Wednesday, September 12, 2012

Why Buffett Prefers Using Cash Over Stock in Acquisitions

Both stock and cash was used for the merger of Burlington Northern Santa Fe (BNSF) into a subsidiary of Berkshire Hathaway (BRKa) back in early 2010. Yet, whenever possible, Warren Buffett has made it very clear he prefers using cash instead of stock in mergers/acquisitions.

In the 1997 letter, Buffett said the following about prior deals involving Berkshire's stock up to that point:

"If you aggregate all of our stock-only mergers (excluding those we did with two affiliated companies, Diversified Retailing and Blue Chip Stamps), you will find that our shareholders are slightly worse off than they would have been had I not done the transactions. Though it hurts me to say it, when I've issued stock, I've cost you money."

The problem wasn't that the businesses they did deals for ended up being poor performers or that they were somehow misled by the sellers.

Not at all.

"Instead, our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. When we issue shares in a merger, we reduce your ownership in all of our businesses -- partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.

Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better."

Buffett later added...

"These acquisitions have delivered Berkshire tremendous value -- indeed, far more than I anticipated when we made our purchases."

In 1998, not long after the 1997 letter was written, Berkshire would go on to use its stock to merge with General Re for roughly $ 22 billion. It was a deal that added meaningfully to Berkshire's share count (it was a more than 20 percent increase in shares outstanding).

The far more recent BNSF deal was structured to be roughly 60 percent cash and 40 percent stock. Buffett explained it this way in the 2010 Berkshire letter:

"It now appears that owning this railroad will increase Berkshire's 'normal' earning power by nearly 40% pre-tax and by well over 30% after-tax. Making this purchase increased our share count by 6% and used $22 billion of cash. Since we've quickly replenished the cash, the economics of this transaction have turned out very well."

In a perfect world he'd have not used stock but this BNSF deal had a much smaller impact on shares outstanding. Buffett said this to CNBC just after the deal was announced:

"I don't like to use stock, but on this one, because of the size and because they wanted a tax-free option for shareholders..."

The deal was structured (along with the 50-1 split of the 'B' shares) to enable even those with a small number a shares of BNSF to exchange their shares tax-free for Berkshire stock.

At least compared to prior occasions, it's pretty clear that the BNSF deal was a reasonably good use of the stock. It was certainly a great use of their cash. Using some Berkshire stock to make this happen was also consistent with Buffett's preference to always have lots of cash around. Making sure Berkshire's liquidity remained ample has always been a priority for them (and, I might add, should be for any well run enterprise). After the deal was done there was more than $ 20 billion of cash on the balance sheet. From the CNBC interview:

"...after doing it we will be left with over 20 billion of consolidated cash. So, we like to have a lot of cash around and we'll have a lot of cash around straight through this."

Still, I don't doubt they'd still have rather not used stock in the deal. Yet the opportunity arose to buy a very good large business and they did the deal that made sense consistent with their principles but within real world constraints. If they waited until they could do the deal with all cash who knows if the opportunity would have been there to buy the business at an attractive valuation.

So Buffett doesn't like to use Berkshire's stock but, under the right circumstances, it happens. There was 1.23 million Class A equivalent common shares outstanding at the end of 1997. These days, there's more like 1.65 million.

That increase in share count over 15 years or so comes mostly down to the General Re and BNSF deals.

Adam

Long BRKb

Berkshire Hathaway To Acquire Burlington Northern Santa Fe - Nov. 2009
Berkshire and BNSF Close Merger - Feb. 2010
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