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On Feb. 26, the Fox Business show “Countdown to the Closing Bell with Liz Claman” ran a segment highlighting Warren Buffett’s recent disclosure that Berkshire Hathaway is holding on to $116 billion in cash. One of the reasons Buffett is sitting on such a large pile of cash is he’s struggling to find good companies to buy at a reasonable valuation.
Claman interviewed Mariann Montagne, a senior portfolio manager for Gradient Investments, who identified three potential acquisitions for Buffett, including Fastenal and Grainger. She named the two distributors because with “Fastenal and Grainger, you are providing the inputs for that infrastructure build-out without the risk of the infrastructure.”
Buffett’s most recent shareholder letter expands on the barriers he sees in finding companies to buy with all that cash. The legendary investor notes that good acquisition targets have, “durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.”
Buffett goes on to say, “That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
He blames this in part on the CEOs of strategic buyers: “The CEO job self-selects for ‘can-do’ types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.
Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase.”
Another problem is that Buffett says “we never factor in, nor do we often find, synergies” – but synergies are often a large part of the forecasted valuation growth for strategic buyers. Of course, debt is still very cheap and the recent tax cuts mean corporations are generating even more cash. What all this suggests is that the buying frenzy is likely to continue but finding targets priced attractively without taking into account synergies is hard for financial buyers like Buffett.
So, what does this mean for the distribution industry? Do Grainger and Fastenal meet Buffett’s requirements? We obviously can’t know what the Grainger and Fastenal boards would consider a sensible selling price, but Buffett has proven he has some interest in distribution.
Berkshire Hathaway owns electronics components distributor TTI Inc. – No. 4 on MDM's 2017 Market Leaders list for electronics distributors. And last fall Berkshire Hathaway purchased Production Tool Supply for an undisclosed sensible price and renamed it Berkshire eSupply.
Berkshire eSupply is the latest evolution of a master distributor. The firm provides tools to allow smaller distribution companies to build “private label websites.” Berkshire eSupply says, “Our e-commerce system becomes yours, with your branding and pricing for a low up-front fee. As buyers become younger and customer expectations rise, you need a highly capable website.”
This is truly a modern version of Mark Kahn’s brilliant idea of producing private label catalogs and marketing materials as well as providing fulfillment for other distributors when he ran Production Tool Supply successfully for so many years. Berkshire eSupply still offers those services and it also helps its distribution customers get into the private label vending business.
This is an intriguing value proposition but it’s a different angle on distribution than what Buffett would get if he bought Grainger or Fastenal. Both of those companies (especially Grainger) compete directly with Amazon Business and thus have to slug it out for “long tail” MRO purchase contracts with a much larger foe.
That’s not what Buffett’s doing with the former Production Tool Supply. His Berkshire eSupply strategy avoids pitting his capital directly against Jeff Bezos’ – a battle that would be very fun to watch but perhaps not ideal in terms of generating returns for two of the world’s three richest people. Instead, he’s inviting thousands of distributors to buy services from him so they can go into battle directly against pure digital competitors in the marketplace.
Berkshire eSupply is the Amazon Business third party marketplace turned on its head – it’s a third-party supply base for distributors. Indeed, at some point, distributors will buy through Berkshire eSupply and sell through Amazon Business, adding two intermediaries in a world that was allegedly disintermediating not so long ago.
On the Fox Business segment, Montagne said, “If you think of Warren Buffett, back in the gold rush days, 150 years ago, he’d be the guy at the side of the road selling you the flour, the grains, the picks and the shovels and the jeans on your way out west.” In her view, Buffett isn’t interested in speculating on a gold mine but he’s happy to sell all of those risk-taking gold miners the stuff they need to go prospecting themselves.
Montagne implies that Buffett should avoid cyclical, federal budget and regulatory risk by investing in the distributors that support infrastructure instead of the companies that build it. I interpret Buffett’s actions a little differently. He’s not selling to the individual prospectors competing with giant mining conglomerates – he’s selling to the merchants who sell to the prospectors. In other words, he is avoiding risk by buying capabilities to support the distributors who fight Amazon instead of buying the distributors themselves.
Of course, if Grainger or Fastenal are willing to sell at Buffett’s “sensible price,” he may be interested – but they will need to prove they have “durable competitive strengths” in a rapidly evolving competitive environment in order to make him an interested buyer. Both companies have very strong management teams, but in my view, Fastenal is better equipped to sell directly to the gold miners in the long run. On the other hand, Grainger probably makes a better acquisition target for Amazon. By virtue of my making this assessment, of course, it’s more likely that the outcome will be the reverse or different entirely.
In the meantime, staying one step back in the supply chain is a great way for Berkshire Hathaway to experiment in industrial distribution as the current wave of disruption works its way through the industry. Buffett has a track record of understanding industry dynamics better than anyone and he demands rational valuations, so if he starts buying more distributors, it’s probably a good time to be a buyer. But that could also mean you already missed your best opportunities as a seller.
We’ll keep watching, reporting and analyzing – and we’d love to hear your thoughts. Please email them to me at email@example.com.
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