Ralph’s previous post
focused on some questionable M&A motives driving current M&A activity.
My experience suggests M&A waves are driven by managerial risk appetite
amplified by leverage. Risk appetite is a function of wealth. Managers feel
wealthy when their stock price is high(er) reflecting robust earnings. This
wealth based confidence encourages them to use leverage, especially when rates
are low, to enhance their buying power i.e. do bigger and more expensive deals.
Other factors include the pressure to grow and to match acquiring competitors
(no one wants to look wimpy). These characteristics underlie the cyclical and
mixed M&A record of most acquirers.
Just as in politics, all M&A is local i.e. deal
specific. I previously
listed a checklist of factors characteristic of questionable acquisitions. The
rest of the post focuses upon using the checklist factors to evaluate Berkshire
Hathaway’s (BH) announced
Precision Cast Parts (PCP) acquisition.
The application is as follows:
1)
Size: bigger transactions entail more financial
and integration risks. PCP, while large in an absolute sense, represents less than
10% of BH’s market value. The SVAR
appears reasonable as well given the relatively modest premium paid (more on
this later). Integration risk is low given BH’s conglomerate strategy of having
PCP operate as an autonomous standalone entity. The enduring wisdom of
conglomerates will be tested once the uniquely qualified Buffett is gone.
Alternatively, I may have misclassified BH as a conglomerate. It could be a
stealth PE firm with permanent capital and extremely long hold periods. PE firms
operate their portfolio investments on a standalone basis and thereby have low
integration risk.
2)
Consideration: using stock indicates a lack of
confidence in the acquisition. Here, BH is offering a 100% cash deal-suggesting
lots of confidence
3)
Financing: over leveraged (i.e. non investment
grade) transactions limit the flexibility to realize on the target’s potential.
BH is funding the deal 2/3rds with equity (excess cash) and the remainder with
debt. It will operate under the BH investment grade umbrella as well. Thus,
flexibility is high.
4)
Buyer: weak deals involve weak buyers buying out
of desperation frequently to cover up operating problems. BH is a strong and experienced
buyer.
5)
Deal Type: high risk transactions involve
transformational and turnaround aspects. This is more of an opportunistic
acquisition of a well performing market leader; albeit one operating under some
performance problems in its energy sector. Time will tell if the sector
recovers-that is the bet.
6)
Timing: acquisitions made later in the M&A
cycle are highly competitive and prone to being overpriced. The current M&A
cycle could be view as closer to late stage given its current record volume
pace. Nonetheless, even in the later stage, it is still possible for
disciplined buyers to avoid overpaying as is the case with PCP with a modest
purchase premium.
7)
Price: it
appears BH got a relative bargain-subject to due diligence verification.
Investors concerned about PCP’ slumping energy segment dumped the stock causing
a 30% price drop from the LTM high since the beginning of the year. BH’s modest
20% premium (well below the 40% red zone) is actually 15% below the LTM high.
This is rare as most deals are closed above the LTM high which serves as a
pricing anchor. Furthermore, the price represents a modest 12X forward EBITDA
and 18X forward earnings-both of which (EBITDA and earnings) are expected to be
flat this year. BH pricing is similar to PE not strategic acquirers (perhaps,
BH is a PE firm not conglomerate after all). BH is capitalizing on a
discrepancy between public and private valuation. The question is why PCP would
agree to sell at that price?
Bottom line, BH
remains a disciplined buyer able to make promising acquisitions even in a
difficult market following a proven formula. As with most things Buffett
does-it is easy to understand, but difficult to copy. Unfortunately, many
acquirers are prone to the dubious M&A rationales outlined in Ralph’s post.
J
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