BERKSHIRE HATHAWAY BRK.A
March 05, 2019 - 9:09am EST by
MadDog2020
2019 2020
Price: 303,400.00 EPS 26,400 28,800
Shares Out. (in M): 1,643 P/E 11.5 10.5
Market Cap (in $M): 498 P/FCF 0 0
Net Debt (in $M): 0 EBIT 33 36
TEV ($): 473 TEV/EBIT 14 13

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  • Conglomerate
  • Compounder
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  • Poor management
  • Poor corporate governance

Description

Time for the eye-rolling, this idea is as intellectually interesting as watching paint dry.  However, Buffett’s change in focus on book value made it worth a review, despite being on VIC in the past. 

Change in book value as a metric

In the 2018 annual letter, Buffett described three key reasons why change in book is no longer the relevant metric and the question is why.  The first reason is that Berkshire is moving away from the importance of securities.  Technically that’s true but it’s also not new information.  Berkshire started moving away from the importance of securities in the late ‘90s so I view that justification as a bit of a throwaway.  The second reason is that Berkshire’s wholly owned businesses aren’t marked to market.  This one seems like a partial issue- the operating earnings from those businesses are coming through the P&L into retained earnings so they are getting picked up in book value but I get the point that businesses purchased a number of years ago can be worth significantly more and those changes in value aren’t reflected in Berkshire’s balance sheet.  Third, Buffett specifically calls out that, “it is likely that – over time – Berkshire will be a significant repurchase of its shares…”  I don’t think he’s ever made this point so explicitly and this leads me to two conclusions.  If Berkshire does repurchase a significant number of shares, it’s a fair point that it will begin to distort book value as those shares become treasury stock.  I believe this third point is the key and effectively only reason why it makes sense to shift from evaluating Berkshire on a change in BV basis to a change in operating earnings/sum-of-the-parts basis. More importantly, the market is arguably pricing Berkshire as if it will never deploy its excess capital and therefore the ROEs are in permanent decline.  The emphasis that Buffett places on share repurchases in the 2018 letter leads me to lower the probability that Berkshire becomes a perennial cash hoarder and never mind the fact that calling the end of Berkshire’s ability to compound has been a fools’ game so far.

Sum-of-the-parts (five components of value)

Despite Buffett’s explicit definition, Berkshire has actually outlined a variation of these components necessary for valuing Berkshire since 1995, although it used to be described as securities per share and non-investment income per share.  As you’ll see below, the two key drivers of Berkshire’s value is how to value its operating businesses and whether or not Berkshire will ultimately deploy its excess capital.  On the former, I’m assuming the 10 year treasury goes back to 5% and then add 300bps for equity risk on top of that.  If the business can grow at 2%, that gives you a multiple of 17x fair value for their businesses.  We could debate all day where interest rates will go, and I’d take the under on 5% for the US 10yr, but the numbers get silly below 4% for the 10 year bond.  On Berkshire’s ability to reinvest its excess capital, call it $100B by subtracting Buffett’s stated minimum of $20B and give them a $10B buffer on that, I think the comment on share repurchases suggests that’s likely how they’ll deploy the majority of that.  Listening to Munger’s comments at the recent Daily Journal meeting, I think it’s likely that Berkshire will either make a couple of large operating business acquisitions during the next recession/major market decline or they’ll aggressively repurchase shares.

Operating businesses

$B

Multiple

$B Value

$/A share

Non-insurance businesses

$16.80

17

$285.60

$174,043

Non-control owned businesses

$1.30

10

$13.00

$7,922

Insurance earnings

$1.69

5

$8.44

$5,142

Operating business value

   

$307.04

$187,107

Balance sheet assets

       

Securities

$158.06

 

$158.06

$96,319

Cash and equivalents

$132.00

 

$132.00

$80,440

Total Balance sheet value

   

$290.06

$176,759

         

Sum of the parts

   

$597.09

$363,865.71

Market Cap ($B)

   

496.329

$302,000

P/IV

   

83.12%

83.00%

 

Kraft Heinz exposure

This has clearly gotten a lot of attention over the last year so here are two thoughts.  Kraft Heinz is immaterial in terms of Berkshire’s overall net worth.  As of 12/31/18, Berkshire’s portion of KHC was held at $13.8B and would be worth $10.7B at today’s price, immaterial in the context of Berkshire’s $348B book value.  The more relevant question is whether or not this suggests future Buffett investments and specifically Berkshire/3G deals will destroy capital.  Based on Buffett’s interview on CNBC 2/25/19, I think the odds are overwhelming against value destructive 3G deals.  Buffett clearly stated that they overpaid for the Kraft business as well as misjudged the amount of negotiating leverage that the branded goods companies have with retailers.  Interesting sidebar, Costco’s private label business called Kirklands is now doing $39b per year in revenue, which is more than KHC’s $26B.

Expected Returns

With Berkshire retaining 100% of its earnings, the $64k question is can they reinvest all of this capital.  Over the past 20, 10, and 5 years, Berkshire has grown book/share by the following annualized rates: 9.0%, 11.7%, and 9.5%.  Given the explicit mention of share repurchases as a justification for changing the metric away from book value and to stock price, this incrementally improves the odds that Berkshire will be able to reinvest their capital and compound at similar rates.  Given their explicit focus of buying operating businesses, the last five years have been quite difficult given private valuations and they’ve still been able to compound book value at HSDs.  The second question is valuation- over the past 20, 10 and 5 years, Berkshire has averaged 1.5xBV, 1.37xBV, and 1.44xBV.  Today, the stock trades at 1.43x BV so I assume no change in multiple over the next five years.  However, you could make an argument that the multiple increases back towards 1.5x if Berkshire is successful in reinvesting their excess liquidity.  Berkshire clearly will run out of revinestment opportunities in the medium term, I’ll take the under on 10 years, but given Buffett’s continued discussion of capital allocation, I expect the BoD will return the excess capital largely through share repurchases post Buffett. 

Taxes

For a family office or individual, an investment in Berkshire presents a material advantage relative to other strategies because it defer a shareholder’s gains for a long period of time.  As a thought experiment, I’ve compared Berkshire’s after-tax returns to an absolute return strategy that generates 100% ordinary income and to a single stock strategy where the stock is sold each year but all of the gains are taxed at long-term rates.  If, which is a big if, Berkshire compounds at 9%, a shareholder of 15 years would need almost 13% annualized in an A/R strategy or ~10% annualized in a single stock with 100% annual turnover strategy to match Berkshire’s after tax returns. 

Risks

Keyman risk- optically this is with Buffett but I actually think the bigger concern is keeping Ajit Jain and Greg Abel in their positions.  Clearly the promotion of each to Vice-Chairman is a step in that direction but I would be concerned about either of them leaving, given Buffett’s reduced involvement in the operating businesses.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Probably my favorite aspect of an investment in Berkshire is that the forward looking returns of Berkshire increase with both overall stock market declines as well as with a $400B cat event.  Berkshire’s stock will absolutely decline under either of these scenarios but the forward returns on its $100B of excess liquidity should increase from today’s paltry 2.4% T-bills yield to over 10% conservatively.  The second catalyst could be a meaningful acquisition to change the market’s perception of the value of the excess cash.

    sort by    

    Description

    Time for the eye-rolling, this idea is as intellectually interesting as watching paint dry.  However, Buffett’s change in focus on book value made it worth a review, despite being on VIC in the past. 

    Change in book value as a metric

    In the 2018 annual letter, Buffett described three key reasons why change in book is no longer the relevant metric and the question is why.  The first reason is that Berkshire is moving away from the importance of securities.  Technically that’s true but it’s also not new information.  Berkshire started moving away from the importance of securities in the late ‘90s so I view that justification as a bit of a throwaway.  The second reason is that Berkshire’s wholly owned businesses aren’t marked to market.  This one seems like a partial issue- the operating earnings from those businesses are coming through the P&L into retained earnings so they are getting picked up in book value but I get the point that businesses purchased a number of years ago can be worth significantly more and those changes in value aren’t reflected in Berkshire’s balance sheet.  Third, Buffett specifically calls out that, “it is likely that – over time – Berkshire will be a significant repurchase of its shares…”  I don’t think he’s ever made this point so explicitly and this leads me to two conclusions.  If Berkshire does repurchase a significant number of shares, it’s a fair point that it will begin to distort book value as those shares become treasury stock.  I believe this third point is the key and effectively only reason why it makes sense to shift from evaluating Berkshire on a change in BV basis to a change in operating earnings/sum-of-the-parts basis. More importantly, the market is arguably pricing Berkshire as if it will never deploy its excess capital and therefore the ROEs are in permanent decline.  The emphasis that Buffett places on share repurchases in the 2018 letter leads me to lower the probability that Berkshire becomes a perennial cash hoarder and never mind the fact that calling the end of Berkshire’s ability to compound has been a fools’ game so far.

    Sum-of-the-parts (five components of value)

    Despite Buffett’s explicit definition, Berkshire has actually outlined a variation of these components necessary for valuing Berkshire since 1995, although it used to be described as securities per share and non-investment income per share.  As you’ll see below, the two key drivers of Berkshire’s value is how to value its operating businesses and whether or not Berkshire will ultimately deploy its excess capital.  On the former, I’m assuming the 10 year treasury goes back to 5% and then add 300bps for equity risk on top of that.  If the business can grow at 2%, that gives you a multiple of 17x fair value for their businesses.  We could debate all day where interest rates will go, and I’d take the under on 5% for the US 10yr, but the numbers get silly below 4% for the 10 year bond.  On Berkshire’s ability to reinvest its excess capital, call it $100B by subtracting Buffett’s stated minimum of $20B and give them a $10B buffer on that, I think the comment on share repurchases suggests that’s likely how they’ll deploy the majority of that.  Listening to Munger’s comments at the recent Daily Journal meeting, I think it’s likely that Berkshire will either make a couple of large operating business acquisitions during the next recession/major market decline or they’ll aggressively repurchase shares.

    Operating businesses

    $B

    Multiple

    $B Value

    $/A share

    Non-insurance businesses

    $16.80

    17

    $285.60

    $174,043

    Non-control owned businesses

    $1.30

    10

    $13.00

    $7,922

    Insurance earnings

    $1.69

    5

    $8.44

    $5,142

    Operating business value

       

    $307.04

    $187,107

    Balance sheet assets

           

    Securities

    $158.06

     

    $158.06

    $96,319

    Cash and equivalents

    $132.00

     

    $132.00

    $80,440

    Total Balance sheet value

       

    $290.06

    $176,759

             

    Sum of the parts

       

    $597.09

    $363,865.71

    Market Cap ($B)

       

    496.329

    $302,000

    P/IV

       

    83.12%

    83.00%

     

    Kraft Heinz exposure

    This has clearly gotten a lot of attention over the last year so here are two thoughts.  Kraft Heinz is immaterial in terms of Berkshire’s overall net worth.  As of 12/31/18, Berkshire’s portion of KHC was held at $13.8B and would be worth $10.7B at today’s price, immaterial in the context of Berkshire’s $348B book value.  The more relevant question is whether or not this suggests future Buffett investments and specifically Berkshire/3G deals will destroy capital.  Based on Buffett’s interview on CNBC 2/25/19, I think the odds are overwhelming against value destructive 3G deals.  Buffett clearly stated that they overpaid for the Kraft business as well as misjudged the amount of negotiating leverage that the branded goods companies have with retailers.  Interesting sidebar, Costco’s private label business called Kirklands is now doing $39b per year in revenue, which is more than KHC’s $26B.

    Expected Returns

    With Berkshire retaining 100% of its earnings, the $64k question is can they reinvest all of this capital.  Over the past 20, 10, and 5 years, Berkshire has grown book/share by the following annualized rates: 9.0%, 11.7%, and 9.5%.  Given the explicit mention of share repurchases as a justification for changing the metric away from book value and to stock price, this incrementally improves the odds that Berkshire will be able to reinvest their capital and compound at similar rates.  Given their explicit focus of buying operating businesses, the last five years have been quite difficult given private valuations and they’ve still been able to compound book value at HSDs.  The second question is valuation- over the past 20, 10 and 5 years, Berkshire has averaged 1.5xBV, 1.37xBV, and 1.44xBV.  Today, the stock trades at 1.43x BV so I assume no change in multiple over the next five years.  However, you could make an argument that the multiple increases back towards 1.5x if Berkshire is successful in reinvesting their excess liquidity.  Berkshire clearly will run out of revinestment opportunities in the medium term, I’ll take the under on 10 years, but given Buffett’s continued discussion of capital allocation, I expect the BoD will return the excess capital largely through share repurchases post Buffett. 

    Taxes

    For a family office or individual, an investment in Berkshire presents a material advantage relative to other strategies because it defer a shareholder’s gains for a long period of time.  As a thought experiment, I’ve compared Berkshire’s after-tax returns to an absolute return strategy that generates 100% ordinary income and to a single stock strategy where the stock is sold each year but all of the gains are taxed at long-term rates.  If, which is a big if, Berkshire compounds at 9%, a shareholder of 15 years would need almost 13% annualized in an A/R strategy or ~10% annualized in a single stock with 100% annual turnover strategy to match Berkshire’s after tax returns. 

    Risks

    Keyman risk- optically this is with Buffett but I actually think the bigger concern is keeping Ajit Jain and Greg Abel in their positions.  Clearly the promotion of each to Vice-Chairman is a step in that direction but I would be concerned about either of them leaving, given Buffett’s reduced involvement in the operating businesses.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Probably my favorite aspect of an investment in Berkshire is that the forward looking returns of Berkshire increase with both overall stock market declines as well as with a $400B cat event.  Berkshire’s stock will absolutely decline under either of these scenarios but the forward returns on its $100B of excess liquidity should increase from today’s paltry 2.4% T-bills yield to over 10% conservatively.  The second catalyst could be a meaningful acquisition to change the market’s perception of the value of the excess cash.

    Messages


    SubjectQuestion
    Entry03/05/2019 10:49 AM
    MemberHolland1945

    To what extent are Jain and Abel involved with Berkshire's large whole company acquisitions? What deals have their fingerprints on them?

     

    I think it's sad that Howard Buffett is going to one day be the chairman of this company. 


    SubjectRe: Question
    Entry03/05/2019 11:01 AM
    MemberMadDog2020

    Thanks Holland. I share your sentiment on Howard although the important caveat is that he'll be non-executive chairman.  Given his limited involvement, I'm betting he knows his sole responsiblity is to have the backbone to replace a bad CEO pick but time will tell.

    On the large acqusitions, I'm not sure Jain/Abel have been involved with any of the recent ones.  Buffett publicly gave credit to Todd Combs for the Precision castparts deal and the Duracell/PG share swap.  Outside of bolt-ins within their respective areas, I'd expect Todd/Ted to primarily orchestrate future M&A.


    Subjectmore detail
    Entry03/05/2019 11:13 AM
    Membergrizzlybear

    Can you elaborate on your sum of the parts analysis? 

    Specifically isn't some of that excess cash required for the insurance business?  

    What do the operating businesses deserve a 17x multiple?  Other than Burlington they seem to be a pretty cyclical bunch of assets.    

    How do you value the significant embedded capital gains taxes associated with selling the securities or individual business lines.  

     


    SubjectRe: more detail
    Entry03/05/2019 11:37 AM
    MemberMadDog2020

    Thanks Grizzly.  On the securities, I crystalized the securities so that number is a net of cap gains number.  Obviously they're unlikely to sell them today so we should get some additional compounding on the DTL but I went ahead and realized all of the securities for the SOTP.

    On the operating businesses, about half ($141B)of the $285b in value comes from BH energy and Burlington.  The remaining comes from the MSR group of businesses (Manufacturing, sercie and retailing), which Buffett stopped itemizing in the letter in 2016 but still disclosues in the MD&A of the K.  This is where Precision, Lubrizol and ISCAR all sit and in 2016, he stated that this group of businesses generates 12-20% returns.  Over the last three years, this group of businesses generated the following in net earning to BRK: $9.3B, $7.2B, and $6.8B.  Given that, I think it's reasonable to pay a similar multiple.


    SubjectGRA: What Berkshire Should Buy with that War Chest?
    Entry03/05/2019 02:00 PM
    Memberfalcon44

    Buffett has long complained about the lack of targets to deploy his cash balance war chest into, but as his deputies take on more responsibilities, perhaps a business
    Ted Weschler has long been familiar with may come to market?  

    See our GRA write-up on VIC for details, but what isn't in the write-up is that Weschler himself made his career on GRA, which helped him get the Berkshire job in the first place:

    "Ted Weschler’s first job after college was at chemical maker W.R. Grace & Co. (GRA)In 2007, six years after the company filed for bankruptcy, his hedge fund held 15 percent of the shares... Over a three-hour dinner at Charleston’s Oak Steakhouse, the men started a conversation about resolving the case in a manner that would be fair to workers and shareholders. Weschler picked up the check. His initiative paved the way for a settlement a year later that helped Grace’s stock climb 40-fold since the bankruptcy and an investing record that earned him a job at Warren Buffett’s Berkshire Hathaway Inc. (BRK/B)." 

    http://oxstones.com/weschler-rise-from-grace-leads-to-role-advising-buffett/

    Could GRA be for sale?  We don't know, but there are a few things that make you go "HMMMM..."

    GRA agreed to appoint two board member recommendations provided by 40 North (14.0% shareholder and 13-D filer) on 2/21/19: 

    https://www.icis.com/explore/resources/news/2019/02/21/10322667/us-wr-grace-agrees-board-appointments-with-investor/

    One of the board member appointees is Kathleen Reiland, an M&A expert.  Kathy is currently head of Corporate Development & Strategy for Standard Industries and a former senior investment banker from Evercore: https://www.standardindustries.com/our-team/

    The day before the board additions were announced, executives from UOP (a subsidiary of Honeywell and comp to GRA), attended a Barclays conference.  Per the conference transcript on 2/20/19, UOP President John Gugel stated:

    "We certainly will look for M&A when it becomes actionable in other verticals of, let's say, petrochemical technologies if they should become available. And we also  strategically have a bias towards looking for additional opportunities to continue to build up our aftermarket, which for us, oftentimes means our catalyst space."

    HON has long been rumored as a suitor of GRA, and a focus on "petrochemical technologies" and "catalysts" seems to potentially describe GRA?  We thought this sounded like an unusually specific call-out...

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