Warren Buffett Buys Lubrizol, a Cleantech Powerhouse

Energy was the top sector for M&A activity in 2010 and this trend should continue well into 2011; oil prices are soaring, major companies are flush with cash, and debt capital remains inexpensive.

– Elliott Gue, Stocks on the Run

Warren Buffett’s finger turned out to be itchier than I imagined. Less than three weeks ago, Buffett wrote in Berkshire Hathaway’s (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder letter that “our elephant gun has been reloaded, and my trigger finger is itchy.” With $38 billion in cash, Berkshire had a lot of ammunition and was ready to put it to work. Back in November 2009 at Columbia University, Buffett explained why he hates to hold cash:

The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it. We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially.

For Buffett, holding cash really does burn a hole in your pocket! This past Monday (Mar. 14^th), he pulled the trigger of his elephant gun and announced the acquisition of Lubrizol (NYSE: LZ), an Ohio-based chemicals company, for $9 billion in cash or $135 per share. The deal is expected to have no problem with regulatory approvals and is scheduled to close in the third quarter. If the deal falls apart, Buffett gets a $200 million termination fee. Nice work if you can get it.

Lubrizol is Cleantech

Not as large an acquisition as the $26.5 billion paid for the coal-shipping Burlington Northern railroad, but it’s still one of the largest acquisitions in Berkshire’s history. Lubrizol’s specialty is lubricant additives, which include additives for gasoline and motor oil. These additives increase fuel efficiency and, consequently, are part of the cleantech revolution that is the greatest investment opportunity ever. If you think about it, Lubrizol is just the latest of Buffett’s cleantech investments. Iowa-based electric utility MidAmerican Energy is one the nation’s largest wind power companies, China’s BYD Co. (HKSE: 1211.HK) (Other OTC: BYDDF.PK) (Other OTC: BYDDY.PK) produces electric cars, and transportation via Burlington Northern’s railroad is three times more fuel efficient than trucking.

Lubrizol is a Market Leader

Buffett’s $135 per share offer constitutes a 28 percent premium over Lubrizol’s closing price on the day prior to the announcement and is also 18 percent higher than Lubrizol’s all-time high closing price. It goes to show that good investing does not equal bottom fishing. Buffett has often said that he would rather “buy a great business at a fair price than a fair business at a great price.” Lubrizol definitely qualifies as a great business. Only four companies in lubricant additives control 90% of global revenues and, among these, Lubrizol is the global leader with a 35% global market share.

A little more than two years ago on March 3, 2009, Lubrizol sold for under $24 a share. Despite the stock having risen 344% since then, Buffett still thought it was worth buying. Lubrizol has doubled its earnings and operating margin over the past two years and a $135 per share price is very reasonable at 7.3 times trailing EBITDA (cash flow) and 12 times earnings. According to Bloomberg, 7.3 times trailing EBITDA is the cheapest takeover price for a specialty chemical company in the past 12 years.

Lubrizol Has Stable Cash Flows

Multiples don’t mean squat if the company’s cash flow is cyclical, but Lubrizol’s cash flow is amazingly predictable. Price wars simply don’t happen when your market is divvied up among only four players. Furthermore, Lubrizol has no trouble passing through oil price increases to customers. Customers who buy a couple quarts of motor oil every three months don’t notice when prices rise and aren’t going to waste their time trying to find motor oil that is a few cents cheaper.

The facts don’t lie; over the past 40 years, Lubrizol’s annual free cash flow was never negative. Its annual revenue and earnings growth has been 10% and 31%, respectively, over the past five years and Lubrizol’s profitability is also outstanding, with the company earning a super-high 34% return on equity (ROE) last year.

Bottom line: Buffett likes to buy market leaders with predictable cash flows and he has that with Lubrizol.

Warren Buffett Stock Screen

In retrospect, Lubrizol was a no-brainer but let’s try to find the next Lubrizol before Buffett or a value investor like him snatches it up. Even after swallowing Lubrizol, Berkshire will still have $29 billion in cash burning a hole in Buffett’s pocket. I performed a stock screen on my trusty Bloomberg terminal for high-growth, high-profit, and low-value companies that matched the following criteria:

• Market cap of at least $5 billion
• Return on equity of at least 25%
• Five-year compounded earnings growth of at least 25%
• Five-year average P/E Ratio below the S&P 500 median P/E Ratio

You know the drill — these are not recommendations but just some ideas to vet with further due-diligence research.

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When researching growth-oriented companies I look for catalysts. There’s no point in buying or selling a stock that’s just going to trade sideways or follow the broader market in lockstep.

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