St. James Investment Company Updated: 05-September-16
B E RK S H I RE H ATHAWAY (BRK- B )
COMPANY DESCRIPTION
Berkshire Hathaway is a conglomerate holding company owning subsidiaries engaged in a number of business activities, including property and casualty insurance and reinsurance, utilities and energy, finance, manufacturing, service and retailing.
INVESTMENT THESIS
Last year (2015) was a difficult year for Berkshire Hathaway. Wall Street focused on Buffett’s lagging performance in the company’s equity investment portfolio, as well as the company’s difficult operating environment in its railroad and insurance operations. The company’s stock dropped more than 12% in 2015; highly unusual and certainly below investor expectations. In 2016 to-date, the shares have rebounded nicely despite the global market selloff in January and February and the volatility created by the Brexit vote at the end of June.
Going forward, concern about the company’s investment and operating performance will diminish as year-over-year comparisons highlight the company’s improving performance. More importantly, investors will begin to appreciate how material the Precision Castparts acquisition will meaningfully add to the company operating performance. Despite our skepticism several years ago, we have grown increasingly comfortable with Berkshire Hathaway's ability to continue generating attractive annual growth in its book value per share. We now believe that it may take some time before the company finally succumbs to the headwinds created by the sheer size and scope of its operations. Additionally, we now appreciate that the ultimate departure of Warren Buffett and Charlie Munger will have less of an impact on the business than many investors believe, as the “Buffett premium” usually afforded the stock has diminished over time and now actually weighs against the company’s stock.
Despite the significant amount of capital allocated to the Kraft Heinz and Precision Castparts transactions over the past year, Berkshire Hathaway continues to hold ample cash on its balance sheet along with maintaining a contingent and disciplined share-repurchase program in place. This program allows the company to step in and buy back meaningful levels of stock in the event that the share price drops below 1.2 times book value. Berkshire Hathaway currently trades at roughly 81% of our fair value estimate of $180 per Class B share. We believe at these levels, Berkshire Hathaway offers an attractive, long-term investment in a stable and diversified conglomerate with exposure to industrial, consumer, and financial businesses primarily focused on U.S. markets, with the added benefit of downside protection in more volatile markets.
COMPANY HISTORY
Berkshire Hathaway traces its roots to a textile manufacturing company established by Oliver Chace in 1839 as the Valley Falls Company in Valley Falls, Rhode Island. In 1962, Warren Buffett began buying stock in Berkshire Hathaway after noticing a pattern in the price direction of its stock whenever the company closed a mill. Eventually, Buffett acknowledged that the textile business was waning and the company's financial situation was not going to improve. In 1964, the company’s CEO made a verbal tender offer of $111/2 per share to buy back Buffett's shares. Buffett agreed to the deal. A few weeks later, Warren Buffett received the tender offer in writing, but the tender offer was for only $113/8.
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Buffett later admitted that this lower offer made him angry. Instead of selling at the slightly lower price, Buffett decided to buy more of the stock to take control of the company and fire the CEO—which he in turn did. However, this put Buffett in a situation where he was now majority owner of a textile business that was failing.
Buffett initially maintained Berkshire's core business of textiles, but by 1967, he was expanding into the insurance industry and other investments. Berkshire first ventured into the insurance business with the purchase of National Indemnity Company. In the late 1970s, Berkshire acquired an equity stake in the Government Employees Insurance Company (GEICO), which forms the core of its insurance operations today and is a major source of capital for Berkshire Hathaway's other investments. In 1985, the last textile operations, Hathaway's historic core business, closed.
BUSINESS OVERVIEW
Berkshire Hathaway’s competitive advantage is more than just the sum of its parts. The company's insurance operations (Geico, General Re, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group) remain a critical component to the overall business. The company’s insurance operations account for one-third of Berkshire's pretax earnings, and perhaps more importantly, they also generate low-cost float. Float is the industry term to describe the temporary cash holdings that accrue from premiums being collected in advance of future claims paid. Float, for any insurance company, is a major source of funding for investments. The insurance industry typically does not provide one a sustainable competitive advantage—the product that insurers sell is essentially a commodity. Excess returns, or returns on invested capital in “excess” of the company’s cost of capital, are difficult to achieve and sustain on a consistent basis.
Consumers normally do not pay a premium for insurance brands. The products offered by insurance companies are easily duplicated. Furthermore, competition among insurance firms is brutal, and insurers can quickly reduce prices in order to gain market share. Insurance is also one of the few industries where the cost of goods sold, or insurance claims, may not be known for years. This time lag provides an incentive for competitors to sacrifice long-term profitability in favor of near-term premium growth. This dynamic is even more pronounced in the reinsurance market. Reinsurance losses tend to be large in nature and may not occur until many years after a reinsurer issues a policy. However, an insurance company can create a sustainable cost advantages by either focusing on less commodified areas of the market or by developing efficient or scalable distribution platforms. By contrast, an insurance company does NOT create a sustainable competitive advantage through investing, even when someone like Warren Buffett manages the investment portfolio.
Insurance companies that can consistently achieve positive underwriting profitability are the only entities that can create and sustain a competitive advantage, because insurance profitability is more sustainable than investment income. Geico continues to increase its direct-selling operations, jumping from the fourth-largest private auto insurer in the U.S. in 2005 with 6.0% market share to currently the second-largest underwriter with an 11.4% share. Similar to its closest competitor, Progressive, Geico differentiates itself by its scale in the direct response channel. Scaling is typically difficult for insurance companies, but Geico remains well-positioned to better spread its fixed costs over a wider customer base. Geico’s business model does not require as much human capital and specialized underwriters as other insurance lines of business. One readily notices this scaling benefit in Geico's expense ratio, which average 18% over the past five years, or 7% below the industry average.
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Berkshire's two reinsurance companies (General Re and Berkshire Hathaway Reinsurance Group) do not necessarily provide a competitive advantage for the company. Reinsurance companies will assume all or part of an insurance or reinsurance policy written by another insurer for a simple premium payment. While any insurance company can technically underwrite reinsurance, only a handful of the largest companies (Munich Re, Swiss Re, Hannover Re, Lloyd's, and Berkshire Hathaway) operate in the global reinsurance market. The policies underwritten by reinsurers often contain large long-tail risks that few companies have the capacity to carry. When reinsurance companies price these contracts appropriately, they can generate favorable long-term returns. But, reinsurers compete almost exclusively on price and capital strength, thereby, making it almost impossible to build structural cost advantages. Losses in the reinsurance market are uneven and may not occur for years after a policy is written. This peculiarity magnifies the importance of disciplined and accurate underwriting skills. Berkshire Hathaway's reinsurance arms are unique, because they walk away from business when they cannot obtain an appropriate premium. Although this price discipline sounds simple, it is something Berkshire’s competitors cannot always replicate. Despite the lack of a sustainable competitive advantage, Berkshire remains in the reinsurance business, because it generates large amounts of float that it can then in turn reinvest for longer periods of time than short-tail lines like auto insurance.
Berkshire Hathaway Primary Group (BHPG) is Berkshire's most profitable insurance business. BHPG is actually a conglomeration of multiple insurance operations that include National Indemnity's primary group, Medical Protective Company, U.S. Investment Corporation, and Applied Underwriters. BHPG offers coverage that ranges from workers' compensation to commercial auto and property coverage. BHPG also contains the company's latest venture—Berkshire Hathaway Specialty Insurance (BHSI). Berkshire formed BHSI in June 2013, and this new business focuses on U.S. excess and surplus insurance lines. The goal is to take advantage of the growing demand for customized insurance. This new company should nicely compliment and benefit Berkshire's insurance operations overall. Specialty insurers are able to focus on the least commodified areas of the insurance market, such as excess and surplus lines, are much more likely to generate consistent underwriting profitability—the strongest source of a competitive advantage within the insurance industry.
Outside of the insurance operations, there are more than seventy operating businesses that constitute Berkshire's remaining subsidiaries. Of these seventy businesses, Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy (BHE) are the two largest contributors to the company's profitability, generating around 29% of pretax earnings. The most interesting thing about these two particular businesses is that neither of them contributed to Berkshire's pretax earnings ten years ago. Buffett's move into these leveraged, capital-intensive businesses, such as railroads and utilities, represents a material change from many of his other acquisitions over the years. Historically, Buffett focused on companies requiring less ongoing capital investment and little to no need of debt. These higher-capital businesses will provide lower returns on invested capital than the asset-light businesses Berkshire acquired over the past. We can only speculate but perhaps Buffett now buys more capital intensive companies in order to leave his eventual successor with less cash to reinvest longer term. Berkshire generated an average of $16 billion in free cash flow, defined as cash flow from operations less capital expenditures, over the past three years and is on pace to generate $18 billion in free cash flow this year.
Berkshire acquired BNSF in full in February 2010. BNSF is a Class I railroad operator, an industry designation for a large operator with an extensive system of interconnected rails, yards, terminals, and expansive fleets of motive power and rolling stock. North American Class I railroad companies benefit from enormous barriers to entry because of their
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established, impossible-to-replicate networks of right-of-way and continuously welded steel rail. While barges, ships, aircraft, and trucks also haul freight, railroads are by far the lowest-cost option when no waterway connects the origin and destination, especially for freight with low value per unit weight. Most Class I railroad companies operate as duopolies with some actually a monopoly supplier to the end client in many markets. Meaning, customers have few choices and limited negotiating power. These competitive advantages provide the major North American Class I railroad companies an efficient scale to operate. BNSF’s low operating cost and efficient scale should continue to generate returns on invested capital in excess of their cost of capital over the long run.
Buffett built Berkshire Hathaway Energy (BHE) through investments in MidAmerican Energy, starting with a 76% equity stake in early 2000 with additional purchases that have raised its interest up to 89.8%; acquired PacifiCorp in full during 2005; acquired NV Energy in full at the end of 2013; and acquired AltaLink in full at the end of 2014. The BHE business operates with a moderate competitive advantage. Although BHE owns some very attractive pipeline assets, the majority of its revenue and profitability, as well as ongoing capital investment, comes from its three main regulated utilities: MidAmerican Energy, PacifiCorp, and NV Energy. Regulated utilities operate with a limited competitive advantage but are typically not able to expand that advantage, even with their difficult-to-replicate networks of power generation, transmission, and distribution. State and federal regulators must approve rate increases and control their returns on equity.
Berkshire Hathaway's manufacturing, service, and retailing operations constitute the next- largest contributor to pretax earnings. These businesses comprise a wide array of operations in more than a handful of different industries. Unlike BNSF and BHE, both of which file annual and quarterly reports with the Securities Exchange Commission (SEC), there is little financial information available on the companies operating within this segment. Past transactions for Lubrizoil and Precision Castparts provided a decent sense of the operating profitability and competitive positioning of the operations, but once Berkshire Hathaway folded them into a catchall reporting segment, one can no longer conduct a proper assessment. However, understanding that Buffett’s predisposition for acquiring companies that have consistent earnings power, generate above-average returns on capital, have little debt, and are run by solid management teams, though, one should assume that the businesses that make up the manufacturing, service, and retailing segment collectively generate ongoing attractive returns on invested capital.
The same guesswork applies to Berkshire's finance and financial products segment, which includes Clayton Homes (manufactured housing and finance), CORT Business Services (furniture rental), Marmon (rail car and other transportation equipment manufacturing, repair and leasing), and XTRA (over-the-road trailer leasing). While the recession and collapse of the housing market that followed the 2008 credit crisis impacted many of these businesses, they have all benefited from being under the Berkshire capital structure, which allowed them to recover on their own terms.
Warren Buffett manages Berkshire Hathaway on a decentralized basis. He empowers managers of its operating subsidiaries to make their own business decisions. In most cases, the managers running Berkshire's subsidiaries are the same individuals who originally sold their companies to Buffett, leaving them with a vested interest in the businesses they continue to operate. Barring a truly disruptive event in their respective industry, we expect these underlying companies to continue functioning with the same advantages that attracted Buffett to them in the first place. However, that does not mean that there will not be companies within Berkshire whose competitive advantages diminish over time. This point is perfectly exemplified by the original textile manufacturing business that Berkshire
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Hathaway derives its own name from. A large collection of attractive companies that reside within Berkshire's manufacturing, service, and retailing operations, as well as its finance and financial products division, is more likely to maintain but not increase their competitive advantage.
To summarize the current operating environment for Berkshire Hathaway: declining energy prices continue to weigh on the railroad companies as declining coal and crude oil shipments severely impacted revenue and profitability for the Class I railroad companies. However, renewables remain a big investment opportunity for Berkshire. The company's utilities and energy subsidiary, Berkshire Energy, invested heavily in the renewables segment and it remains one of the nation's largest producers of both wind and solar power. Insurance management changes raise questions about succession. With Ajit Jain taking on oversight of both of Berkshire's reinsurers, General Re and Berkshire Hathaway Reinsurance Group, potential cost-cutting opportunities exist that can then redirect investment capital towards international growth. All of which likely leaves Ajit as the potential successor to Buffett.
Warren Buffett remains committed to share repurchases at the right price. He commented that he would buy back stock if the price dropped down below the 1.2 times book value per share threshold the board established. Interestingly, Buffett would consider stepping in to repurchase shares based on book value per share information that had yet to be published. Berkshire's shares remain undervalued despite the shares performing exceptionally well year-to-date. Trading at $145 per Class B share, Berkshire Hathaway's common stock is trading at a price to fair value multiple of 0.80 times our estimate of $180 per Class B share, a 20% discount to our fair value estimate. With book value expected to grow at a mid-to-high-single digit rate both this year and next, our estimate is equivalent to 1.5 times projected book value 2017. At quarter end, shareholders’ equity was $263 billion; this equals $107 per “B” share. At the repurchase authorization of 120% of book value, the company can repurchase its own stock at $128 per share, or 12% below the current stock price.
Regarding Warren Buffett, he has been chairman and CEO of Berkshire Hathaway since 1970. Charlie Munger has served as vice chairman since 1978. Berkshire has two classes of common stock, with Class B shares holding 1/1,500th of the economic rights of Class A shares and only 1/10,000th of the voting rights. Warren Buffett is Berkshire Hathaway's largest shareholder, with a 33.0% voting stake and an 18.8% economic interest in the firm. He has been a strong steward of investor capital, consistently aligning his own interests with those of shareholders. There is no doubt that Warren Buffett affords Berkshire Hathaway some degree of a competitive advantage. His success in melding the company's financial strength and underwriting ability with his own investment acumen are unmatched. Under Buffett's stewardship, Berkshire Hathaway increased its book value per share at a compound annual rate of 19.2% during 1965-2015, compared with a 9.7% return for the S&P 500 Total Return Index. The company has not only grown its book value per share at a double-digit rate annually forty separate times during 1965-2015, but it has reported declines in its book value just twice during the past 51 years (in 2001 and 2008).
Despite the impact from the 09/11 terrorist attack and the 2008 financial crisis during the first decade of the new millennium, Berkshire Hathaway still generated double-digit rates of annual growth in its book value per share on seven different occasions during 2001-10. While we think the company is unlikely to consistently grow its book value per share at a double-digit rate going forward, given the ever increasing size and complexity of its operations, Berkshire Hathaway still retains the ability to grow book value per share at a high-single to double-digit rate of growth, much like it did during the first decade of the millennium, as well as during the 2011-15 period. Given Warren Buffett's impressive long-
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term track record, investors naturally wish that Buffett’s edifice remain intact after he departs. Berkshire Hathaway formally addressed the issue of succession in 2005, when the company noted that Buffett's three main jobs (chairman, chief executive, and chief investment officer) would be handled by one chairman, expected to be his son, Howard Buffett, one CEO with candidates identified but not revealed, and several external hires reporting directly to the CEO to manage the investment portfolio. While we have clarity on the investment side with Todd Combs and Ted Weschler expected to be the only outside hires to work with Berkshire Hathaway's investment portfolio, questions linger over who will be the firm's next CEO.
Many envision the main role of the next chief executive to be one of capital-allocator-in- chief. With all of Berkshire Hathaway's operating businesses managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility for each business down to the subsidiary level, Warren Buffett maintains the freedom to focus on managing the investments in the firm's portfolio and making capital allocation decisions. Warren Buffett has publicly commented that the job requires more than investing prowess and that he would not want to put someone in charge of Berkshire Hathaway who only had investing experience, with no operational experience. He has also stated that the next CEO will come from within the company's ranks. Ajit Jain, who heads Berkshire Hathaway Reinsurance Group, is clearly the board of directors' first choice to run the company once Warren Buffett steps down. Not only does Ajit Jain understand risk better than anyone else at Berkshire Hathaway, but Warren Buffett even admitted that Jain has "probably made a lot more money" for the company than Buffett has over the years. While Jain's experience has primarily been on the underwriting side of the business, his success there has been built on his ability to avoid making "dumb decisions" rather than making "brilliant" ones. The only problem is that Jain has stated publicly several times that he does not want the job. This is the main reason Greg Abel could be the next choice. Abel not only has the operational experience of running Berkshire Hathaway Energy for many years but also has the of experience of overseeing several large acquisitions. With insurance still a complex and integral part of Berkshire Hathaway's operations, Jain may remain and oversee all of Berkshire Hathaway's insurance operations, while Abel assumes the CEO role once Warren Buffett departs.
VALUATION
When one opens the annual report for Berkshire Hathaway, the first thing investors see following the table of contents is a table comparing Berkshire Hathaway’s book value growth versus the S&P 500. Of course, growth in book value is not the same as total shareholder returns. This is an important distinction. Although over long periods, share price and book value converge, it is not true annually. For example, in 2008 Berkshire Hathaway's stock price dropped by 30%, but its actual book value fell by just 10%. Regardless, Berkshire Hathaway has performed remarkably well over the last half-century. Interestingly, twenty years ago, Buffett acknowledged that while book value is important, this should not be the single metric investors use to value Berkshire Hathaway.
In his 1996 letter to Berkshire Hathaway shareholders, Warren Buffett wrote, "I dwell on this rise in per-share book value because it roughly indicates our economic progress during the year. But, as Charlie Munger, Berkshire's Vice Chairman, and I have repeatedly told you, what counts at Berkshire is intrinsic value, not book value." In Warren Buffett's own words, "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." Meaning, intrinsic value is the worth of the business based on the future capability of its earnings and not simply what one sees on a company’s balance sheet. For example, Buffett wrote in 1999, "Businesses such as See's
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and Buffalo News are now worth fifteen to twenty times the value at which they are carried on our books." When one considers that See's Candy continues to deliver incredible returns, that difference between fair market value and book value is even greater today. Which naturally begs the question—what is the actual intrinsic value of Berkshire Hathaway and the conglomerate of underlying businesses that it owns? Warren Buffett addressed that very question is his 2013 letter to shareholders, "As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares nor, in fact, for any other stock." That quote applies to every stock today. Buffett does actually provide some guidance as to how one can estimate Berkshire Hathaway’s intrinsic value. In his 2010 letter to shareholders, Warren Buffett suggested one should focus on two easily identifiable quantitative measures, and one additional measure that is much more difficult to determine.
(e) (f) (e) - (f) = (g) 3 Year Average CL A Shares Investments/ Operating Investment Operating YE Intrinsic Class B Intrinsic Intrinsic Value Year End Investments Outstanding Share Earnings Income Earnings/ Share Value/Share Value Growth 2002 80,303 1.53329 52,373 6,843 2,943 2,544 77,808 $ 52 2003 94,840 1.53541 61,769 12,063 3,098 5,839 87,208 $ 58 12.1% 2004 102,299 1.53772 66,527 6,711 2,816 2,533 96,607 $ 64 10.8% 2005 114,478 1.53978 74,347 6,978 3,487 2,267 103,011 $ 69 6.6% 2006 122,220 1.54181 79,271 14,313 4,382 6,441 110,853 $ 74 7.6% 2007 137,977 1.54575 89,262 14,859 4,979 6,392 131,294 $ 88 18.4% 2008 116,354 1.54896 75,117 15,359 5,140 6,597 145,984 $ 97 11.2% 2009 147,371 1.55117 95,006 11,286 5,531 3,710 142,126 $ 95 -2.6% 2010 144,861 1.63566 88,564 17,291 5,215 7,383 145,197 $ 97 2.2% 2011 150,289 1.64989 91,090 17,171 4,792 7,503 153,540 $ 102 5.7% 2012 172,259 1.65129 104,318 20,079 4,532 9,415 175,660 $ 117 14.4% 2013 194,342 1.64361 118,241 23,260 4,934 11,150 198,109 $ 132 12.8% 2014 189,911 1.64346 115,556 24,536 5,026 11,871 220,825 $ 147 11.5% 2015 198,922 1.64346 121,039 26,241 4,633 13,148 238,841 $ 159 8.2% 2016 202,415 1.64346 123,164 29,875 5,102 15,074 253,562 $ 169 6.2% 2017 224,734 1.64346 136,745 33,134 5,758 16,657 276,578 $ 184 9.1% 2018 247,780 1.64346 150,767 36,283 6,849 17,910 302,363 $ 202 9.3% 2019 273,200 1.64346 166,235 39,528 8,053 19,152 330,313 $ 220 9.2% 2020 294,267 1.64346 179,054 42,690 8,879 20,573 357,469 $ 238 8.2%
The first is the value of Berkshire's "investments: stocks, bonds and cash equivalents," which stood at a value of $198,922 at the end of 2015. The next measure is the "earnings that come from sources other than investments and insurance underwriting." Last year’s pre-tax operating earnings excluding investment income were $26,241. The final and least tangible factor is "the efficacy with which retained earnings will be deployed in the future." Buffett wants investors to determine how the company will be able to redeploy the cash it generates to grow its future earnings; "what-will-they-do-with-the-money" factor. An investor must understand management’s ability to retain and reinvest capital. If management executes this crucial task well, the reinvestment prospects add to the company's current value. By contrast, if management’s motives are suspect, the investor must discount today’s value.
To gauge the value of Berkshire Hathaway, we apply some simple math. We assume that the company’s investments do not command any premium, therefore we apply a conservative price-to-earnings (P/E) of ten to Berkshire's pre-tax operating earnings excluding investment income. With these assumptions, we estimate that Berkshire Hathaway’s fair value is roughly $184 per Class B share in 2017.
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BERKSHIRE HATHAWAY, INC. CLASS B $180
$160
$140
$120
$100
$80
$60
BRK.B $40 Intrinsic Value $20
$- 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
A second valuation approach uses a simple long-term, average price-to-book value multiple. Our fair value estimate for Berkshire Hathaway's Class B shares is $175 per share, which is equivalent to 1.5 times Berkshire Hathaway's reported book value per share of $107 at the end of the second quarter of 2016. Based on our estimates for book value per share at the end of 2016 and 2017, our fair value estimate is equivalent to 1.5 and 1.4 times book, respectively.
2.2 Berkshire Hathaway: Price / Book Value
2.0
1.8
1.6 Average = 1.48
1.4
1.35 1.2
1.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Lastly, we employ a sum-of-the-parts methodology to arrive at a fair value estimate of $186 per Class B share of Berkshire Hathaway. We value the different pieces of the company separately and combine them to arrive at an estimate for the whole company. We believe Berkshire Hathaway's insurance operations are worth $59 per Class B share. We value Berkshire Hathaway's investment in Kraft Heinz separately from the company's insurance operations. Berkshire Hathaway owns 325.4 million shares of KHC, currently trading at $89.50 per share. The KHC current value is roughly $12 per Class B share.
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Insurance 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Assumptions Stage I Grow th Forecast Horizon 5.0 Years Perpetuity stage grow th forecast horizon 20.0 Years Grow th rate of terminal value 9.5% Return on equity Discount rate 10.0% Cost of equity Free Cash Flow: STAGE I
Net Income 6,444 6,181 8,473 3,955 7,254 5,606 4,848 7,766 8,761 11,669 7,588 7,666 8,617 10,143 11,517 Plus: Unrealized Gains (Losses) 4,213 (1,018) (13,250) 10,379 2,093 (2,197) 7,385 12,394 (970) (6,563) 5,391 4,248 4,427 3,453 2,763 Minus: Increase in Equity (5,522) (9,370) 9,920 (15,064) 9,241 3,411 (14,530) (8,446) (10,404) 9,916 8,222 (11,914) (13,044) (13,596) (14,281) Equity Cash Flow 5,135 (4,207) 5,143 (730) 18,587 6,820 (2,298) 11,714 (2,613) 15,022 21,201 0 0 0 (0)
Share Repurchases 0 0 0 0 0 67 1,296 0 0 0 21,201 0 0 0 0 Dividends 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Equity Cash Flow 0 0 0 0 0 67 1,296 0 0 0 21,201 0 0 0 0 Discounted Equity Cash Flow 19,273 0 0 0 0
Free Cash Flow: Perpetuity Perpetuity Stage Calculation 848,435 Free Cash Flow : Stage I 19,273 Total shareholder equity 72,267 Perpetuity Stage Discounted Value 126,114 Free Cash Flow : Perpetuity 126,114 Implied future value 73,121 Insurance Segment Valuation 145,388 Insurance Segment Valuation 145,388
Class A value per share $ 88,435 1.6 Class A shares outstanding Class B value per share $ 59 2,466.0 Class B shares equivalent
As for Berkshire Hathaway's non-insurance operations, our estimate for BNSF is $36 per Class B share. We expect carload volumes to continue declining in 2016 but stabilize in 2017, and then revert to our long-term expected growth rate in the low single digits.
BNSF EBT 37.5% EBIT(1-t) 17.0% 10.0% Discounted Discount Period Rate Revenues NOP Margin Taxes NOPAT CapEx DEPR INVEST W/C FCFF FCFF Factor 2015 22,133 7,849 2,943 8.0% 2016 -4.9% 21,054 7,795 37.0% 2,923 4,872 3,579 2,105 1,474 (172) 3,570 3,306 0.9259 2017 4.0% 21,894 8,419 38.5% 3,157 5,262 3,722 2,189 1,533 (191) 3,920 3,361 0.8573 2018 4.0% 22,771 9,108 40.0% 3,416 5,693 3,871 2,277 1,594 3 4,096 3,251 0.7938 2019 4.0% 23,685 9,703 41.0% 3,639 6,064 4,026 2,369 1,658 (132) 4,538 3,336 0.7350 2020 4.4% 24,716 10,125 41.0% 3,797 6,328 4,202 2,472 1,730 (59) 4,658 3,170 0.6806 Terminal Year 3.1% 25,482 10,442 41.0% 3,916 6,526 4,332 2,548 1,784 153 4,589
Residual Value Assumes 4.0% Sustainable Grow th Longer-Term 4,589 78,088
Discounted Excess Return Period FCFF 16,424 Total Corporate Value 111,934 Discounted Corporate Residual Value 78,088 Less Debt (21,737) Short-Term Assets 17,423 Less Preferred Stock - Total Corporate Value 111,934 Less Short-Term Liabilities (926) Total Value to Common Equity 89,271 Class A shares outstanding 1.644 Class B Per Share Value $ 36 Class B shares equivalent 2,466.0
Our fair value estimate for the company's manufacturing, service, and retail operations (MSR) includes the financial results from Precision Castparts. We value this segment at $53 per Class B share. Precision Castparts resides completely within Berkshire Hathaway’s MSR group, making it difficult to value.
Manufacturing, Service and Retailing EBT 35% EBIT(1-t) 2.5% 2.1% Discounted Discount Period Rate Revenues NOP Margin Taxes NOPAT CapEx DEPR INVEST W/C FCFF FCFF Factor 2015 109,300 7,547 2,641 8.0% 2016 2.9% 112,467 8,276 7.4% 2,897 5,379 2,812 2,390 422 134 4,824 4,466 0.9259 2017 4.6% 117,637 8,683 7.4% 3,039 5,644 2,941 2,500 441 523 4,681 4,013 0.8573 2018 4.6% 122,994 9,089 7.4% 3,181 5,908 3,075 2,614 461 509 4,937 3,919 0.7938 2019 4.5% 128,539 9,542 7.4% 3,340 6,202 3,213 2,731 482 493 5,227 3,842 0.7350 2020 4.4% 134,132 9,926 7.4% 3,474 6,452 3,353 2,850 503 1,139 4,810 3,274 0.6806 Terminal Year 4.3% 139,900 10,370 7.4% 3,630 6,741 3,498 2,973 525 1,154 5,062
Residual Value Assumes 4.2% Sustainable Grow th Longer-Term 5,062 90,668
Discounted Excess Return Period FCFF 19,514 Total Corporate Value 147,416 Discounted Corporate Residual Value 90,668 Less Debt (4,269) Short-Term Assets 37,233 Less Preferred Stock - Total Corporate Value 147,416 Less Short-Term Liabilities (12,655) Total Value to Common Equity 130,491 Class A shares outstanding 1.644 Class B Per Share Value $ 53 Class B shares equivalent 2,466.0
Our fair value estimate for Berkshire Hathaway Energy is $21 per Class B share.
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BHE EBT 25.0% EBIT(1-t) 19.0% 12.0% Discounted Discount Period Rate Revenues NOP Margin Taxes NOPAT CapEx DEPR INVEST W/C FCFF FCFF Factor 2015 18,628 4,708 1,177 6.0% 2016 4.4% 19,444 5,109 26.3% 1,277 3,832 3,694 2,333 1,361 1,324 1,147 1,082 0.9434 2017 4.0% 20,216 5,462 27.0% 1,366 4,097 3,841 2,426 1,415 1,456 1,226 1,091 0.8900 2018 4.0% 21,018 5,820 27.7% 1,455 4,365 3,994 2,522 1,471 1,340 1,554 1,305 0.8396 2019 3.8% 21,824 6,186 28.3% 1,547 4,640 4,147 2,619 1,528 1,220 1,892 1,499 0.7921 2020 4.4% 22,774 6,455 28.3% 1,614 4,841 4,327 2,733 1,594 1,189 2,058 1,538 0.7473 Terminal Year 4.0% 23,685 6,716 28.4% 1,679 5,037 4,500 2,842 1,658 1,159 2,220
Residual Value Assumes 4.0% Sustainable Growth Longer-Term 2,220 82,949
Discounted Excess Return Period FCFF 6,515 Total Corporate Value 90,977 Discounted Corporate Residual Value 82,949 Less Debt (37,417) Short-Term Assets 1,513 Less Preferred Stock - Total Corporate Value 90,977 Less Short-Term Liabilities (2,494) Total Value to Common Equity 51,066 Class A shares outstanding 1.64 Class B Per Share Value $ 21 Class B shares equivalent 2,466.00
Finally, we place a value of $5 per Class B share for the company's finance and financial products division.
Financial Products EBT 32.5% EBIT(1-t) 15.0% 7.5% Discounted Discount Period Rate Revenues NOP Margin Taxes NOPAT CapEx DEPR INVEST W/C FCFF FCFF Factor 2015 7,112 2,004 651 10.0% 2016 7.0% 7,610 2,114 27.8% 687 1,427 1,141 571 571 161 695 632 0.9091 2017 6.0% 8,066 2,259 28.0% 734 1,525 1,210 605 605 138 782 646 0.8264 2018 5.0% 8,470 2,372 28.0% 771 1,601 1,270 635 635 111 855 642 0.7513 2019 4.0% 8,809 2,466 28.0% 802 1,665 1,321 661 661 80 924 631 0.6830 2020 4.4% 9,192 2,574 28.0% 836 1,737 1,379 689 689 78 969 602 0.6209 Terminal Year 3.1% 9,477 2,655 28.0% 863 1,792 1,422 711 711 76 1,005
Residual Value Assumes 3.0% Sustainable Growth Longer-Term 1,005 8,912
Discounted Excess Return Period FCFF 3,153 Total Corporate Value 29,795 Discounted Corporate Residual Value 8,912 Less Debt (12,736) Short-Term Assets 17,730 Less Preferred Stock - Total Corporate Value 29,795 Less Short-Term Liabilities (4,810) Total Value to Common Equity 12,249 Class A shares outstanding 1.64 Class B Per Share Value $ 5 Class B shares equivalent 2,466.00
For simplicity purposes, we combine the three valuation methodologies and assume a fair value estimate of $180 per Class B share. Given the potential volatility in cash flows as market conditions and economic conditions change, offset by the fair amount of certainty we assume when forecasting the results from Berkshire's operations, we assign a medium- to-low risk to our future cash flow projections. We assume a base-case fair value estimate of $180 per Class B share, a potential upside scenario of $220 per share, and a lower case projection of $128 per share—the floor where Berkshire Hathaway would begin repurchasing outstanding shares. Factors affecting our scenario analysis include the company's ability to continue growing its book value per share at an annual rate of 8% to 9%, which is dependent on the company’s ability to continue intelligently allocating its excess capital into acquisitions and investments that add value over time.
The potential upside hinges on whether or not Berkshire Hathaway's insurance operations perform better, which would entail premium growth and underwriting profits exceeding our expectations during our five-year forecast period. We assume Geico rebounds from its current headwinds and continues to take meaningful share from competitors, while BHPG quickly becomes a significant player in the commercial specialty insurance market, and improvements in the company's reinsurance business materialize quicker than expected. This scenario also assumes improvement in both the U.S. and global economies, with Berkshire's two main noninsurance segments (manufacturing, service, and retailing and railroad, utilities, and energy) building on the revenue and profitability gains generated since the 2008 financial crisis. This scenario is a rather large “if” and frankly, we are not anticipating it to develop.
Our downside scenario assumes that Geico struggles in a more competitive environment for auto insurance, BHPG takes longer to gain traction with commercial clients, and
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improvements in the company's reinsurance business take longer to materialize. It also assumes growth at Berkshire Hathaway's manufacturing, service, and retailing operations flat line after producing several years of solid revenue growth and profitability, with concerns over global economic growth working against the company’s more economically sensitive operations. Our downside case also encompasses a far more pessimistic outlook for the company's railroad, utilities, and energy division, due to a weaker U.S. economy and significantly higher fuel costs affecting the results for these businesses.
RISK TO INVESTMENT
The obvious issue facing Berkshire Hathaway is the longevity of Chairman and CEO Warren Buffett, who turns 86 this year, and managing partner Charlie Munger, who will be 93 at the start of next year. Berkshire's insurance operations face competitive and highly cyclical markets that occasionally produce large losses. Berkshire always carries large potential losses through its insurance operations. While the company believes its super catastrophe underwriting can generate solid long-term results, the volatility of this particular line of business, which has the potential for especially large losses, tends to be high. Berkshire Hathaway maintains much higher capital levels than almost all other insurers, which mitigates some of this risk. Several of the company’s key businesses—insurance, energy generation and distribution, and rail transport—operate in industries that are subject to higher degrees of regulatory oversight, which could have an impact on future business combinations, as well as the setting of rates that it charges to customers. On top of that, many of the company's noninsurance operations are cyclical in nature and exposed to macroeconomic forces, with results typically suffering during economic slowdowns and recessions.
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ST. JAMES INVESTMENT COMPANY
We founded St. James Investment Company in 1999, managing wealth from our family and friends in the hamlet of St. James. We are privileged that our neighbors and friends have trusted us for over a decade to invest alongside our own capital.
The St. James Investment Company is an independent, fee-only, SEC- Registered Investment Advisory firm, providing customized portfolio management to individuals, retirement plans and private companies.
I M P O R T A N T D ISCLAIMER
Information contained herein was obtained from sources believed reliable but is not necessarily complete and accuracy is not guaranteed. Any securities mentioned in this issue are not to be construed as investment or trading recommendations specifically for you. You must consult your advisor for investment or trading advice. The publisher of this report and one or more of its affiliated persons and entities may have positions in the securities or sectors recommended in this report and may therefore have a conflict of interest in making the recommendation herein. 4834-9369-8309, v. 1
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