Wednesday, November 12, 2008

The Warren Buffett Way: Chp 5 Part 4: Permanent Holdings

Capital Cities/ABC is a large media and communications business involved in publishing newspapers and magazines, as well as operating and publishing for tv and radio stations, and cable programming.

(note: subsequent to Hagstrom's publishing of this book, Cap cities merged with Disney).

Starting in the 1960's (and for the next 30 years), Tom Murphy and Dan Burke were responsible for running Capital Cities. They were widely considered the best managers in the media business at the time. In particular, Murphy was known as a hands-off manager who hired the best and brightest people and generally let them run things the way they saw fit. However, Murphy would not hesitate to get involved if he saw costs rise. Murphy's ability to increase the cash flows of acquired businesses by cutting costs was well known in the industry.

Warren bought Berkshire's stake in the company while he was helping Tom Murphy do a merger deal between Capital Cities and ABC. To prevent from getting acquired post merger, Tom Murphy was looking for the right type of investor to help capitalize the deal to acquire ABC. Tom already had a good relationship with Warren Buffett and asked him to participate in the deal. Interestingly, Tom had asked Warren to be a director of Capital Cities some 15 years earlier, but Warren had declined. However, when Warren was asked again by Tom Murphy to become a director at Capital Cities during the ABC deal, Warren finally agreed.

Warren agreed to purchase three million newly issued shares (before the merger announcement) at a price of $172.50/share. In 1985, at the time of the deal, Capital Cities was averaging around 19 percent return on equity and had a 20 percent debt to capital ratio. In order to have had a margin of safety on the purchase price of $172.5/sh of Capital Cities, Warren likely had to believe that Tom Murphy would once again be able to increase cash flows by reducing expenses. Buffett is quoted as having said "I doubt if Ben's up there applauding me on this one".

Two important factors in Buffett's decision to purchase Capital Cities included 1) the competence and shareholder conscious attitude of Tom Murphy and Dan Burke, and 2) the healthy operating profits and ability to grow cash flows without a need for capital investment in excess of normal depreciation rates.

During 1985 to 1992, one dollar of retained earnings at Cap Cities/ABC resulted in the creation of $2.01 of market share. The market value of the company rose from $2.9 billion in 1985 to $8.4 billion in 1992.

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