Warren Buffett just illustrated for his shareholders three valuable lessons.
These lessons came from Berkshire Hathaway's failed takeover attempt of Tech Data Corporation.
This shows the company's founding principles are still intact and it illustrates that there's significant upside potential in an interesting market.
If there's anybody who has been around long enough and who has done enough to know that you can't win them all, it's Warren Buffett, the CEO of Berkshire Hathaway (BRK.A) (BRK.B). Late last week, news broke that the Oracle of Omaha was stepping away from a potential purchase of Tech Data Corporation (TECD) after being outbid by a subsidiary of Apollo Global Management (APO). Though disappointing, this bid by Berkshire, as well as its decision not to compete with Apollo, tells us three very important things about the conglomerate.
Buffett is eager for a deal
Many years ago, Buffett was known for saying that he liked to keep between $20 billion and $40 billion in cash and cash equivalents on hand at Berkshire. Since then, the company has grown, and as the market has become generally pricey, few opportunities have come along that have been large enough to take up a sizable portion of the company’s cash. Paying out a dividend is always an option, but Buffett has been a staunch opponent to paying out the conglomerate’s cash to shareholders. So bad did the situation become that, in April of this year, Buffett said that the company might go on to buy back up to $100 billion worth of its own stock.
This has come as the company’s cash holdings have grown considerably over time. In the graph above, for instance, you can see that from the first quarter of its 2017 fiscal year through the third quarter of its 2019 fiscal year, the company's cash and cash equivalents (including short-term investments) has risen from $87.02 billion to $128.15 billion (the highest on record for the firm). To put this in perspective, that much cash would theoretically allow the company the ability to buy up to 47% of the stock outstanding in The Walt Disney Company (DIS) or it could buy back nearly 24% of its own shares outstanding (assuming current prices hold) if it so desired.
Clearly, this cash is burning a hole in Buffett’s pocket. After all, in the past, Buffett has decried the thought of having too much cash, since it can increase the risk of making bad choices while decreasing return prospects if you do nothing with it. At the same time, buying into other holdings at a time when the market is already pricey is not a particularly pleasant idea either. As of this writing, the S&P 500’s P/E ratio stands at about 23, while the cyclically-adjusted P/E ratio is even higher at 30.3. Both of these measures are particularly lofty.
Buffett is sticking to his principles
Buying up Tech Data Corporation would have been an excellent (but expensive) way to burn some cash. After a subsidiary of Apollo initially agreed to acquire Tech Data Corporation for $130 per share in cash, Buffett swept in and offered $140 per share. This offer by Buffett valued the firm at $4.98 billion. To counter his offer, Apollo had to jump back in the fray with an even higher proposal of $145 per share. This new deal translated to a purchase price on Tech Data Corporation of about $5.16 billion.
Based on Berkshire's size and the size of its balance sheet, Buffett could have beat any proposal made by Apollo. By market cap alone, Berkshire is more than 30 times the size of Apollo, so Buffett could have made a higher offer to win Tech Data Corporation and could swoop up Apollo, and still have plenty of cash left for other deals. However, responsible management and wise investing isn’t about winning competitions, it's about making deals that will add sufficient value over time, and the couple of hundred million dollars more that Buffett would have needed to offer to top Apollo's offer must have, in Buffett's mind, breached the very principle that is responsible for his success today.
Looking at Tech Data Corporation’s financials, it's no wonder why Buffett decided not to go higher. At the buyout price he offered, it translated (using 2019’s financials) to a price/earnings ratio of 14.6, while its price/operating cash flow ratio was 13.1. These are not incredibly high, but for a value investor like Buffett, it would fall under the category of a fine, but not beautiful, price. Some investors might point out that the company's historical growth could justify a price that's higher than that. After all, as the revenue and earnings path of the past five years illustrate (shown below), the company has done well to expand. The catch here, though, comes down to how Tech Data Corporation has grown over time. Over the years, the company has acquired a lot of businesses in order to expand. The biggest of these was its purchase in February of 2017, of Avnet Inc.'s Technology Solutions business, for which the firm paid $2.8 billion. This obscures the picture considerably.
Buffett is looking to the future
There was once a time when Buffett would have balked at the idea of acquiring anything tied to the technology space. In recent years, however, that picture has begun to change, as he sees more of the businesses operating in technology as service enterprises and/or as consumer platforms. Tech Data Corporation, as an IT firm, falls right into the service enterprise category. Not only does the company generate (in aggregate) 38% of its revenue from Apple (AAPL), HP Inc. (HPQ), and Cisco (CSCO), it is also a diversified provider of IT products and services. According to Tech Data Corporation’s latest investor presentation, it actually works with more than 1,000 vendors and has 125,000 customers across 40+ countries, and sells more than 150,000 different IT products ranging from Belkin technologies to database software to display mounts, and more.
Of its $37.2 billion in sales last fiscal year, $16 billion came from the US. This was up from $9.5 billion two years earlier. The company generates a further $20 billion in sales from Europe (up from $14.7 billion two years earlier), and its remaining sales of $1.2 billion come from the Asia/Pacific region. Though this shows the company is definitely ‘western-centric’, this matches up reasonably well with the $5.2 trillion IT industry. $1.7 trillion worth of the industry is located in the US, while about $1 trillion is located in Europe. From 2013 through 2019, the growth rate in this space has fluctuated consistently between 4% and 5% per annum. While some forecasts suggest growth next year could be as high as 5.4%, the mid-point of guidance suggests global expansion of about 3.7%.
This growth rate is far greater than the global population growth we are seeing today, and the industry is large enough that it leaves a lot of long-term growth opportunities for the owner of the firm to benefit over time. Buffett probably understood this better than anybody. As 5G rolls out, as IoT, AI, and Cloud services come of age, he understands that a prime prospect to play in this market was/is Tech Data Corporation. Apollo apparently understands that too.
Over the past few years, Berkshire Hathaway has been burdened by excess cash and it looks like this trend might continue for some time. In an effort to create value, Buffett bid for a company that, quite frankly, seems to have a bright future, but that was not at the price he wanted. While playing the market trend is always entertaining, Buffett prioritized one of his founding principles over this, and that’s alright. It shows the conglomerate is still alive, well, and excellently managed. Does it miss out on an excellent chance to create even more value in the long run? Perhaps. But knowing Buffett, he will, as always, find a great path forward for his shareholders.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.