Warren Buffett's $1.4 Billion Arbitrage on Phillips 66

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Stocks were essentially unchanged today; with one trading day left in 2013, that means they will see the year out at or near a record high. The S&P 500 was down just two hundredths of a percentage point, while the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) did achieve a new all-time high off a 0.16% gain.

Berkshire Hathaway (NYSE: BRK-B  ) CEO Warren Buffett likes to cultivate the image of a down-to-earth businessman, but when it comes to deal-making, he can get pretty creative. In a deal announced after the market close on Monday, Berkshire is acquiring Phillips Specialty Products, or PSPI, from downstream energy company Phillips 66 (NYSE: PSX  ) for roughly $1.4 billion. But here's the kicker: Buffett will be paying for the acquisition with shares of Phillips 66 from Berkshire's stock portfolio! Why structure the deal that way?

PSPI develops polymers (large molecules) that maximize the flow in pipelines. Buffett's to-the-point comment on the business: "The flow improver business is a high-quality business with consistently strong financial performance, and it will fit well within Berkshire Hathaway. I plan to have James L. Hambrick, CEO of The Lubrizol Corporation, oversee its strategic direction." Lubrizol is the specialty chemicals manufacturer that Berkshire acquired in September 2011 for around $9.7 billion, so Hambrick is a logical choice for that role.

The exact number of Phillips 66 shares Berkshire will fork over "will be determined by the share price at deal closing," which is expected to occur in the first half of 2014. However, in a filing with the SEC on Monday, Phillips 66 pegs the payment at "approximately 19 million shares." Nineteen million shares are worth $1.42 billion at Monday's closing price.

Why is Buffett paying for the deal with shares rather than in cash? First, it might give him an advantage: There is no mistaking the value of cash, but I think Buffett probably has a better idea of Phillips 66 shares' intrinsic value than the company's own executives. Berkshire has owned shares of Phillips 66 since the company was split off from ConocoPhillips in the second quarter of 2012.

Nevertheless, Buffett can only achieve that advantage if the Phillips 66 shares are actually overvalued, which doesn't appear to be the case -- not to any obvious degree, in any case. At 11.7 times the next 12 months' earnings-per-share estimate, they trade at a lower multiple than another Berkshire energy holding, ExxonMobil (NYSE: XOM  ) (12.9 times).

Instead, I think it's likely the market valuation of Phillips 66 is expensive relative to the valuation Buffett obtained on PSPI. Without more financial data on PSPI there is no way to verify this, of course, but Phillips 66 was a motivated seller, as they want to focus "growth on our Midstream and Chemicals businesses." Finally, using the Phillips 66 shares enables Buffett to concentrate Berkshire's energy exposure on the name he likes best, ExxonMobil -- instead of one that reminds him of ConocoPhillips, an investment he described in his 2008 Annual Letter as a "major mistake of commission."

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  • Report this Comment On December 31, 2013, at 3:48 AM, soccerfan wrote:

    It's an interesting observation that Buffett is paying for PSPI with Phillips 66 shares. When I first read about this, I figured that Buffett structured the deal this way because it may be tax efficient (avoid paying taxes on the gains in Phillips 66 via this swap) and may allow him to get a better price on the shares because his sale/swap will not release additional shares on the market. And Phillips may have agreed to it because a share buyback immediately raises earnings, and it is easier and cheaper to buy a large number of shares from an individual in a private transaction than on the open market. Thoughts?

  • Report this Comment On December 31, 2013, at 11:33 AM, Aanderson wrote:

    Buffetts believes on market ratios and most of his analysis based on 3 market ratios ROE, D/E and Profit Margin.

    Is that's the simple technique he use for his investment decisions or being rich, having resources and social connection makes him best investor ?...........http://bit.ly/warren_buffetts

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10/24/2014 4:30 PM
^DJI $16805.41 Up +127.51 +0.76%
DOW JONES INDUSTRI… CAPS Rating: No stars
BRK-B $139.40 Up +0.72 +0.52%
Berkshire Hathaway CAPS Rating: *****
PSX $76.49 Up +0.37 +0.49%
Phillips 66 CAPS Rating: *****
XOM $94.49 Up +0.38 +0.40%
ExxonMobil Corp CAPS Rating: ****

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