Buffett's bargain

Think Warren Buffett is paying $4 billion for Iscar? Think again.

1. What brought the worlds biggest investor to Israel? The answer is much simpler than people think: He found an investment that meets his strict criteria in Israels Tefen Industrial Park. Having created substantial value for his investors for decades, Warren Buffett has had difficulty continuing his success over the last two years. The markets have been rising consistently, and the search for long-term quality investments has become much more competitive. When theres competition, prices rise, and yields go down, not the sort of thing Buffet likes. And when Berkshire Hathaway Inc. (NYSE:BRK.A; BRK.B) begins to falter, the need for investment outside the US grows ever stronger.

This brings us to the investment in Iscar. On the face of it, Buffet paid $4 billion for 80% of the Israeli metal cutting toolmaker company. Why only on the face of it? Because in actual fact, the sum was a great deal lower.

While the structure of the deal is not known, it seems that Buffett has set up a local company that will acquire 80% of the activity of Iscar from the Iscar group, controlled by the Wertheimer family. The family will retain control over the old Iscar, which will own 20% of the activity. In the next stage, a company will be formed, into which Iscar's activity will be transferred (by both sides), leaving Buffett with an 80% stake in the new company, which will take in all Iscars activity.

Buffett, therefore, is buying activity, rather than company stock. The significance for tax is a benefit of around $1 billion over a 10 year period. Why? Because income tax regulations allow the recognition of amortization of goodwill on deals for acquisition of current activity at an annual rate of 10% of the goodwill. Almost all the sum paid for Iscars activity will be attributed to goodwill, resulting in an annual tax-deductible expense of $400 million. This expense will generate a tax saving of $100 million, assuming an effective tax rate of 25% for Iscar (for which it qualifies as a company with approved enterprise status). $100 million over 10 years is the expected saving, amounting to $1 billion.

Thats not all. Buffett will probably be granted (quite rightly) strategic investor status. This will mean that (subject investment in plant), any increase in profit is tax free, and there will also be no tax on capital gains or dividend distributions for 10 years. Iscars current profits are estimated at $400 million; the benefit for Buffett will amount to several hundred million dollars at least.

To sum up: Buffett is actually getting 80% of Iscar for around $2.5 billion. Iscars value for Buffett will therefore total $3 billion, giving a profit multiple of 7.5, compared with multiples of 20 and 30 that his other companies have. This is why the legendary investor didnt even bother to come to Tefen to close the deal. Anyone would have seized the opportunity.

2. Buffett is the worlds most important, best known, and most respected investor. He is not just a successful investor; he has become a real guru. His investment in Iscar made Israel the lead story in economic and financial columns across the world. Some will say that publicity like this is worth a lot of money to the Israeli economy and the Israeli capital market.

That's all well and good, but the question that must be asked is, how far should the accommodation of foreign investors go, and will the contribution made by the Iscar deal to state funds really be higher that its cost to the taxpayer? That cost is the forfeiture of hundreds of millions of dollars in tax that Buffett will save as a result of being granted strategic investor status, while any contribution will come in the form of indirect taxes. Buffett will, under the terms of his status, commit to major investment and the expansion of existing manufacturing, a commitment that will also entail hiring new employees. It will naturally contribute to an increase in indirect taxes (on labor). Will this ultimately be worthwhile for the state? It is apparently the price that any country must pay to attract investors of Buffett's stature.

3. The Wertheimer family apparently probably received higher offers for Iscar, of $7-8 billion for Iscar, but they preferred Buffett. Iscar was founded in 1952, and so the Wertheimers could have sold the company itself and not just the activity and paid a substantially lower rate of tax. Capital gains tax rates on assets formed at around the time of the founding of the State of Israel in 1948 vary from 14% to 24% (depending on the year of establishment). The Wertheimer family would have had to pay tax at a rate of 18%, $720 million, but it chose instead to sell the activity. The ostensible tax rate on activity is 31% (company tax), but in a sale of goodwill it stands at 25% (most of the consideration Iscar received from the activity sale will be attributed to goodwill) bringing the tax liability to about $1 billion.

Published by Globes [online], Israel business news - www.globes.co.il - on May 16, 2006

Copyright of Globes Publisher Itonut (1983) Ltd. 2006

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