If you are lucky enough to be sitting on a huge profit in a stock, the decision is either to hold on in hopes it continues to climb, or sell and pay taxes on the gain.
If you are even luckier and happen to be Warren Buffett while owning a heavily appreciated stock, there is a third sweet option: Swap the shares back to the issuing company tax-free in exchange for a choice asset and some cash.
For the third time this year, Buffett executed such an enviable maneuver when he exchanged his $4.7 billion worth of Procter & Gamble Co. (PG) shares for P&G’s Duracell battery division and $1.7 billion in cash.
Buffett’s Berkshire Hathaway Inc. (BRK-A, BRK-B) came by its P&G position through Buffett’s longtime ownership of Gillette, which acquired Duracell in 1996 before Gillette sold itself to P&G in 2005. P&G is in slim-down mode and recently announced it was considering shedding the Duracell unit.
Berkshire has said that its cost for the P&G stake was about $336 million – now cashed in tax-free at a value of $4.7 billion, replaced by a high quality, profitable battery business. This implies he might have avoided some $1 billion in potential taxes, the amount his company might have owed on the $3 billion-plus capital gain on the P&G shares.
Buffett’s ability to acquire Duracell using the P&G shares on his books helps both partners to the deal generate tax savings. Because P&G is folding cash and Duracell into a package to split off as a separate entity and swap for its own shares, it also avoids triggering a taxable gain.
This means Buffett could get a good price for the business, but one that on a tax-adjusted basis is also attractive for P&G.
Procter calculated that Buffett is paying 7-times this year’s cash flow for Duracell. Yet for Procter, this is equivalent to having sold it for 9-times cash flow to a cash buyer. P&G also effectively executes a big stock buyback without using any cash or having to venture into the open market to bid for it.
Buffett executed a similar trade early this year when he exchanged his shares in Graham Holdings Co. (GHC) – the former Washington Post Co., now a media and education-services conglomerate – for a new stub company containing a TV station, some Berkshire shares held by Graham and some cash. By some estimates, he might have averted around $400 million in potential taxes. He also exchanged a stake in Phillips 66 (PSX) for a pipeline business under similar terms.
(Buffett, who has long claimed he and his fellow super-rich Americans are under-taxed, has drawn some criticism as a hypocrite for pursuing such tax-avoidance dealings.)
These types of transactions are not exactly typical, but they surface now and then -- usually involving companies that have a deal-savvy controlling investor.
Liberty Media Corp. (LMCA) founder and chairman John Malone, known for his tax-skirting transactional creativity – exited his stake in Time Warner Inc. (TWX) in 2006 using the same sort of “tax-rich splitoff” structure.
In this case, he swapped his Time Warner shares for a bundle that combined cash and the Atlanta Braves baseball team, which Time Warner had ended up with through its acquisition of Ted Turner’s company years earlier. Liberty Media, based near Denver, continues to own the Braves.
While it’s hard to generalize too much about Bufffett’s current investment posture from this one, seemingly opportunistic deal, the Duracell swap does reinforce an appearance that Buffett views stocks as fairly fully priced today.
Aside from his willingness to part with P&G and Graham Holdings stock at recent market prices, a certain caution about market valuations is evident in Berkshire Hathaway’s $62.4 billion cash hoard as of the end of the third quarter, up from $42 billion a year earlier.
While there is no indication that Buffett is eager to dispose of any of his other longtime holdings in blue-chip companies, the Graham and P&G deals suggest a path to realizing value from these stakes tax-efficiently, should Coca-Cola Co. (KO), Wells Fargo & Co. (WFC) or International Business Machines Corp. (IBM) elect to hand off a smaller business to Buffett down the road.