Berkshire Hathaway – Shrinking Its Way To ProfitabilityThe Acquirer's Multiple
During his recent interview with Tobias, Christopher Bloomstran, President and CIO of Semper Augustus Investments Group discussed Berkshire – Shrinking Its Way To Profitability. Here’s an excerpt from the interview:
Chris Bloomstran: We really haven’t had to whack the machete that much a lot of it is more of a scalpel. If you take Berkshire, there’s this anchor cornerstone of our business go through the big moving parts. The insurance operation, 45% of the business, highly invested in common stocks. Well, you take the insurance industry and the investment capital insurers is largely, again, like what January looked like in the late 90s. It’s bonds and cash. Well, we’re back to a 0% climate on short rates. The government does a lot. The federal do a lot to compress longterm interest rates as close to zero as possible. Credit spreads will thus necessarily have to be higher than they were at year in ’19 where they were really tight. In Berkshire’s case, because they’ve got so much surplus capital in the insurance operation, GEICO writes more than half of Berkshire’s premiums in auto insurance, which is written on an admitted basis, meaning the insurance commissioners in each state.
Chris Bloomstran: Bless your rate filings. GEICO and all the auto insurers are allowed to write $3 a premium for each dollar of statutory capital. We think GEICO has always written at about two to one. If they’re going to write $37 billion, they only need 13, 14, 15, $16 billion. Well, Berkshire’s statutory capital in the insurance operation was over $200 billion a year end. It’s probably 185 or $190 billion today. The rest of the insurers, National Indemnity, Gen Re, the specialty business, the home state business, all of them put together, they write call it $30 billion, not even $30 billion, probably 27 or $28 billion. Find another insurance company that writes $27 billion. Let’s say on almost $200 billion of statutory capital. What that tells you is there’s so much surplus capital in the insurance companies alone. And then you take the businesses that are held outside of the insurance operations and the profitability there and the lack of leverage there.
Chris Bloomstran: And there’s an enormous amount of capital inside Berkshire where if this pandemic winds up being really bad, Berkshire’s not going to be out having to raise capital. Losses may develop a lot worse than they think. There’s a sense that they’re going to have some losses and they’ve taken some business that was really badly written in Europe. Lloyd’s is probably in big trouble today. There are a couple of others, but there’s no permanent impairment. They’ve already sold the airlines. I think there’s some lousy businesses, honestly, in the stock portfolio. But the portfolio went in trading a decent number to earnings. If $40 billion, let’s say as the normal earning power of Berkshire Hathaway, and I had $42 billion a year end, and that assumes that they’re going to earn that 7% on the residual cash.
Chris Bloomstran: If you take that out and make that a more conservative number, call it $40 billion. And so today, Berkshire is trading at $420 billion market cap on what I still think is close to normalized $40 billion earning part. The earning power of the insurers are not diminished. They will underwrite profitably. They’re worth every bit of the invested assets of the firm. And with the stocks being down as much as they are, if we have a depression, the stocks are going to get cheaper, but Berkshire will never have to reach into its pocket to liquidate securities to pay losses on the insurance operation. It’s just not going to happen. That piece of the business, which is 45% is as durable as can be. It will fluctuate with the capital markets. But it’s a fortress. It truly is a Fort Knox.
Chris Bloomstran: Then you move onto the other two biggies. The rail and the energy operations. You heard Greg Abel talk about the energy businesses and it was music to my ears. Part of our analysis of the earning power of the utility and the rails is hitched on the fact that they pay less in cash taxes every year than they report in gap earnings. And that stems from the use of accelerated depreciation for the fixed asset and investments that are made. So because the rails at some level, but certainly regulated utilities, electric utilities exist in part for the public good. They’re allowed to use for tax purposes, accelerate depreciation. The whole world is on accelerated depreciation on steroids today, thanks to the tax code change in 2017. But the use of that method was limited more narrowly to businesses like those two within Berkshire.
Chris Bloomstran: So you have a 40 year asset and you depreciate it on a straight line basis, over 40 years for gap purposes, you take 2.5% depreciation charge per year. While for accelerated appreciation you may be allowed to write down 50% in year one. And so what that means is your cash taxes are less than your one. They’re going to be later in the out years. But as long as you’re spending more CapEx incrementally over a long period of time, there’s always a tax benefit. The energy business has been paying at a very low rate. You lay in the use of accelerated depreciation. Now with the tax credits they get for all of the investments they make in wind and solar, and effectively the government is writing Berkshire Hathaway energy a cheque. And so here we are with industrial production down pick a number, 20% 30% unemployment, wherever we think it is.
Chris Bloomstran: There are another 3 million this morning, 15% let’s say arguably headed higher depending on how long we shut the economy down, we’re still using power. We still have some portion of the manufacturing base that’s up. You and I are online here using a lot of broadband. That’s getting sucked out of some natural gas plant somewhere, we’re using power. Their revenues were down maybe 4%, and there’s a lot of variable costs in electric utility. In the deepest of declines, you’ll see very little diminution of the earning power of the regulated utility and it earns 10 on equity. And if we have a period where we go through a deep, deep, deep decline, they will be allowed to adjust their pricing to reflect a return on the invested capital to the business.
Chris Bloomstran: If everybody was paying attention to you heard Greg talk about the $30 billion in the 100 billion dollars that Berkshire could spend over time on CapEx. As I’ve taken heat over my assumption that there’s probably a billion for in earning power for the benefit of, again, the Berkshire pays less than cash taxes. People have always said, well, Warren has always said that with CapEx exceeding depreciation that CapEx really doesn’t equal depreciation, that a lot of that is required investment, that they’re not going to return. And I’ve always said, no, no, no, you may be right. But they’re getting a regulated return on every dollar of capital that they’re spending. They’re earning 10% on every dollar of capital and they talk about all of these investments they’re making in transmission assets. Pipelines if you like.
Chris Bloomstran: I’ve got a table in my letter of the last 20 years of CapEx and depreciation across the railroad, the utility and the rest of Berkshire. And they’ve been spending 40% more, let’s say on CapEx, the depreciation. These are all at a creatively high returns on invested capital. Of all of the businesses inside of Berkshire, the utilities are an absolute fortress and they’re worth probably somewhere between 50 and $60 billion. Then you have the rail, we see have rails on one hand and everybody says, well transportation’s terrible because there’s freight traffic is down, car loading has been down for the last two years. It wasn’t just the Coronavirus, we’ve had less trade with China. So really every type of goods that trains will move with the exception of grains have already been in decline, a very steep decline and now they’re down a whole bunch.
Chris Bloomstran: Let’s say they’re going to be down 25% almost every expense inside of the railroad is variable. If you go back to ’08, ’09 when industrial production was down 25% and look at Union Pacific and the Burlington Northern and the Canadian rails revenues were down 25%, earnings were down 25% so that business, the rail is going to be off, but it’s not going to bleed red ink. These three businesses are going to produce cash and that’s 75% of the value of Berkshire Hathaway. The problem you have is in the MSR businesses, which we’ve been struggling with for a long time because there are some genuinely mediocre businesses in the portfolio and there are a lot of reasons that some of those are mediocre. Part of the problem is Berkshire’s had to pay such large control premiums for businesses. Precision Castparts being the largest, most recent big deal.
Chris Bloomstran: Well they paid, Oh, I don’t know. 37 billion, I think it was for the whole business, might’ve been low 40s with debt. And we own precision when they bought it. Berkshire bought it at a price that we never would have paid. The business was already in trouble. They bought it and I think late 2015 the energy business, oil and gas oil especially had already rolled over. And so the turbine business was already in trouble. Don again, and his guys had built that business up through acquisition. It was very much a roll up and I’ve always thought, if you’re going to buy a roll up, who’s got more information in the sale of that business? The seller or the buyer. I think Berkshire made a mistake with precision, but who would have known that the airline side of their business, the commercial airline side of the business would be weak.
Chris Bloomstran: And that’s really where precision is bread and butter is. Forgings and what have you that go into the manufacturing of jet engines and the fuselage. This downturn is going to be a huge problem for that business. If you look at the evolution since 2003 of the MSR businesses, they’re run on an unlevered basis. If you look at the disclosures that used to exist in the chairman’s letter, you can see where cash would net out any little bit of debt that existed. But these were unlevered. And over the course of 15, 16 years, you would see a decline from high nines return on unlevered equity down to after the precision deal for a couple of years, about 6.5%. Well, I’m not in the business of owning anything that is going to earn six and a half on equity, even if it’s on lever. That’s just not our game. That’s not our deal.
Chris Bloomstran: And so what’s happened is between the control premiums and this culture of Berkshire Hathaway, Toby, you sell your business to Berkshire and you’ve got a home for your employees and you’re going to get a good price. How are you going to run that business? I mean you admire this guy in Omaha, he’s a God and you know everybody sends profits upstream to Omaha. And part of the problem with this decline in profitability, and I was thinking about this over the weekend and the wake of watching the meeting, my suspicion is that some of these businesses probably have required more what you would call maintenance CapEx or investment in growth than has taken place. I think if you know that the culture is, Hey, we’re going to make the money and send it to Omaha and let this genius reinvest it because this is how this thing works.
Chris Bloomstran: You may have under invested in your business, but regardless, if you now have a group that has benefited immensely from the changes in the tax code, I mean, that MSR business that does about a 50 billion in revenues generates 10 billion in profits, which is 25% of Berkshire Hathaway. The other businesses I talked about are three quarters. This group, that’s a quarter of the business in aggregate is not profitable enough. You heard Mr. Munger talk about the notion that coming out of this thing, there would be some businesses that probably did not reopen. Greg talked about a food business inside of Marmon that probably wouldn’t open. And so the ones that are not going to reopen are going to be small. But there are enough businesses in that group without getting into specifics that just donor their cost of capital.
Chris Bloomstran: And you saw, they did the deal with the newspapers, sold them to Lee, but they actually made a larger investment in the newspapers. I wrote about it in the letter this year. Now they’re in a creditor position and they own the real estate of Lee. I suppose the machete that we’ve had to take to Berkshire has been exclusively in the MSR group. I’m not going to give you a number with any precision because I don’t know what that number is. But the earning power of that business is not $10 billion. As I had assumed that year end, which wasn’t a high enough return on their 125 billion in capital to begin with. And now that we’re on the Coronavirus program and a diminished level of economic output, that group in aggregate is a struggling group.
Chris Bloomstran: And I think over time it’s going to make sense to sell some of those businesses where they can because there’s this giant amount of liquidity sitting on the sideline and private equity that needs to go somewhere. And whether these guys can do it or not, they’ll tell you they can take a five ROE and lever it up properly and turn a business into a 15 or a 20. Now, whether they can do it or not, or whether it’s smoke and mirrors and magic on leverage, so be it. But I’d rather give them a shot than leave some of these things unlevered inside of Berkshire, earning inadequate returns on capital. There’s a lot to be said for owning a business that shrinks its way by eliminating places that are not profitable. I’d rather own a smaller Berkshire Hathaway that’s more profitable than a larger Berkshire Hathaway that’s not.
Tobias Carlisle: Shrink your way to profitability. Absolutely. Fascinating insights Chris. Thanks very much for that very detailed explanation of Berkshire. I really do appreciate the amount of research that you’ve put into that. If folks are looking to follow along with what you’re doing or to get in contact with you, how do they go about doing that?
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