By Dana Mattioli, Anupreeta Das and David Benoit 

Warren Buffett's Berkshire Hathaway Inc. continues to reap rich dividends from a canny loan extended to Dow Chemical Co. seven years ago. But a recent rally in Dow's stock is putting that income stream at risk.

Shares of Dow have spent much of the past month hovering above $53 -- perilously close to a level that would cause Berkshire to lose a $255 million-a-year dividend.

Since 2009, when Berkshire lent Dow Chemical $3 billion to help finance its purchase of Rohm & Haas, Dow has been on the hook for paying an 8.5% annual dividend on three million shares of preferred stock. Those shares have resulted in more than $1.5 billion for Berkshire. As Mr. Buffett likes to say, that amounts to $8 a second.

But the agreement has an escape hatch: If Dow's shares exceed $53.72 for at least 20 trading days in a 30-day period, the chemical company can convert Berkshire's preferred shares into common stock, which pays a 3.4% annual regular dividend but no special dividend. Kuwait's sovereign-wealth fund also lent Dow $1 billion under the same terms.

Dow executives haven't made a secret of their desire to execute that conversion and to shut off the dividend spigot -- and Mr. Buffett, conversely, wants to avoid the evaporation of those dividends.

Dow believes someone is selling the stock short -- or betting that its price will fall -- to keep it from rising above $53.72, according to people familiar with the matter.

Mr. Buffett declined to comment on whether he or his company have been shorting Dow's shares as a way to exert downward pressure on the stock and avoid triggering the conversion.

"We have no knowledge or facts to support the position that it is directly Berkshire Hathaway" shorting Dow's shares, said Dow spokeswoman Rebecca Bentley.

The 2009 preferred-stock agreement had barred Berkshire from shorting Dow shares until April 2014.

Since then, Dow's stock has repeatedly flirted with that magic $53.72 level, and occasionally breached it, only to quickly retreat. Propelled in part by Dow's pending deal to merge with DuPont Co., the shares peaked last year above $57 before rapidly declining to the low $50s. The shares were trading at $53.72 midday Wednesday in New York.

Although short interest in Dow, or the amount of shares of Dow stock that are sold short, is down for the year and dropped to $600 million at the end of July, short sellers have increased their positions by almost $100 million in August, up 16%, said Ihor Dusaniwsky, head of research at S3 Partners, a financial analytics firm.

Its failure to breach the mark is despite improved earnings and margins, cost cuts, the shedding of assets, an activist shareholder who shook up the board and a combination with its biggest rival.

Dow is trading at steep discounts to its largest rivals based on price/earnings metrics, at 7.87 times its earnings versus a median 27.52, according to FactSet. Wall Street analysts have also turned more bullish on the stock. Heading into 2013, more than half of analysts called the stock a "hold" and had a median price target of $42.79, FactSet shows. Today, 65% of analysts rate the stock a "buy" and the median price target is $59.63, well above the threshold.

The stock's failure to go higher is proving frustrating to the company, people familiar with the matter say.

Dow executives have occasionally floated the idea to Berkshire executives of finding a way to terminate the deal, although there has never been a formal proposal, according to people familiar with the matter. Ms. Bentley said Dow continuously reviews its capital structure, "with the best interests of all of our shareholders as our sole criteria for any actions we take."

The agreement, and others like it, date back to the financial crisis. When credit markets seized up in 2008, some blue-chip companies turned to Mr. Buffett and Berkshire's store of cash for help in shoring up their balance sheets or completing acquisitions. Of course, these companies were getting more than just the cash -- they were also winning public votes of confidence from the billionaire investor.

From 2008 to 2011, Berkshire shelled out roughly $25 billion for preferred securities of Dow Chemical, Bank of America Corp., General Electric Co., Goldman Sachs Group Inc., Swiss Re and Wm. Wrigley Jr. Co.

Preferred-stock deals typically come with conditions under which the issuing company can redeem those shares, such as a threshold price or an additional payout. For instance, GE, which got a $3 billion infusion from Berkshire in 2008, agreed to pay Berkshire $300 million in annual dividends and another $300 million whenever it redeemed the preferred stock. In 2011, the industrial conglomerate paid $3.3 billion to Berkshire to buy back those shares.

The billionaire investor often laments the loss of these income streams when companies choose to redeem their preferred shares from Berkshire. He has described the redemptions by Goldman and GE as an "unwelcome" development. Mr. Buffett likes these deals because they are a relatively easy way for Berkshire to make money, simply by using a portion of the cash on its balance sheet at a high interest rate.

Companies have paid up for the privilege of having Mr. Buffett's name attached to their deals even without crisis conditions. In his most-recent annual letter, the billionaire wrote that Kraft Heinz Co., of which Berkshire owns 27%, would redeem $7.7 billion of preferred stock in June, which was "bad news for Berkshire." Although Kraft did redeem the stock for $8.3 billion, paying Berkshire $620 million in the process, the conglomerate loses dividends totaling $720 million a year from now on.

Bank of America and Dow are among the few companies that haven't redeemed their preferred shares from Berkshire's crisis-era investments. Berkshire invested $5 billion in the bank in 2011, which pays about $300 million in annual dividends. Berkshire also has until 2021 to exercise warrants for 700 million common shares for an additional $5 billion at $7.14 a share. Based on the bank's current stock price of about $15, the warrants create a paper profit of around $5.5 billion.

Write to Dana Mattioli at dana.mattioli@wsj.com, Anupreeta Das at anupreeta.das@wsj.com and David Benoit at david.benoit@wsj.com

 

(END) Dow Jones Newswires

August 25, 2016 02:48 ET (06:48 GMT)

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