Friday, March 29, 2013

Dell's Proxy Materials: Deal or No Deal?

For those who want to add to future global warming by killing lots of trees, Dell has issued hundreds of pages of proxy materials, including the background and timing of board discussions from the earliest days of going private to the opinions of JP Morgan, Evercore, and Goldman Sachs regarding alternative transactions.

Without doing a close reading of the materials with my  Eberhard Faber No. 2 Blackwings, here's what I put into my notebook.

The advisors agree that the issues for Dell going forward as a public company in the status quo mode include,

  1. The medium-long term growth of the PC market will be challenging, with low unit growth and lower margin sales driving gross margin downward by historical standards.  This would contrast with Dell's historical strength in sales of higher margin machines, driven by its premium name and efficient manufacturing structure. 
  2. The company has yet to demonstrate an ability to penetrate the tablet and smartphone markets.
  3. Dell has yet to leverage the more than $13 billion of recent acquisitions into a "compelling enterprise stack."  Of course, this is the peer sector where the higher valuations reside for a "new" Dell. 
  4. Can the company make the difficult, long and expensive transition from an equipment-based sales force to an Enterprise-based solutions sales force?  This is a critical question, which almost certainly accounts for the issue in point (3).  
  5. By all measures, Dell's stock performance has been abysmal, and it has almost no goodwill with equity shareholders, even with "deep value" investors. Over the past five years, Dell's stock performance was (47.6%).  HPQ was even worse at (64.1%).  Dell's PC-heavy peers were down (11.2%) as a group, excluding HPQ.  Dell's Enterprise peers were up 34.7% over the five year period.  
Put all this together, and it could make a case for taking the company private, depending on the near-term outlook for Dell as it exists today.  Well, guess what?  The near-term outlook is dismal.  Surprise, surprise!

In the earliest version of FY14, management's internal plan presented to the board,  projected revenue of $59.9 billion, with non-GAAP gross margin of $13.6 billion, and non-GAAP operating income of $4.1 billion.  The board eventually realized that this was a "pie in the sky" plan, and after a downward revision that was still not convincing, management was directed to work with board member Shantaru Narayen, the CEO of Adobe, to come up with a FY14 plan in which the board and management could be confident. 

The final FY14 plan had projected revenue of $56.5 billion, about a 6% reduction from the prior plan. Gross margin was reduced to $12.5 billion, an 8% reduction better reflecting the pressures on the PC business.  Finally, a 27% reduction in projected non-GAAP operating income to $3 billion became the latest benchmark. 

Ironically, the genesis for taking the company private was a friendly approach from Southeastern Asset Management, which was kind enough to present its spreadsheets to CEO Michael Dell. For whatever reason, SAM was never a part of the MD-SLP transaction.  Now, fast forward to evaluations of various alternatives to shareholder value creation.

JP Morgan's slides do consider a leveraged recapitalization alongside an alternative for a special dividend payment to shareholders in conjunction with going private.  The leveraged recap is said to have certain benefits for supporting the share price and perhaps being EPS accretive in the short-term; the obvious drawback, not unique to the recap, is the pressure on uncertain cash flows, given the continuous weakening in the near-term projected results.  It doesn't appear that the leveraged recap as contemplated by SAM gets the same level of consideration as does the MD-SLP plan at the given price.  

It is clear that the executive suite in a private Dell should be cleared of the executives who occupy it now, as they haven't been delivering and they are probably not suited to where the company would have to go in the future.  There are questions about Michael Dell himself: he made the $13 billion in acquisitions and allowed them to flounder.  

"Go Shop" procedures, according to Evercore's slides, produced a 6% median increase over the initial announced transaction price in larger deals.  This is a benchmark that could be met. 

It's pretty easy to see a scenario where the board could accept the MD-SLP deal at a 6% or so higher consideration.  The other players, at this point, might be out in the cold in this very cynical process.  

Thursday, March 28, 2013

Dell's Process: Go Shop or Store Closed?

There seems to be a distinct lack of buzz surrounding the Dell board's go shop process for the company. Here are some of the more puzzling developments.  First, as Fortune reports,
"Sources close to the situation say that Blackstone (BX) repeatedly requested the concession, threatening to otherwise walk away from the table during the "go-shop" process. Dell's (DELL) special committee eventually favored the move, believing that it would increase the odds of getting a superior offer."
The concession is that Dell would reimburse Blackstone for its due diligence costs, regardless of whether or not Blackstone were to make a serious, formal bid.  This makes no sense from the perspective of the current shareholders.

Also, Dell's former executive leader of mergers and acquisitions, Dave Johnson, moved to Blackstone in January 2013.   Among other acquisitions, he was responsible for the decision to acquire storage company Compellent and Quest Software, among others. If anyone knows where the bodies are buried and if anyone can do surgical due diligence on Dell, it should be Blackstone under Johnson's direction.

If Carl Icahn is not getting his due diligence fees reimbursed, and he hadn't even requested such a thing, then why on earth would the Dell board succumb to Blackstone's rather brazen ploy?

Southeastern Asset Management, apart from a puff piece in the New York Times about one of its founders, has been very quiet.

Finally, none of the rumors about who might run Dell in the future are comforting.  First is the rumor that founder Michael Dell would remain as CEO under a combined Blackstone/Icahn bid.  But, since the founder returned to spend billions in acquisitions and failed to energize the company's results since his return, is this a variation of the Jerry Yang story?  New money, new ideas and new management usually come together.

Finally, there is a rumor that HP/Oracle exec Mark Hurd would come to run the new Dell.  Now there's a scary thought for new investors.

Could it be that even with a peek under the covers, folks are trying to figure out a face saving exit for all concerned?

Wednesday, March 27, 2013

Cargill's 2012 Report: Thinking About Food.

Cargill's 2012 revenues of $133.9 billion increased by 12% over the prior year. Earnings from continuing operations were $1.17 billion, down 56% from the 2011 record level of $2.69 billion.  Cash flow from operations in 2012 was $3.51 billion.  The company deployed $4 billion in capital, including $2 billion to acquire Provimi, an animal nutrition company.

Despite the sharp drop in earnings, one third of their businesses exceeded the prior year's results.  The Food Ingredients business, comprising 26 business units, produced record earnings in 2012.  Among other 2012 record-setting businesses:

  • Brazil--grains, oil seeds, cocoa and foods
  • North America--corn milling
  • Trade finance
  • Specialty canola oils and industrial oils.
So, where did things go badly wrong?  Cargill's agricultural supply chain results were well below the prior year, as the CEO noted the trading giant "misread markets."  Cargill has operations in 65 countries, of which two-thirds are classified as "emerging market economies."  

One of the hot topics at forums on global food issues is that of food security.  The big question is "Can the world feed itself?"  Cargill's CEO noted in a 2012 presentation, "It's demonstrably true that the power of the currently existing technology--without the need to invent new technologies--will allow us to use existing water and soil to feed the anticipated 9 billion people expected to inhabit the planet by 2050."  This view is not out of the mainstream, and it's certainly encouraging, as it should allay the neo-Malthusian concerns expressed by professional alarmists.  

Cargill uses the num√©raire of calories to measure the output of world food production, and it is certainly convenient.  While the total supply of calories produced is adequate to satisfy demand, there are surplus and deficit areas, as the theory of comparative advantage would suggest. World trade in agricultural products and foodstuffs should reallocate the supplies to satisfy demand.

Unfortunately, some 85% of global agricultural output is consumed where it is grown, and only 15% enters the world trading system.  So, part of Cargill's "essential work" is described as trading and logistics that connects surplus calorie areas with deficit calorie areas. Some of the trading vehicles, such as management of agricultural pools in Australia provide a flexible menu of options for grain farmers.  

Of the 15% of global output that is traded--such as corn, wheat, soybeans (whole, milled, and oil), rapeseed oil, cocoa, sugar, coffee, rice---Cargill's largest share of any particular commodity is said to be 25% or less.  

Price volatility shows up only in the traded commodity sector, as governments manipulate their own stocks in order to keep local food prices stable for political reasons.  Recent periods of higher price volatility have been laid at the feet of corporate commodity traders.  These arguments are unconvincing and unreasonable.  So what else is going on? 

Biofuel mandates in the United States are certainly a factor, as forty percent of our corn production is absorbed by ethanol as a result of non-market, Federal mandates.  All this for food which goes into the fuel tanks of our SUVs.  Also, ethanol has a marginal, if any, benefit to net GHG reduction.  So, in the words of Cargill CEO Page,
 "If we have the demand for 40 percent of our food production as completely inflexible (because of government mandates) then movements in supply..are going to have an outsized impact on price.  Today, 2 and 3 percent changes in supply are causing 40 percent changes in price, and much of that volatility is caused by the inelasticity in some portions of the mandated demand." 
A second factor is a global transportation, distribution and storage infrastructure which contributes to delays, higher costs, and significant crop spoilage. In the U.S., our inland waterways, including canals and river locks, have been neglected for decades and slow the movement of goods along major arteries like the Mississippi River.

Even in poster child success stories like Brazil, the picture isn't rosy for realizing its agricultural potential.  As a recent Bloomberg story points out,
"However, some problems may take years to sort out. The growth of the past decade has left Brazil's infrastructure straining to keep up, and cash crops often rot while trucks wait in lines to get into overcrowded ports. Companies struggle to find qualified workers due to poor quality schools." 
So despite Cargill's 2012 success in moving certain Brazilian commodities, Brazil itself lost potential export or consumption volumes to infrastructure inefficiencies that cannot be cured in the short term due to the inability to finance significant investments.   Today, paradoxically, the US imports corn from Brazil because of our own ill-conceived ethanol mandates.

According to Robert Zoellick, the President of the World Bank,
"First, we need to increase food productivity and production in developing countries, especially in sub-Saharan Africa and with smallholder farmers. To do so, we need to fix problems all along the value chain, including property rights, research and development for seeds and inputs, irrigation, fertilizer, agricultural extension, credit, rural infrastructure, storage and connection to markets."
Writing on the issue of food security, Roz Naylor, of Stanford's Center on Food Security and the Environment, notes,
"The third and much more difficult issue is the lack of political stability that would enable markets to work efficiently so food producers could sell their commodities and consumers could buy them at a reasonable price."
In fact, global companies like Cargill and Bunge step into this breach by providing training, agricultural extension services, and financing to small farmers in Asia and Africa.  People in the developing world need their own governments to step up and take responsibility for their own food security.

To put the somewhat abstract discussion of global distribution of calories into perspective, here's a story about the experience of one village in India.

There's no doubt that we've made progress, but there is so much more to do.

Wednesday, March 20, 2013

Dell's Board Should Come Clean

Today's Wall Street Journal talks about shareholders being on tenterhooks awaiting a proxy in which some self-interested firm will produce a valuation for Dell which will magically manage to support how little Dell's shares are worth based on future results.  Think about the question for a second: this whole process makes no sense.

The easiest thing to do in the meantime?  Have the board release all of the financial and analytical material on which the board decided that a leveraged recap and other alternatives were inferior to the management's proposed buyout.  Then, shareholders would have a benchmark against which to measure the forthcoming guesstimates. It's a really simple proposal, and it would substantiate what are otherwise unconvincing statements by the board.  Have them redact out any intra-board commentary if they want.  As Joe Friday would say during an interview, "Just the facts, ma'am."

I wouldn't hold out hope given all the conflicts of interest in the board room, but it is officially Spring.

Thursday, March 14, 2013

Afghan Commander Issues Threat Advisory

What we earlier termed Karzai's Afghan madness endangering our troops has been confirmed by one of our top generals in Afghanistan, according to the New York Times.

"Frustration with Mr. Karzai was clear in the alert, known as a command threat advisory, sent on Wednesday by Gen. Joseph F. Dunford Jr. to his top commanders. “His remarks could be a catalyst for some to lash out against our forces — he may also issue orders that put our forces at risk,” the advisory read....While threat advisories are circulated routinely, one directly from the commanding general is unusual, one Western official said.The threat advisory specifically mentioned Mr. Karzai’s comments about Bagram Prison, calling it an “inflammatory speech,” and warning commanders to be on guard against heightened insider attacks by Afghan forces against Westerners, as well as opportunistic Taliban violence. The order came after a recent rise in violence, including an insider attackthat killed two American service members and a bombing that struck the capital just after Defense Secretary Chuck Hagel arrived for a visit last week."
Going back to Jake Tapper's "The Outpost," the collapse of COP Keating could not have forced without members of the ANA cooperating with the Taliban.  Even members of the local village council were co-opted by the threat of violent reprisals against their family members by Taliban insurgents.  This event came against the background of a cooperative spirit engendered by the Keating commanders at the time.  Little of that spirit exists today, and the risks will be greater as the specifics of our planned withdrawal plan become known by our enemies.

Tuesday, March 12, 2013

Manic Depressive Analysts Move BBY to Buy

According to the Star Tribune, ten analysts have raised BBY shares "Buy" within the past nine weeks.  Back in November, we took the position that '" 'Renew Blue' Is A Good Start for Best Buy."  Among other things, the group think consensus at that time was (1) Hubert Joly was not the right CEO for the job; (2) the company needed a highly experienced, retail exec, and  (3)  BBY was in a death march due to being a showroom for Amazon and other online customers.  Now, scant weeks later, all of these concerns have evaporated.  Such is the world of financial lemmings.

There was a recent story in the Minneapolis paper about opportunities in large appliances for Best Buy, which is something we pointed out last November.  No chain, including Home Depot and Lowe's does a "category killer" job in major appliances, while Sears has been living off its brand equity.  If Best Buy goes all ultra-high end, that is a risky business.  The whole story is going to boil down to "Right brands. Right Assortments. Right Price Strategy, with good installation and aftermarket service."  Nobody has all the elements right. Local competitors in every market come the closest.

There is still LOTS of  organizational and cultural deadwood to be hacked away by machete, and lots of low hanging fruit to yield near-term improvements.  The cultural change is going to take time and a broom sweeping through the organization.  It may not be the analysts preference for quarter-to-quarter and quarter-over-quarter straight lines, but the potential is definitely there, as it was from the day that Mr. Joly and his team came on board.

Sunday, March 10, 2013

Karzai's Madness: Real or Feigned, It's Dangerous

Here's the latest from the WSJ about our untrustworthy ally:

"We have indicated to him in private that public criticism is unhelpful to the partnership, especially when there is no basis in fact for some of the claims he makes," said one senior U.S. official. "We understand that there are issues, but every close relationship has issues and we need to work through them in a constructive manner."This isn't the first time that Mr. Karzai accused the U.S. of conniving with the Taliban. In 2009, he alleged that the U.S. was secretly flying insurgents into northern Afghanistan in helicopters, as part of a plan to destabilize the country.Related Coverage
The U.S., other Western allies and Mr. Karzai's administration are engaged in discussions over what foreign military presence, if any, will remain in Afghanistan after 2014.
The U.S. has also been negotiating with the Taliban, but these talks have stalled over several issues, such as a possible swap of Taliban prisoners held in Guantanamo Bay, Cuba, for a U.S. soldier in Taliban captivity, and the Taliban's refusal to talk with Mr. Karzai's representatives.
U.S. officials have envisaged that North Atlantic Treaty Organization allies would make up a large part of the residual force after 2014. Mr. Karzai, however, on Sunday reiterated his opposition to any deal with NATO as a whole, saying countries willing to keep troops here would need to negotiate individual deals with Kabul.
"If you want to stay beyond 2014, all of you separately need to sign agreements with the Afghan people," Mr. Karzai said Sunday. "Limited numbers, in a location we chose and under our conditions and framework, with respect for our laws, our sovereignty, our traditions and culture."
Few if any Western allies would agree to contribute troops to an Afghan mission that is not within the NATO framework, Western diplomats say. "They want us out, that is for sure," a Western official said. "They feel that we are part of the problem."
The only currency that will work with Mr. Karzai is money, not more of our money, but less of his accessible from his numbered bank accounts or other hidden assets.  Relationships are fine, but this one is dysfunctional and manipulative; we are on the wrong end of the manipulation.  The sooner this gets put on the right footing, the safer our troops, personnel and allies will be as we withdraw.

How could we expose our troops to agreements about fixed locations under Afghan jurisdiction? How would any Western allies agree to this foolishness?  Karzai is exposing the Pillsbury Doughboy core of our inept foreign policy and exploiting it to this advantage.

Thursday, March 7, 2013

Dell Receives The Letter from Icahn

In our whimsical scenario, Michael Dell had received a letter from Warren Buffett. Subsequently, Dell has received a follow-up letter from Southeastern Asset Management.  Today, Dell has received "The Letter," from Carl Icahn.  Here's an excerpt from the letter, as reported in the Wall Street Journal,

"Dear Board Members:We are substantial holders of Dell Inc. shares. Having reviewed the Going Private Transaction, we believe that it is not in the best interests of Dell shareholders and substantially undervalues the company.Rather than engage in the Going Private Transaction, we propose that Dell announce that in the event that the Going Private Transaction is voted down by shareholders, Dell will immediately declare and pay a special dividend of $9 per share comprised of proceeds from the following sources: (1) $4.26 per share, or $7.4 Billion, from available cash as proposed in the Going Private Transaction, (2) $1.73 per share, or $3 Billion, from factoring existing commercial and consumer receivables as proposed in the Going Private Transaction, and (3) $4.26, or $5.25 Billion in new debt.We believe that such a transaction is superior to the Going Private Transaction because we value the proforma “stub” at $13.81 per share using a discounted cash flow valuation methodology based on a consensus of analyst forecasts. The “stub” value of $13.81 combined with our proposed $9.00 special dividend gives Dell shareholders a total value of $22.81 per share, representing a 67% premium to the $13.65 per share price proposed in the Going Private Transaction. We have spent a great deal of time and effort in determining the $22.81 per share value and would be pleased to meet with you to share our analysis and to understand why you disagree, if you do."
It's very clear, simply written and entirely consistent with the initial ideas proposed by Southeastern Asset, supported by T. Rowe Price and other large shareholders.  The letter raises another good point, namely that the way in which the Going Private Transaction was handled by the CEO and Board of Directors make it a related party transaction.  It certainly looks and smells that way.  So far, this is a case where shareholders are duly and respectfully exercising their rights to be treated fairly by their company.

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.  

Tuesday, March 5, 2013

Berkshire Hathaway: Conundrums in Buffett's Letter

Having read Warren Buffett's letters for many years, I was puzzled after my initial reading of the 2012 Shareholder Letter. It is different in style and tone from the previous letters.  Waiting a bit and rereading helped me reach a couple of conclusions.  The letter from front to back probably reflects the author's changing emotional state during the writing of the lengthy letter.

With a beginning containing apologies and "bad news," the conclusion of the letter where Mr. Buffett reprises "Owner Related Business Principles" shows the Chairman at his optimistic, incisive and feisty best.  Overall, it was a really good, fundamental business year, and shareholders who can hold without the comfort of a dividend should be well rewarded.  There are a few cautions, however.


The typical comment about BRK is that it is a property-casualty ("P-C") insurance company at its core.  That is true, to an extent.  The share of net income attributable to shareholders provided by the Insurance operations was 30% in 2012, down from 36% in the prior year and from almost 40% in 2010.  The decline in the net income contribution share in 2012 was driven by a sharp decline in the y-o-y investment income contribution share from the Insurance operations. It's no surprise that an insurance analyst is among the BRK bulls appearing on the panel at the Annual Meeting.  BRK's Insurance operation's performance and financial strength have been  extraordinary, almost magically consistent by industry standards.  In the Chairman's words these businesses "shot the lights out" in 2012, and that is not an understatement.

Berkshire Hathaway Reinsurance ("BH Re") is run by the rightly, oft-praised Ajit Jain.  BH Re generated $35 billion in 2012 float, comprising 48% of the float provided by all the businesses in the segment.  It also swung from an underwriting loss in 2011 to a $304 million profit in 2012, quite an achievement.

General Re produced a float of $20 billion and generated an underwriting profit of $355 million.  The P-C industry is characterized by classic underwriting cycles.  When conditions are flush, companies chase new business by taking on more risk with inadequate premiums; if economic conditions deteriorate and extraordinary losses hit, combined ratios go haywire.  Books shrink and the adjustment of premiums to appropriate levels takes some time.  In 37 of the past 45 years, the P-C industry's combined ratios have exceeded 100%, which is another way of saying that premiums failed to cover claims plus expenses.

BRK's reinsurers seem to not participate in the industry game of chasing business, which is why the Chairman seems to call out the Jain and Montross on a regular basis.

GEICO's year-end float was some $400 million higher than 2011 at $11.6 billion in 2012.  However, its underwriting profit was $680 million on a GAAP basis, but $1.1 billion excluding the effects of an industry-wide change in accounting standards that didn't affect cash or the fundamental numbers; the adjusted underwriting profit was 91% above the prior-year level.  Vehicle losses from Hurricane Sandy were more than three times higher for GEICO than the losses from Katrina.  The Chairman "rubs his eyes" at these numbers, and I have to scratch my head.  They are quite extraordinary.

The insurance businesses earned $34,545 million in premiums in 2012, compared to $32,075 in 2011, an incremental $2,470 million in earned premiums.  Against this, insurance losses and adjustment expenses were $20,113 million in 2012, compared to $20,829 million in 2011, a decline of $716 million.  This cushion allowed the businesses to absorb a significant increase in underwriting expenses and higher life, annuity and health benefit payouts to produce an underwriting profit of $1,625 million in 2012 compared to a profit of $248 million in the prior year.  Yes, they did shoot the lights out.

An Ernst and Young study about the effects of the low interest rate environment on insurer portfolios says that the fixed income portion of the portfolios will continue to be under pressure. Ernst and Young estimate that bond yields in the general accounts of P-C insurers could decline by 50 basis points from current levels, over three years. For most companies, this signal would flash yellow.

I strongly suspect that one of the reasons that Todd Combs and Ted Wechsler were brought on as new investment managers was to manage the fixed income portfolio aggressively to mitigate these kinds of pressures on the fixed income portfolios.  These are big stakes, given the size of BRK's insurance businesses.

However, the way BRK is structured, there are many layers of liquidity to support the businesses. If indeed the general accounts of other insurers are pressured, and they were to pull back from writing new, or renewing old, business, this would be an ideal scenario for BRK's businesses to gain share with the appropriate premium levels.  I can see why insurance analysts are bullish, particularly on the opportunities for GEICO.

Regulated, Capital-Intensive Industries

Let's get right to my point: the acquisition of BNSF was a gem of a pickup.  Pre-acquisition, it was a well managed company that consistently invested in its capital-intensive rail system, making it efficient and modern.  From BRK's acquisition criteria, it is an easy business to understand, with motivated management interested in leveraging growth and margin opportunities under the Berkshire umbrella. 

Since 2009 revenues have grown from $16,850 million to $20,835 million in 2012.  The net margin rate has increased by 160 basis points over the same period to 16.2% in 2012.  The Chairman talks about his Powerhouse Five non-insurance businesses: BNSF, Mid-American, Marmon, Iscar and Lubrizol.  They together earned $10.1 billion, pre-tax in 2012, slightly more than 6% above their 2011 earnings as a group. 

BNSF earned 53% of the total pre-tax earnings of the Powerhouse Five, recording pre-tax income of $5377 million, for a margin rate of 25.8% that appears to be easily the highest among the group. 

The Marmon Group seems like an extraordinarily profitable business with scale and opportunities for growth and margin expansion. It too appears to be a candidate for writing a business school case on how to manage a sprawling number of companies in three distinct segments.  For the Chairman and Charlie Munger to give their blessing by acquiring them says all that needs to be said.  Marmon's 2012 revenue was $7,171 million, on which it earned $1,137 million pre-tax, which is a margin rate of 15.9%. 

Rounding out the Powerhouse Five are Iscar and Lubrizol, which together should account for about $2.3 billion in pre-tax income for 2012, if my estimates are correct; the bulk of this amount should come from Iscar, but I couldn't find the breakout for these two businesses. Lubrizol was a great company for a long time, and I knew it working as a security analyst in Cleveland where a research colleague of mine regularly reported on its strong performance.  It should be another fine acquisition for BRK. Iscar also seems like a great business.  Both of these businesses should improve in 2013, particularly as Lubrizol is probably reshaping itself a bit. 

MidAmerican Energy is a solid collection of businesses, the majority of which won't knock anyone's socks off.  70% of consolidated 2012 revenue of $11,747 million comes from the two regulated utilities, PacificCorp and MidAmerican Energy; the utilities account for 50% of the consolidated operating profit of $1,958 million in 2012.  

MidAmerican's utility revenues have declined slightly each year since 2010, and the operating margin has been range bound between 7-8%.  The stronger performing businesses have been Natural Gas Pipelines and Northern Powergrid, which have higher rates of profitability on a much smaller revenue base.  Owning this business for a BRK investor gives cash flows that can be redeployed by Messrs. Buffett and Munger, along with an economically sensitive element to the portfolio mix.  Beyond that, it's hard to say much or to get excited about this collection of businesses.  The Chairman made some comment about owning a large chunk of solar energy capacity through the utilities: c'mon, really?  

We're going to stop here and break the analysis into at least one more post.  So far, we've seen an extraordinarily well managed and profitable property-casualty business portfolio that had an extraordinary year.  We've seen one recent acquisition, BNSF, which has been hitting on all cylinders. The Marmon Group is a terrific business in the Manufacturing, Services and Retailing segment of BRK.  Iscar and Lubrizol are fine businesses too, and Lubrizol's prospects should improve as it continues under the Berkshire umbrella.  

So, the Shareholder Letter begins with the Chairman apologizing for sub-par performance and for not making a mega-acquisition in 2012.  In the face of what we've talked about, what gives?  We'll continue later.