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Berkshire Enters into Agreement to Acquire Wesco; “Afternoon With Charlie” Planned February 7, 2011

Berkshire Hathaway and Wesco Financial Corporation have announced (pdf) a definitive  merger agreement in which Berkshire will acquire the remaining 19.9 percent of Wesco’s common stock that it does not currently own.  Berkshire announced its intention to pursue the acquisition in August 2010 and the final terms of the agreement appear to mirror the initial offer.

Although there was some speculation at the time regarding the potential for Berkshire to pay a premium over Wesco’s book value, Warren Buffett indicated that Berkshire had no plans to do so.

Terms of the Agreement

According to the news release issued this morning, each share of Wesco common stock not owned by Berkshire Hathaway will be converted into the right to receive an amount either in cash or Berkshire Hathaway Class B common stock in a manner that should closely reflect Wesco’s book value when the transaction closes:

The merger agreement provides that each share of Wesco common stock not owned by Berkshire Hathaway will be converted into the right to receive an amount, either in cash or Berkshire Class B Common Stock, at the election of the shareholder, equal to: (i) $386.55 (which represents Wesco’s per share shareholder’s equity as of January 31, 2011, estimated for purposes of the Merger Agreement), plus (ii) an earnings factor of $.98691 per share per month from and after February 1, 2011 through and including the anticipated effective time of the merger (pro rated on a daily basis for any partial month), plus or minus (iii) the change in net unrealized appreciation of Wesco’s investment securities and the amount of net realized investment gains or losses with respect to Wesco’s investment securities (expressed on a per share basis, net of taxes) from February 1, 2011 to the close of business on the second full trading day prior to the date of the special meeting of the shareholders of Wesco to vote on the transaction (the “Determination Date”), minus (iv) the per share amount of cash dividends declared with respect to Wesco’s common stock having a record date from and after February 4, 2011 through and including the anticipated effective time of the merger, and minus (v) certain fees and expenses incurred by Wesco in connection with the transaction (expressed on a per share basis).

Wesco shareholders who elect to receive Berkshire stock will receive Class B shares with the exchange ratio based on the volume-weighted average price per share of Berkshire Class B stock for the 20 trading days prior to the close of the transaction.

The transaction is subject to approval of a majority of the outstanding shares that are not owned by Berkshire Hathaway and the vote is expected to occur at some time during the second quarter.  The companies indicate that if the vote occurs prior to early June, there will be no 2011 Wesco annual meeting but Charlie Munger will plan to hold an “Afternoon with Charlie” event in Pasadena soon after the transaction to answer questions “about business, economics and life (but not about Wesco)”.

For more information regarding Berkshire Hathaway, pre-order The Rational Walk’s upcoming report:  “In Search of the Buffett Premium”, scheduled for release in early March or subscribe to The Rational Walk’s Berkshire Hathaway Corner to receive the report and ongoing updates regarding the company.

Disclosure:  Long Berkshire Hathaway, no direct position in Wesco Financial.

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Berkshire Hathaway Will Not Increase Wesco Bid September 1, 2010

Warren Buffett is not planning to increase the terms of his offer for the 19.9 percent stake in Wesco Financial Corporation that Berkshire does not already own.  In a filing with the SEC today, Mr. Buffett characterizes the current offer as “fair” and clearly states that Berkshire has “no interest in effecting a transaction at a higher price”.

As we reported last week, Berkshire Hathaway has made an offer to acquire Wesco shares at book value which represents a premium to the market price of Wesco shares prior to the announcement of Berkshire’s bid.  The deal has been structured in a manner that allows Wesco shareholders to exchange their shares for Berkshire Hathaway Class B shares in a tax free transaction. Wesco shareholders may also elect to receive cash for all or part of their holdings.

Mr. Buffett’s letter also clarifies the manner in which the purchase price will be calculated.  The starting point for the calculation will take Wesco’s September 30, 2010 book value and then adjust that value based on an estimate of Wesco’s retained earnings from October 1 to the date of Wesco’s special meeting to vote on the proposal.  In addition, changes in the fair value of investment securities will be calculated and Wesco’s book value will be adjusted accordingly. This assumes that the transaction will take place sometime during the 4th quarter.

Over the past few days, there have been reports of shareholder lawsuits claiming that Berkshire’s offer does not treat Wesco’s minority shareholders fairly.  This seems like a dubious claim given the fact that the transaction will not proceed without a majority of the Wesco shares voting in favor excluding shares owned by Berkshire. While Mr. Buffett indicates no interest in a richer bid, he does say that if the transaction is not approved, there will be no “hard feelings” and Wesco will continue to operate as it has in the past.

In related news, Wesco announced today that CORT will acquire Lounge22.  Terms of the transaction were not disclosed.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.  No direct position in Wesco Financial.

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CORT Acquires Lounge22 Rental Business

According to a press release issued today, CORT has acquired the rental operations of Lounge22, including product and exclusive rights to market the rental brand on a global basis.  CORT is a subsidiary of Wesco Financial Corporation which is an 80 percent owned subsidiary of Berkshire Hathaway.  Last week, Berkshire Hathaway filed a disclosure with the SEC indicating that it will attempt to acquire the 20 percent of Wesco that it does not already own.

CORT’s business operations suffered during the recession and sales remain weak.  However, as we discussed in our review of Wesco’s Q2 results, management has returned the business to profitability through cost cutting initiatives.  The acquisition of Lounge22 may be intended to boost long term growth prospects by expanding the selection of high end furnishings that are available to CORT customers.

As the main player in the “rent to rent” market, CORT’s business operations have suffered due to slower business formation during the recession as well as decreased activity in trade shows and similar events.  CORT reported net income of $6.7 million for the second quarter and $8.4 million for the first half of 2010 which was up sharply over prior year levels.  However, revenues dropped 4.25 percent for the second quarter and 9 percent for the first half compared to the same periods in 2009.

Terms of the Lounge22 acquisition were not disclosed in the press release.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.  No direct position in Wesco Financial.

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Berkshire Hathaway May Acquire Full Ownership of Wesco Financial August 26, 2010

In a 13D filing today with the SEC, Berkshire Hathaway has disclosed its intention to acquire the remaining 19.9 percent of the shares of Wesco Financial Corporation that it does not already own.  Wesco has been a majority controlled subsidiary of Berkshire Hathaway for over thirty years but shares continue to trade independently.  Charlie Munger serves as Chairman of Wesco and is also Vice Chairman of Berkshire Hathaway.

The terms of the transaction call for acquiring the remaining shares of Wesco in exchange for Berkshire Hathaway Class B shares and/or cash valued at the book value per share of Wesco “as of a time reasonably contemporaneous with the closing of such transaction.”  The deal would be structured to be tax-free to Wesco shareholders electing stock which could help secure the support of large Wesco shareholders such as Wesco Board Member Elizabeth Caspers Peters.  Berkshire has indicated that the transaction will not proceed without majority support of the shares not presently controlled by Berkshire.

“Wesco is not an equally-good-but-smaller version of Berkshire”

For the last several years, Mr. Munger has stressed that Wesco Financial should not be viewed as an “equally-good-but-smaller version of Berkshire Hathaway”.  Nevertheless, many investors who believe that Berkshire has grown too large to continue providing returns enjoyed over the past several decades (a self-evident mathematical reality) sometimes persist in attaching great expectations to Wesco.  However, in recent months, Wesco has tended to trade at a slight discount to book value and this appears to have created an opening for Berkshire.

We often report on Wesco’s financial results (click here for a review of Wesco’s second quarter) and noted with great interest reports of Mr. Munger’s comments at the 2010 Wesco annual meeting regarding Berkshire acquiring full ownership at some point in the future.  Today’s announcement and the terms of the transaction should not have been much of a surprise to close observers of the company for the following reasons:

  1. Mr. Munger has stated that Wesco’s current status as a publicly traded company is more of a historical accident than any explicit desire for Berkshire to limit its ownership or a desire to see the shares trade.
  2. While Mr. Munger has said clearly that each dollar of book value at Wesco does not deliver as much intrinsic value as a dollar of book value at Berkshire Hathaway, by definition Mr. Munger must believe that Wesco’s intrinsic value is at least book value or he would be compelled to write down the value of goodwill assigned primarily to the CORT acquisition.  Berkshire’s offer to pay book value for Wesco validates the company’s stance that CORT’s goodwill has not been permanently impaired.

Valuation of Deal

Since Mr. Munger previously stated that the relative values of Berkshire and Wesco stock would have to be appropriate in order to consummate a transaction involving stock, let us consider the valuation of both companies based on the price to book value ratio on May 5 when Mr. Munger made his comments at the Wesco annual meeting and yesterday (August 25) when Berkshire’s management decided to initiate the current offer:

We can see that Wesco’s stock price approximated book value at the time of the Wesco annual meeting when Mr. Munger did not believe that an appropriate relationship existed between the valuation of Berkshire and Wesco stock.  At that time, Berkshire traded at about 129 percent of book value.  On August 25, the situation had changed with Wesco trading at 92 percent of book value and Berkshire trading at 133 percent of book value.

While this difference does not appear to be dramatic, the fact that Wesco was trading at a slight discount to book value made it possible for Berkshire to offer shareholders a deal priced at book value representing a substantial premium to Wesco’s trading level on August 25.  Berkshire could have obviously made a similar book value offer in May, but such an offer would not have been a premium to the then-prevailing price of Wesco and may not have been viewed as favorably by Wesco minority shareholders.

Of course, book value is only one valuation metric and we know that it is an imperfect proxy for intrinsic value.  Other factors may have changed over the past three months that led Berkshire management to act at this time.

Why is Wesco Now Trading Above June 30 Book Value?

After the 13D filing made the news today, Wesco stock immediately rose substantially with some trades taking place above $382, far in excess of June 30 book value.  The terms of the proposal call for Berkshire to offer Wesco shareholders book value “as of a time reasonably contemporaneous with the closing of such transaction.”  We know that book value was $352.66 on June 30, but has this changed over the past two months?

Without insight into Wesco’s business results, we cannot be sure what book value might be today vs. June 30.  However, we can draw some basic conclusions by looking at Berkshire Hathaway’s recent 13F filing with the SEC which lists equity positions held by Berkshire and its subsidiaries as of June 30. The exhibit below lists positions included in Berkshire’s 13F filing that are attributed to Wesco (codes 18, 19, and 20).  Note that the total does not tie to Wesco’s total equity securities as of 6/30/2010 listed at fair value of $1,936,171,000 due to the presence of untraded securities such as Wesco’s share of the Goldman Sachs 10% perpetual preferred stock.

Barring any major changes in Wesco’s portfolio of equity securities, which would be unusual based on the company’s long term investment strategy, it does not appear that the valuation of the publicly traded equity portfolio has changed very much since the end of the second quarter.

Other factors such as strong business results could have boosted Wesco’s book value, but it seems speculative to think that book value has risen far above the level that was reported at June 30.  If this is the case, speculators buying Wesco stock at a premium to June 30 book value may be disappointed with the final outcome if the transaction is consummated according to the terms proposed by Berkshire.

End of an Era …

Many Berkshire Hathaway shareholders have made an annual trip to Pasadena each year to attend Wesco’s annual meeting which offers a rare opportunity to listen to Charlie Munger for an extended amount of time.  Those who have attended report that Mr. Munger offers far more personal opinions regarding the state of the economy and business than he typically offers at the Berkshire Hathaway annual meeting.  If this transaction is completed, it is likely that Wesco’s 2010 meeting represented the end of an era — and a source of regret for those of us who never made it to a Wesco meeting in the past.

In addition to the annual meeting, many Berkshire shareholders followed Wesco in order to gain more insight into CORT and other Wesco subsidiaries that do not receive much attention in Berkshire Hathaway’s financial reports.  This detail will disappear in the event of Berkshire assuming full ownership.  None of this is to say that Berkshire’s move to own all of Wesco doesn’t make sense, but obviously there will be less granularity for the small minority of Berkshire shareholders who care to delve into as many details as possible.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.  No direct position in Wesco Financial.

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Wesco Financial’s Results Improve Despite Continued Weak Sales at CORT August 9, 2010

Wesco Financial Corporation reported improved results (pdf) for the second quarter of 2010 with net income rising to $31.3 million compared with $12.9 million for the second quarter of 2009.  The improved performance is primarily attributed to the stronger underwriting results of Wesco’s insurance business along with the impact of cost cutting measures at the company’s CORT furniture rental unit.  While CORT posted net income of $6.7 million for the quarter compared to $1.5 million for the second quarter of 2009, sales were slightly lower although management states that “core rental revenues” have shown recent improvements.  The Precision Steel subsidiary posted a 43 percent improvement in sales which generated a $183,000 net profit for the quarter compared to a $285,000 loss a year earlier.  Wesco Financial is a publicly traded 80 percent owned subsidiary of Berkshire Hathaway (click here for a summary of Berkshire’s Q2 results.)

Insurance

Wesco’s insurance segment includes Wesco-Financial Insurance Company and Kansas Bankers Surety Company.  For the reinsurance business, written premiums for the second quarter increased 3 percent to $69.2 million compared to the second quarter of 2009 while first half written premiums fell 12.6 percent to $168 million compared to the first half of 2009.

The reinsurance business is mostly represented by participation in the reinsurance transaction between Berkshire Hathaway and Swiss Re.  In 2008, Wesco entered into an agreement with National Indemnity (NICO), another Berkshire Hathaway subsidiary, to assume a ten percent share of NICO’s 20 percent quota share reinsurance of Swiss Re property casualty risks incepting over the five year period ending December 31, 2012.  Written reinsurance premiums for the second quarter included $60.6 million related to the Swiss Re contract and $152.9 million for the first half of the year.  Wesco reports that Swiss Re management is curtailing business when they deem pricing to be inadequate, a likely response to a soft insurance market.

Written primary insurance was roughly flat for the second quarter and first half of the year compared to the same periods in 2009 while earned premiums declined 17 percent for the second quarter and 25.4 percent for the first six months due to Kansas Bankers ongoing wind down of the deposit guarantee bond line of insurance. We first wrote about Wesco Chairman and CEO Charlie Munger’s decision to exit the deposit guarantee bond business in early 2009 and the process is nearly complete.

The reinsurance business posted a pre-tax underwriting profit of $12.9 million for the second quarter compared to an underwriting loss of $192,000 for the second quarter of 2009.  First half pre-tax underwriting profit for reinsurance was $4.2 million compared to $7.4 million for the first half of 2009.  The primary insurance business posted second quarter pre-tax underwriting profits of $1.4 million compared to a $2.8 million loss in the second quarter of 2009.  First half pre-tax underwriting profit for the primary business was $1.9 million compared to a $2.7 million loss for the first half of 2009.  The improvement is primarily due to a lack of deposit guarantee bond losses at Kansas Bankers this year compared to losses of $4.2 million from two bank failures in the first half of 2009.

CORT Results Improve Due to Cost Cutting as Sales Remain Weak

CORT Business Services is the only national player in the “rent to rent” furniture industry.  This business is very sensitive to overall economic conditions and business formation.  CORT posed net income of $6.7 million for the quarter and $8.4 million for the first half compared to $1.5 million for the second quarter of 2009 and $574,000 for the first half of 2009.  However, revenues fell 4.25 percent for the second quarter and 9 percent for the first half compared to the same periods in 2009.  Improved profitability for the business was a result of cost cutting initiatives taken by management over the past year.

CORT management believes that “core rental revenues” is an important statistic for analyzing comparable revenue levels from different periods.  “Core rental revenues” excludes revenues from trade shows and locations that were not in operation throughout each period.  Core rental revenues increased $5.4 million, or 9.4 percent, in the second quarter of 2010 compared to the first quarter of 2010, which followed an increase of $1.7 million, or 3.1 percent, in the first quarter of 2010 compared to the fourth quarter of 2009.  Additionally, the number of outstanding furniture leases increased 13.8 percent at the end of the second quarter compared to the number of contracts outstanding at the end of the first quarter.

We should note that Wesco is carrying $250.5 million of goodwill attributed to the CORT business as of June 30, 2010.  This accounts for the majority of Wesco’s recorded goodwill and represents approximately $35 per share of book value.  Management continues to believe that the goodwill attributed to CORT is not impaired;  however, until revenues show a more sustained recovery, it may be prudent for conservative investors to exclude at least a portion of this goodwill when considering Wesco’s intrinsic value.

Precision Steel

Precision Steel Warehouse posted net income of $183,000 for the second quarter compared to a loss of $285,000 for the second quarter of 2009.  First half net income was $237,000 compared to a net loss of $673,000 for the first half of 2009.  This improvement was primarily due to a 42.9 percent increase in sales for the second quarter of 2010 compared to the prior year’s level.  Sales were up 31.3 percent for the first half of 2010 compared to the first half of 2009.  The business has significant fixed operating costs.

Management notes that sales, in terms of pounds sold, have posted healthy increases over the past few quarters.  However, volumes are still significantly lower than the levels posted in the first half of 2008 prior to the onset of the Great Recession.  Management warns that they do not know whether the recent sales improvement is due to sustainable growth in industrial activity or inventory restocking.

Book Value

Book value per share was $352.66 on June 30, 2010 compared to $358.26 on December 31, 2009 and $370.20 on March 31, 2010.  The decline in book value is due to lower quotations on Wesco’s common stock investments.  As of June 30, Wesco’s largest holdings included Procter & Gamble, Coca Cola, Wells Fargo, Kraft Foods, and US Bancorp.  Since June 30, these securities  have appreciated in value so Wesco’s book value per share today is most likely higher than $352.66.  Wesco shares closed at $341 today representing a modest discount to the company’s book value.  As noted previously, roughly $35 per share of Wesco’s book value can be attributed to CORT’s goodwill which could account for the market’s current reluctance to bid up the stock to book value.

Charlie Munger recently commented on the conditions that would be required for Berkshire Hathaway to acquire the remaining 20 percent of Wesco that it does not already own.  Although it is impossible to know for certain what conditions would be required, a sustained discount to book value may eventually prompt Berkshire to make a move.

Resources:

Wesco Financial Q2 2010 10-Q Report
Wesco Financial Q2 Earnings Press Release (pdf)

Disclosure:  The author of this article does not own shares of Wesco Financial directly but owns shares of Berkshire Hathaway, Wesco’s parent company.

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