Wednesday, March 6, 2013

Berkshire Hathaway: No Worries?

Picking up where we left off in our last post, we continue with the overview of the remaining set of major businesses.

Manufacturing, Services and Retailing

Revenue in these businesses were $83,255 million in 2012, on which the company earned $6,131 million pre-tax and $3,699 net after-tax.  As the Chairman's Letter points out, this group of businesses  employ $22.6 billion in net tangible assets on which they earned 16.3% after-tax.  Very fine businesses, no doubt.  

Marmon Group is included in this segment, and we've talked about it in the context of the Powerhouse Five.  McLane, the wholesale grocery and food service business had revenues of $37,437, and its pre-tax margins have been stuck for the past three years at 1.1%.  Both the Other Manufacturing and Other Services businesses have had pre-tax margins of approximately 11-13% in the past three years.  

The Retailing businesses include Nebraska Furniture Mart, Borsheim's, and See's Candies. See's has been the subject of a shout-out in an old Chairman's Letter, in which Mr. Buffett makes the point that several hundred million dollars of free cash flow from See's was redeployed for higher returns elsewhere in the BRK portfolio over a period of several years .  These three companies are iconic, entrepreneurial stories each worthy of study on their own.  Together the retailing segment revenues were $3,175 million in 2012, and pre-tax margin was 8.2%.  

Looking at BRK as a whole, the Powerhouse Five's share of pre-tax income in 2012 was 45.4%, which is probably why they were singled out for discussion in the Chairman's Letter.  Net income attributable to shareholders in 2012 was $14,824 million, compared to $10,254 million in 2011.  Much of the year-to-year swing in net income was due to Investment and derivatives gains/losses going from ($521) million in 2011 to income of $2,227 million in 2012.  

That gain from derivatives can buy investors some serious bling, and nice furniture to sit on while munching candy!  Berkshire's experiment with writing long-dated option contracts on stock market options is being thankfully wound down.  The Chairman says that after all is said and done, BRK should show a pre-tax gain of $1 billion from this non-core series of side bets.  Wow. 

There is a lengthy, desultory discussion of why BRK has sunk $344 million into 28 local newspapers around the country.  This could be another, astute, Ben Graham investment, but in the scheme of things, it seems like tilting at windmills.

Newspapers made a big deal out of the statement that BRK doesn't plan on paying dividends.  This issue is treated at length, but not so clearly, in pages 19-20 of the Chairman's Letter.  One obvious reason why dividends are not on the menu are taxes, since dividend income is taxed twice.  Retained earnings stay sheltered inside the company.  Retained earnings can be redeployed to create value above their opportunity cost through acquisitions (like BNSF, Lubrizol, and Heinz) or share buybacks when BRK's share price goes below a stated threshold of 110% of book value.  Dividends were never in the model of BRK, going back to the earliest days of the public entity, and it certainly appears that more value has been created by retaining earnings than by distributing them.  

I'll Have Ketchup With That

The $28 billion buyout of H.J. Heinz by Berkshire Hathaway of Brazil's 3G Capital is another masterstroke, using a new model for Berkshire.  First, Berkshire invests alongside a partner whose co-founder Mr. Buffett has known for decades through board service. Second, instead of buying and retaining the top executive management at the target company, Berkshire's investment partner will supply the top operating management, based on their track record with other investments.  

Heinz has had a long history of good financial performance dating back to its flamboyant Chairman, former Irish international rugby star Anthony O'Reilly. Current CEO William Johnson took over operations fifteen years ago, beginning a period of superior total shareholder returns from 2002-2012. 

24% of Heinz's sales are in emerging markets.  This is exactly what Mr. Buffett has talked about in multiple presentations over the years, and now BRK is positioned there with iconic brands, established supply chains, and executive leadership with roots in Brazil, a great potential market and gateway to Latin America.  Brazil is also a leading supplier of food ingredients.  

For all the unnecessary apologies about not doing a big deal in 2012, this is the kind of deal that is worth waiting for.  Most of BRK's debt capacity will be used by the utility businesses and by BNSF.  A food business like Heinz will not require large capital investments and it should provide terrific cash flows to the two owners, BRK and 3G Capital.  Berkshire shareholders also get an attractive preferred equity instrument through the deal.  I will take ketchup with that, please!

Is There a Problem?

Berkshire Hathaway is a rare company, run by two founders with enviable qualities of financial savvy, market experience, emotional intelligence, intuition, fiscal conservatism, and an unwavering alignment with their shareholders.  Their long-standing personal relationship is also a key to the organization's success and a meaningful intangible asset.

As an analyst, I covered a company that was organized on a similar model to BRK, namely RPM, Inc.
When I covered it, revenues were about $500 million, while today the revenues are $3.8 billion and it is a worldwide company.  The thirty year golden growth era for the company rested on a unique partnership between the son of the founder, Tom Sullivan, and his CFO/COO Jim Karman.  Over five and ten year periods, RPM has outperformed the Standard and Poors and its peer index for total shareholder return, by a substantial margin.  I knew this company very well, but it is not a transparent company to understand, and it is aggressive about using debt.  Of course, it is a tiny company compared to BRK. 

My point is that successful execution of a Berkshire model is not singular, but it is extremely rare.  It is certainly singular for its size and diversification.  The diversification is achieved in a relatively concentrated sectoral portfolio that gives BRK a unique risk profile. 

So, succeeding Warren Buffett and Charlie Munger is not at all like the usual question of corporate succession, where one big ego is replaced by another big ego.  My concern is that successful execution of this model is not easily reproducible. 

It is not a matter of picking one successor, because the current model, as a shareholder can read in every single letter, benefited from the congruity and differences between Messrs. Buffett and Munger.  There would never have been any question of who was the "top dog."  But that is always the question in typical corporate succession: just think of General Electric when Jack Welch was retiring.  What if David Sokol had been anointed the next Chairman of Berkshire Hathaway?  

In the back of the Chairman's letter, a section is entitled, "The Managing of Berkshire." In it he writes, "Charlie and I mainly attend to capital allocation and the care and feeding of our key managers."  This says it all: what's different about this pair of executives.  

We've written in other blog posts about Berkshire about how the redeployment of cash flows among Berkshire's operating companies and the building of multiple liquidity layers within the complex structure are, for me, the real genius of this company.  I've met many hundred CEOs from public and private companies around the world, most of whom were astute, driven, focused individuals with records of success.  Yet, I could count on one hand the number of CEOs who were interested in and accomplished at allocating capital among businesses in their portfolio to add economic value: two of the fingers on my hand would be taken for Messrs. Buffett and Munger.  

Yet, one could probably replace this ability, in theory, by hiring a hedge fund manager to run Berkshire.  Do you think that this person would also be capable of developing long-term  personal relationships with many key operating executives?  "Care and feeding" for a hedge fund manager would be about compensation formulas and little else.  That would destroy the Berkshire model. 

I certainly don't have any suggestions or answers to the questions, but there are no obvious answers.  This decision will be much harder for the founders than any business decision they have taken to-date in their distinguished careers.  

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