No. of Recommendations: 3
" The OxyChem Deal Is The Perfect Model
First, the context has to be right. Then the market sector has to be right. Then you must have the specific opportunity. It's ideal to seize a moment when the other side needs the deal (Dominion, for example, which wanted to shift focus in its business) as well as Alleghany and Pilot Flying J (the owners of both wanted to get out). The business must be stable and predictable and have a high likelihood of decent return over the long term. It may be dull and unsexy, but historically the tortoise often beats the hare, as demonstrated by the fact that in the very long term, value has beaten growth. In any case, it has to promise bond-like stability with returns high enough to produce better returns, which will beat super-safe income from Treasuries of any duration. The OxyChem deal checks all the boxes.
It's important to note that three of the four acquisitions named above are non-primary parts of a business sector that function almost as toll-bridges. In the energy sector, the big money is in exploration and production, while processing, transportation of the product, and production of dozens of basic and specialty chemicals are more or less a side business, which is highly stable but capital intensive with a strong barrier to entry along with a steady but modest rate of return. One way to look at the OxyChem deal is that it mainly shuffles the ownership of an overall asset of which Berkshire Hathaway already owns a major share of all parts of the asset. What the deal does is to separate the risky but in the long run more profitable EP side of Occidental from the stable and moderately profitable side, which produces dozens of products requiring energy as an input.
From the perspective of Occidental, the OxyChem deal swaps the chemical business for the earlier acquisition of CrownRock assets in the Permian Basin acquired 14 months ago. The cash prices are $9.1 billion OXY paid for CrownRock assets versus the $9.7 billion Berkshire is paying for OxyChem. The additional roughly $3 billion in shares OXY paid for CrownRock could be seen as offsetting legal liabilities, which will remain with Occidental. In effect, Occidental is swapping a more stable and defensive business for a higher-risk, higher-reward part of the energy sector. In the process it will pay down the debt occasioned by the CrownRock purchase, thus offsetting some of the added EP risk by getting its debt down to the $15 billion goal, which was set before paying a chunk of cash for CrownRock. Thus the OxyChem deal not only reduces overall risk but also reorganizes the two parts of the deal in a way favorable for both sides.
Berkshire Hathaway, on the buyer side of the deal, acquires a safe and dependable business with a return on capital likely in the 8%ish area and likely to improve as its business is currently near the trough. Berkshire's cash for the deal will come from T-bills currently yielding a bit under 4%, but with Fed rate cuts likely to reduce that yield promptly and continue lowering short-term rates for a year or two. With the net increase of return - from just under 4% (likely to be cut in half again within a year) to 8% for OxyChem in the same time period. The return advantage very much justifies the minuscule increase in risk.
When you think of the deal in its totality, it explains one thing that Buffett and Occidental CEO Vicki Hollub did not do. Several articles have expressed disappointment that the deal didn't include a tax-free swap of Berkshire's $10 billion of preferred stock paying 8% for a large part of the OxyChem price. Yes, that would erase an annual payment of $800 million to Berkshire, but the cash payment of $9.7 billion, even after taxes, goes a long way toward matching that number while enabling OXY to reach its very important goal of debt reduction to $15 billion. Buffett, on the other hand, would be reluctant to relinquish an asset like the preferred stock with a yield well above any safe asset offered elsewhere and backed by Occidental's improved debt level, which upgrades the quality of its debt. Not swapping the preferred stock for OxyChem was the right non-action from the perspectives of both deal partners.
In the large perspective, the structure of the OxyChem deal is one of those Buffett actions that show wily macro thinking and an ability to look through the cold numbers of accounting to grasp the larger implications for the outcome. In several letters and essays, Buffett has written about the importance of understanding accounting which he describes as "the language of business" in order to be a successful investor. Buffett's detailed command of accounting was crucial to the way he managed to shuffle the location of different units of Occidental in a way that made 2 plus 2 add up to 5 in a way that allowed both parties of the deal to profit.
Can You Piggyback Buffett?
On first thought the answer is obviously no. You can't organize an asset swap to work wonderfully and profitably using two companies in which you have partial ownership. As you see, it took some complicated thinking. It also took two entities with complementary goals and reasons to trust the other. It's obvious that nothing you do in buying individual stocks can match that.
On second thought, however, the OxyChem acquisition is a model for the way to invest when the market as a whole is overpriced. Along with the list above, it serves as an example of the kind of asset you might want to buy when the market is overpriced but too much low-return cash is burning your pockets. The secret is to take the basic rule of investing, which is to look at absolute value and ignore what the market thinks at a given moment. A business that is safe and pumps out a solid and growing amount of cash will always serve you well in the long run. That's the Buffett model, and it applies equally well to acquisitions and purchases of publicly traded stocks.
Unlike an acquisition, the market price for an individual stock will fluctuate with shifting levels of perceived value, but the only factor that matters is careful analysis of absolute value based upon present and future cash flows and a solid estimate of the long-run prospects of the business. I'm well aware that one or two analysts on this site, for whom I have respect, take a different approach to stock prices. It's clear that the two sides of the OxyChem deal had good reason for differing views of the relative value of OxyChem, but both had a clear understanding of absolute value, ignoring the market opinion while differing only in their own situation with respect to context and risk.
This article was written by
Jim Sloan
22.83K Followers
I am a retired professor, a retired investment adviser, and"
https://seekingalpha.com/article/4831011-berkshire... 