Published by Nick McCullum on July 11th, 2017
“I hate cash. I mean we are investing. But [cash] is a holding position until you find something else. But the very fact that interest rates are that low makes it hard for us to buy other things because other people buy things with borrowed money, and borrowed money is so cheap.”
– Warren Buffett in a CNBC interview, May 2017
Warren Buffett has been lamenting equity valuations for some time now. This has prevented him from finding any compelling buying opportunities for his Berkshire Hathaway (BRK.A) (BRK.B) investment portfolio.
In the same interview quoted above, Buffett said that Berkshire is always looking to ‘buy a big business’. It appears that that opportunity has finally arrived.
On Friday, Berkshire announced a $9 billion cash offer to acquire Oncor, a Texas-based electric utility currently navigating through prolonged bankruptcy proceedings.
This is welcome news for Berkshire Hathaway investors. Berkshire Hathaway’s cash account has ballooned to ~$80 billion over the past several years, a substantial sum that is earning little return in today’s low interest rate environment.
Because of Berkshire’s cash position, the Oncor acquisition comes at an opportune time. This article will analyze the rationale behind Berkshire Hathaway’s acquisition of Oncor in detail.
Buffett is known for buying companies when they are experiencing some sort of temporary distress.
This Oncor purchase is no different.
Oncor’s parent company – Energy Future Holdings – is working through bankruptcy proceedings that have lasted for three years.
Energy Future Holdings was created in 2007 in a $45 billion leveraged buyout – the largest ever at the time. The formation of Energy Future Holdings and the entity’s later success was highly dependent on natural gas prices.
During the financial crisis, natural gas prices plunged and failed to meaningfully recover (partially due to the introduction of fracking).
The price of natural gas since Energy Future Holdings’ inception can be seen below.
Now that the company is bankrupt, Buffett is swooping in to buy the company’s distressed assets and energy distribution network on the cheap.
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”
Buffett’s bid came after two other suitors, Hunt Consolidated and NextEra Energy, already presented bids but were declined approval from the Texas Public Utility Commission.
Why Is Buffett Buying Oncor?
The Oncor purchase has many of the characteristics of a typical Buffett investment.
First, Berkshire is acquiring this business at a very attractive valuation.
Berkshire’s cash offer for Oncor’s parent company is $9 billion. Including the assumption of debt, the deal has a total enterprise value of just below $18 billion.
Those familiar with the acquisition have stated that Berkshire’s bid is about $1 billion less than the $18.4 billion proposal brought forward by NextEra Energy earlier this year.
As mentioned in the introduction, Buffett’s $9 billion cash consideration also helps to reduce Berkshire’s massive cash pile, which he has been eager to deploy for some time. It still leaves Buffett with plenty of dry powder, as he prefers to have about $20 billion of cash and Berkshire’s current cash and equivalents account sits at ~$80 billion.
More specifically, Berkshire had $86.4 billion in cash and equivalents at the end of 2016 and $79.4 billion of cash and equivalents at the end of 1Q2017.
Since the financial crisis (when Berkshire prudently deployed much of its cash), rising valuations across the market has led the company’s cash pile to expand noticeably (shown below).
In another typical Buffett move, Oncor will be managed by competent and trustworthy executives.
Normally, Buffett prefers to acquire businesses with highly skilled in-house executives, welcoming them to the Berkshire team after he acquires their business. The Oncor acquisition is different in this regard (although the new unit will still be managed by an experienced Berkshire leader).
Energy Future Holdings has shaken up its top ranks noticeably during the bankruptcy proceedings, so management expertise is not likely a key motivator behind this transaction.
Instead, Oncor and Energy Future Holdings will join Berkshire Hathaway Energy, led by Greg Abel. Abel is one of Buffett’s most seasoned executives and has been seen as one of Buffett’s likely successors (along with insurance head Ajit Jain).
Third, the company being acquired holds an entrenched position in its industry and benefits from a considerably low-risk business model.
Oncor is Texas’ largest electric-transmission operator and the sixth-largest electric utility in the nation. The company delivers power to more than 3 million homes and businesses and operates more than 117,000 miles of transmission and distribution lines throughout Texas.
Interestingly, the Oncor purchase might be a bit personal for Buffett. The Oracle of Omaha lost $873 million pre-tax on Energy Future bonds back in 2013. Here’s what he wrote about the situation in Berkshire Hathaway’s 2013 Annual Report:
“In addition to our equity holdings, we also invest substantial sums in bonds. Usually, we’ve done well in these. But not always.
Most of you have never heard of Energy Future Holdings. Consider yourselves lucky; I certainly wish I hadn’t. The company was formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas. The equity owners put up $8 billion and borrowed a massive amount in addition. About $2 billion of the debt was purchased by Berkshire, pursuant to a decision I made without consulting with Charlie. That was a big mistake.
Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014. Last year, we sold our holdings for $259 million. While owning the bonds, we received $837 million in cash interest. Overall, therefore, we suffered a pre-tax loss of $873 million. Next time I’ll call Charlie.”
Source: Berkshire Hathaway 2013 Annual Report, page 17
All said, the Oncor acquisition has many of the characteristics of a Buffett investment: great value, strong management from Berkshire’s existing energy leadership, and the favorable economics of the regulated utility industry.
Implications For Berkshire Hathaway
For Berkshire Hathaway shareholders, the main implication of Berkshire Hathaway’s acquisition of Oncor is Buffett’s continued focus on growing his energy business.
Energy was Berkshire Hathaway’s third most profitable segment in fiscal 2016 (as measured by net income), behind BNSF and Manufacturing.
Berkshire’s energy business has grown considerably over the past several years. In fact, the segment’s earnings have more than doubled since 2009.
Source: Bloomberg Markets
Berkshire’s Oncor acquisition also reflects Buffett’s continued bullishness on the domestic economy.
Buffett has long maintained that betting against U.S. economic growth is a mistake. With the $9 billion acquisition of America’s sixth-largest utility, he is putting his money behind this claim.
Buffett is not the only multi-billion dollar investor who is interested in Oncor.
There are currently rumors suggesting that activist investment firm Elliott Management Corporation is planning a bid that will surpass Buffett’s $9 billion all-cash offer.
Elliott has a vested interest in taking over the company. It is the largest creditor to Oncor’s parent company Energy Future, holding $2.9 billion of deeply distressed debt that was acquired between October and May.
While the legal details of Elliott’s status as an Oncor creditor are complicated, it is possible that Elliott can use its status as Oncor’s largest creditor to block Berkshire’s acquisition proposal.
This would be highly undesirable for Berkshire. It introduces the possibility that Berkshire’s bid will not be successful. Buffett has stated that he prefers to avoid bidding wars where possible, as it increases the probability that he overpays for an investment.
Arguably, an investment from Elliott would also be far more disruptive to Oncor’s business.
Elliott is a notoriously disruptive investment firm, known for a battle with the government of Argentina over dishonored debt that lasted more than a decade. When the Argentine president Cristina Kirchner attempted a massive debt restructuring, Elliott refused and sued the country in U.S. courts. Eventually, the lawsuit led to the detainment of an Argentine naval training vessel with a crew of 220, pressuring the country to settle for $2.4 billion – four times Elliott’s original investment.
So far, Elliott’s disruptive investment strategy has been successful. This can be seen in the ease that the firm raises capital. In May of this year, the fund raised $5 billion in 24 hours to compliment its existing asset base of ~$33 billion.
While Elliott Management is presenting a small threat to the successful completion of this acquisition, I believe that it is unlikely that Buffett’s intended acquisition is not completed, primarily because of the hefty breakup fees embedded in the offer contract.
More specifically, Energy Future Holdings would have to pay Berkshire Hathaway a $270 million breakup fee if the merger is not completed (subject to some conditions).
This comes after the holding company is set to pay a $275 million breakup fee to NextEra Energy after its failed acquisition attempt (unless Energy Future Holdings or its creditors can convince the bankruptcy judge to rule otherwise).
After investigating Oncor’s business and the terms of Buffett’s deal, it is not surprising that the Oracle of Omaha has agreed to acquire this business.
The transaction has many classic Buffett characteristics. Berkshire is acquiring the company during a period of financial distress for a solid valuation and is integrating the business into Berkshire’s successful energy enterprise.
With that said, investors should watch closely to see the impact of a potential counterbid from Elliott Management Corporation.