Has Buffett Lost It?

A common phrase these days, “what´s wrong with Warren”. When these ideas are floating around, it might be a good time to take the other side and bet with Buffett…but that is just speculation.

The critique likely comes from share price performance in 2019. That gives you a sense of how short term oriented some market pundits really are. The market is up 25%+ and Berkshire is only up single digits, etc. For market participants who focus on the underlying performance of the business and in long term investments, these comments are just non-sense.

If we look at the numbers, Berkshire has been performing very well. There are some businesses that are struggling, but that is expected since there are a wide array of subsidiaries. We will continue to have troubled investments, that we can be sure of. It is just part of the game.

Going back to the “What´s wrong with Warren” phrase, some arguments focus on lagging performance compared to S&P 500. Let´s look at the numbers.

We can compare the growth in book value per share of Berkshire and the S&P 500 total return, since right before the crisis. I am using this period since I think it is fair to use the whole cycle, not just the “bull” market that started in 2009.

As we can see, Berkshire has outperformed by a significant margin in this period. Very different from what we constantly hear in the media these days. During this period, the annualized growth in BVPS for Berkshire has been 10.3% while the S&P 500 TR 8.5%.

bvps spy

This is not a great comparison since book value is not as relevant as it used to be for Berkshire. Also, it is not fair to compare book value growth to total return. But at least, it is a valuable exercise and it shows that Berkshire´s underlying performance has been very good.

I prefer to use another metric, which in my opinion tracks performance more closely. That is growth per share in operating earnings (excluding insurance) and in liquid assets.

Since 2007, annual growth per share in operating earnings and liquid assets has been 12.3% and 8.2%, respectively. Those are impressive results.



I think over time, intrinsic value and share price will likely track the growth in these 2 figures (operating earnings and liquid assets per share).

Currently, liquid assets and operating businesses add similar value to Berkshire. Liquid assets stand at $380bn. Earnings from operating businesses ~$18.5bn, if we apply a market multiple, we get close to $330bn. That is not relevant to this discussion, it’s just a curiosity.

Other market participants make a more rational argument that cash is continuing to pile up and that might be a problem. I agree, it actually is a problem with no easy solution. Having said that, I believe 1) cash balance will almost always be higher that most would expect or prefer; 2) current cash balance won´t be a huge drag on results. I might post on these 2 comments another day.

Looking at solutions, here are some avenues to deploy cash:

Repurchases: There have been some issues 1) the stock price has not suffered a major decline since the new repurchase strategy was announced; 2) trading volume of Berkshire compared to other equities, is low so it has not been easy to repurchase large amounts of stock when price has been temporarily depressed; 3) Buffett has demonstrated a lack of appetite for repurchases of Berkshire stock in the past (that might change).

Dividends: Berkshire could do a large one-time dividend of say $50bn. That would temporarily solve the issue of a large cash balance. On the negative side, that would be a taxable event which makes it less likely.

Public Investments: Some commentators don´t realize this, but Buffett has been active on this front in the past few years. Starting in 2016, he made his largest investment ever in public equities buying close to 5% of Apple. The investment is currently worth more than $60bn and it has been close to a double so far. Berkshire also took a 10% holding in each of the large US airlines. More recently, Berkshire made a significant investment in JP Morgan.

This is an area where Buffett has successfully deployed large amounts of capital with good results. One benefit, is Berkshire doesn´t have to pay a takeover premium for these investments. In the past few years, there has arguably been better value in public markets compared to takeovers, etc.

Acquisitions:  Here is the thing, we have been in a bull market coupled with low rates. This is a difficult environment for large investments at reasonable prices. It is not easy to compete with private equity, when they can finance half of the acquisition with debt and are playing with other people´s money. Berkshire makes the investments to hold “forever” and thinks about the rate of return assuming the transaction is paid with equity.

I think we won´t see much action here unless we get some volatility and the credit markets dry up. In the current environment, Buffett won´t be the best offer as competitors are willing to pay higher prices.

I think there is less competition in large acquisitions compared to things below say $10bn. So we might get a surprise from a special situation in which Berkshire is the only real option (e.g. PG&E, Bloomberg, etc.). In general, I am not too optimistic here.

Special Situations: Berkshire has lent money when companies needed the cash quickly (GE, BAC, GS, Mars, etc). Recently, this has been a business without much activity since credit markets have been open. Buffett managed to close a deal with Occidental Petroleum offering  $10bn in exchange of an 8% preferred with warrants. He has also supported Home Capital Group, Kraft Heinz, Seritage, etc. Companies see the value of a quick yes and the approval from Berkshire. Hopefully, we will get more of these deals.

We can see why Buffett has not been able to keep cash from piling up. It is a problem with no easy solutions. That might change quickly and Berkshire will be prepared for that.

To wrap it up, Buffett has not lost it. Berkshire is doing quite well as shown by results in the past few years. I expect that results from subsidiaries and investments will be quite satisfactory in the long run.

One of Buffett’s attributes is patience. In the past, Munger has even called it “almost inhuman patience”. For example, after doing the Cap Cities deal in 1985, Buffett went 3 YEARS without buying a SINGLE stock. Then he made one of his best investments ever, taking a huge and outsized position in Coca-Cola.

Some might see the lack of action as if Buffett is losing it. I see it as discipline. As a long-term Berkshire shareholder, I am comfortable with this.

A Reason to be Optimistic

For years, Berkshire investors have been “worried” of the growing cash pile. The company has + $100bn in cash, and more of it is coming in every day that needs to be redeployed. Some investors have argued that Buffett should return some of that cash as it is becoming a “drag” on returns.

I think there is some hope. Specially, for investors like me, that would prefer if Buffett is able to redeploy the cash into attractive opportunities or via buybacks. The preference of buybacks over dividends is due to tax efficiency.

The challenge is that at Berkshire´s current size, there are a limited number of opportunities that can move the needle. So, deploying all the cash has not been easy. It is also important to note that Buffett is very disciplined. He will only act when there are decent opportunities.

Another good “problem” has been that the insurance division has been able to grow float at a CAGR of 8% in the past decade. Buffett has been saying throughout this period that “further gains in float will be tough to achieve”. Well, the division has been able to surprise him on the upside. And the most important aspect is that this growth has been achieved while maintaining underwriting discipline and generating an attractive combined ratio, well below 100.

The issue with this success is that float went from $63bn in 2009 to current levels of $123bn. That is an additional $60bn in float that needed to be redeployed during that period. Not an easy task in a low rate environment.

But we also need to add the cash flow from operating businesses, etc. So, the task for Mr. Buffett has been even “tougher”.

In the past 10 years Berkshire has generated $282bn in operating cash flow!!

Fortunately, not all that amount gets back to headquarters in Omaha since $110bn was invested in capex by the subsidiaries.

After capex, we are left with $172bn, which is still a big task but better than the original figure.

With that cash Buffett has been able to acquire companies, invest in public equities, do special deals, etc.

To be specific, $102bn has been spent in business acquisitions which include BNSF, Precision Castparts, Kraft Heinz, etc. That is a pretty significant number.

After these acquisitions, we are left with $70bn of cash flow that had to be deployed. A portion of that has obviously gone into public equities like Apple, JP Morgan, etc. But the figure is very low, at least compared to what I expected before looking into the numbers. Net purchases have “only” been $28bn in the last 10 years. If we take away the Apple investment, which was significant and done in the last couple of years, the net amount might have been close to zero. I know it is a big “IF”, but still…

This was a surprise to me. Of course, he has found opportunities, but he has sold shares in some of the holdings as they became expensive or reached the 10% threshold. Point is, public equities has not been a field that has consumed a large pile of Berkshire´s cash. That of course might change if the market hits a rough patch, etc.

Going back to our $282bn operating cash flow number, Berkshire has been able to deploy most of it through capex, acquisitions and public equities. To be exact, Berkshire deployed $240bn in these 3 fields.

We can conclude then that the company was able to deploy most of the cash flow, except $42bn which just built up. On top of that, there were some bond maturities, redemptions, etc. that increased the cash amount.

Not bad Warren.

Back to our original topic, why am I optimistic that Berkshire will find ways to efficiently allocate cash going forward?

Of course, the modification to the repurchase policy is a major change. Now, the company will repurchase shares whenever it considers the price attractive for remaining shareholders. That provides flexibility considering that for years the mandate was that repurchases could only occur below 1.2x book value. This proved ineffective and too restrictive, making repurchases difficult to execute.

In the past decade, repurchases were close to insignificant. I predict going forward, this will change for the better. This will be a relief for Mr. Buffett and Berkshire shareholders as this will consume some of the cash (hopefully).

I am not a fan of financial models since they are usually wrong and there is much more to investment than only looking at the “projections” but let´s play with some numbers.

I believe operating cash flow for the next couple of years should be close to $35bn. I get that figure assuming float grows by 3% a year (much lower than the past decade) and cash flow from “non-float” sources stands close to $30bn.

Capex in the last 5 years has averaged close to $14bn. So, let´s assume that cash flow after capex currently stands at $20bn.

We are looking at $20bn per year that needs to be deployed. Options include repurchases, public equities, acquisitions, special deals, etc.

Looking at repurchases, there is a possibility (slim though) that in a given year, Berkshire can spend $20bn in its own stock. That figure is achievable by buying close to 10% of daily trading volume. Of course, we would need to assume that the stock remains undervalued throughout the year and that Berkshire remains “very” active in this department for almost 12 months in a row. Not easy. But there is also the possibility of a tender or a large “estate” transaction like the one that occurred some years ago.

There is a possibility that all of the free cash flow is consumed by repurchases. That would be great for long term shareholders. If there is a company Buffett knows well, that is Berkshire. He is only buying below a conservative estimate of value. These are value generating repurchases that also reduce the famous “cash” drag and provide relief to headquarters.

Buffett might also get the opportunity to deploy large amounts of cash if there is a large decline in the stock market. Or people will go to him looking for special deals, “a home for their business”, or the need for large, quick financing (Occidental Petroleum 8% prefs is an example), etc…

I am optimistic that returns will be satisfactory going forward and that there won´t be a need to do a large special dividend. Hopefully, the stock remains slightly undervalued for years and Buffett can direct the $20bn in annual free cash flow to repurchases.

Fingers crossed…

2018 BRK Letter & More

Buffett is a great teacher. He has an ability to synthesize very complex issues into simple stories that are easy to understand. For this reason I think reading the Berkshire annual report is a great course on investing.

For many investors, the letter is boring. Reasons abound, including it is repetitive, Buffett is full of it, etc. That is ok. There are people who don’t think Buffett is the real deal and some that just think that they won’t get much out of reading another similar letter. All of that is ok.

I still read everything he writes since I get a lot out of it (or so I believe).

Here are some comments and thoughts on the 2018 annual report and his subsequent interview with Becky Quick.

5 Groves

Buffett has provided a new valuation method for Berkshire. For years, the method he recommended was the 2-column method, which was basically adding the value of wholly-owned subs to the liquid assets (cash, bonds and equities).

Now, Buffett has provided a new method which he referred to as the 5 groves. The five groves are: 1) wholly-owned subs, 2) equities, 3) shared control companies, 4) cash & fixed income and 5) insurance. Adding the values of the first four groves should give us an approximation of intrinsic value. Insurance is a source of “cost-free” funding. So far it has been even better than that as the combined ratio has averaged <100% and float has grown.

I used this method with my approximation of value for the different “groves” and came up with an estimated Intrinsic Value. Value of liquid investments are as of 12/31 so it might be reasonable to adjust upwards.

1) Wholly-Owned Subsidiaries: $320BN

2) Equities: $158BN (after subtracting $14.7BN in deferred taxes)

3) Shared Control Investments: $17BN

 4) Cash, Equivalents & FI: $132BN

5) Insurance: 0

Berkshire Value: $627BN (BRK-A $382,119; BRK-B $254.75)

Float & Low Expectations

Float continues to be the fuel that pushes Berkshire forward. Back in 2011, Buffett stated the following: “It’s unlikely that our float will grow much – if at all – from its current level.” At the time, float was $70.6bn. In 2018, float hit $122.7bn. So float has grown at a CAGR of 8.5% since 2011. Many investors thought float was peaking when Buffett made that statement. Once again, he lowered expectations and outperformed.

Float has grown while being better than cost-free. In 2017, due to various catastrophes, underwriting losses before taxes were $3.2bn. Since 2011, that is the only year with an underwriting loss. Adding up all the underwriting results since 2011, we get to a total pre-tax gain of $12.1bn. Pretty attractive funding source!


Buffett thanked Tony Nicely for his work at Geico. In his comments he gave us interesting information on Geico´s estimated value. He mentioned: “By my estimate, Tony’s management of GEICO has increased Berkshire’s intrinsic value by more than $50 billion.”

So we know, Buffett thinks Geico si worth at least $50bn. Probably more than that, since Nicely became CEO in 1993 and in 1995 Berkshire valued Geico at $4.6bn in its acquisition of the 50% interest the company did not own.

For now, let´s assume Geico is worth at least $50bn. That represents mora than 3x Geico´s surplus. Pretty amazing how much value has been created here and it continues to grow. Premiums written grew 12% in 2018, reflecting 3.3% policies-in-force growth and 6.4% premium per auto policy growth.

Geico is another important reason why intrinsic value is higher than book value, and also why book value has lost relevance.

Missing the December Market Dip

After Berkshire released its 13-f, many investors were disappointed. Buffett made very few investments during the 4q18 market dip. Trying to find an explanation for this lack of activity, some investors argued that he probably was busy repurchasing his own shares. To the surprise of many, Berkshire released its repruchase activity on saturday and figures were underwhelming. Berkshire repurchased less than $500mm during this period.

Now we know why the numbers were so disappointing. Apparently, Buffett was trying to close a large acquisition and the deal fell through. I have no idea what type of elephant he was aiming at. But we know it was a failed attempt…

Buffett also said there were many opportunities in the market during November & December…what a shame.


Buffett loves banks. That is obvious. He has maxed out his position in BAC, WFC, USB and possibly on its way with JPM. Of the large US banks the only one he does not “like” is Citi.

When asked why so much exposure to the sector? He mentioned how they are great businesses earning 15-17% ROTE but are trading at undemanding valuations. Then he went on to give an example. For how much would you sell a fictional bank account that paid 15% on your deposits, forever? He thought that account was worth more than 3x book value in a world of 3% rates. Of course, the required return for the equity investor in a bank is more than 5%, but we also get to reinvest a portion of the earnings at that 15% return. I like large US banks and found this analysis interesting.

Buffett is arguing that the required return equity investors are asking for large banks is probably too high…and that is ok since banks are large repurchasers of their own stock.

On a side note, he mentioned how this year banks won´t have to pay quarterly surcharges that cover FDIC costs. That, coupled with the tax reform, will continue to help large banks.


Results at the railroad continue to be impressive. Revenue grew 12%, helped by 4.1% volume growth and 6.2% revenue per car/unit growth. The economy has helped, but the story here continues to be pricing. Railroads have been able to reprice many of their contracts while maintaining volume growth. That combination has been great for shareholders.

Another interesting aspect has been how free cash flow has exploded in the past 3-4 years. In 2015, BNSF invested $5.8bn in capex, this figure has declined dramatically to $3.4bn in 2018 and expected to be $3.6bn in 2019. This is attractive since the railroad continues to grow, and at a nice rate. In 2015, EBITDA was $9.7bn while in 2018 this number expanded to $10.2bn. So this combination of cash flow growth with declining capex has meant an explosion in free cash flow generation. Before paying interest and taxes, free cash flow has grown from $3.9bn in 2015 to $6.8bn in 2018. That is 75% growth in 3 years!

Also, it is important to highlight that this expansion if free cash flow is not due to underinvestment. Union Pacific, which is a similarly sized railroad, invested less than BNSF last year. To be specific, 2018 capex for UNP was $3.2bn.

Kraft Heinz Debacle

In 2017, KHC was trading at $90/share when the financial world was in love with the 3G model. At the time, the stock traded at roughly 30x earnings for a no growth business. The market thought KHC could keep growing by acquiring other companies and repeating the cost-cutting process. Well, that did not happen as multiples were too high for a sector that had no top-line growth and declining margins. During these last few years, the industry has gone through a rough patch as private label offerings have taken share, retailers have toughened up on pricing, etc.

KHC has gotten destroyed by the market, falling 70%. This decline is well deserved given the deterioration in financial results. Also, last week the company announced an SEC investigation into its accounting and internal control, a dividend cut and a $15bn impairment. Woof.

Ok, so that is the story of KHC.

Berkshire owns 27% and has been a cheerleader of the Brazilian team. So headlines were all over this, understandably so. In an interview, 2 days after releasing the shareholder´s letter, Buffett talked about KHC and he was very honest, as usual.

 “We overpaid for Kraft

Buffett was very specific in mentioning that they paid too much for Kraft, but not for Heinz. So the first deal was good, but not the second.

He mentioned how they misjudged the leverage retailers were gaining over them and the competitive position of the Kraft brands.

Buffet accepted his mistake but did not talk about the result of the Berkshire investment. Surprisingly, they have not been bad (so far).

Heinz bought Kraft by paying with an arguably overvalued stock that some analysts estimated was priced at 4x the cost basis of the original Berkshire-3G investment. So at the moment, they were using that currency to buy scale in the sector. Unfortunately they had to pay too much and the economics of the target deteriorated over the following years. But my point is that by using their pricy stock, instead of only cash, the final outcome is not as bad as it could have been. In a perfect world they would have not bought Kraft, but still results at standalone Heinz might have followed a similar path as the CPG sector.

Something that is very interesting about this mess, is the way Buffett structured the deal. And this is classic Buffett. In 2013, 3G approached Berkshire about buying Heinz. They agrred to the following structure, Berkshire would invest $12.3bn, out of that amount $8bn would be in 9% preferreds. Berkshire also got some warrants. So he was protecting his downside by buying a fixed income security but also looking at the upside with the warrants. In 2015, when Heinz acquired Kraft, Berkshire exercised the warrants and invested an additional $5.3bn.

3 years after the initial investment, KHC redeemed the 9% preferred paying a $300mm premium. For years, before the dividend cut, Berkshire received annual dividends that amounted to high-single digit percent of the invested amount. Applying the current market price, KHC is worth $11.3bn to Berskhire compared to the invested amount of $9.6bn.

Yes, KHC is a mess right now and there is not a lot of hope, but Berkshire has not done bad with this investment. Results have been pretty decent in part due to the way Buffett structured the original deal.


Buffett is 88 and he seems to be as sharp and mentally agile as ever. It was great to see that.

Outsized Returns in a Regulated Industry

Last post we talked about a 10 year investment, now we will look back 20 years!

In October 1999, Berkshire, Walter Scott and David Sokol agreed to pay a 27% premium to acquire MidAmerican Energy for $35.05 a share.

Initially, Buffett offered $35.00, but the bankers kept asking for more. This was probably the only public investment were Berkshire ceded to demands from the seller. It was only 5 cents, but still I think this is not the message Buffett wants to send.

The transaction had a complicated structure, since certain regulations prohibited Berkshire from gaining voting control over the utility.

So here it is:

Berkshire invested $1.25bn in common stock and convertible preferred stock plus $800mm in an 11% fixed-income security.

The investment gave Berkshire 76% economic ownership of MidAmerican, but less than 10% voting power. Walter Scott and David Sokol were co-investors. The Scott family brought their total investment to $280 million and became the controlling shareholder.

At the time of the acquisition, MidAmerican served 3.4 million customers electricity and natural gas in the Midwest and UK, primarily. The company also had other power generation assets.

The plan was to use this platform to keep growing, organically and through acquisitions.

MidAmerican was a possible solution to one of the problems Berkshire was starting to face, even back in 1999.

Berkshire needed to allocate excess capital and earn adequate returns. The utility industry provided a long runway.

It didn´t take long after Berkshire made its investment, for MidAmerican to start its expansion.

In 2002, MidAmerican acquired 2 gas pipelines, Kern River and Northern Natural Gas. Both investments were opportunistic as the sellers needed cash. In the case of Kern River the seller was Williams and in the case of Northern Gas it was Dynegy. The pipeline was actually an Enron asset that ended up in Dynegy´s hands in the middle of that mess…

To fund that acquisition, MidAmerican asked Berkshire for cash. Berkshire bought $1.3bn in an 11% FI security and $402mm in common stock (6.7mm shares for $60/share) bringing total economic ownership to over 80%.

There are many interesting aspects of these transactions.

MidAmerican was an opportunistic buyer that bought distressed assets at great prices. They were able to act quickly given the company had the financial support of Berkshire (it took Berkshire 3 days to sign a deal after receiving the call from Dynegy). Also, MidAmerican instead of paying dividends clearly became a place for Buffett to allocate additional cash, when the company found a deal and needed capital.

A similarly structured transaction occurred in 2006, when MidAmerican asked Berkshire for $3.4bn. This time the funds were used to acquire Pacificorp, a utility with 1.6mm customers in the West Coast.

MidAmerican also was opportunistic during the GFC when Constellation Energy ran into trouble. CEG had a commodities trading business used to hedge the company´s risks. As volatility in commodities spiked, trading partners asked for higher collateral requirements. The company ran into trouble with rising liquidity needs, credit downgrades, etc. MidAmerican came to the rescue, by offering a loan of $1.0bn (8% preferred stock) for a $25mm fee and also an all cash proposal to acquire CEG at $26.50 a share. 3 days later a consortium led by KKR offered $35/share, but CEG needed reliability and speed since the situation was deteriorating quickly. After agreeing to a deal with MidAmerican, a couple of months later CEG terminated the agreement. But they had to pay dearly for this breakup. MidAmerican got a termination fee of $175mm, 19.9mm shares of CEG (10% of S/0) and $1.0bn in 14% notes in exchange for their $1.0bn 8% preferred stock. MidAmerican sold its shares in CEG for approximately $500mm. After all, MidAmerican made more than $800mm from a failed deal. Excellent.

There have also been deals in which MidAmerican didn´t ask Berkshire for capital, as they were funded with available cash and new debt. In 2014, they acquired NV Energy for $5.6bn and Altalink for $3bn. Also, the company has been active acquiring realtors and expanding its real estate services business.

Fair to say, MidAmerican has been opportunistic and that has created value. They have been able to close deals faster than the competition since they had the financial backing of Berkshire and didn´t depend on the capital markets or banks. Also, the Berkshire sign of approval has been critical.

Now, MidAmerican has been renamed Berkshire Hathaway Energy. BHE has a series of assets including electric distribution, 27,500MW of generation capacity, gas pipelines, and real estate services.

That was a quick summary.

The reason why I decided to dig deeper into BHE is because it has become a large and significant subsidiary of Berkshire. Results here matter. This might be due to the combination of good performance, no dividend policy and Berkshire investing additional capital throughout the years into BHE.

Once I started looking at the numbers I was amazed.

I was expecting ~10% type returns since this is a regulated industry with allowed returns in that range. Here are the allowed ROEs:

I think Buffett also expected returns in that range. At various times, he has invested in junior subordinated debt of the company with an 11% coupon. In an annual letter he stated the following: “By charging 11% interest, Berkshire is compensated fairly for putting up the funds needed for purchases, while our partners are spared dilution of their equity interests.” A junior subordinated fixed income security in this industry is very similar to equity so there is a reason to think something in the range of 11% was the expected return for the equity.

So I am not alone in this camp. Buffett also thought 11% was adequate.

Let´s look at EPS growth.

I know EPS is not the best measure to calculate value creation, but it is helpful. I was impressed by this chart. When Buffett decided to invest in MidAmerican in 1999, EPS were $2.59 and that number has increased 14x to $37.19 in 2017. That is 16% per year. Way higher than the ~10% type number we expected.

I initially thought something was wrong, but fortunately we got help from our man at Omaha. There are some data points that are very helpful:

  1. Berkshire has bought shares in 2 different transactions, besides his initial investment. The shares were issued at what was considered “fair value”
  2. Berkshire has acquired shares from the Scott Family at “fair value” in certain years.

So we know what was considered “fair value” per share through the years:

BHE has not paid dividends since Berkshire became a shareholder, so it´s easy to calculate the return from the initial investment 20 years ago at $35.05 per share. Surprisingly, “fair value” per share growth was the same as EPS growth, 16%!

The obvious question is, how has BHE generated 16% returns if the allowed ROE on its subsidiaries has been in the 10-11% range?

I have a couple of reasons why I believe this has been such a success, but I obviously might miss some.

Distressed Investments: BHE has closed deals when sellers where desperate for cash and needed quick execution. The company was able to close many of these transactions because it had the financial backing of Berkshire. For example, the acquisitions of Kern River and Northern Gas summed $1.3bn and these assets were soon earning more than $200 million per year. Another example, is when MidAmerican came to save Constellation Energy and ended up making more than $800mm even after failing to close the deal. These investments at low prices have bossted returns.

BYD Investment: In 2008, MidAmerican acquired 10% of the shares outstanding of BYD for $230mm. That investment has been a success and now is worth almost 10x what the company originally paid for.

Holdco Leverage: BHE has used its low cost of funds to improve its equity returns. The company has constantly employed parent company debt, in addition to subsidiary level debt, to increase the return profile. Given the Berkshire name and the various stream of assets, BHE is able to issue at the parent level at low costs. This is a big benefit.

There are many other reasons including tax credits/efficiency, management, luck, etc…but that will take us forever.

I think this investment has been even better for Berkshire than the 16% headline number suggests. I know the number alone is impressive, but…

BHE has not paid a dollar in dividends since 1999, so Berkshire has “reinvested” all its earnings. This reduces the pressure at headquarters to allocate excess cash. BHE has even asked Berkshire for additional capital when it found large deals. So Berkshire has invested additional amounts at great returns. Besides the equity returns of 16%, Berkshire has also invested in 11% fixed income securities in a high quality issuer.

Berkshire also found Greg Abel, which will likely be an important figure at Berkshire…hopefully for a long time.

Buffett has guided to ~10% type returns for Berkshire in the next decade, let us hope we get a similar surprise…crossing fingers.

10 years since BNSF

Berkshire acquired BNSF a decade ago. Time flies.

This deal changed Berkshire. Suddenly wholly-owned operating businesses were REALLY important.

Back in 2009, some said Buffett had lost it. The old guy had gone crazy. We are used to that at this point, as it has been a common theme for the last few years. Apple’s stock decline and Berkshire’s massive position is bringing a ton of these comments back to stage. Well, Buffett is probably laughing at these guys back in Omaha.

In November 2009, many were looking for answers. BNSF was not the typical Buffett business.

Not to pick on Bruce Greenwald, but he was one of the critics at the time. Here are his thoughts:

“It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex.”

These are perfectly rational comments from a respected professor. It is interesting to look at what attracted Buffett to BNSF. Also, with the benefit of hindsight, why Buffett was right and his detractors wrong.

One very important fact of this transaction, was his level of conviction. In November 2009, there were a ton of cheap opportunities. Buffett picked BNSF, and paid a 30% premium to gain full ownership. Also, 40% of the total consideration was paid with arguably deeply undervalued BRK shares. So, safe to say he really wanted BNSF.

The $34bn paid for BNSF, represented almost 25% of Berkshire’s equity! It was a huge bet, with significant repercussions.

At the time, Buffett said it was an all-in wager on the economic future of the US. That is fine, but we know he was looking at other details that made BNSF a great value. Even at prices considered high by many experts.

Ok, so 10 years (a bit less actually) have passed. It might be time to look at the results so far…

Since the acquisition, BNSF has paid Berkshire more than $30bn in dividends. That is almost the complete purchase price in less than 10 years! Very similar to a bond with a 10% coupon, but with likely rising coupons and PAR value. Great. That is impressive for a capital intensive business, also given the optically “high” purchase price.

Earnings have jumped from $1.8bn in 2009 to +$5.0bn. I know earnings were at a cyclical trough in 2009 and might be reaching a cyclical peak now, but those are still impressive numbers. It is more impressive if we take into account how much capital Berkshire has taken out of the company in the form of dividends.

Something that is quite useful for our exercise is that UNP is a public company. And it is a very similar railroad, operating a similar network. They generate basically the same amount in revenue at ~$23bn. UNP is slightly more profitable as they have a bit higher margins, arguably for structural differences (business mix).

An interesting fact is that UNP headquarters are in…you guessed it…Omaha, Nebraska. Buffett picked the other railroad. Well, that is not relevant but it is a funny fact.

What is relevant is that we know what the market thinks about UNP and how its stock has performed in the past 10 years. Also, in this period BNSF and UNP results have been very similar with revenues up 50% and cash flow doubling.

Since November 2009, UNP has offered its investors an IRR of 22%. That is impressive.

During this period, the S&P 500 generated an 11.8% return, which is very good, but almost half the return offered by the railroad.

UNP currently has an enterprise value of $130bn and a market cap of $110bn. This represents 12.5x EV/EBITDA and 19x P/E. Those are some helpful figures that we can use to get to an approximation of market value for BNSF.

Applying similar numbers, we get to an Enterprise Value of $125bn and an equity value of $105bn for Berkshire´s railroad. Once again, Buffett paid $34bn, took out $31bn in dividends and is left with +$100bn in value…Good job Warren.

So we know returns for this massive investment have been impressive, but let´s get to a number. And the number is…~18%. That is massive for an investment many thought at the time would produce mediocre returns. Remember many experts thought he was overpaying for a capital-intensive, regulated and cyclical business.

18% is 1.5x the return of the S&P 500 during a bull market. But it gets better…At the time of the acquisition, Berkshire already owned ~20% of BNSF stock…so he didn´t have to pay the takeout premium on 100% of the shares outstanding. In reality, he had to pay ~$26bn for the shares he didn´t own. Also, Berkshire employed a bit of leverage to fund the acquisition. The company issued $8bn in bonds, so we get, leveraged returns. If we take into account the leverage and the shares of BNSF Berkshire already owned, then the return on the equity would go…way up. But I think we get the point.

There is also a negative aspect to the deal. Berkshire issued $10.6bn in undervalued BRK shares to complete the acquisition. It is fair to assume that this dilution was not optimal. But looking at the numbers, I think it is safe to say that we are better off now with BNSF. Even if it required issuing some shares.

Something interesting about this acquisition is that Berkshire had a lot of cash on hand. $20bn to be more precise. So why did he issue shares? Well, Buffett has mentioned in recent years that he won´t go below the $20bn in cash line. There was a lot of temptation at that time to go below that mark, and he didn´t. That is discipline.

So, what has changed in BNSF since the acquisition…

On the balance sheet, the company has put on $12bn of additional debt. Most of it has gone to Berkshire in the form of dividends. I guess this makes sense since the cost of debt is so low for this high quality issuer.

Revenues have also increased 50%. In 2009, during the middle of the crisis, revenues were $14bn. Since then, with economic tailwinds and some help from the US oil boom, revenues increased 50% to $23bn. Important to note that coal was 25% of sales, and that has been a significant headwind throughout this recovery.

50% revenue growth over a decade is decent, but that is not the main cause of the success. I believe the key for this investment has been pricing power. BNSF has repriced most contracts with its customers as these came up for renegotiation. Industry consolidation, an underpriced service and a competitive advantage over trucking have helped railroads push pricing over the last decade and more.

This combination of volume and pricing growth plus management keeping expenses tight, has boosted margins. EBITDA margins have increased from 35% at the time of the acquisition to current levels of 45%. Also, the additional financial leverage has amplified the returns.

Well, Buffett has been right so far. He has made a ton of money out of businesses that have untapped pricing power (See´s, Coca-Cola, Moody´s, etc). This formula of volume and pricing growth over long periods of time has been very productive.

Going forward, this looks like an asset that should continue sending dividends to Omaha for many years to come. Hopefully.

And a final thought…

BNSF´s carrying value is $43bn, and we are saying it is worth $105bn. Here we found a reason why real business value might exceed book value in the case of Berkshire. We can leave that for another post.