …Continue reading » Buffett Buys Burlington Northern Santa Fe
Archive for the 'Acquisitions' Category
Berkshire Annual Letter 2000 (Part 1)
In the introduction of this letter, Warren Buffett mentions that most of his stock holdings were fully priced and the long term prospect for equities in general was far from exciting.
Year 1999 was the year technology stocks outperformed the rest of the market, but they are not something that Warren Buffett will buy.
Berkshire Annual Letter 1999 (Part 2)
When an acquisition takes place, there are two generally accepted accounting principles (GAAP) methods of recording the transaction.
In the “purchase” method, a goodwill account has to be established and subsequently written off against earnings. Payment can be made in either cash or stock.
Berkshire Annual Letter 1998 (Part 4)
Michael Kinsley has said about Washington: “The scandal isn’t in what’s done that’s illegal but rather in what’s legal.”
Many CEOs have no hesistation about manipulating earnings to meet the desires of Wall Street.
Their first assumption is that their job is to encourage the highest stock price possible, something which Warren Buffett disagrees. To get a high price, operational excellence is required failing which they will resort to accounting gimmicks.
Berkshire Annual Letter 1997 (Part 7)
Whenever Warren Buffett buys into an industry whose leading participants aren’t known to him, he will always ask his new partners, “Are there any more at home like you?”
Here’s something interesting. When he asked that of the Blumkin family upon buying Nebraska Furniture Mart in 1983, he was given three names – R.C. Willey, Star Furniture and one other.
Many years later, Warren Buffett puchased R.C. Willey and put the same question to the CEO, Bill Child. He was given two names which matched the remaining two given by Blumkin.
Warren Buffett holds a view that most acquisitions do damage to the shareholders of the acquiring company. Often, the finanical projections made by the sellers paint a more rosy picture than the actual scenario. The seller will always know more about the business than the buyer and they get to pick the best time of sale (from their perspective).
One of the few advantages that Berkshire has in buying companies is that they don’t have any strategic plans. They are free to consider any acquisition opportunities (including the purchase of shares in the stock market) on their own merits without the need to proceed in any particular direction.
Another advantage is that they can offer sellers shares of Berkshire, a company with a collection of outstanding businesses. An individual can defer personal tax indefinitely by exchanging their ownership in a single business for shares of Berkshire.
Also, sellers know that placing their companies with Berkshire will give their managers autonomy to operate as before, with pleasant and productive working conditions.
Warren Buffett likes to deal with sellers who care about what happens to their businesses after the sale, rather than those sellers who are simply auctioning off their businesses. The latter often comes with unpleasant surprises.
Making an acquisition is like marrying a spouse: It pays to be active, interested and open-minded, but it does not pay to be in a hurry.
Warren Buffett analogises the acquisitions of many managers to that of princesses kissing toads, hoping that they would one day turn into princes.
He himself was guilty of “dating” toads in his early days but finally revised his strategy to buy good businesses at fair prices rather than fair businesses at good prices.
In 1992, Berkshire made a purchase of a company that matched the definition of what they were looking for. The purchase was 82% of Central States Indemnity, an insurer that makes monthly payments for credit-card holders who are not able to pay themselves because they have become unemployed or disabled.
This acquisition had much in common with the very first one made 26 years ago, another Omaha insurer, National Indemnity Company.
On top of purchases made by the parent company, the subsidiaries of Berkshire sometimes make small “add-on” acquisitions that extend their product lines or distribution capabilities.
These add-on acquisitions are expected to contribute modestly to Berkshire’s value in the future.
The percentage of operating earnings as a percentage of beginning equity capital dropped to only 9.8%. One reason was that for partially-owned (<20%), nonoperated businesses, accounting rules dictate that only the dividends received can be reported as earnings.
Even the earnings of 35% owned GEICO were not included. For accounting purposes, the company was treated as a less-than-20% holding as the voting rights had been assigned.
Thus, only the dividends received from GEICO in 1982 of $3.5 million after tax were included in the “accounting” earnings. An additional $23 million that represented Berkshire’s share of GEICO’s undistributed operating earnings for 1982 were totally excluded.
There’s accounting madness at work here. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – reported earnings would have remained unchanged.
Warren prefers using a concept of “economic” earnings. This includes all undistributed earnings, regardless of ownership percentage. The point to bear in mind is that accounting numbers are the beginning, and not the end of business valuation.
To further highlight this point, Berkshire’s share of undistributed earnings from four of their major non-controlled holdings came to well over $40 million in 1982. This number, which is totally unreflected in the earnings report, is much higher than the total reported earnings of $14 million in dividends received from these companies.
The gigantic auction arena of the stock market continues to offer value investors opportunities to purchase fractional portions of businesses at bargain prices. This is possible as long as the market is moderately priced.
For the investor, an over-priced purchase of an excellent company can undo the effects of even a subsequent decade of favorable business developments. Value investors want the market to be cheap, not expensive!
Insurance Industry Conditions
The insurance industry continued to bleed. It is a good example of an industry with substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc).
If prices or costs can be controlled, the ‘bleeding’ can be stopped. This can be carried out legally through government intervention, illegally through collusion, or “extra-legally” through OPEC-style foreign cartelization.
Unfortunately, for the great majority of industries selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without controlled prices (or costs). This results in poor profitability.
Over-capacity may eventually self-correct, either as capacity drops or demand expands. When they finally occur, there usually follows an enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.
What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years.
The insurance industry operates under substantial overcapacity as it can be instantly created by capital and an underwriter’s willingness to sign his name.
Since there can be no surge in demand for insurance policies comparable to one in copper or aluminum, the only way for it to return to profitably is to reduce the supply.
Unfortunately, major sources of insurance capacity are unlikely to turn their backs on very large chunks of business, thereby sacrificing market share and industry significance. Major capacity withdrawals will require a shock factor such as a natural or financial “megadisaster”.
Issuance of Equity
In a merger, the first choice of the buying company is to use cash or debt to fund the purchase. In cases where these are insufficient, the issuance of new equity might be used.
When this happens, you will have to take notice. Why?
Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely in a negotiated transaction, it usually can receive full business value in whatever kind of currency the value is to be delivered.
If cash or debt is to be used in payment, the seller’s calculation of value received is quite straightforward. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.
If the buyer’s stock is selling in the market at full intrinsic value, using it as currency for the purchase doesn’t pose any problems.
But suppose it is selling at only half intrinsic value. In that case, the buyer will be using a substantially undervalued currency to fund the purchase of a company at full intrinsic business value.
The issuance of shares to make an acquisition amounts to a partial sale of the business. Using it to fund an acquisition means that you sell it at whatever value the market happens to be granting it at that time.
And if the market price is under-valuing the business, you will have to scrutinize the deal carefully no matter what ‘reasons’ the managers might give you.
However, there are three ways to avoid destruction of value for old owners when shares are issued for acquisitions.
One is to have a true business-value-for-business-value merger, with each receiving just as much as it gives in terms of intrinsic business value.
The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock may actually enhance the wealth of the acquiring company’s owners.
The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. This essentially converts it to a “cash for stock” purchase.
Another variable in mergers that is given too much attention is the effects of dilution on earnings. There have been plenty of non-dilutive mergers that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing.
What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value.
Finally, there is also a “double whammy” effect on the owners of the acquiring company when value-diluting stock issuances occur. A management that has a record of wealth-destruction through unintelligent share issuances will have a lower stock price for the company as the market accords a lower price/value ratio to them.