At the end of 2013, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) announced another energy deal. For $1.4 billion it will acquire the Phillips Specialty Products business from Phillips 66 (NYSE:PSX).
The "tax-creative" deal is one of Buffett's latest tricks. The deal is not that significant for investors in Phillips 66, representing just 3% of the current market capitalization. Yet the deal structure and implicit profit taking by Buffett makes me cautious on the prospects for the company.
Not Your Typical Deal
Buffett will spend about $1.4 billion, or use roughly 19 million shares of Phillips 66, which Berkshire Hathaway already owns to finance the deal. As a result, Buffett will cut his holdings in Phillips 66 significantly, cutting Berkshire's stake from 4.5% at the moment to an anticipated 1.3% going forwards.
Buffett loves the business, being a "high quality business with consistently strong financial performance." The unit produces large molecule chemicals, called polymers, which improve the flow of pipelines. Buffett appoints Lubrizol's CEO Hambrick to lead the new business.
The deal structure is rather complicated. Buffett will finance the purchase using 19 million shares already owned by Berkshire, following past investments in ConocoPhillips. By using those shares to finance the deal, Buffett will be able to forfeit capital gain taxes to partially exit his investment. The unit is expected to have $450 million in cash and equivalents on its balance sheet at the time of closing, lowering the effective closing price.
The deal is expected to close in the first half of 2014.
Phillips 66 Is Happy
CEO Greg Garland was happy to sell the strong business after Berkshire made a "strong offer." Following the sale Phillips 66 will focus on oil and natural gas transportation, processing and refining, and other chemicals.
The expected deal tag at $1.4 billion is relatively modest, amounting to roughly 3% of the current market capitalization of the company. Unfortunately, no financial details other than the price tag have been announced.
Analysts at Wells Fargo (NYSE:WFC) believe that Phillips 66's entire specialty division generates some $250 million in EBITDA per year. Yet the acquired PSPI business is expected to generate just a portion of those earnings. Analyst Roger Read sees the PSPI business generating roughly 4% of firmwide EBITDA for next year, while Phillips 66 receives proceeds of roughly 3% of its market capitalization.
Note that Phillips 66 has been spun off from ConocoPhillips (NYSE:COP) in 2012, and shares have performed very strong in 2013, rising little over 50% over the past year. Notably in the last few months of the year, momentum has been strong as shares have risen some 35% in the last three months of the year alone.
Buffett Remains Energy Hungry
Warren Buffett famously invests in stable companies, which he can understand. Unlike his traditional investments in major food companies and financials, Buffett has more and more focused on energy investments in recent times.
Back in November, Buffett bought a $3.5 billion stake in Exxon Mobil (NYSE:XOM). Other prominent investments in the sector includes the $10 billion purchase of Lubrizol in 2011. Earlier in 2013, MidAmerican Energy, which is a unit from Berkshire, acquired NV Energy for $5.6 billion. Yet the biggest play on the energy boom in North America remains the $34 billion deal to acquire Burlington Northern Santa Fe. At the time, Buffett named the deal a "bet on the recovery of the US economy."
The deal was a true winner, with much oil and gas found near its tracks in the years following, making Burlington a big transporter of oil and gas given the limited pipeline access of many shale basins.
Note that Buffett remains a shareholder in Phillips 66 despite using existing shares to finance the deal. Buffett owns about 27 million shares, and expects to use some 19 million shares to finance the deal. Rather than simply avoiding taxes, Buffett can furthermore lock in the profits on the majority of the investment in Phillips 66 after the strong momentum in recent months.
Implications For shareholders
The reported price tag and sale of the business is modest, and does not likely have a great impact on the prospects for shareholders.
The shareholder-friendly management of Phillips 66, who raises dividends, buys back stock and forms MLPs to benefit shareholders, has created strong momentum in 2013. This is despite volatile operating conditions, including the Brent/WTI spread, which has seen a huge unfavorable move until a few months ago.
After this momentum the deal has some significance, especially in the way in which Buffett structured the deal. Berkshire will cut its holdings in Phillips 66 by roughly two-thirds as a result of the deal, which is essentially a big profit taking action. Buffett swaps his holdings in a blended but volatile refinery based business into the chemicals transportation business.
Back in May of 2013, I last had a look at the outlook for the shares. At the time shares traded around $60 per share, but shares have risen nearly 30% ever since, partially on the back of the widening Brent-WTI spread in recent months. I concluded that the company's strategy to reduce reliance on refining earnings was sensible by investing in chemicals and pipelines. Yet the company now sells very nice pipeline flow assets to a very sophisticated investor, which is somewhat confusing to me.
At the time I liked the prospects of the business, as a result of share repurchases and dividend hikes. Given the strong absolute and relative performance of the business ever since, and the signal being sent by the "Oracle of Omaha," I tend to be cautious and remain at a neutral stance.