Issuance of Equity
Berkshire and Blue Chip are considering merger in 1983. If
it takes place, it will involve an exchange of stock based upon
an identical valuation method applied to both companies. The one
other significant issuance of shares by Berkshire or its
affiliated companies that occurred during present management’s
tenure was in the 1978 merger of Berkshire with Diversified
Retailing Company.
Our share issuances follow a simple basic rule: we will not
issue shares unless we receive as much intrinsic business value
as we give. Such a policy might seem axiomatic. Why, you might
ask, would anyone issue dollar bills in exchange for fifty-cent
pieces? Unfortunately, many corporate managers have been willing
to do just that.
The first choice of these managers in making acquisitions
may be to use cash or debt. But frequently the CEO’s cravings
outpace cash and credit resources (certainly mine always have).
Frequently, also, these cravings occur when his own stock is
selling far below intrinsic business value. This state of
affairs produces a moment of truth. At that point, as Yogi Berra
has said, “You can observe a lot just by watching.” For
shareholders then will find which objective the management truly
prefers - expansion of domain or maintenance of owners’ wealth.
The need to choose between these objectives occurs for some
simple reasons. Companies often sell in the stock market below
their intrinsic business value. But when a company wishes to
sell out completely, in a negotiated transaction, it inevitably
wants to - and usually can - receive full business value in
whatever kind of currency the value is to be delivered. If cash
is to be used in payment, the seller’s calculation of value
received couldn’t be easier. If stock of the buyer is to be the
currency, the seller’s calculation is still relatively easy: just
figure the market value in cash of what is to be received in
stock.
Meanwhile, the buyer wishing to use his own stock as
currency for the purchase has no problems if the stock is selling
in the market at full intrinsic value.
But suppose it is selling at only half intrinsic value. In
that case, the buyer is faced with the unhappy prospect of using
a substantially undervalued currency to make its purchase.
Ironically, were the buyer to instead be a seller of its
entire business, it too could negotiate for, and probably get,
full intrinsic business value. But 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.
The acquirer who nevertheless barges ahead ends up using an
undervalued (market value) currency to pay for a fully valued
(negotiated value) property. In effect, the acquirer must give
up $2 of value to receive $1 of value. Under such circumstances,
a marvelous business purchased at a fair sales price becomes a
terrible buy. For gold valued as gold cannot be purchased
intelligently through the utilization of gold - or even silver -
valued as lead.
If, however, the thirst for size and action is strong
enough, the acquirer’s manager will find ample rationalizations
for such a value-destroying issuance of stock. Friendly
investment bankers will reassure him as to the soundness of his
actions. (Don’t ask the barber whether you need a haircut.)
A few favorite rationalizations employed by stock-issuing
managements follow:
(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?)
There are three ways to avoid destruction of value for old
owners when shares are issued for acquisitions. One is to have a
true business-value-for-business-value merger, such as the
Berkshire-Blue Chip combination is intended to be. Such a merger
attempts to be fair to shareholders of both parties, with each
receiving just as much as it gives in terms of intrinsic business
value. The Dart Industries-Kraft and Nabisco Standard Brands
mergers appeared to be of this type, but they are the exceptions.
It’s not that acquirers wish to avoid such deals; it’s just that
they are very hard to do.
The second route presents itself when the acquirer’s stock
sells at or above its intrinsic business value. In that
situation, the use of stock as currency actually may enhance the
wealth of the acquiring company’s owners. Many mergers were
accomplished on this basis in the 1965-69 period. The results
were the converse of most of the activity since 1970: the
shareholders of the acquired company received very inflated
currency (frequently pumped up by dubious accounting and
promotional techniques) and were the losers of wealth through
such transactions.
During recent years the second solution has been available
to very few large companies. The exceptions have primarily been
those companies in glamorous or promotional businesses to which
the market temporarily attaches valuations at or above intrinsic
business valuation.
The third solution is for the acquirer to go ahead with the
acquisition, but then subsequently repurchase a quantity of
shares equal to the number issued in the merger. In this manner,
what originally was a stock-for-stock merger can be converted,
effectively, into a cash-for-stock acquisition. Repurchases of
this kind are damage-repair moves. Regular readers will
correctly guess that we much prefer repurchases that directly
enhance the wealth of owners instead of repurchases that merely
repair previous damage. Scoring touchdowns is more exhilarating
than recovering one’s fumbles. But, when a fumble has occurred,
recovery is important and we heartily recommend damage-repair
repurchases that turn a bad stock deal into a fair cash deal.
The language utilized in mergers tends to confuse the issues
and encourage irrational actions by managers. 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.
The attention given this form of dilution is overdone:
current earnings per share (or even earnings per share of the
next few years) are an important variable in most business
valuations, but far from all powerful.
There have been plenty of mergers, non-dilutive in this
limited sense, that were instantly value destroying for the
acquirer. And some mergers that have diluted current and near-
term earnings per share have in fact been value-enhancing. 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).
A second language problem relates to the equation of
exchange. If Company A announces that it will issue shares to
merge with Company B, the process is customarily described as
“Company A to Acquire Company B”, or “B Sells to A”. Clearer
thinking about the matter would result if a more awkward but more
accurate description were used: “Part of A sold to acquire B”, or
“Owners of B to receive part of A in exchange for their
properties”. In a trade, what you are giving is just as
important as what you are getting. This remains true even when
the final tally on what is being given is delayed. Subsequent
sales of common stock or convertible issues, either to complete
the financing for a deal or to restore balance sheet strength,
must be fully counted in evaluating the fundamental mathematics
of the original acquisition. (If corporate pregnancy is going to
be the consequence of corporate mating, the time to face that
fact is before the moment of ecstasy.)
Managers and directors might sharpen their thinking by
asking themselves if they would sell 100% of their business on
the same basis they are being asked to sell part of it. And if
it isn’t smart to sell all on such a basis, they should ask
themselves why it is smart to sell a portion. A cumulation of
small managerial stupidities will produce a major stupidity - not
a major triumph. (Las Vegas has been built upon the wealth
transfers that occur when people engage in seemingly-small
disadvantageous capital transactions.)
The “giving versus getting” factor can most easily be
calculated in the case of registered investment companies.
Assume Investment Company X, selling at 50% of asset value,
wishes to merge with Investment Company Y. Assume, also, that
Company X therefore decides to issue shares equal in market value
to 100% of Y’s asset value.
Such a share exchange would leave X trading $2 of its
previous intrinsic value for $1 of Y’s intrinsic value. Protests
would promptly come forth from both X’s shareholders and the SEC,
which rules on the fairness of registered investment company
mergers. Such a transaction simply would not be allowed.
In the case of manufacturing, service, financial companies,
etc., values are not normally as precisely calculable as in the
case of investment companies. But we have seen mergers in these
industries that just as dramatically destroyed value for the
owners of the acquiring company as was the case in the
hypothetical illustration above. This destruction could not
happen if management and directors would assess the fairness of
any transaction by using the same yardstick in the measurement of
both businesses.
Finally, a word should be said about the “double whammy”
effect upon owners of the acquiring company when value-diluting
stock issuances occur. Under such circumstances, the first blow
is the loss of intrinsic business value that occurs through the
merger itself. The second is the downward revision in market
valuation that, quite rationally, is given to that now-diluted
business value. For current and prospective owners
understandably will not pay as much for assets lodged in the
hands of a management that has a record of wealth-destruction
through unintelligent share issuances as they will pay for assets
entrusted to a management with precisely equal operating talents,
but a known distaste for anti-owner actions. Once management
shows itself insensitive to the interests of owners, shareholders
will suffer a long time from the price/value ratio afforded their
stock (relative to other stocks), no matter what assurances
management gives that the value-diluting action taken was a one-
of-a-kind event.
Those assurances are treated by the market much as one-bug-
in-the-salad explanations are treated at restaurants. Such
explanations, even when accompanied by a new waiter, do not
eliminate a drop in the demand (and hence market value) for
salads, both on the part of the offended customer and his
neighbors pondering what to order. Other things being equal, the
highest stock market prices relative to intrinsic business value
are given to companies whose managers have demonstrated their
unwillingness to issue shares at any time on terms unfavorable to
the owners of the business.
At Berkshire, or any company whose policies we determine
(including Blue Chip and Wesco), we will issue shares only if our
owners receive in business value as much as we give. We will not
equate activity with progress or corporate size with owner-
wealth.
Miscellaneous
This annual report is read by a varied audience, and it is
possible that some members of that audience may be helpful to us
in our acquisition program.
We prefer:
(1) large purchases (at least $5 million of after-tax
earnings),
(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
“turn-around” situations),
(3) businesses earning good returns on equity while
employing little or no debt,
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we
won’t understand it),
(6) an offering price (we don’t want to waste our time or
that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
We will not engage in unfriendly transactions. We can
promise complete confidentiality and a very fast answer as to
possible interest - customarily within five minutes. Cash
purchases are preferred, but we will consider the use of stock
when it can be done on the basis described in the previous
section.
* * * * *
Our shareholder-designated contributions program met with
enthusiasm again this year; 95.8% of eligible shares
participated. This response was particularly encouraging since
only $1 per share was made available for designation, down from
$2 in 1981. If the merger with Blue Chip takes place, a probable
by-product will be the attainment of a consolidated tax position
that will significantly enlarge our contribution base and give us
a potential for designating bigger per-share amounts in the
future.
If you wish to participate in future programs, we strongly
urge that you immediately make sure that your shares are
registered in the actual owner’s name, not a “street” or nominee
name. For new shareholders, a more complete description of the
program is on pages 62-63.
* * * * *
In a characteristically rash move, we have expanded World
Headquarters by 252 square feet (17%), coincidental with the
signing of a new five-year lease at 1440 Kiewit Plaza. The five
people who work here with me - Joan Atherton, Mike Goldberg,
Gladys Kaiser, Verne McKenzie and Bill Scott - outproduce
corporate groups many times their number. A compact organization
lets all of us spend our time managing the business rather than
managing each other.
Charlie Munger, my partner in management, will continue to
operate from Los Angeles whether or not the Blue Chip merger
occurs. Charlie and I are interchangeable in business decisions.
Distance impedes us not at all: we’ve always found a telephone
call to be more productive than a half-day committee meeting.
