Street Capitalist: Event Driven Value Investments

For years Berkshire Hathaway (NYSE:BRK.A) has held two core positions in financial firms: Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP). One of the things I did when the financial crisis began is put these two companies on my watch list. I thought that if they were good enough for Warren Buffett, maybe they could be good enough for me, especially if they experienced any sudden drops in their stock prices.

For much of the crisis, Buffett remained close lipped about his investments in either of these two companies. In the last 13F-HR filing, there appeared to be no addition to either of them. But today, on CNBC, Buffett announced a couple of things that I would take as positives for Wells Fargo:

[Buffett] told Becky that the Wachovia deal was indirectly spurred by a recent change in the tax laws. Buffett also praised Wells and its CEO, Bob Steel, saying no bank has done a better job for shareholders and depositors during the financial crisis.

He noted that he owns only two domestic stocks personally, Berkshire and Wells, and revealed that Berkshire has been adding to its Wells Fargo holdings over the year.

Warren Buffett to CNBC: Rescue Bill Not “Panacea” for Economy (CNBC)

So we now know that he’s been adding to the position and it’s actually the only domestic stock besides Berkshire that he’s holding personally. This is a pretty strong vote of confidence for the company, who is currently trying to acquire Wachovia (NYSE:WB). For much of the crisis, Wells Fargo has stayed out of the limelight of the big acquisitions we’ve seen. John Stumpf of Wells Fargo is a pretty sharp guy who is managed to create a great culture that has been conservative when compared to the rest of the excesses that have sickened the banking industry.

To get an idea for how he thinks, look at this article from the Financial Times:

In an interview with the Financial Times, Mr Stumpf quashed repeated speculation that Wells, the fifth-largest US bank, would take advantage of the collapse in the shares of many rivals to clinch a big deal.

“A large transformational [deal] is highly unlikely. Not impossible, but highly unlikely,” he said.

“We don’t need to do a deal. Organic growth is the core growth engine in this company.”

…

“We come from a culture where bigger is not better. You get bigger by being better, you don’t get better by being bigger,” he said, adding that Wells was also unlikely to stray from its western focus by buying on the East Coast.

Wells Fargo rejects speculation over deal for a struggling rival (FT)

Here’s more about Stumpf and the Wells Fargo culture from another FT article:

When, in the heady markets of 2005 and 2006, Mr Stumpf was staring down a different kind of barrel, he chose a similarly prudent route for the fifth largest bank in the US.

Faced with deciding whether to follow Wells’ rivals in selling lucrative securitised debt and subprime loans with few strings attached, Mr Stumpf and Dick Kovacevich, his long-time mentor who hand-picked him as successor in June last year, concluded the high risks did not justify the potentially high rewards…

“You can imagine the pressure on us. We were the number one mortgage originator and we had to give up market share and earnings,” Mr Stumpf says. “[But] it is more difficult to attend a party and leave before the trouble starts than not to attend the party at all. Part of my job here is to make sure we don’t attend parties that make no sense.”

With his laid-back delivery and penchant for catchy metaphors – traits he shares with Warren Buffett, his occasional bridge opponent and Wells’ largest shareholder – the 54-year-old Mr Stumpf makes Wells’ escape from the crisis sound easy. The reality is that the lender’s bold counter-cyclical call saved the company from the worst US housing bust since the Great Depression…

Asked to identify the biggest change he has introduced since taking over the CEO job from Mr Kovacevich, who is staying on as chairman until December, his brisk response is “None”. Noting that he has been with the company for more than 20 years, he adds: “There is no sea-change. I am fully invested in the culture, and one of my roles here is as the keeper of the culture…I don’t have any passion or ego to put my mark on the company. This is about sticking to our knitting”…

A strong balance sheet, an enviable competitive position and a satisfied workforce: Wells is such an outlier in the ravaged US financial sector that rivals have begun to wonder if it has a secret formula.

Mr Stumpf shakes his grey-haired head: “It’s about culture. I could leave our strategy on an aeroplane seat and have a competitor read it and it would not make any difference”.

Wells Fargo cracks the whip (FT)

I can’t say if the deal with Wachovia is a good deal for Wells Fargo (the pains of integration post-merger) or will even go through. As you know, Citigroup tried to buy the company with assistance of the US Government at a substantially lower price. If I had to bet though, I would say that the Wells Fargo deal has a greater likelihood of passing, simply because it doesn’t rely on assistance from the government. If Citigroup revises their bid to include that, there could be a good bidding war for Wachovia and its $448 billion in deposits.

Apologies for the blog being quiet this week. I’ve been following most of the bailout news that’s come out. The revised plan seems better (the added pork — not so much). From the voting numbers, it appears to have passed:

WASHINGTON – The House voted 263-171 to pass the $700 billion financial-markets rescue bill, two days after the Senate passed the legislation. Several prominent members of the House who voted against the measure Monday announced their support for the revised bill, giving it well more than the the 218 votes needed.

Earlier, House Republican leaders expressed confidence about the prospects for the House vote, but had stopped short of predicting the legislation would pass.

House Passes Bailout Bill (WSJ)

I know that there was some doubt out there about whether we needed a bailout or if it would be possible to wait longer. Warren Buffett indicated that it really needed to happen soon, or the problems could quickly become worse, even saying that he might have to go back to his paper route! I think the way he put it best in his interview with Charlie Rose:

Charlie Rose:

So we come down to the close of this conversation and you have been warning
us about certain kinds of things. I hear from this conversation too this
plan is essential now. Otherwise we’re in a very, very difficult place and
each week we go beyond not doing something we get deeper and it becomes more
irreversible.

Warren Buffett:

And, yeah, whoever said, you know, an ounce of prevention is worth a pound
of cure understated it and I you know a pound of cure that’s delayed another
six months is going to need a ton of cure later on I mean it would be crazy
not to do this. It will not produce dramatic results though in the economy.
That’s what people have to understand. You’re going to see unemployment go
up. You know, you’re going to see lousy earnings in many businesses. And
they’re not –

Charlie Rose:

You’re going to see people unemployed.

Warren Buffett:

You’re going to see more people unemployed. But the difference Charlie if
we bottom this thing out at seven percent unemployed versus nine percent,
that’s three million people, that’s three million people that if we do it
wrong you know lose their jobs unnecessarily in my view I mean you know I’ve
never been unemployed. I’ve never been very fully employed either but just
think of what it’s like, you know, to go home with a mortgage payment you
know and kids and everything else. My dad had that happen to him in the
early ’30s. It you know you don’t want to create three million people more
unnecessarily. But I don’t think you –

Charlie Rose:

That’s the depression –

Warren Buffett:

It really is. And you can’t help some increase from this point. I don’t
want any viewer to go away think a magic wand exists in Congress. So they’re
going to see some more bad news. But if we do this, we’re doing the right
thing. And if — the system will work over time. There’s no — we got a
wonderful system.

I’d recommend the whole interview to anyone who’s interested, a link can be found here.

While Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) has mostly come out with praise for Henry Paulson’s bailout plan, he has reserved some criticism aimed at the “hold-to-maturity” price that tax payers would be footing the bill for:

JOE: It’s just that, you know, they want these details, Warren. They said — Paulson says there’s the hold-to-maturity price and there’s the firesale price. We’re going to go somewhere in between, get a much better price but still leave enough for the people that are buying it to make some money. That can be done in principle? There’s a way to do that, do you think?

BUFFETT: I think what I would be looking for -- I heard that hold-to-maturity price. I’m not as excited about that. I basically like a market, or something very close to a market-related price. And there are ways to determine that and I don’t think that Uncle Sam should be in the business of paying somebody a whole lot more than it’s worth in the market today. And if the guy that bought it doesn’t like it, he doesn’t have to sell it, and it was his problem, he bought it in the first place. I think a market price will enable people to be leveraged. The problem they have now is that some of the institutions, they’re loaded with this stuff, they’re having trouble funding, and they’re worried about being able to sell a ton of it. But take the Merrill Lynch deal. Merrill Lynch had to take back 75 percent of the sales price. Well, they didn’t want to take back that 75 percent. I would let ‘em sell it for the same price, but I’d pay them the whole thing in cash. So they’d be a lot better off if they could have sold the whole thing at that same price but gotten paid a hundred percent in cash instead of having to take back 75 percent. And I see the government fulfilling that kind of a function.

CNBC INTERVIEW TRANSCRIPT & VIDEO, Part 3: Warren Buffett Explains His $5B Goldman Investment (CNBC)

We know that Buffett announced his investment in Goldman Sachs (NYSE:GS) shortly after details about the bailout plan actually emerged. It’s easy to see why. The government would be purchasing the cancerous toxic assets that have infected financial institutions and forced them to write down their values. Buying these assets at fire sale prices makes sense, even Buffett thinks that there may be opportunities in this area and on CNBC expressed that he would love to have $700 billion to go buy them up.

Unfortunately though, fire sale and hold-to-maturity prices are quite different and are likely to be spread vastly apart. It’s simple to see why he’s not enthusiastic about this aspect of the bailout plan. Warren Buffett is a value investor, he hunts for bargains. Bargain hunting means investing in securities with a sufficient margin of safety or the spread between what a security is selling for and its intrinsic value. Investors usually wish to find wide margins of safety in case something unintended happens, perhaps a problem grows worse than you expect or that you overlooked some aspect of the company your analysis.

The lack of market prices reduces any margin of safety that the government could obtain on these assets and puts taxpayer money at risk for losses. The folks in Washington should try to do something to avoid it. So far, Congress seems to be resisting Paulson’s plan and may have some room to make modifications. They seem to be fighting for basically a few added options - equity stakes in the companies that are bailed out, market pricing, and curbed executive pay. I can see the merits in the first two, equity stakes would provide the government with an upside when bailing out these financial firms. After all, once those toxic assets are taken away many of these companies have nice businesses.

I feel like the executive pay idea is a little too rhetorical and may be too small of a problem when compared to everything else Congress has to worry about. Plus there is the added risk that Congress would waste taxpayer money on the hiring of compensation consultants to tackle the problem which brings to mind a funny quote by Charlie Munger- “I would rather throw a viper down my shirtfront than hire a compensation consultant.”

Even though I’ve mostly been posting about AIG (NYSE:AIG) and their impending liquidation and business line sales, one interesting situation that I monitored was Constellation Energy (NYSE:CEG). The Lehman Brothers bankruptcy had a highly negative impact on CEG’s stock because the company had received $150 million in financing from Lehman. I thought the situation was weird because in the context, that amount of debt is small. $150 million when the overall package was for $2 billion. The stock subsequently dropped 60% as a result of market jitters over what would happen to the company.

Today though, it’s been announced that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) is acquiring CEG. Berkshires subsidiary MidAmerican Energy Holdings is doing the deal, and for all cash.

DES MOINES, Iowa & BALTIMORE, Sep 18, 2008 (BUSINESS WIRE) — MidAmerican Energy Holdings Company and Constellation Energy today announced the companies have reached a tentative agreement in which MidAmerican will purchase all of the outstanding shares of Constellation Energy for a cash consideration of approximately $4.7 billion, or $26.50 per share. The companies expect to enter into a definitive merger agreement by close of business, Sept. 19. Upon signing a definitive merger agreement, Constellation Energy will issue $1 billion of preferred equity yielding 8 percent to MidAmerican…

“We strongly believe this transaction is in the best long-term interest of our investors, employees and the customers and communities we serve,” said Mayo A. Shattuck III, chairman, president and chief executive officer for Constellation Energy. “The financial services sector and energy commodity markets have witnessed unprecedented volatility. Backed by the significant industry expertise and financial stability of MidAmerican and Berkshire Hathaway, Constellation Energy will build on its reputation as a first-choice energy solution provider for our many customers.”

“MidAmerican has been a wonderful steward of its energy assets and the acquisition of Constellation Energy, when completed, will prove beneficial to all constituents,” said Warren E. Buffett, chairman, Berkshire Hathaway.

MidAmerican Energy Holdings Company Reaches Tentative Agreement to Acquire Constellation Energy (Market Watch)

MidAmerican’s purchase price of $26.50 per share seems like a good deal. Only a week ago the company traded at $60! This just shows you the fragile nature of leveraged companies operating in a market that lacks liquidity. Any adverse move to their financing, even small amounts, can put the whole company in jeopardy:

The business relies heavily on its ability to access financing, which is highly sensitive to Constellation’s credit-worthiness. While Constellation has a credit line of $150 million with Lehman Brothers Bank, it also has about $2 billion in other liquidity available, according to the SEC filing.

Still, some analysts pointed to credit concerns exacerbated by recent market turmoil.

Constellation “remains under significant pressure [yesterday] as investors remain concerned about the company’s potential loss of access of liquidity and the potential evaporation of trading counterparties for its commodity business in the wake of financial market turmoil,” JPMorgan analyst Andrew Smith wrote in a research report yesterday.

He noted that increased costs to insure Constellation’s debt also may be adding to liquidity concerns.

Constellation stock falls 36% on vague fears about financing (Baltimore Sun)

The Constellation acquisition may be the first of many for Buffett during this crisis. His strategy may be to simply buy good companies in safe industries (non-sub prime) that were affected negatively by financial factors rather than economic factors. Buffett has a huge advantage over corporate acquirers because unlike them, he’s able to complete deals in a much faster time frame than corporate boards. That, combined with Berkshire Hathaway’s enormous cash horde, really makes this Buffett’s market.

While I was never a believer that Warren Buffett would infuse capital in AIG (NYSE:AIG), or buy the company, I did think that he would be interested in Steven Udvar-Hazy’s aircraft-leasing unit International Lease Finance Corp. (ILFC). This belief mostly rode on two facts:

1. ILFC is a great business with a great moat that Berkshire Hathaway (NYSE:BRK.A) is not a part of.
2. Udvar-Hazy is the type of manager that would fit perfectly with Berkshire’s culture. No news has surfaced about Buffett or Berkshire and ILFC so far, but today the WSJ reported that Udvar-Hazy is attempting to buy ILFC from AIG:

Mr. Udvar-Hazy and other top ILFC officials have been in around-the-clock discussions with potential investors since late Sunday. Among the candidates for capital are private equity, pension funds, European banks, sovereign wealth funds and other non-U.S. equity. The discussions have involved a variety of options, ranging from an outright purchase to the potential of buying the bulk of the leasing company’s assets.

Mr. Udvar-Hazy and his management team are widely considered to be one of the most important ingredients behind ILFC’s ability to move nimbly in a daunting credit market. According to people familiar with the situation, he and other senior executives at ILFC have concluded that it would be virtually impossible for the leasing company to remain competitive as long as it is part of AIG. The deterioration of AIG’s once-impeccable AAA credit rating has raised ILFC’s borrowing costs to the point that the company would be unable to prosper in an increasingly crowded leasing market, the thinking goes. On Monday, Standard & Poor’s cut AIG’s long-term credit rating three notches to A-minus from AA-minus, and even with the federal loan it is unlikely that the insurer would be able to quickly restore its creditworthiness to previous levels.

Mr. Udvar-Hazy, a Hungarian immigrant, pioneered ILFC’s leasing niche when he founded the company 35 years ago with the help of countrymen Leslie and Louis Gonda, a father-and-son team. The founders sold ILFC to AIG in 1990 for $1.3 billion in stock, and Mr. Udvar-Hazy was given the reins to run the company in an entrepreneurial way…

ILFC officials have been frustrated for months that ILFC has been dragged down by the parent company’s woes, even as the leasing unit turned in record profits. In March, Mr. Udvar-Hazy began pursuing a corporate divorce, but was persuaded to hold off by AIG’s new top management team. As AIG’s position continued to deteriorate in recent days, it put further pressure on ILFC to begin exploring options that would allow the firm to disentangle itself from its parent.

ILFC Chief Is Trying to Buy Company Back From AIG (WSJ)

The article lists a varied group of financial entities that could be interested in helping Udvar-Hazy purchase ILFC from AIG. However, the company’s large debt load makes me believe that a private equity buyer will be less likely. Usually the PE model involves picking companies that can be leveraged to the hilt, not companies that are already highly leveraged.

Sovereign wealth funds on the other hand may be better suited for this kind of acquisition, at least for once they’d be purchasing a good company that has a nice competitive advantage for years to come - unlike the wave of capital infusion deals they made this last year or so.

Finally, a corporate buyer makes a lot of sense too because the current dealmaking environment seems more conducive to corporate deals over private equity deals. General Electric (NYSE:GE) is the owner of GECAS (GE Commercial Aviation Services) which is ILFC’s competitor and has an aircraft portfolio worth $45 billion dollars versus ILFC’s portfolio of $48 billion. Berkshire Hathaway is again positioned well for an acquisition like this. They have their AAA rating and a cash horde that could easily handle ILFC’s debt. Outside of these two, there are a host of financial firms who may see ILFC as an attractive business based on its strength, it could bring a safe stream of earnings.

This will be a good situation to keep watching, just to see how it plays out. It’s always insightful to see a great manager working to make his company better and I think we’ll be able to learn quite a bit from Udvar-Hazy’s actions as he tries to save ILFC from AIG’s problems.