Berkshire Buys Lubrizol

So Berkshire has announced its latest acquisition—Lubrizol (LZ).

In its latest 10-K, Lubrizol describes its primary business—lubricant additives (primarily for engine and driveline lubricants):

“We believe we are the market leader in lubricant additives, and we intend to remain the leader by continuing to invest in this business. Our Lubrizol Additives segment’s growth strategy is to continue to optimize our product mix while closely aligning production capacity with product demand. Challenging market forces and conditions continue to influence the Lubrizol Additives segment. A key factor is the low long-term global growth rate for this market, which we believe is in the range of approximately 1% to 2% per year.”

Pre-tax operating income in 2010 was $1B, on $5.4B in revenues—both records for the company. At an estimated purchase price of $9.7B (which assumes $0.7 net long-term debt), Berkshire is paying 10x pre-tax OI. And almost 4x shareholder equity.

Lubrizol’s gross profit percentage for 2010 was 33.1%, which also appears to be an all-time high. (2008 marked the five year low, at 22.3%; 2006 saw 24.6%.)

Lubrizol has earned very good returns on shareholder capital (excluding special items) in recent years. Its average return on shareholder equity for 2010 was 34.4%, also an all-time high.

I will not extend the theme, but the drift is clear: this purchase price is not a bargain for Berkshire, given Lubrizol’s results over the last five years. Any margin of safety then must lie solely in expected (and highly likely, one would presume) future performance. At minimum, I would think, Berkshire must expect revenues and margins to remain close to their 2010 performance, for at least the majority of the next decade.

Berkshire was not willing to offer LZ shareholders the option of Berkshire stock (as in the Burlington deal), so that should indicate Buffett’s thoughts on each’s relative value.

Longer term, LZ’s future revenues and earnings may face risks—if, e.g., 1) improved engine design increases drain intervals, 2) new vehicle purchases slow and stagnant, or 3) input costs (particularly petroleum) increase faster than expected.

Clearly, I’m missing some important piece of this puzzle.

Disclosure: I hold shares of Berkshire Hathaway.

Why Did Berkshire Stop Selling Moody’s?

[Warren Buffett recently entertained CNBC and its viewers in what now seems to have become an annual three hour session (transcript here).  Amid the inopportune interruptions and political meanderings, some interesting things emerged.  For one, the central reason why Berkshire has stopped selling Moody's...]

“BECKY:  That’s one of many questions that have come in, but we also have questions that have come in about Moody’s. Achit in Arizona writes in, “In your FCIC interview, you spoke of the inherent advantages of a duopoly that Moody’s and S&P share. Why does Berkshire continue to reduce its interest in Moody’s? Is there too much headline risk” for you?

BUFFETT: Well, I think that duopoly is in somewhat more danger than it was simply because people are mad at the ratings agencies and the ratings agencies totally missed what was going on in the mortgage market and that was a huge, huge miss. I don’t think they were, you know–I think they were just wrong, like a lot of people were wrong about in thinking that housing prices couldn’t go down a lot, but they were rating agencies and they’ve gotten a lot of criticism for it and their business model is sensational when it’s a duopoly. I mean, I have no bargaining power. I’m going to see Moody’s in the week or I think or something about our ratings.

BECKY: Mm-hmm.

BUFFETT: And you know, I dress up and do everything I can to, you know, talk about my balance sheet. But they–they’re God in the ratings field and Standard & Poor’s, and I need their ratings. And if they tell me the bill is X, I pay that, and if they tell me the bill is X plus 10 percent, I pay that. You know, if Coca-Cola charges too much, you know, you may think about drinking Pepsi Cola, but in the rating agency business, you need those two. And if that–either people get so upset with them or whatever it may be, or Congress gets upset, that could disappear. It won’t disappear from natural reasons. I mean, it is a natural duopoly, just like–it’s a little different than Freddie and Fannie were, but they also had some specific advantage. Sometimes you find situations where you get a natural–well, you used to have that in the newspaper business. You had a natural monopoly in big cities. It wasn’t–it wasn’t illegal, it just worked out that way.

BECKY: Mm-hmm.

BUFFETT : And that’s what happened in ratings agencies. But it’s not as bullet-proof as it was. Although, I will say that…

BECKY: Does that explain why you’ve been selling?

BUFFETT: Well, we haven’t sold that aggressively.

BECKY: Mm-hmm.

BUFFETT: I mean, if you look at it during the course of 2010, we sold a very small amount of the–it looked to me that that threat was receding to some degree. But it’s different than it was five years ago…” [Emphasis added.]

[A couple years ago, I suggested that Moody's Structured Products Group (SPG) would find it difficult to match past peak revenues ($873m in 2007).  In their latest 10-K, 2010 revenues from the Structured Finance Group appear down 5% v. 2009, to $291m.

In the meantime though, revenues from their Corporate Finance Group have held strong, and increased 38% YOY in 2010, to $564m.  Income before tax (for the whole company) was $714m in 2010, compared to $730m in 2008.  Despite a substantial revenue decline in their largest business line from 2008 to 2010, income before tax (for the company as a whole) has held relatively steady, even with a tarnished reputation.  So Berkshire will hold.]

Disclosure: none.

Financial Panics and Commercial Revulsions

Advance apologies for being two years late and perhaps a bit sour for today’s ebullient mood…

But a copy of “A Brief Popular Account of all the Financial Panics and Commercial Revulsions in the United States, From 1690 to 1857: with a More Particular History of the Two Great Revulsions of 1837 and 1857″ found my hands in recent days. (Google eBook here)

Written at a time when the United States’ “business system” was laboring under “difficulties” (i.e., 1857), the author endeavors to uncover “the causes of financial revulsions” and distinguish them from financial panics, with the ultimate aim of “prevent[ing] the recurrence of similar periods of panic and disaster.”

Whereas a panic “is a pressure in the money market without adequate cause,” a revulsion “is pressure with adequate cause, and that cause invariably is a previous Destruction of Value” (1).

In other words, “a national Revulsion is a national pay day.  The nation has been drawing on the Future, and the Future dishonors the draft.  The forcing process is then applied, widespread ruin is the result, and long period of paralysis ensues.”

A simple insight and a memorable analogy–business transactions flourish or cease, largely based on the beliefs we hold about the future.  Most of the time, our beliefs imperceptibly wax and wane; of course, when they change in an instant, we write a book about it.

Two Improbable Statements Before Breakfast

I ran across two stunning statements this morning in a press release from Contango Oil & Gas Company. The release announced that Contango had revised its oil and gas reserve estimates down by 48.5 Bcfe, to 300 Bcfe.

Regarding the revised estimates, Ken Peak, Contango’s Chairman and CEO, remarked:

“The downward reserve revision is an enormous personal disappointment. I know full well the complexities and numerous uncertainties of reserve estimation, especially early on in a field’s production history. Moreover, the impact of a downward revision is particularly acute when all the Company’s reserves are in essence concentrated in one reservoir. I have full confidence that our reserve estimates were prepared in a careful, conscientious manner and fully consistent with SEC and SPE guidelines. Nonetheless, it is right that the economic pain of this downward revision be shared, therefore, neither myself nor any Contango employee will receive a bonus or stock options for the fiscal year ending June 30, 2010.” (my emphasis added)

Lest the reader miss the economic impact of that statement, be it known that $2.47m of Peak’s $2.64m 2009 compensation derived from options and bonus pay. That’s an extreme pay cut–one of the largest self-inflicted I’ve ever seen (in terms of percentage).

Peak concluded with some commentary on the Gulf oil spill and its impact on Contango:

“The question on many minds these days is the impact of the Gulf of Mexico oil spill on the industry and in our case, Contango specifically. Obviously no one knows, but I will venture an opinion since it goes to the core of our business model and future. I am certain we will face increased regulatory and permitting costs and scrutiny. I believe we can deal with these challenges. I am certain we will face an increased emphasis on safety, and in particular, redundancy in “fail safes”. I welcome these new standards, but believe everything we are currently doing already meets a very high threshold of safety adherence. Hopefully, it is recognized and understood that no human endeavor is ever, and can never be made to be, absolutely, totally and flawlessly 100% fail safe.

“There are two areas that give me great concern. The first is the concept of unlimited environmental liability for a spill, or a limit so high that a debt-free company with an approximate $1.0 billion market cap like Contango is in essence, asked to “bet the Company” every time we drill a well. The move in recent days by some in Congress to retroactively change the law regarding environmental liability does not give me great confidence in our government. Nor do comments about “boots on throats”. The second area that causes great concern is the thought of going to jail for a judgment error or equipment failure – especially if the MMS approved the procedures that were being followed.

“There is at the moment, an enormous amount of understandable emotion and anger together with political populism spewing forth along with the Gulf of Mexico spill, but I believe, and hope, that once the spill is contained, that serious reflection and thought will be brought to bear on how the nation, coastal states in particular, and the livelihood of tens of thousands who depend on a vibrant offshore exploration industry, can beneficially coexist. Contango’s capital expenditure plans, even before this spill, were to “wait out” the upcoming hurricane season, so no adjustment to our capital expenditure plans is required.”

I’ll restrain any tendency to wax philosophical about contemporary political discourse and its relation to a nation’s moral fiber. Indeed pertinent facts still remain hidden from public view. What stands clear–the tone of our conversation today will shape the arc of an industry’s future.

Disclosure: no position

Seanergy Revisited

Over the last few months, many have asked for an update to our previous analysis of Seanergy Maritime. Since January, much has changed. Seanergy did follow through on its planned capital raise, which brought in $30m, but executed at a much worse price (about 1.2 per share) than we expected. A few days later, their plans to acquire a 2009 Capesize vessel were nixed. Though in May, Seanergy announced its new plans to acquire a 51% ownership interest in Maritime Capital Shipping Limited, of Bermuda (“MCS”) for a purchase price of $33m.  Last week Seanergy announced that the MCS deal had closed.  And the following day, they reported Q1 results.

In light of these changed conditions, anglers want to know—would you still “throw it back” at these prices? Frankly, I would.

On first glance, today’s $1.2 per price may appear cheap. With about 60m shares outstanding, and 1m warrants with strikes near these prices, Mr. Market values Seanergy’s equity at ~$73m.

Yet, following the close of the MCS acquisition (i.e., June 3rd), Seanergy’s total assets (including now a fleet of twenty vessels) are approximately $730 million, its total debt approximately $430.8 million, and cash reserves near $84.5 million. These numbers suggest a book value (ex-goodwill) near $4.6 per share. This discount to book has led Seanergy’s management to conclude that today’s price represents “a great entry point.” And according to management’s recent CC remarks, the Restis family (i.e., Seanergy’s majority shareholders) thinks today’s stock price is cheap as well.

Apparently, angling for this bargain need not be a lonely endeavor.

Though in principle I appreciate the support of fellow anglers, my reasons for casting back here are threefold:

1) Seanergy operates in an industry with very weak business franchises (see Buffett’s discussion here). Barriers to entry (or, at least, capacity expansion) are low, with banks today still lending a substantial portion of the cost for new ship construction. Consequently, new supply looks abundant. As of April 2010, the total world drybulk fleet could carry 475.6m Dwt. 2010 should see an additional 109.5m Dwt increase in global drybulk capacity (that’s 23%). And we’ll see 104.3m Dwt more capacity in 2011, with 74.4m Dwt more in 2012 and beyond (according to Clarkson Research Services). As Seanergy plainly acknowledges, the current dry bulk order book is 60% of the world fleet, and most of this will come online in the next 2.5 years. Though I won’t make any predictions about dry bulk rates for 2011, it’s hard for me to see the global shipping trade increasing at a rate sufficient to soak up this oncoming supply.

2) On a liquidation basis, Seanergy’s (now twenty) ships are likely worth less than their current $430m in total debt, and after accounting for minority interests. Run your own back-of-the-envelope calculations on their aging fleet, but recent amendments to their outstanding credit agreement with Marfin Bank of Greece show that their leash is tethered.

3) Even though their current market cap to EBITDA ratio may appear cheap, the metric ignores their significant debt load, and assumes that today’s corporate debt levels will be available in perpetuity. Better always, in my lights, to value businesses based on their enterprise value to EBITDA (or better yet, enterprise value to “owner earnings”).

Let’s say Seanergy earns 48m-60m EBITDA for 2010. If you bought the whole company at today’s market price of ~$1.2 per share, you’d be paying $72m for the equity (given 60m shares out), taking on the $430m in debt, and getting $85m in cash (as of 6/3/10). Call it $417m in enterprise value. For me, that’s not an attractive price to buy the business as a whole, particularly in an industry where depreciation is real and significant industry headwinds loom ahead.

Disclosure: no position

Trolling for Bargains

The daily troll for bargain securities will always produce a few nibbles. Yet, it is not until after the important and sometimes tedious work of reeling in requisite information that one actually gets a glimpse of his catch.

One nibble this week was Seanergy Maritime Holdings Corp (SHIP). Having shown up on The Graham Investor’s NCAV screen, and having seen the substantial stake owned by Pine River Capital management, I took a closer look.

According to its recent prospectus, Seanergy is an “international company providing worldwide transportation of dry bulk commodities through our vessel-owning subsidiaries and Bulk Energy Transport (Holdings) Limited, or BET. Our existing fleet, including BET’s vessels, consists of one Handysize vessel, one Handymax vessel, two Supramax vessels, three Panamax vessels and four Capesize vessels. Our fleet carries a variety of dry bulk commodities, including coal, iron ore, and grains, as well as bauxite, phosphate, fertilizer and steel products.”

On many metrics—price to book, price to net current assets, and price to owners earnings—Seanergy looks stunningly cheap. With a “hard” book value (ex-goodwill) near $210 m, the current market price near $2.5 per share implies that the company is worth only $83m (given its 33.26m shares outstanding, as of 1/7/10).

Plausible reasons may be offered for this apparent discount: a) a short operating history (having only been public since 2008), b) a significant debt load (with $278m in long-term debt at 9/30/09), and c) general uncertainty about global shipping rates in the near term. While each is important, none would lead this analyst to immediately toss it back.

That is, until one notices their recent preliminary prospectus from Jan. 11, 2010, in which Seanergy proposes to sell up to $33.75m in common stock (and grant warrants to the underwriters), in order to “purchase a 2009-built Capesize vessel for $89.5m pursuant to the terms of a memorandum of agreement entered into on December 16, 2009 with an unrelated third party.”

Though the prospectus is only preliminary, and the pricing has not yet been set, if the offering priced at current levels (near $2.5 per share), nearly 13.5m shares would be sold, and the outstanding share count would increase by more than 40%.

In some respects, such behavior seems standard fare—acquisitions are made, cash is raised, and revenues are grown. Yet, for the investor, the only real interest is the effect of such decisions on (per-share) business value. And here the investor should be sorely disappointed.

Before the proposed offering, the shareholder is able to purchase a claim on $6.30 per share in hard assets ($210m / 33.26m shares outstanding) at a nearly 60% discount (given a market cap of $83m). After the offering, that same shareholder—after having seen $33.75m added in equity to buy a $89m asset, with the remainder financed with debt—would have a claim on $244m in hard assets. But, given the increase in shares outstanding (to near 47m), that claim is now against only $5.2 per share in hard assets.

In other words, the buyer of shares today is likely to see the per-share value of his claim on Seanergy’s assets fall by nearly 20%, if the proposed offering goes through near today’s market prices. Of course, were Seanergy’s price to fall further, the damage to existing shareholders could be greater.

Most simply, there is only one way that the offering makes sense for a rational capital allocator–that is, if the desired Capesize vessel can be purchased at a greater discount than the current discount of Seanergy’s shares. Relative to Seanergy’s “hard” book value, its shares are currently trading at a greater than 60% discount. Even if Seanergy’s current “hard” book value overstates the value of its current ships by 50%, today’s share price would still represent a significant (perhaps 20%) discount to this lower figure.

So does Seanergy’s new proposed purchase meet this test? Is the new Capesize available at a 20% discount to its fair value? Using the proxy’s most recent estimates, a new Capesize was selling for about $58m in September 2009 (p. 126). Paying $89m for such a vessel hardly looks like a 20% discount.

Better throw this fish back.

Disclosure: None

Review: ‘Why Are We So Clueless about the Stock Market?’

Are you clueless about the stock market? Or perhaps better, could you admit to being clueless? For myself, as much as I purport to know about businesses, the stock market frequently baffles the mind. Reflecting the investing world’s immediate hopes, fears, beliefs, and dreams, the movement of prices seemingly offers a window into the shallower parts of our soul. Even for the seasoned observer, the market’s waves of euphoria and despair cast him reeling for clues–a narrative, a story–that can explain and predict its moves.

In the midst of the storm, Mariusz Skonieczny of Classic Value Investors offers the interested observer a map—Why Are We So Clueless about the Stock Market? (Investment Publishing, 2009)

Written with the beginning investor in mind, Skonieczny provides a compact, readable introduction that teaches how to analyze financial statements, value businesses, discern competitive advantages, and scout for bargains in the stock market. Skonieczny also puts his tools to the test by surveying four excellent businesses with durable competitive advantages—Burlington Northern Santa Fe, Thor Industries, Wells Fargo, and Moody’s. These case studies alone are worth the price of admission.

Throughout, I appreciated Skonieczny’s persistent attentiveness to economic moats and competitive advantages. Following Pat Dorsey’s The Little Book That Builds Wealth (Wiley, 2008), economic moats derive primarily from four sources—a) intangible assets, like brands, patents, and regulatory licenses, b) high switching costs, like that enjoyed by Alcon’s ophthalmological surgery equipment, c) network effects, enjoyed by services like Match.com, and d) cost advantages. While these four competitive advantages are rarely quantified on balance sheets, they provide a consistent tailwind for future business returns, particularly when measured over years and decades.

Of course, those same advantages—once fully utilized and recognized by the market—may encourage industry leaders into sloth. And sometimes the sleepy stumble and fall.

If I had one quibble with Skonieczny, it would be with his rather sanguine analysis of Moody’s. As we’ve worried about here and here, despite Moody’s regulatory imprimatur, network effects, and switching costs, their future looks much less certain than anytime since the 1930s. Whether too sleepy or greedy, Moody’s foray over the last decade into all manner of Wall Street’s structured financial products has tarnished its reputation, and perhaps more importantly, its cash flows. As late as 2007, structured finance ratings provided near half of Moody’s Investor Service’s revenues. And until the structured finance markets return (and assuming that they will), Moody’s will not be able to grow their earnings at the 10-20% that they—in the past—easily have.

All told, I enjoyed Why Are We So Clueless about the Stock Market? and would readily introduce it to family and friends interested in thinking about stocks as shares of a business.

Disclosure: None