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What's the Next Berkshire Hathaway Acquisition?

- By Jonathan Poland

With the Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual meeting convening this Saturday, many investors are wondering what and when the company's next big acquisition will be. Berkshire has around $75 billion in cash and the speculation has been that Warren Buffett ( Trades , Portfolio ) is looking for companies with market values of $25 to $75 billion. I built a screen to find companies in that ballpark that also have economic moats, and then created a list of potential prospects.


With any company Berkshire would buy outright, there are going to be (and I hate to use this word) synergies under the umbrella. The biggest problem with buying another company is that if successful, its profit stream will be 100% to 200% greater in a decade, forcing further and bigger acquisitions. In the end, while I think there is no safer place to have your money long term, safe does not equal oversized returns. Remember that young Buffett would not be getting his 50% annualized returns buying today's Berkshire.

Some of the companies I would love to see Berkshire own but could not see it buying include the CME Group (CME) and Intercontinental Exchange (ICE), because what better owner and steward of the markets; or CSX Corp. (CSX), Canadian National (CNI) and Norfolk Southern (NSC) because if there should be a rail monopoly, it should be under Berkshire. Alas, I think these would pose too high of hurdles to complete and we all know Buffett likes one-foot hurdles.

That leaves over 30 possible targets from my screen, which, considering the size of capital he has to allocate, is still a considerable amount of companies to analyze. Buffett probably is not too concerned about the 52-week trading range in these companies, but rather the price to value based on his core tenets.

Step one: Screen

This was a simple Morningstar screen for companies that have market caps between $25 and $75 billion and some type of economic moat. For the sake of time, I am relying on Morningstar to do a lot of the upfront due diligence, and what is interesting is very few companies valued at less than $5 billion garner economic moats according to the service. Again, this produced 34 candidates ranging from Hershey (HSY) and Colgate-Palmolive (CL) to Lowe's (LOW) and Costco (COST).

Step two: Qualify

The next step was to narrow this list down to companies that have very solid sales, profit and book value growth rates, coupled with excellent financial positions and priced for take out. Almost any public company Berkshire buys would receive some premium to its current price. I do not imagine Buffett would pay 30 times earnings and then a premium to buy any company regardless of how strong its durable competitive advantage may be.

In the first pass, I took out any company that just did not produce growth in the underlying financials over the last five to 10 years or that were industries that do not fit the company's acquisition criteria.

In the second pass, I took out any company with too large of a debt pile, which usually means total debt minus total cash greater than five times the net income of the company.

I took out the two remaining financial companies - American Express (AXP) and Discover Financial (DFS) - because I cannot see Buffett wanting to be in that business as a direct owner, or he would have bought a long time ago. I also took out Chubb (CB), which merged with ACE in January 2016, because Berkshire already has a stronghold on property and casualty insurance. Finally, I removed Danaher Corp. (DHR) because of its heavy focus on merger and acquisition activity, despite the company now being focused in businesses that could be really accretive to Berkshire

This leaves three companies. Each have demonstrated excellent growth in sales, profit and book value over the last decade, while keeping capital spending low and accumulating debt sparingly.

The Hershey Co. (HSY)

Market cap: $22.8 billion

Last summer, Hershey rejected an offer from Mondelez International (MDLZ) (maker of Oreos and Cadburry), which put the value at the same price as it is currently trading. Modelez is not Berkshire, and acquiring Hershey would add the first globally recognized brand to its holdings. The company generates over $1.7 billion a year before taxes and spends very little on capital expenditures. Tading at 45 times (20 times forward earnings), however, I have a hard time with this deal. Wrigley also failed to acquire the company back in 2002. I cannot see Buffett paying too much of a premium, which means this one will have to wait until a severe correction.

McKesson Corp. (MCK)

Market cap: $29.3 billion

McKesson is the largest pharmaceutical distributor by revenue and is the main supplier to large pharmacy outlets CVS Health's (CVS) mail-order pharmacy and Wal-Mart (WMT). The risk is two- fold: price transparency and lower consumer spending. In the last 30 years, the pharmaceutical industry and companies reliant on it have benefited greatly. With an aging population comes more reliance on drugs. McKesson could be the right target to buy because of its existing contracts and excellent distribution network, making it the most attractive in an industry dominated by three companies - AmerisourceBergen (ABC) and Cardinal Health (CAH) being the other two.

Cummins Inc. (CMI)

Market cap: $27.1 billion

Buffett likes the auto industry, which I might find foolish. Cummins makes engines and engine components for heavy and medium-duty trucks, buses, recreational vehicles (RV), light-duty automotive and agricultural equipment markets. On a global basis, the company is 100% to 200% larger than the next largest engine manufacturer. Production and leverage from past research and development investments contribute to a durable advantage over competitors. More importantly, this segment of the auto industry will be the last to convert to clean energy, allowing Cummins to keep reaping the profits while spending less than 45% of its income on capital expenditures for some time to come. The price-earnings is a little frothy at 20 times, which is why I do not think Buffett would pay up, even for this great business.

Conclusion

There were a lot of companies I started to look at that possessed wide economic moats, yet were priced too high or whose business model did not fit well with Berkshire. Many of the companies on the list may have a moat around them, yet that does not always matter. Any target Buffett would move on needs to be agreeable to the acquisition as Berkshire does not "engage in unfriendly takeovers."

Of this trio, the only worthwhile acquisition would be McKesson. Growth across all major areas: sales up 113%, profit up 108% and book value up 80% in the last decade. Free cash flow upwards of $3 billion and trading at just 10 times forward earnings puts the company squarely in sight, even with a sizeable premium.

The one caveat is these companies were found on Morningstar using its "economic moat" criteria. While I respect the research, there are many companies that do not make the list that could be potential targets.

Disclosure: I do not own any stocks mentioned in the article.

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This article first appeared on GuruFocus.