By Andrew Bary (Barron’s)
Warren Buffett threw cold water last week on Kraft Foods’ bid for British candy maker Cadbury. But in doing so, he seems to be saying: “Do as I say, not as I do.”
Buffett’s Berkshire Hathaway (ticker: BRKA), Kraft’s largest shareholder, with a 9% stake, voted against a proposal that would let Kraft (KFT) sharply boost its share count to facilitate a higher bid for Cadbury (CBY) — which has rejected Kraft’s original offer. Buffett views Kraft stock as undervalued, and issuing more shares dilutes existing stockholders’ stakes.
Yet Berkshire is issuing $10 billion in shares of its own stock, which some investors view as quite undervalued, for its $34 billion cash-and-stock acquisition of Burlington Northern Sante Fe railroad (BNI), at $100 a share.
This could be a factor keeping Berkshire stock trailing the market, despite a strong 2010 profit outlook, stemming in part from Buffett’s smart high-yield investments in Goldman Sachs (GS), General Electric (GE) and other companies during the financial crisis. Berkshire made over $20 billion in such investments, and the $2 billion in resulting annual income could help lift its operating profits to a record $6,000 per Class A share this year, from an estimated $4,900 in 2009.
Based on earnings and book value, Berkshire fans consider the Class A very attractive now, at around $100,000 a share. After rising just 3% in 2009, the stock, which is way below its late 2007 peak of $149,000, fetches a mere 1.2 times our estimate of the company’s year-end 2009 book value of $84,500 a share — compared with an average 1.65 times in the past decade. The stock rarely has been cheaper, relative to book value, in 15 years.
Says one longtime Berkshire holder: “Buffett appears to be giving up a piece of a very cheap company to buy one that is fairly priced. He is not so happy when his investment companies do the same thing.”
Book value, moreover, understates what Buffett calls Berkshire’s intrinsic value: the discounted value of its cash flow. Buffett won’t estimate this, but has stated that it “significantly” exceeds book value, because auto insurer Geico and some other businesses are worth more than their carrying value on Berkshire’s balance sheet.
Berkshire’s book value could hit $92,000 to $95,000 a share this year if the financial markets stay strong. Thus, Berkshire may be trading below its 1.1 times forward book value. Why, then, is Buffett willing to issue equity for Burlington? He declined to comment last week, but he likes the railroad business, having accumulated a 22% stake in Burlington prior to the deal. In the past, he’s called the transaction “an all-in wager on the economic future of the United States.” And he’s said that, while he’s not enthusiastic about issuing more shares, the deal is too large to be all-cash and that he wants to give Burlington shareholders a tax-free option. Some think the 79-year-old investor wants to trim Berkshire’s $24 billion in cash to cut the pressure on his successor to make investments.
Still, Berkshire is paying a full price for Burlington — 18 times projected 2010 profits for a capital-intensive business. Other major rail companies are valued at about 15 times estimated 2010 earnings. One saving grace: Berkshire is using cash on its balance sheet and an estimated $8 billion in cheap financing for the deal, which uses a 60/40 mix of cash and stock.
The last time Berkshire did a major all-stock deal — the $22 billion purchase of reinsurer Gen Re in 1998 — its shares were at a lofty three times book value, a far cry from the currently low price/book ratio. If Berkshire’s intrinsic value is $125,000, as some bulls assert, Burlington holders will get about $110 a share in value for their stock, which was trading near 99 late last week.
Berkshire watchers say the stock may be depressed from arbitrage activity ahead of the deal’s closing, expected in the current quarter. The stock may get a lift subsequently, because arbitrage pressure will end and because Berkshire’s Class B shares, now trading around $3,320, will become more accessible to individuals after a 50-for-1 split that will drop the price to about $66.
It’s possible that Berkshire could be added to the S&P 500 when Burlington is removed, assuming that the deal clears antitrust hurdles. S&P has kept Berkshire out of the index due to concern about the stock’s liquidity. But the Burlington exit may give S&P an opportunity to reconsider. Joining the S&P 500 probably would boost Berkshire’s share price, as index funds, whose holdings mirror the index, buy the stock.
The Burlington deal doesn’t dent the investment case for Berkshire, which has a stock-market value of $155 billion. But it’s surprising to see Buffett parting with a stock that is at its lowest valuation in a decade to buy an asset that seems fairly valued, at best. Maybe the railroad business has better prospects than most people think.