A full price is sometimes worth paying - lessons from Warren Buffett's investment in Capital Cities/ABC

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In his March 1986 letter to Berkshire shareholders Buffett said that the January purchase of 3 million shares in Capital Cities enabling it to acquire ABC would result in “economics that are likely to be unexciting over the next few years.”

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This is not exactly what Berkshire shareholders wanted to hear, but Buffett did offer a little comfort, “This bothers us not an iota; we can be very patient. (No matter how great the talent or effort, some things just take time: you can’t produce a baby in one month by getting nine women pregnant.)”

So, the returns were not going to be quick, but he was sure it was a good investment, despite him saying in a newspaper interview that Benjamin Graham would not be applauding him on this one – it was not a deep value investment.

“Our Cap Cities purchase was made at a full price, reflecting the very considerable enthusiasm for both media stocks and media properties that has developed in recent years (and that, in the case of some property purchases, has approached a mania). it’s no field for bargains.  However, our Cap Cities investment allies us with an exceptional combination of properties and people – and we like the opportunity to participate in size.” (1985 Letter)

Prior to the merger, in early 1985, both Capital Cities and ABC had market capitalisations around $2.2bn, despite ABC having much higher revenue at $3.7bn than Capital Cities (under $1bn). But the profit numbers were much closer together – see table.

Capital Cities and ABC earnings after tax

Capital Cities

(a)    Total

(b)   Per share

ABC

(a)    Total

(b)Per share

1982 (a)    $160m

(b)   $5.54

1983 (a)    $114m

(b)   $8.53

(a)    $160m

(b)   $5.45

1984 (a)    $143m

(b)   $10.98

(a)    $195m

(b)   $6.71

1985 (a)    $142m

(b)   $10.87

Capital Cities bought all the 29.1m shares outstanding in ABC for $3.5bn – that is, $118 per share plus a warrant (worth $3 or so).  A warrant gave the holder the right to buy Capital Cities shares at $250 for a period of 2½ years following completion of the merger.  Ten ABC shares were required to obtain one warrant.

Price versus value

We might start thinking about price versus value from the 1985 perspective by assuming that the combined company will produce earnings of about $300m –  $350m, which is a rough estimate created by adding together what they earned as separate businesses.

But that would be to forget the massive debt this enterprise carried – over $2bn. In 1986 corporate bonds offered at least 9% interest, and so this company had an interest burden north of $180m, leaving earnings at under $200m per year. This is for a company which was priced by the market at 16.08m shares x $224.5 = $3.6bn (there were 13.08m shares before Berkshire’s purchase of an additional 3m).

But the analysis so far fails to allow for the potential of the company’s business franchises in an expanding media market, its excellent management and the finding of some great synergies.

First, look at the assets it held

In those days the majority of viewers tuned in to watch the three giant networks broadcast through TV station affiliates – cable was around, but was pretty small.  The ABC network reached just about every American.   As well as the network, Capital Cities/ABC owned eight stations, each ranked one or two in their markets. Advertisers spent more as each year passed, competing for TV slots to reach a mass audience.

ABC Radio Networks had over 2,000 affiliates as well as 17 radio stations and broad range of paper publications, including Institutional Investor and The Kansas City Star/Times It also owned a motion pictures studio.

ESPN, the sports cable business, was the hidden jewel – ABC held 80% of its shares.  Its numbers looked pretty bad in the 1980s, but it was destined to be of great interest to Disney in the 1990s.

Murphy recalls Goldenson (ABC’s creator) telling him that one day ESPN would be really valuable, “ESPN is unbelievably successful. When we bought it in 1985, it was losing $40 million a year. Leonard Goldenson said to me, “Tom, someday that’s going to be worth as much

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