M&A Activity and the Precision Cast Parts Deal: All M&A Is Local

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

Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J