Berkshire’s Fishing Expedition Pays Off By Bill Mann (TMF Otter) Three years ago, Berkshire Hathaway (NYSE: BRKa)(NYSE: BRKb) put together a unique financing deal, selling negative-coupon bonds called SQUARZ. These bonds, somewhat unique in that their holders pay Berkshire while they own them, were not offered because Berkshire needed the money.
Warren Buffett, Berkshire’s chairman, said at the time that he did the deal mainly to raise the profile of his company among a very specific constituency: business owners who might be inclined to sell their firms. As a subset, Buffett specifically singled out international businesses.
Dear Thomas Kostigen: Still think Buffett doesn’t use “advanced techniques”? Man, a negative-coupon bond that’s meant to attract whole businesses? Top that.
Well, apparently the phone finally rang, and Berkshire is getting the chance to deploy a chunk of its $46 billion war chest. Overnight, MidAmerican Energy, 80% owned by Berkshire and the largest electric utility in Iowa, announced that it has purchased electric utility PacifiCorp for a combined cash and debt assumption price of $9.4 billion. The seller in this case is an international company, Scottish Power (NYSE: SPI). PacifiCorp has 1.6 million electric and natural-gas customers and operates under the name Pacific Power in California, Oregon, Wyoming, and Washington, and Utah Power in Utah and Idaho.
One of my colleagues immediately noted to me that it must be bittersweet for companies to sell to Warren Buffett, since they know that he never overpays. In this case, there are plenty of reasons why Scottish Power would be motivated to sell PacifiCorp, and both counterparties have reason to believe they got a good deal. Scottish Power has been motivated to back out of its American subsidiary, which has expressed the need to focus on its core components. Several thousand miles away and without much hope of synergy with the parent company, PacifiCorp certainly did not fit this description.
For Berkshire’s part — and specifically for MidAmerican’s — capturing PacifiCorp fulfills a long-stated company ambition to expand its energy and utility franchise, something that has been hindered by the existence of PUHCA, the Public Utility Holding Company Act.
The deal breaks down into a cash component of $5.1 billion, plus the assumption of $4.3 billion in PacifiCorp debt. Given Berkshire’s AAA credit rating, PacifiCorp’s borrowing costs on that debt are almost certain to drop as the company refinances.
According to Scottish Power documents, PacifiCorp earned about $914 million in operating profits in 2004. If PacifiCorp is paying 9% on its debt, that comes to an annual servicing of $387 million. Berkshire will be able to lower that cost of service by at least $100 million per year. Operating profits, of course, are pre-tax and pre-depreciation, so the actual number of cash-on-cash return is somewhat lower. Still, MidAmerican Energy owns diverse properties like CalEnergy — which cooperates with FX Energy (Nasdaq: FXEN) in natural-gas development projects in Poland — as well as Kern River Gas Transmission and Northern Natural Gas Company, not to mention its core Iowa utility operations. All of these may have some synergies with PacifiCorp, a potential benefit that Scottish Power completely lacks.
But if we use last year’s numbers for PacifiCorp, we have to conclude that the after-tax return to Berkshire is below 10% (the annual earnings divided by the cash purchase price). This is somewhat low, but it speaks to a few things: the near inevitability of returns from well-run utilities, the potential for operational and capital-structure improvements at PacifiCorp, and, perhaps, a prime example of just how hard Berkshire has struggled to deploy its billions in liquid assets. Think about this: Buffett could pull the trigger on five more deals the size of PacifiCorp and still have money he’d need to deploy.
But his no-cost honey deal from three years ago seems to have attracted a bee or two