Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1982 letter.
The 1982 letter has a very interesting section on the issuance of equity. This analysis follows Buffett’s assertion that Berkshire and Blue Chip were considering a merger in 1983.
Dollar bills in exchange for 50-cent pieces
Buffett starts with the axiomatic policy that Berkshire always follows a simple rule: it will not issue shares unless it receives as much intrinsic business value as it gives. That should be obvious, but Buffett noted that many corporate managers do not follow this basic idea.
In mergers and acquisitions, managers must choose to use cash or debt. If, as is often the case, equity is needed to finance any shortfall, sometimes a manager will find the M&A is happening when his own stock is selling far below intrinsic business value. Buffett calls this a moment of truth for shareholders and quoted Yogi Berra, who said, “You can observe a lot just by watching.”
The investor continued, "For shareholders then will find which objective the management truly prefers - expansion of domain or maintenance of owners’ wealth."
Buffett then says if we flipped the situation – the buyer was instead selling its entire business, then he could probably negotiate in the sale to receive full intrinsic business value. However, in this case, “when the buyer makes a partial sale of itself - and that is what the issuance of shares to make an acquisition amounts to - it can customarily get no higher value set on its shares than the market chooses to grant it.”
If the acquirer continues and uses an undervalued (market value) currency to pay for a fully valued (negotiated value) asset, the acquirer is, in effect, “giving up $2 of value to receive $1 of value,” If this happens, even a marvelous asset bought at a fair sale price becomes a terrible acquisition.
"For gold valued as gold cannot be purchased intelligently through the utilization of gold - or even silver - valued as lead," Buffett wrote.
Do not ask the barber whether you need a haircut
Nevertheless, many acquirers do just this and find many self-rationalizations for such a value-destroying issuance of equity. Investment bankers will, of course, egg the acquirer on.
Buffett notes three favorite rationalizations employed by stock-issuing managements:
(a) “The company we’re buying is going to be worth a lot more in the future.” (Presumably so is the interest in the old business that is being traded away; future prospects are implicit in the business valuation process. If 2X is issued for X, the imbalance still exists when both parts double in business value.)
(b) “We have to grow.” (Who, it might be asked, is the 'we'? For present shareholders, the reality is that all existing businesses shrink when shares are issued. Were Berkshire to issue shares tomorrow for an acquisition, Berkshire would own everything that it now owns plus the new business, but your interest in such hard-to-match businesses as See’s Candy Shops, National Indemnity, etc. would automatically be reduced. If (1) your family owns a 120-acre farm and (2) you invite a neighbor with 60 acres of comparable land to merge his farm into an equal partnership - with you to be managing partner, then (3) your managerial domain will have grown to 180 acres but you will have permanently shrunk by 25% your family’s ownership interest in both acreage and crops. Managers who want to expand their domain at the expense of owners might better consider a career in government.)
(c) “Our stock is undervalued and we’ve minimized its use in this deal - but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want.” (This argument acknowledges that it is beneficial to the acquirer to hold down the issuance of shares, and we like that. But if it hurts the old owners to utilize shares on a 100% basis, it very likely hurts on a 51% basis. After all, a man is not charmed if a spaniel defaces his lawn, just because it’s a spaniel and not a St. Bernard. And the wishes of sellers can’t be the determinant of the best interests of the buyer - what would happen if, heaven forbid, the seller insisted that as a condition of merger the CEO of the acquirer be replaced?)
Three ways to avoid destruction of value when issuing equity for M&A
So how can companies avoid value destruction? First is to have a “true business-value-for-business-value merger.” This should be fair to shareholders of both sides, and if done correctly each party receives what it pays in terms of intrinsic business value.
Second is when the acquirer’s equity trades at or above its intrinsic business value. This is the best time to use equity as currency because it should enhance the acquiring company’s shareholder value.
The third way is for the acquirer to do the acquisition, and simultaneously repurchase equity equal to the amount issued in the merger. This has the effect of turning a stock-for-stock merger into a cash-for-stock acquisition. Buffett noted this is not ideal, but is essentially a damage-repair move.
Merger language
Buffett warns us that M&A nomenclature tends to confuse the issues and encourages irrational actions by managers. He wrote:
"For example, 'dilution' is usually carefully calculated on a pro forma basis for both book value and current earnings per share. Particular emphasis is given to the latter item. When that calculation is negative (dilutive) from the acquiring company’s standpoint, a justifying explanation will be made (internally, if not elsewhere) that the lines will cross favorably at some point in the future. (While deals often fail in practice, they never fail in projections - if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.) Should the calculation produce numbers that are immediately positive – that is, anti-dilutive - for the acquirer, no comment is thought to be necessary."
As we know, Buffett is not a fan of earnings per share as a metric. So, it is no surprise that he says we should not put too much attention on dilution or accretion of EPS in mergers. He notes that plenty of mergers that were “non-dilutive” still instantly destroyed value for the acquirer. Conversely, some mergers that did dilute current and near-term earnings per share were, in fact, quite value-enhancing. He wrote:
"What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value (a judgment involving consideration of many variables). We believe calculation of dilution from this viewpoint to be all-important (and too seldom made)."
If a board and management would not sell 100% of their company at an unfavourable valuation, then they must ask themselves why would they sell part of it at an unfavourable valuation. Buffett said, “A cumulation of small managerial stupidities will produce a major stupidity - not a major triumph.”
Concluding lessons
How management treats M&A finance can be a good indicator for how it considers the interests of shareholders. Shareholders will lose if the price-value ratio afforded their equity (relative to other equity valuations in the market), regardless of the assurances management gives. Value-diluting action is an important signal to avoid a bad management team. Ceteris paribus, the market will award high valuations relative to intrinsic business value to companies whose managers are disciplined and demonstrate their unwillingness to ever issue equity on terms unfavorable to the owners of the company.
