Behind Buffet's Lubrizol deal; A bit of a gamble

Berkshire Hathaway’s USD 9 billion cash bid for U.S. specialty chemical company Lubrizol on March 14 is not classic Warren Buffet value investing, as several commentators said, but rather a big bet on a structural change in Lubrizol’s future operating margins.

By many classic value metrics Lubrizol would not be an attractive investment, so the deal looks to have been structured around two data points and a dinner between Lubrizol CEO, James L. Hambrick and former crown prince of Berkshire Hathaway, David Sokol.

When we first looked at the Lubrizol numbers we could not get our heads around the deal. According to our Benjamin Graham-based valuation model the offer did not make sense. Our valuation came in the range of USD90 to USD100 per share depending on the assumptions about growth and profitability. Needless to say, the range was far lower than the Sage of Omaha’s “elephant gun” bid at USD 135 per share.

Looking at Lubrizol’s EBITDA-margin since 1987, as we have done in the chart below, we would expect a value investor to carry the average of the last five years into the next five - around 15.6 percent. For Buffet’s bid to make sense, however, the last two above average data points must have been extrapolated into the future.

 Also, over the last 20 years or so, inflation-adjusted earnings per share and the share price have not exactly indicated this company is the new Coca Cola. Earnings and the share price have been moribund until the last two years, and the company made a loss in 2008. Value investors would normally steer clear from these warning signs and not get carried away by the euphoria of two years’ earnings.

The key to Berkshire’s bid, therefore, lies not in value investing, but in what David Sokol said about the lead-up to the deal in the now infamous CNBC interview March 31. Sokol explained what Buffet initially said of the move: “I am not sure it makes economic sense”. Indeed, Buffett sent Standard & Poor’s company fact sheet to David Sokol just before the latter’s dinner with Hambrick highlighting the last two years’ operating margins and questioning whether they were sustainable. Well, he obviously got his answer!

Lesson learned… Private equity (which is a considerable activity for Berkshire Hathaway) is a valuable strategy when used the right way. You get information not otherwise easy to obtain or interpret from public information.

But the rich bid is still a bit of a gamble for the ‘Sage’. Yes, ignoring the future operating margin sustainability conversation, Lubrizol is interesting because it has pricing power in an industry with very few players. It manufactures and sells specialty chemicals used in various industries such as transportation, industrial and consumer markets. But is that still enough to produce above 22 percent EBITDA-margin in the future?

Time will tell. But according to Sokol in the CNBC interview, this structural change in operating margins is what you have to get comfortable about. Buffet is.