Why Did Berkshire Hathaway Buy Lubrizol Corp.?

Two weeks ago, Warren Buffett’s company Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) entered a deal to buy Lubrizol Corp. (LZ, Financial) in an all-cash transaction at $135 per share. The deal is valued at approximately $9.7 billion, including approximately $0.7 billion in net debt, making it one of the largest acquisitions in Berkshire Hathaway history. This price represents a 28 percent premium over Lubrizol’s closing price on Friday, March 11, 2011, and is also 18 percent higher than Lubrizol’s all-time high share closing price.


Berkshire shareholders have been anticipating a big move from Buffett after he wrote in the latest shareholder letter that “my elephant gun has been reloaded, and my trigger finger is itchy.” At the close of last year, Berkshire’s cash holdings had soared to $38.2 billion.


Lubrizol is a premier oil additives business, creating environmentally sensitive technologies for customers in the global transportation, industrial and consumer markets. Many analysts believe that demand for their products will increase along with the demand for cleaner burning transportation.


Lubrizol is definitely the company that Buffett looks for. It has predictable and proven earnings and a good management team. In a statement, Buffett noted the two factors that influenced him to purchase the additives corporation. “Lubrizol is exactly the sort of company with which we love to partner—the global leader in several market applications run by a talented CEO, James Hambrick. Our only instruction to James—just keep doing for us what you have done so successfully for your shareholders,” Buffett said.


In a statement, Lubrizol told investors that Buffett chose the company on the basis of its consistent earning power, straightforward business model and strong management—criteria Buffett has laid out for acquiring companies.


As we looked into the business performance of Lubrizol, we found that it does have what Buffett looks in acquiring a business. Here are some highlights.


Predictable Business Growth


GuruFocus Rank of Business Predictability is the best indicator of the consistency of a business. In Business Predictability Rank we look into the consistency of both revenue per share and EBITDA of a business over the past 10 years. The business needs to be consistently profitable on EBITDA basis and grow the revenue per share at a steady rate. For details, go to What is Business Predictability Rank? Lubrizol ranked three stars. Among the approximately 10,000 companies we cover, only about 300 companies ranked better. Check out the top predictable companies and undervalued predictable companies.


The consistency of Lubrizol’s business is clearly reflected in its growth of per share revenue:





Over the past 10 years, Lubrizol grew its revenue from $36 a share to $83.7 a share, which averaged 9.8% a year. Its revenues in 2010 totaled $5.4 billion.


Moat


“Moat” is one of the most important factors that Warren Buffett considers in his acquisitions. The business needs to have a high barrier of entry and price power. As discussed before, the moat of a business is reflected on its long term resilience of its profit margins. Please see the chart below:





We can see that Lubrizol had quite consistent profit margins before 2007. The operating margin shrank in 2008 because of the restructuring and impairment charges of $383 million. It then recovered to even higher levels in the last two years.


Valuation


The price of $135 a share that Berkshire Hathaway is about to pay is not particularly cheap. For a predictable business like Lubrizol, GuruFocus DCF Calculator works pretty well in estimating the company’s intrinsic value. An assumption of 10% a year of growth in the next 10 years, and a 4% terminal growth rate gave an intrinsic value of $155 per share. Berkshire’s deal at $135 a share is probably slightly undervalued.


If we look at the historical valuation of LZ stock, we can see the LZ was traded at historical high price/sales (P/S) and price/book (P/B) valuations even before the deal was announced. The P/S ratio was about 1.3 and P/B was about 3.


Just about two years ago, the P/S and P/B ratios were at a multi-year low, with P/S at 0.5 and P/B at 1.2. The company had a market cap of about $2 billion. It would have cost much less for Berkshire Hathaway if Warren Buffett had bought some shares of LZ in the open market. Of course, we all know that Warren Buffett was busy investing in Goldman Sachs (GS) and GE at the time, and was selling stocks to raise cash.


This is similar to the Burlington Northern acquisition that Berkshire did. Buffett had chances to buy Burlington shares at much lower prices two-three years before he started to buy in the open market. Eventually he bought the whole companies with about 20% of premium.


How we wish that we have cash when we need it the most. Everyone is short of cash at some point, even if you are Warren Buffett.


Therefore, Berkshire is probably paying a fair price for Lubrizol. This is one of Buffett’s “good company at fair prices” deal.