How Oil Made Berkshire Very Happy This Week

The bidding war for Anadarko Petroleum (APC) hasn't calmed down since we last reported on it a few weeks ago. On this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool analyst Matt DiLallo catch listeners up on the changes -- why Chevron (CVX 0.44%) bowed out, how Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%) ties into the picture, how Occidental Petroleum (OXY -0.09%) is scraping up the cash to pay for this, and what it all means for Occidental's long-term future.

On the back half of the show, the guys take a deep dive into Berkshire Hathaway's earnings report -- the most important numbers, some exciting trends in a few of its uber-diversified collection of businesses, why Warren Buffett isn't so keen on Kraft Heinz (KHC 1.31%) these days, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on May 9, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, May 9, and we're talking about Berkshire Hathaway. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Matt DiLallo via Skype. How's it going, Matt? 

Matt DiLallo: Going well! How are you? 

Sciple: I'm doing great! This Anadarko/Occidental Petroleum/Chevron deal, we just can't seem to get away from it. We talked about it last time we had you on the show, April 18. Chevron had just made an offer to buy Anadarko. Twelve days later, Warren Buffett and Berkshire Hathaway jumped into the mix. We're going to talk about that today. But then this morning, Chevron announced they're pulling out of the deal. Every time we come on this show, we're getting new news, new stuff to talk about here at this deal. The news of the day, before we dive in deep into the details of this deal, what's your thoughts on Chevron pulling out today, taking that billion-dollar breakup fee and taking the ball and going home? 

DiLallo: Yeah, I think that makes total sense for them, even though the deal really looked good from a Chevron perspective. There's so much more strategic benefits for them than I think for Occidental. But $1 billion, I think anyone would take that, especially in the oil industry. Oil prices have been so volatile, this deal could really hamper Occidental long-term. I did like something that Chevron's CEO said. He said winning in any environment doesn't mean winning at any cost. Their ability to look at the cost and say, this isn't worth overpaying for, I think that makes a lot of sense for them. 

Sciple: Yeah, and $1 billion doesn't hurt, either. Just to break down how things shook out, Chevron had offered a deal at $62 a share. But then Occidental came over the top and offered $76 a share with $59 of that in cash. Earlier this week, Anadarko's board said that the Occidental bid was bigger. Then Chevron pulled out today. So as we sit today, this is where we're at. What really made this deal possible were a few moves that Occidental was able to make to generate some cash. There are two deals there. We have the Berkshire deal, which we'll talk about. But first, let's talk about Total. They're going to divest $8.8 billion worth of assets in North Africa. Occidental had said they were going to divest $10 billion in assets to be able to make this Anadarko bid work. This gives them $8.8 billion of that. What should we know about this deal? What does it mean for Total to take that position in North Africa and take these assets away from Anadarko?

DiLallo: It makes sense for Occidental to pawn these off on Total. They're not really big in international markets, especially in Africa. So it makes a lot of sense. The question I have is, there was really no bidding on this that we know of. It was like, "Hey, could you take these off our hands?" $8.8 billion is a lot of money for this. It does take off the LNG project that Anadarko was working on in Mozambique. That could be a big deal for Total over the long run. LNG is this huge, fast-growing market. China's consuming a lot of natural gas, so they need LNG. It makes a lot of sense for Total to pick that up. They want to be a bigger player and LNG and rival Royal Dutch Shell. I think it's a good deal on their side. I don't really think Occidental got full value for it. But that's my opinion. 

Sciple: Yeah, that seems to be the case. It seemed that Occidental felt a little thirsty on this deal. They're making a lot of moves to generate the cash to be able to make it happen. Going to the Berkshire side of this deal, Berkshire got really an incredible deal from Occidental as well. Buffett committed $10 billion to a preferred stock investment in Occidental Petroleum with an 8% coupon. That means Berkshire is going to get $800 million annually every year from this deal. For an investment-grade company, that's the high end of normal. Really favorable deal for Berkshire as well as, he got a sweetener in the form of warrants to purchase up to 80 million shares at $62.50 a share. When you look at this deal, same question. It obviously it appears very favorable for Berkshire. What does this mean for Occidental? What was the rationale behind this deal? 

DiLallo: There are two main concerns from investors on this deal. One of them is, all the shares that they were going to issue to Anadarko. If they issued more than 20%, they would have a shareholder vote. They were concerned that shareholders would vote the deal down. There's been a lot of talk that now shareholders will vote out the board. In order to get around that, they need to offer more cash. That's where the assets on Africa, and then this thing from Buffett come in. Because there were concerns about the balance sheet. Occidental has a great balance sheet, A-rated credit. However, they're taking on a lot of debt in this deal. They're assuming Anadarko's debt, and they're paying all this cash. One of the ways to get around that is to use preferred stock. It's like common shares plus equity. It's got that 50/50 balance, so it doesn't weigh down the balance sheet in the eyes of credit rating agencies. So, it was a way to get around that. But the price they're paying is really incredible. Some analysts thought they could have got 6% if they did this deal through the public markets. And it's perpetual. Warren Buffett could conceivably get this, $800 million a year forever. He even got $50 million dollars just for signing the contract, whether the deal went through or not. And then you throw in the dilution from the shares that he can get... that's how he made all that money back in the financial crisis. He invested in Bank of America and made big bucks from those warrants. I think he's coming out well ahead on this deal. 

Sciple: Yeah. Again, you look back at the financial crisis, you had folks who needed money quick in uncertain times. Here, it seems that Occidental really wanted to get access to this cash quick so they could get over the top of Chevron's bid. And somebody like Warren Buffett and Berkshire are one of the few people out there that have the capability. Listening to Buffett talking over the weekend about the deal, the details of it, I want to say he first heard wind of it on Friday, and the deal was closed on paper by Sunday. There's not a lot of folks out there that could have made that deal happen that quickly. The ability to do that allows Berkshire to extract some pretty favorable terms. This is a classic deal for Warren Buffett. It seems like there's not a lot of downside for them from this deal. Again, Occidental looked a little thirsty. You mentioned some investors, at T. Rowe Price in particular, said, "Hey, if this doesn't go to a vote, we're probably going to vote against your board of directors here." I can see it making a whole ton of sense. It does, obviously, make a whole ton of sense for Total and Berkshire here. We'll see how things play out for Occidental. Some question marks about how much they paid. 

With this payment going forward into perpetuity, do you think this is going to restrict the flexibility of the business moving forward? Now that this merger happens, what is this liability going to do to the company's ability to invest further into the future? 

DiLallo: It does a lot of things for the company. They've already said that they're going to slow down their growth rate. They were supposed to grow maybe at an 8% to 10% rate going forward. Now, they're going to slow that down to 5%. That's off a larger base, there's a little bit of that. But they want to generate more free cash flow so that they can pay Buffett and pay down debt and things like that. But the structure of these preferreds really hampers them. The way it works out is, if they pay out more than $4 a share to their investors -- which would be the dividend plus buybacks; the current dividend's $3.12 a share -- they have to redeem these preferreds at 110%. So, $10 billion plus and other billion. It just hampers their ability to buy back stock, it hampers their ability to raise a dividend. And then, if oil prices crash, Occidental can do very well at $40 a barrel, but if oil prices sustained a long downturn, they could have to cut the dividend or things like that because they're paying so much for this. 

I really question this deal. I hope I'm wrong. From their perspective, I know why they're doing it. The Permian Basin is just a phenomenal basin. They're picking up a lot more land. They should be able to get a lot more drilling. But it just seems like they were way aggressive. 

Sciple: Yeah, feels a little thirsty, like I said before. We'll see how things play out. The Permian has the chance to really drive a lot of upside but time will tell. 

Alright, Matt, now I want to talk a little bit about Berkshire's earnings. First off, the numbers. When you see this net income number off the top, it's really eye-popping. $21.7 billion. But you need to take a little bit of that with a grain of salt. $15.1 billion of that is just mark-to-market on the equity portfolio. The S&P was up 13% during the first quarter. Obviously, that provided a whole lot of ballast for Berkshire's equity portfolio. When you back out to the core business, you're looking at about $6.6 billion in net income. A lot of cash, but not quite what you're going to see from that headline number. 

As you dig into Berkshire's actual operating businesses, Matt, what stood out to you from this report? What's going on in that part of Berkshire's universe?

DiLallo: I really liked the railroad earnings. Pre-tax earnings were up 10% to $1.7 billion. They benefited from higher rates per car and fuel surcharges. That big boost came even though there was really bad weather during the winter and flooding in the Midwest. That hurt volumes, but they made all that up on pricing. Lots of other railroads do the same thing. Tennessee and Wyoming, they reported really strong earnings, even though there was all this flooding and stuff. 

The big things were industrial and consumers -- your oil, your construction materials. That painted a really strong economy. The weaknesses were in coal and agriculture. It was really good. It shows that that investment in Burlington Northern is really paying off. 

Sciple: Yeah. Those railroads fit what Warren Buffett has done in the past. Used to always invest in newspapers, those are little monopolies. You look at a railroad, we've talked about with pipelines before, those are little monopolies, too. You control those routes. They're not building a lot of new railroads these days. When folks need to move things around, they have to go to Berkshire or these other folks. When the economy is doing well, it really works out for these railroads. We've talked in the past to about pipeline constraints as well taking away oil from some of these plays. Railroads are a good substitute for that. That explains some of where you might see that strong performance in that part of the business. 

Their utilities and energy also had a pretty good quarter as well. What did you see from that part of Berkshire's operating businesses? 

DiLallo: Utilities earnings pre-tax is up 11% to like $500 million. That was pretty good. But it was interesting. There's a lot of mixed results. They own several utilities. MidAmerican's probably their most famous one. Earnings there doubled. But a lot of the other ones are up or down. That just shows the diversification of Buffett's energy portfolio. He had some other energy businesses. He has pipelines, and he has investments in renewables and regulated electricity transmission. Those were down there, they reported a loss. The diversification really helped him. He had some really good assets out there. Those are performing well and they're offsetting some weak areas. 

Sciple: Yeah. Again, that's what you get from Berkshire, this super diversified industrial conglomerate in areas where regardless how the economy is performing, some part of that business is going to be doing well. The number a lot of folks want to look at today with Berkshire is their cash on hand. They've got $114 billion in cash on the balance sheet, at least at the end of the most recent quarter. Berkshire has said they want to keep $20 billion in cash at all times. That means they've got $95 billion in usable cash on the balance sheet hanging out. Maybe you want to say $85 billion, now that this $10 billion loan or contingent cash infusion to Occidental is going to take place. You've got a lot of cash on hand. Berkshire did buy back $1.7 billion in shares during the first quarter of 2019, which is more than they bought in the whole second half of 2018. Still, a lot of cash sitting around for Berkshire to go to work. Folks have been asking Buffett whether he's going to buy back stock. What are your thoughts? Are you looking for Warren to write a big check and buy back a big chunk of stock? What are your thoughts on how they've been slow playing these buybacks and rumors about them?

DiLallo: I know he's threatened, so to speak, to buy back $100 billion in shares. However, I think he'd much prefer to buy good businesses than buy back stock. You can make more money by investing in a good business than buying back your own stock. Stock buybacks only work in certain circumstances, like if the stock's depressed. If we have a big market pullback -- there's a drawdown this week, with all the trade talk collapse rumors. That could instigate Buffett to buy back more shares. However, I think he really wants to buy a really good business, and they just haven't been there because the market's been doing so well. He's patient. It's a good lesson to all of us to just have cash on the sidelines and be patient. It does drag in the near term, but long-term, you get a good business at a good price, and that's how he's created so much value over the years. 

Sciple: Yeah. He's just talked about having that elephant gun wanting to get that haul, big acquisition. But he did mention during the annual meeting over the weekend that it's just become more competitive as more private equity has come out in the market. There's just a lot more people competing for these deals, bidding up the prices of these businesses that might be attractive to Berkshire. It's just been very difficult for them to find deals that are compelling, of very compelling value for them. In an ideal world, Buffett wants to find the deal like we talked about on the first half of this show -- heck, I get 8% in perpetuity on a big old $10 billion slug of an investment? That's what he's looking for. When conditions present themselves, he won't hesitate, like he did with the Occidental deal. 

Talking about acquisitions and how you need to time how you buy things. Another thing that Buffett talked about at the meeting was the Kraft Heinz deal. He just came out and said, "Hey, we overpaid for this deal. They're doing well operationally, but if you pay too much, any deal can be a bad deal." As you look at the Kraft Heinz deal and how that's fitting into Berkshire's portfolio, what are your thoughts how its role is going to continue as part of Berkshire? What are your thoughts on that deal in a broad sense? 

DiLallo: That's a good example of a deal where you had two big companies merging together, and there was questionable strategic sense at the time -- you had ketchup merging with mac and cheese. Doesn't seem to make sense. It's not really a growth business. There's been a lot of changes with how people are eating. We're trying to eat healthier, we're not eating the packaged foods that you have with the Kraft business. That's weighing on that business. They're not getting the sales and the synergies and all that. So, yeah, he overpaid, but he overpaid just because the business isn't growing. That's the risk with these big deals. They're trying to manufacture growth by doing big mergers. I don't know what the turnaround strategy will be for Kraft Heinz. They're going to need to get into more of these healthy food product businesses to be successful going forward. 

Sciple: Yeah. And those brands, traditionally in the consumer's mind, are just not associated with that segment of the market. We'll have to see how things develop. It's a rare instance where Buffett comes out and says, "Hey, I made a mistake." But you have to respect that. As an investor, you're going to make mistakes. But to recognize it, analyze where you went wrong, and incorporate those lessons moving forward, from what's regarded as the best investor maybe ever, it's a good example for us -- when you make mistakes, just own it and try to learn from your mistakes and not repeat them going forward. 

We haven't seen Berkshire's 13-F yet, what new investments they've been making. We're expecting that on May 15. But we did get a little bit of kernel of information over the weekend that a lot of folks have been buzzing about. I want to talk about it for a couple of minutes here with you, Matt. Berkshire's investment managers, Ted Weschler and Todd Combs, one of those has reportedly been buying Amazon recently. When you see Berkshire Hathaway, Warren Buffett, this business that's been the paragon of value investing -- buying low P/Es, all those sorts of things -- moving into Amazon, what's your reaction to that? What's your reaction to Berkshire breaking the mold on what they've traditionally invested in? 

DiLallo: It goes back to our earlier conversation. They have all this cash and they need to figure out how to invest it and how to invest it well. There's just been this shift in the marketplace. Old school companies just aren't performing well, but you have these new school companies like an Amazon that are just putting retail out of business. I think you see the disruption there and the upside there. I know myself, it took me years to try to pull the trigger on Amazon because it was just going up and up and up. I think I paid $300 a share at the time. I just had to do it. And now it's skyrocketed from there. I'm glad. This could be one of those familiar situations. Amazon's a very volatile stock. I'm sure he'll have to answer questions at some time. "Why'd you buy it at the high?" Or something like that. 

But Berkshire's really started to shift into technology lately, which has been something that Buffett has avoided. It's just because that's where our world is heading. We're a much more connected world. Online retail is such a big part of it. So I can see them doing more of these types of things and in the future. It'll just shift how value investors look for value and look at the total addressable market vs. where things are today.

Sciple: Yeah. I think we're seeing an evolution, whether Buffett wants to admit it or not, or whether traditional value investors want to talk about it or not. Value as an analytical style is different than value on a P/E basis. You can have a company like Amazon that has been, by traditional metrics, overvalued its entire history. You could go back from 1997, when it IPOed, to today, and by every traditional valuation metric, this is a company that's going to look overvalued on a P/E basis. But if you're looking at it from an analytical style, the valuation of the company today relative to the future cash flows it can deliver, I think the market starting to recognize that that's another way to find value. 

Matt, before we go away, it's always fun to talk about with Berkshire, they've got all this cash on hand. If you're sitting on this big $90 billion portfolio today, and you could deploy it anywhere, what would be the big elephant gun acquisition you'd be looking for if you were king of Berkshire Hathaway for a day?

DiLallo: Because he's so into value, the one place that I see value -- and I cover it every day, so it's kind of the only place that I look -- is pipelines. They're trading at such cheap valuations, sometimes less than 9 times cash flow. Kinder Morgan, I think that's 9 or 10 times cash flow. He could buy something like that and still have some spending money, and get a really good return. These are regulated assets. They throw up a ton of cash, there's growth there. And that was one of the initial things that they thought with the Anadarko deal, that maybe he was interested in Western Midstream, which is their MLP. I could definitely see that being something that, if he hasn't looked at it yet, he should. 

Sciple: Yeah, I think that would be really interesting. We've talked about Brookfield Asset Management. That's kind of like the Canadian Berkshire Hathaway. I'd love to see them make a run or make an investment in them, partner up with that business. I think payments is something that Warren Buffett has always been involved with in a meaningful way. I mean, he's been invested in American Express for decades. Somebody like Square would fit in really nicely with that portfolio. We'll have to watch and see. The 13-F is coming out here in a couple of weeks. I'm sure we'll have something to talk about there soon. 

Matt, thanks for coming on the show! Love having you on, as always!

DiLallo: Thanks for having me!

Sciple: Thanks so much! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Matt DiLallo, I'm Nick Sciple. Thanks for listening and Fool on!