Buffett Brings Lubrizol Into The Fold

By Stephen D. Simpson, CFA | March 14, 2011 AAA

Buffett-spotting is practically a cottage industry in the financial media, as is predicting the next thing that the Berkshire Hathaway (NYSE:BRK.A) CEO is going to buy. These predictions tend to be consistently off the mark, though, and so there is almost always an element of surprise to Buffett's next buy. So too was it with Monday's announcement that Berkshire Hathaway would acquire Lubrizol (NYSE:LZ) - while the deal makes a great deal of sense, precious few people were publicly predicting this one. (Check out some of Buffett's other surprise picks in 4 Lesser-Known Companies Buffett Owns.)

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Berkshire Hathaway Buys Lubrizol
Buffett is striking the kind of deal here that he prefers - an all-cash transaction for 100% control. Berkshire Hathaway will be paying $135 per share in cash for all of Lubrizol's outstanding shares. Including Lubrizol's net debt, this is a $9.7 billion transaction for Berkshire Hathaway - and a 28% premium for Lubrizol shareholders. All in all, shareholders who bought or held Lubrizol through the worst of the recession have seen these shares come back more than fives times over since early 2009.

What Berkshire Hathaway Is Getting
Lubrizol is a chemical company, but it is not so much a commodity player like Huntsman (NYSE:HUN) or Westlake (NYSE:WLK). Instead, Lubrizol focuses on additives and advanced materials. Lubrizol has a leading share in additives for products like motor oil, gear oils and transmission fluids, as well as significant businesses in engineered polymers, performance coatings, and so on.

Although many chemical companies struggle to attain a double-digit return on equity, let alone maintain it, Lubrizol has done quite well by this metric. Likewise, although Lubrizol was not immune to the effects of the recession, the company has shown a relatively uncommon ability to deliver consistent revenue growth compared to other chemical companies. (For more, see How Return On Equity Can Help You Find Profitable Stocks.)

That fits in pretty nicely with what Buffett always says he wants - a defensible market position in a business that can grow consistently. Unlike Berkshire Hathaway's purchase of Burlington Northern, this purchase is not based on capital leverage. Lubrizol does not have the need for gobs of lower-priced capital that a railroad does - although it also lacks the duopoly position that would allow it to earn a return on capital like a U.S. railroad. (For more, see Lubrizol's Profits Add Up.)

The Decks Keep Shuffling
The chemical industry does not get much love or interest from retail investors, but this has been a relatively active sector over the past few years. DuPont (NYSE:DD) stepped up with a multibillion dollar bid for Danisco, BASF (OTC:BASFY) gobbled up Cognis, not to mention a host of deals overseas.

Why all the activity? Big chemical companies have cleaner balance sheets than before and also have been working hard to diversify away from cyclical commodity businesses into higher-value specialty businesses. At the same time, scale still matters and some smaller companies are finding it hard to fight the "if you can't beat them, join them" momentum.

The Bottom Line
Buffett clearly has a strong and abiding interest in industrial-oriented companies. Will he look to add more chemical companies to the fold? Although companies like Albemarle (NYSE:ALB), H.B. Fuller (NYSE:FUL), Cytec (NYSE:CYT), Aceto (Nasdaq:ACET) and Ferro (NYSE:FOE) might be interesting to analyze and ponder, it's unlikely that Berkshire Hathaway will double-dip in this sector right away. But with so many other large chemical companies on the hunt for diversification and growth, more activity in this sector seems more likely than not.

As for Berkshire Hathaway and the "who's next" guesses, that game will go on as before. You can bet that Buffett will concentrate on value-added businesses with sizable markets, but also count on most specific predictions to be completely wrong. (For more, see Emulate Buffett For Fun And Profit - Mostly Profit.)

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