Occidental, Enterprise Rebalancing, and Preferred Stock $OXY
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The standard pitch for private equity goes like this: I buy a company using a combination of equity and debt (but mostly debt), and make a series of operational improvements that lift the business’ top-line, bottom line, EBITDA, or some combination of the three. As a result of my operational know-how that business is now worth more, and so I sell that company to another P.E. firm or take it public, realizing a substantial monetary gain in the process. Under this view, the key drivers of PE returns come down to two things: operational improvements and benefiting from the illiquidity premium.
Not everyone buys this pitch, albeit for different reasons. One of the more notable critics has been Dan Rasmussen of Verdad, an asset management firm that attempts to replicate private equity in the public markets. Verdad argues that private equity’s historically strong returns are not a result of investment managers’ skill at improving businesses, but rather a consequence of buying statistically cheap, small-cap companies that have sufficient free cash flow to pay down the debt they are purchased with. In other words, the returns are a consequence of the value factor and leverage.
The point on leverage is especially interesting, both in its mechanics and because it runs counter to the philosophy of traditional value investing. You’d be hard pressed to find a Buffett letter espousing the importance of buying debt-ridden businesses! Rasmussen and Chingono’s academic paper ‘Leveraged Small Value Equities’ posits three reasons debt paydown drives better equity returns: it reduces the risk of financial distress, reduces interest payments, and increases equity value.1 The first two points require little explanation, but the third is slightly more complex if it’s not read as an obvious result of the third. A company’s enterprise value is the sum of its market cap, preferred stock, and net debt. Assuming that a company’s enterprise value remains constant, and that management isn’t issuing more preferred stock, paying down debt should mechanistically drive a company’s market capitalization upwards. Said differently, paying down debt doesn’t drive a stock upwards just because it reduces the risk of insolvency, but also because it rejigs the enterprise value.
Occidental Petroleum, a player in the oil and gas space, is a publicly traded case study in the benefits of enterprise value re-balancing, and the perks of using it to incentivize management. The company’s been in the press a lot in recent years for a variety of reasons; it acquired Anadarko Petroleum for $38 billion in 2019, which put it in a less than ideal situation when Covid hit and oil prices turned negative. Carl Icahn then came in as an activist investor, calling the acquisition a financial disaster and demanding board seats. Berkshire began buying shares in Occidental when Russia invaded Ukraine, around the same time that Icahn sold, and now owns 25% of the company. Importantly, Berkshire also partially financed Occidental’s acquisition in 2019, through a $10 billion preferred stock agreement that pays out 8% in dividends per year.
Oil and gas bulls have offered a variety of arguments for why the sector will outperform going forward. Despite a broad societal push towards renewable energy, which has in turn led to reduce drilling projects and thus supply, demand for oil still remains high. O&G companies were burned badly by their growth at any cost philosophy in 2014, leading to managements today that are focused on share buybacks and dividends over heavy capex.2 Occidental is compelling for these reasons and a third, which centers around its preferred stock. In the case of private equity firms, it’s debt paydown that drives a corresponding increase in equity value. But, given the enterprise value formula, that’s not the only way to do so. Redeeming preferred stock is another method by which a company can mechanically increase its market capitalization, and in Occidental’s case is an attractive option. In one of Icahn’s activist letters, he wrote that Buffett “figuratively took her to the cleaners”, and for good reason. A financing arrangement yielding 8% per year in what was then a low interest rate environment is hardly the deal of a lifetime; an 8% that’s even more painful when it’s applied to a sum of $10 billion. Berkshire’s deal enabled Occidental to acquire Anadarko, but also saddled it with substantial yearly interest payments. Much like paying down debt, redeeming this preferred stock lessens Occidental’s interest load while increasing equity value.
In this particular case, the preferred stock agreement has the added benefit of keeping Occidental focused on returning capital to shareholders. Some are skeptical that oil and gas firms will continue to intelligently allocate capital should oil prices remain elevated longer term, especially given Exxon and Chevron’s recent blockbuster acquisitions. These specific actions may turn out to be prudent, but generally speaking the oil industry going on an M&A splurge is probably not a positive indicator for shareholder returns. Buffett was thinking ahead on this, likely because he was dealing with a company making such a sizable acquisition, and so heavily incentivized Occidental management to focus on shareholder yield. The company’s annual report reads:
“The (preferred share) agreement includes a mandatory redemption provision that obligates Occidental to redeem the preferred at 110% of the par value on a dollar-for-dollar basis for every dollar distributed to common shareholders above $4.00 per share, on a trailing 12-month basis. Occidental cannot voluntarily redeem the preferred shares before August 2029.”3
If Occidental wants to redeem its preferred stock, and thus lessen its interest load before 2029, it has to return capital to shareholders. Theoretically the company could decide to neglect share buybacks/dividends and instead just aggressively begin new drilling projects, but it would come at the cost of having an annual 800mm dividend payment for the next five years. Buffett’s provisions also ensure management can’t only put its cash towards eliminating its preferred obligations: funds must be used to reward common equity holders first. This is probably at least a partial explanation for why Buffett holds such a large portion of the business: the company’s current financial position makes it extremely unlikely that executives will pivot away from buybacks/dividends and into speculative acquisitions. Thus far, the incentives are working, and as of its second quarter earnings call Occidental had bought back over a billion in common stock and redeemed $1.17 billion of its preferred shares for the fiscal year. Those who hold Occidental’s stock benefit not only from the repurchases, but also from the enterprise value rebalancing as the amount of preferred stock lessens.
Of course, the Occidental opportunity exists because of the extreme leverage the business took on in 2019, which makes it a harder lesson to apply to other companies. ‘Invest in businesses that make questionable acquisitions using preferred stock and then do a 180 to focus on buybacks and redeeming said preferred stock’ isn’t a maxim that can be used all that often, but it makes for some fun screens, and is one worth thinking about nonetheless.
Disclaimer: The information in this post is not intended to be and does not constitute investment or financial advice. You should not make any decision based on the information presented without conducting independent due diligence.
Pg 103, Occidental’s 2022 Annual Report.