Is Warrnambool Cheese worth $505 million?

Investor Warren Buffett popularised the term ‘economic moat’. The term refers (at least in part) to a company’s competitive advantage. Ideally Buffett likes to buy companies that he believes have significant competitive advantages and thus can be conceptualised as having a ‘wide economic moat.’

Sometimes a competitive advantage is quite tangible, such as being the lowest cost producer of a good. However on other occasions a competitive advantage can be intangible and difficult to value. One of the best examples of an intangible competitive advantage is the brand power of Coke. With significant global recognition and enormous sunk advertising costs the competitive advantage Coke enjoys amongst the psyche of consumers represents a powerful and wide economic moat.

One way Buffett has described trying to determine the value of a moat is to consider what it would cost to build a worthy competitor. Put a slightly different way, if you were given the market capitalisation plus the debt of a potential acquisition, could you build a worthy competitor?

With Buffett’s thinking in mind, consider for a moment the latest offer, which trumps offers from both Bega Cheese (ASX: BGA) and Saputo’s, by Murray Goulburn Co-Op to acquire Warrnambool Cheese & Butter Factory (ASX: WCB) for $505 million plus debt of nearly $80 million. According to Warrnambool’s latest annual report, of the $161.8 million in stated book value only $1.6 million is ascribed to the value of intangibles. Essentially, the tangible book value of Warrnambool is $160 million.

This $160 million value is in theory the value of all the property, plant, equipment, inventory, cash and other physical assets of the firm less all of its liabilities. Once again, in theory it represents what it would cost to replicate Warrnambool’s operations. Murray Goulburn is currently offering to pay a $345 million premium above this balance sheet value – in other words it is ascribing $345 million in goodwill to the business or alternatively, it doesn’t agree with the assessed fair value of the physical assets on the balance sheet.

Murray Goulburn is already a significant player in the dairy industry so its management team should have good insights into Warrnambool’s operations and potential. Management also obviously understands the strategic importance of the assets better than outsiders. However, given the enormous premium being offered, it would be worth the owners of Murray Goulburn asking “how else could you spend $585 million of our money?”

Foolish takeaway

Interestingly it could be the perceived ‘losers’ from the bidding war for Warrnambool who have the last laugh. If the eventual acquirer pays a price so high that it never earns a return above the cost of capital, it will undoubtedly be a value destroying acquisition and could leave the acquiring company weakened. Under this scenario, it will be the ‘losing’ bidders who may ultimately go on to create more shareholder value than the ‘winner’.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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