The Investor's Consigliere

Buffett on M&A Valuation: How to Evaluate an Acquisition

I struggled a little to conceptualize in my own head the idea of one company issuing undervalued stock in order to acquire another company.  I understood that a company dilutes its existing shareholders when it issues undervalued stock, but I couldn't exactly quantify it.  In this CNBC interview transcript (starting at page 17) Warren Buffett explains one way to do it in the context of Kraft's acquisition of Cadbury, which he opposed:

1)  Start with the acquirer's "headline" valuation of the deal.  In this case, Kraft stated it was buying Cadbury for 13x EBITDA.

2)  Add to the purchase price whatever restructuring expenses the acquirer will have to pay in order to integrate the acquisition. 

3)  Add to the purchase price whatever deal expenses (legal and investment banking fees, etc.) the acquirer will have to pay to pursue and consummate the transaction.

Before even considering the issue of issuing stock, we can already see that Buffett thinks the "headline" purchase valuation is nonsense. 

4)  Now the stock issuance:  Take the number of shares to be issued by the acquirer as deal currency.

5)  Don't multiply that number by the per-share market value of the shares.  Instead, multiply it by your own estimate of the intrinsic value of the shares.  That product represents the stock portion of the deal.  In this case the result is to increase the purchase price of the acquisition, but when the stock of the acquiring company is overvalued, then the effect is to reduce the purchase price of an acquisition. 

6)  In this case, the headline acquisition multiple of 13x EBITDA became, by Buffett's estimation, a true multiple of 16-17x EBITDA. 

Disclosure:  Long Berkshire Hathaway

Buffett--I mean Gaines--on Valuation

To evaluate investors one must evaluate how they evaluate their investments.  One of the things I look for is what I call "elegance" in valuation.  It' s hard idea to define; you kind of know it when you see it.  Warren Buffett rarely discusses valuation, but when he does he almost always demonstrates this quality.

I guess what I mean by elegance is the ability to restate a problem (in the context of investing, the problem is most often "what is this asset worth?" or "is this asset undervalued?" or "what is the expected return of this asset?") in such a way that the solution presents itself with disarming clarity.  Think of the legendary story of a precocious German schoolchild daydreaming in class in the 18th century.  The dour schoolmaster commanded his students to sum all of the integers from 1 to 100, expecting the tedious calculation to occupy at least a half hour of his students' time.  Instead our precocious schoolchild, the youngest in the class, almost immediately blurted out the correct answer, making the dour schoolmaster even more dour.  The child was Carl Friedrich Gauss, who became one of the greatest mathematicians ever, and he solved the problem not by his ability to calculate 1 + 2 + 3 +. . .+ 100 faster than anyone else, but by recognizing immediately that the problem could be restated in a way that made the solution easy: the list of 100 integers could be grouped into 50 pairs, each of which sums to 101 (1+99, 2+98, 3+97, etc.), so the correct answer was simply 50 x 101 = 5050. 

There are many professional investors who can "sum the integers from 1 to 100" the hard way, by outworking everyone else or by using technology.  But the very best investors are almost invariably elegant in their thinking; they have the Gaussian ability to simplify problems so that the difficult process of evaluating an investment becomes much easier.

A recent example of elegance in valuation caught my eye.  It's maybe not up to the level of Gauss' trick but it is elegant nonetheless.  My friend and editor John Mihaljevic recently interviewed Brian Gaines of Springhouse Capital for his Portfolio Manager's Review publication, and posted an excerpt on his blog.  The excerpt included the following discussion of Netflix, a company whose traditionally high P/E ratio and new business model made it unpopular among value investors:

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

What made this analysis elegant was Gaines' ability to restate the "is Netflix undervalued?" problem in a different way, by substituting business reality for accounting "reality."  According to GAAP, subscriber acquisition costs must be treated as an expense on the income statement (I vaguely remember this rule coming about in the mid 1990s and it caused AOL to trade way down).  For a growing enterprise that does a lot of marketing, this will depress GAAP earnings, the E in the traditional P/E ratio, which will in turn raise the P/E ratio beyond the reach of most value investors.  Gaines' insight was to treat subscriber acquisition costs not as an expense, but as mostly an investment in future growth, similar to a capital expenditure.  Only a portion of this expenditure, analagous to maintenance capex, was to be subtracted from the pro forma income statement, as it represented the cost of maintaining then-current volumes.  

Gaines' insight had the effect of significantly increasing the profitability of the non-growth portion of Netflix's business, which in turn lowered its operating P/E to a very value investor-friendly 5-6x.  Having determined that Netflix's product was performing well, having calculated that he wasn't paying anything for the company's future growth, and having assumed that its heavy investment in future growth would likely earn a good return (or else would dramatically be curtailed), Gaines turned a growth investor's speculation into a value investor's investment, with a significant margin of safety, and was well rewarded.  Elegant.

Buffett on Valuation: The Most Important Banking Metric

Here's Buffett again, from the same Fortune interview, on the metric he uses to value a bank:

It's earnings on assets, as long as they're being achieved in a conservative way. But you can't say earnings on assets, because you'll get some guy who's taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn't show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you're doing it in a sound way, that's what I look at.

Disclosure: Long Berkshire Hathaway

Buffett on Valuation: The (Un)importance of Tangible Common Equity

Warren Buffett does a lot of interviews, and I must say that most of the time the questioners repeat the same questions and he repeats the same answers.  But in this Fortune interview on Wells Fargo he reveals some new information about how he values banks and bankers.

Here is his response to a question about tangible common equity, a topic of great importance to banking analysts and regulators:

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they've got huge earning power. And Wells ... you can't take away Wells' customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that's what they do . . .

You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that's where people get all mixed up incidentally on things like the TARP. They say, 'Well, where'd the 5 billion go or where'd the 10 billion go that was put in?' That isn't what you make money on. You make money on that deposit base of $800 billion that they've got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they'll put out the money differently.

Disclosure: Long Berkshire Hathaway

Berkshire Hathaway Letter to Shareholders

is here!  Raise your hand if you sat there clicking "reload current page" until the 2008 letter showed up. I'll have a longer commentary later, but here are some initial thoughts:

1)  Your consigliere is on record saying that value investors who venture into macroeconomics do so at their peril.  I was afraid, I'll confess, that Buffett would do just that in his letter.  But he didn't.

2)  Buffett is well-known for preaching against diversification, but states that one of goals is for Berkshire to maintain "dozens of sources of earnings and cash" and that another is to find "new and VARIED streams of earnings."  In fact, Berkshire is probably the most diversified company in the world.

3)  Kremlinology alert--I'm about to read too much into Buffett's wording:  On page 4 Buffett very precisely writes that the three large PIPE deals he made were "In our insurance portfolios."  Meaning they were funded in large part by cheap/free float.  So a 10% coupon on one of these deals is less than the return on equity to a Berkshire shareholder from doing the deal. 

4)  Berkshire's large equity put portfolio can be understood as partly a bet on future inflation, as they were written on indices that reflect nominal currency values.  There is a chart on page 206 of Barton Bigg's Wealth, War and Wisdom that I'm too stupid to know how to reproduce.   It shows that from 1932 through mid-1957, a period that included both the Great Depression and World War II, the Italian stock market enjoyed near-uninterrupted growth.  But it's a nominal index--in real terms the market fell.  But if you'd written a long-term put on that index on similar terms as the ones Buffett made, you would not have had to pay anything.  Of course Buffett must also navigate inflation when trying to invest the premium he's received on those puts.

5)  Berkshire Hathaway the stock declined 32% in 2008.  Berkshire Hathaway the company declined only 9.6%, as measured by book value.  Keep in mind that the company is now largely in the business at "borrowing" money from policyholder at very low/free/negative rates in order to invest in regulated utilities.  Those two parts of the business did very well.

More later. 

Buffett on Valuation: Mid-Continent Tab Card Co.

Via a nice new blog called Compounding Machines, check out this speech by Buffett's Boswell Alice Schroeder, in which she discusses how he valued a little-known private investment he made in a company called Mid-Continent Tab Card Co.  But I can't quite get the numbers she gave to fit--take a listen and see if you can.

This case study illustrates one of the themes of this blog: value investing is not simply a way to pick stocks.  It's a way of thinking about capital allocation in general, applied here to a private equity investment.

Buffett on Valuation: Risk Arbitrage Edition

My post on Anheuser-Busch and Buffett was, for one brief shining moment, the most popular article on Seeking Alpha.  In the comments I directed interested readers to the 1988 Berkshire Hathaway letter to shareholders, in which Buffett discusses one of his arbitrage positions that year, Arcata.

Below I reproduce the relevant excerpts from the letter for my Buffett on Valuation series:

	To evaluate arbitrage situations you must answer four 
questions: (1) How likely is it that the promised event will 
indeed occur? (2) How long will your money be tied up? (3) What 
chance is there that something still better will transpire - a 
competing takeover bid, for example? and (4) What will happen if 
the event does not take place because of anti-trust action, 
financing glitches, etc.?

   Arcata Corp., one of our more serendipitous arbitrage 
experiences, illustrates the twists and turns of the business. 
On September 28, 1981 the directors of Arcata agreed in principle 
to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), 
then and now a major leveraged-buy out firm. Arcata was in the 
printing and forest products businesses and had one other thing 
going for it: In 1978 the U.S. Government had taken title to 
10,700 acres of Arcata timber, primarily old-growth redwood, to 
expand Redwood National Park. The government had paid $97.9 
million, in several installments, for this acreage, a sum Arcata 
was contesting as grossly inadequate. The parties also disputed 
the interest rate that should apply to the period between the 
taking of the property and final payment for it. The enabling 
legislation stipulated 6% simple interest; Arcata argued for a 
much higher and compounded rate.

   Buying a company with a highly-speculative, large-sized 
claim in litigation creates a negotiating problem, whether the 
claim is on behalf of or against the company. To solve this 
problem, KKR offered $37.00 per Arcata share plus two-thirds of 
any additional amounts paid by the government for the redwood 
lands.

   Appraising this arbitrage opportunity, we had to ask 
ourselves whether KKR would consummate the transaction since, 
among other things, its offer was contingent upon its obtaining 
“satisfactory financing.” A clause of this kind is always 
dangerous for the seller: It offers an easy exit for a suitor 
whose ardor fades between proposal and marriage. However, we 
were not particularly worried about this possibility because 
KKR’s past record for closing had been good.

   We also had to ask ourselves what would happen if the KKR 
deal did fall through, and here we also felt reasonably 
comfortable: Arcata’s management and directors had been shopping 
the company for some time and were clearly determined to sell. 
If KKR went away, Arcata would likely find another buyer, though 
of course, the price might be lower.

   Finally, we had to ask ourselves what the redwood claim 
might be worth. Your Chairman, who can’t tell an elm from an 
oak, had no trouble with that one: He coolly evaluated the claim 
at somewhere between zero and a whole lot.

   We started buying Arcata stock, then around $33.50, on 
September 30 and in eight weeks purchased about 400,000 shares, 
or 5% of the company. The initial announcement said that the 
$37.00 would be paid in January, 1982. Therefore, if everything 
had gone perfectly, we would have achieved an annual rate of 
return of about 40% - not counting the redwood claim, which would 
have been frosting.

   All did not go perfectly. In December it was announced that 
the closing would be delayed a bit. Nevertheless, a definitive 
agreement was signed on January 4. Encouraged, we raised our 
stake, buying at around $38.00 per share and increasing our 
holdings to 655,000 shares, or over 7% of the company. Our 
willingness to pay up - even though the closing had been 
postponed - reflected our leaning toward “a whole lot” rather 
than “zero” for the redwoods.

   Then, on February 25 the lenders said they were taking a 
“second look” at financing terms “ in view of the severely 
depressed housing industry and its impact on Arcata’s outlook.” 
The stockholders’ meeting was postponed again, to April. An 
Arcata spokesman said he “did not think the fate of the 
acquisition itself was imperiled.” When arbitrageurs hear such 
reassurances, their minds flash to the old saying: “He lied like 
a finance minister on the eve of devaluation.”

   On March 12 KKR said its earlier deal wouldn’t work, first 
cutting its offer to $33.50, then two days later raising it to 
$35.00. On March 15, however, the directors turned this bid down 
and accepted another group’s offer of $37.50 plus one-half of any 
redwood recovery. The shareholders okayed the deal, and the 
$37.50 was paid on June 4.

   We received $24.6 million versus our cost of $22.9 million; 
our average holding period was close to six months. Considering 
the trouble this transaction encountered, our 15% annual rate of 
return excluding any value for the redwood claim - was more than 
satisfactory.

   But the best was yet to come. The trial judge appointed two 
commissions, one to look at the timber’s value, the other to 
consider the interest rate questions. In January 1987, the first 
commission said the redwoods were worth $275.7 million and the 
second commission recommended a compounded, blended rate of 
return working out to about 14%.

   In August 1987 the judge upheld these conclusions, which 
meant a net amount of about $600 million would be due Arcata. 
The government then appealed. In 1988, though, before this 
appeal was heard, the claim was settled for $519 million. 
Consequently, we received an additional $29.48 per share, or 
about $19.3 million. We will get another $800,000 or so in 1989.

Buffett on Valuation: Western Insurance Securities (ca. 1952)

Another one from the vault:  15 months after a young Warren Buffett wrote an article pitching GEICO (see my post here), he wrote another one recommending a little-known company called Western Insurance Securities Company.  There is nothing fancy in the valuation discussion, but note how Buffett anticipates and addresses the possible "it looks too good to be true" objections:

Again my favorite security is the equity stock of a young, rapidly growing and ably managed insurance company. Although Government Employees Insurance Co., my selection of 15 months ago, has had a price rise of more than 100%, it still appears very attractive as a vehicle for long-term capital growth.

Rarely is an investor offered the opportunity to participate in the growth of two excellently managed and expanding insurance companies on the grossly undervalued basis which appears possible in the case of the Western Insurance Securities Company. The two operating subsidiaries, Western Casualty & Surety and Western Fire, wrote a premium volume of $26,009,929 in 1952 on consolidated admitted assets of S29,590,142. Now licensed in 38 states, their impressive growth record, both absolutely and relative to the industry, is summarized in Table I below.

Western Insurance Securities owns 92% of Western Casualty and Surety, which in turn owns 99.95% of Western Fire Insurance. Other assets of Western Insurance Securities are minor, consisting of approximately $180,000 in net quick assets. The capitalization consists of 7,000 shares of $100 par 6% preferred, callable at $125; 35,000 shares of Class A preferred, callable at $60, which is entitled to a $2.50 regular dividend and participates further up to a maximum total of $4 per share; and 50,000 shares of common stock. The arrears on the Class A presently amount to $36.75.

The management headed by Ray DuBoc is of the highest grade. Mr. DuBoc has ably steered the company since its inception in 1924 and has a reputation in the insurance industry of being a man of outstanding integrity and ability. The second tier of executives is also of top caliber. During the formative years of the company, senior charges were out of line with the earning power of the enterprise. The reader can clearly perceive why the same senior charges that caused such great difficulty when premium volume ranged about the $3,000,000 mark would cause little trouble upon the attainment of premium volume in excess of $26,000,000.

Adjusting for only 25% of the increase in the unearned premium reserve, earnings of $1,367,063 in 1952, a very depressed year for auto insurers, were sufficient to cover total senior charges of $129,500 more than 10 times over, leaving earnings of $24.74 on each share of common stock.

It is quite evident that the common stock has finally arrived, although investors do not appear to realize it since the stock is quoted at less than twice earnings and at a discount of approximately 55% from the December 31, 1952 book value of $86.26 per share. Table II indicates the postwar record of earnings and dramatically illustrates the benefits being realized by the common stock because of the expanded earnings base. The book value is calculated with allowance for a 25% equity in the unearned premium reserve and is after allowance for call price plus arrears on the preferreds.

Since Western has achieved such an excellent record in increasing its industry share of premium volume, the reader may well wonder whether standards have been compromised. This is definitely not the case. During the past ten years Western’s operating ratios have proved quite superior to the average multiple line company. The combined loss and expense ratios for the two Western companies as reported by the Alfred M. Best Co. on a case basis are compared in Table III with similar ratios for all stock fire and casualty companies.

The careful reader will not overlook the possibility that Western’s superior performance has been due to a concentration of writings in unusually profitable lines. Actually the reverse is true. Although represented in all major lines, Western is still primarily an automobile insurer with 60% of its volume derived from auto lines. Since automobile underwriting has proven generally unsatisfactory in the postwar period, and particularly so in the last three years, Western’s experience was even more favorable relative to the industry than the tabular comparison would indicate.

Western has always maintained ample loss reserves on unsettled claims. Underwriting results in the postwar period have shown Western to be over-reserved at the end of each year. Triennial examinations conducted by the insurance commissioners have confirmed these findings.

Turning to their investment picture, we of course find a growth in invested assets and investment income paralleling the growth in premium volume. Consolidated net assets have risen from $5,154,367 in 1940 to their present level of $29,590,142. Western follows an extremely conservative investment policy, relying upon growth in premium volume for expansion in investment income. Of the year-end portfolio of $21,889,243, governments plus a list of well diversified high quality municipals total $20,141,246 or 92% and stocks only $1,747,997 or 8%. Net investment income of $474,472 in 1952 was equal to $6.14 per share of Western Insurance common after minority interest and assuming senior charges were covered entirely from investment income.

The casualty insurance industry during the past several years has suffered staggering losses on automobile insurance lines. This trend was sharply reversed during late 1952. Substantial rate increases in 1951 and 1952 are being brought to bear on underwriting results with increasing force as policies are renewed at much higher premiums. Earnings within the casualty industry are expected to be on a very satisfactory basis in 1953 and 1954.

Western, while operating very profitably during the entire trying period, may be expected to report increased earnings as a result of expanding premium volume, increased assets, and the higher rate structure. An earned premium volume of $30,000,000 may be conservatively expected by 1954. Normal earning power on this volume should average about $30.00 per share, with investment income contributing approximately $8.40 per share after deducting all senior charges from investment income.

The patient investor in Western Insurance common can be reasonably assured of a tangible acknowledgement of his enormously strengthened equity position. It is well to bear in mind that the operating companies have expanded premium volume some 550% in the last 12 years. This has required an increase in surplus of 350% and consequently restricted the payment of dividends. Recent dividend increases by Western Casualty should pave the way for more prompt payment on arrearages. Any leveling off of premium volume will permit more liberal dividends while a continuation of the past rate of increase, which in my opinion is very unlikely, would of course make for much greater earnings.

Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40. The stock is traded over-the-counter.

Buffett on Valuation (sort of): Borsheim's

This one isn't really Buffett on valuation per se, but I really like it and it's not widely known so I thought I'd include it in the category.  Think of it as the retail course of the "Free MBA" Buffett has been giving all his career.  It's a message on the Borsheim's Jewelry web site from Buffett to potential customers, explaining the economic advantages that allow Borsheim's to offer its merchandise at such low prices:

What You Should Know About the Jewelry Business

Buffett has confessed that he's not very good at the advertising and marketing side of consumer products, and this is a good example.  For most people contemplating that most mystical and romantic of purchases, a piece of jewelry, the last thing they want to hear about is stuff like inventory turnover and overhead costs.  Like Bismarck said about politics and sausage-making, you don't really want to know what's going on behind the scenes.  But that's how Buffett's mind works--it's not enough for him to be told he's paying the best price, he needs to know why. 

Buffett on Valuation: GEICO (1951 edition)

On page 25 of the 2005 Berkshire Hathaway Annual Report, an article Buffett wrote pitching GEICO is reprinted.  It was written in 1951, when he was 21 years old.  Most of the pitch addresses GEICO's competitive advantage, with only a little valuation talk at the end.

Interestingly, I don't think the writer of this piece comes off as an investment genius--it's really just a well-reasoned pitch of the kind you might read in the back of Forbes.  On the other hand, to a 18th century Austrian music lover, this little symphony didn't sound like the work of a genius either--until its composer was revealed to be all of eight years old.   So I would say the article shows precocity, the seed of genius.  Think of what you were doing at age 21 and you'll see my point. 

On yet another (my third?) hand, an investment genius is not always a person.  It can also be a company itself, something I'll address in future posts.  If you define genius as "an extreme outlier among one's peers, a freak of excellence," then GEICO itself deserves the label--then and now it was in the highest percentile of companies in terms of sustainable (and even improving) competitive advantage and growth potential.  It's a compound interest machine.  Buffett's skill here was to recognize this fact and to bet big on it, and to do so at a very early age too.  So maybe I should take back what I said--the writer of the piece does come off as an investment genius after all.

Incidentally, GEICO turned out to be a spectacular investment, a "buy it and hit the beach for twenty years" kind of investment until it ran into problems in the 1970s.  I think I remember reading that later in his life Benjamin Graham himself "confessed" that that's what he should have done instead of working so hard looking for cigar butts in his private partnership.  Of course those cigar butts worked out OK too.  And Graham did find plenty of time for fun, on the beach (La Jolla and the south of France) and elsewhere--but that's for another post.