Last Friday, Procter & Gamble (NYSE: PG) announced that it would sell its Duracell battery business for $2.9 billion. The buyer is none other than Warren Buffett’s Berkshire Hathaway (NYSE: BRK-B).
As a Berkshire Hathaway shareholder, I’m always keen on seeing new ways that Buffett creates value for his investors. After digging into the details, there is a lot to like about this transaction.
Duracell is a good business. The company occupies 25% of the battery market, and its brand is estimated to be worth nearly $5 billion – and that puts no value on the business itself.
One common measure of cash earnings is known as EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization. Last year, Duracell’s EPITDA was $414 million.
The headlines reported that Berkshire is paying $4.7 billion for Duracell. But as part of the transaction, P&G is putting $1.8 billion of its cash into Duracell. As a result, the “net” purchase price is really $2.9 billion.
Based on the purchase price, Berkshire Hathaway is buying Duracell at seven times EBITDA. That compares favorably to the S&P 500, which is valued at more than 12x EBITDA.
The Duracell acquisition allows Berkshire to buy a good brand and healthy business at a reasonable price. It’s a well-known business that’s straightforward, easy to understand, and generates lots of cash for investors. That’s exactly what Buffett likes when he buys a company.
But there’s an even bigger upside to the Duracell deal for Buffett. It allows Berkshire to avoid a big tax bill. Let me explain…
Why Warren Buffett is Selling P&G
Procter & Gamble has made a lot of acquisitions over the years. In 2005, P&G bought Gillette for $57 billion. While Gillette is most known for its razor blades and shaving cream, the company had previously acquired Duracell. Thus, when P&G bought Gillette, it also got Duracell.
Berkshire Hathaway was a long-time investor in Gillette. When the company was acquired in 2005, Berkshire’s Gillette shares were exchanged for P&G stock.
Since 2007, Buffett has reduced his ownership in P&G by roughly 50%. Even so, Berkshire’s current stake is worth $4.7 billion.
One reason that Buffett may be selling is because Procter & Gamble hasn’t performed that well. Over the last three years, revenues are flat and earnings have grown just 10%.
As a result, the stock has underperformed. The five-year PG stock chart compared with the S&P 500 tells the story.
P&G Stock Underperforms By 50%
Source: Yahoo! Finance
Berkshire Hathaway paid just $336 million for its current stake in P&G. Today, that stock is worth $4.7 billion. If the company sold that stock in the market, its capital gains tax bill would be more than $1 billion.
In this transaction, Berkshire is exchanging its P&G shares for ownership of Duracell. Known as a “cash-rich split-off,” this transaction legally allows Berkshire to avoid all capital gains taxes.
Despite its recent underperformance, Buffett is cashing out of Procter & Gamble stock at an all-time high. The stock trades at 20x fiscal 2015 EPS, a 25% premium to the S&P 500.
That valuation is pricey, especially when you consider P&G’s financial outlook. For fiscal 2015, the company’s sales are estimated to be unchanged and EPS should grow less than 4%. With such modest financial expectations, it’s hard to justify a premium valuation.
The bottom line is that Buffett is selling richly priced P&G stock in a tax-free transaction. In exchange, Berkshire is acquiring Duracell at a discount to the market.
That makes this a great deal for Berkshire Hathaway. Duracell will be a very small piece of the Berkshire Hathaway pie. But these smaller transactions add up. Combined, they create a tremendous amount of value for Berkshire shareholders.
In my Million Dollar Portfolio investment account, Berkshire Hathaway is a top holding. Many income investors overlook this stock, since it doesn’t pay a dividend. I think that’s a mistake.
Are you an income investor who has avoided owning Berkshire stock? If so, I would love to hear from you. Send me an email and let me know why you won’t buy the stock. You can reach me at firstname.lastname@example.org.
Full Disclosure: I currently own Berkshire Hathaway shares in my investment account.
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