Berkshire Hathaway: Updating Intrinsic Value

Now that Berkshire’s Q2 10-Q and 13-F have been filed, I thought it would be a good time to review the company’s intrinsic value. If you want to skip straight to the punch-line, here it is: my assessment of Berkshire’s intrinsic value is virtually unchanged from Q4 2019 at $700 billion or about $300 per class B share. To see how I arrive at that conclusion, read on. But before I talk about valuations, I’ll review some of the moving parts in the first half of 2020.

Dominion Energy Acquisition

Perhaps the biggest news out of Berkshire this year is its acquisition of Dominion Energy’s gas transmission and storage business. Berkshire is paying $4 billion in cash and assuming about $6 billion of debt for a total of $10 billion. While this is a large acquisition by any standard, it’s more of a bolt-on acquisition for Berkshire. The $10 billion purchase only amounts to 2% of Berkshire’s market cap and the $4 billion cash outlay will reduce Berkshire’s $143b cash hoard by less than 3%.

The assets are for the most part mission-critical infrastructure that benefit from scale advantages and regulatory moats. They include 7,700 miles of pipeline and 900 billion cubic feet of storage. This represents 10% of all the natural gas carried in the US and brings Berkshire’s share up to 18%.

The deal’s crown jewel is the namesake Dominion Transmission. It’s a massive transmission and storage pipeline which sprawls across Ohio, West Virginia, Maryland, Virginia, and New York. It includes about 400 Bcf of working gas storage capacity, which is 40% of all the storage in the Eastern U.S. This infrastructure is critical for meeting the Northeast’s power and heating demand.

The deal also includes the Questar, Overthrust, Iroquois (50%), and Carolina pipelines. The Questar pipeline is the only major pipeline to serve Salt Lake City and the surrounding rural areas of Utah, Idaho, and Wyoming and faces little competition. The Overthrust pipeline connects the east and west Rocky Mountains and links with pipelines that carry gas into the midwest. This pipeline is in the weakest competitive position of the four. The Iroquois pipeline carries gas into New York city and is well positioned to benefit from incremental demand. Carolina Gas operates a spiderweb network of gas transmission lines across South Carolina. It is mission-critical, hard to replicate, and faces no competition.

The deal also includes a 25% interest in Cove Point LNG. This is a LNG export facility that is 2 years into a 20-year take-or-pay contract. It also offers LNG import, peak shaving, and transmission services. The facility’s import contract ends in 2023 and may not be renewed as current gas prices make imports uneconomic.

Buffett paid 10x EV/EBITDA for these assets, which is higher than the 6-8x he paid for midstream assets (Kern River Pipeline and Northern Natural Pipeline) in 2002. But 10x is far from a nose-bleed price. The higher multiple probably reflects both lower interest rates and a lower hurdle rate due to Berkshire’s growing cash hoard.

This acquisition is consistent with Berkshire’s trend (since 2010’s BNSF purchase) of buying capital-intensive, mission-critical infrastructure assets with dominant competitive positions. Though these assets won’t hit a home run in any given year, they’re virtually certain to grind out singles for decades to come.

Stock Portfolio

Berkshire sold over $13 billion of stocks in Q2. They ditched all of their airlines and common shares of Occidental Petroleum. They also lightened up on banks, selling meaningful amounts of Wells Fargo, Bank of New York, J.P. Morgan, PNC, M&T, and Goldman Sachs. The only banks Berkshire didn’t trim were U.S. Bancorp (sold only 2%) and Bank of America. Berkshire actually increased its Bank of America position by 10%, paying about $2 billion at an average price of $24.33. Bank of America was Berkshire’s only material purchase. It is clear which banks are Buffett’s favorites today

Share Repurchase

In Q1 Berkshire only bought back $1.6B of stock despite prices crashing from $230 to $160. Buffett struck a somber tone at Berkshire’s May 2nd virtual annual meeting and said the wide spectrum of possible outcomes led him to hold cash. Since then the range of possible outcomes has narrowed and Berkshire has begun repurchasing shares in earnest. In Q2 they retired $5.1 billion at an average price of $176. Year-to-date, share count is down about 2%. This isn’t enormous, but shows a willingness to step up to the plate when the conditions warrant it.

Precision Castparts Write-down

Acquisitions are hard: even Buffett doesn’t have a perfect record. In 2016 Berkshire paid $37 billion for Precision Castparts and in Q2 they wrote-off $10 billion of it. This is a non-cash impairment so $10 billion didn’t actually walk out the door. Rather, it reflects Berkshire’s view that the company’s future earnings power no longer justifies its carrying value. In a sense, this is admitting that Berkshire overpaid.

In a prior blog post I observed that Berkshire’s acquisitions tend to cluster around 10x pre-tax earnings. The notable exception was Precision Castparts, which Berkshire acquired for 14.6x. This write-down is a lesson for all investors in the value of price discipline. As Ben Graham wrote, the purpose of a margin of safety is to render a forecast unnecessary. If 2020 has taught me anything, it’s that forecasting the future is a fool’s errand.

Apple

Buffett’s Apple investment is perhaps Berkshire’s greatest investment since GEICO but has largely flown under the radar. Investors who have been waiting for Berkshire to “shoot its elephant gun” and acquire a large company missed Berkshire’s elephant-sized position in a marketable security.

Buffett began buying Apple in Q1 2016 when they traded for $110. He continued buying through Q3 2018 when shares traded $225 and invested a total of $36 billion. Today shares are $460 per share and Berkshire’s stake is worth $112 billion — more than triple its cost. Apple now accounts for half of Berkshire’s entire equity portfolio and 25% of each class B share ($47/sh).

GEICO’s “Give-back”

One reason Berkshire’s stock may have traded so cheaply in Q1 and Q2 was concern that Berkshire’s insurance operations had written huge event cancellation or business interruption policies. Investors didn’t understand that virtually all of these policies explicitly exclude pandemics. Some of these exclusions may be challenged in the courts, but Berkshire looks to be in the clear. Nevertheless, Berkshire’s reinsurance arm did record a loss in Q2. GEICO picked up the slack and recorded a massive underwriting profit as fewer miles driven translated into fewer accidents. GEICO is sharing the spoils with its customers, however, which will dampen GEICO’s results for the next three quarters.

Book Value

For most of Berkshire’s history Buffett encouraged investors to use Berkshire’s change in book value as a proxy for its change in intrinsic value. As more of Berkshire’s value has come to reside in its wholly owned subsidiaries, book value has become less relevant. Nonetheless, it still has utility as a crude indicator of value. Book value is flat year-to-date which would suggest intrinsic value is little changed since 2019.

Until late 2018 Buffett said he’d repurchase Berkshire shares at or below 1.2x book value. That’d be $213 today (8/18/20), adjusting the Q2 numbers for marked-to-market gains in the stock portfolio.

Berkshire trades for $209 today which puts it right at 1.2x book value. Buffett said he would only repurchase shares at a meaningful discount to intrinsic value, so I’d bet he’d peg Berkshire’s intrinsic value at least 25% higher around $284 per share or 1.6x book value.

Five Groves

Berkshire’s 2018 letter encouraged investors to think of Berkshire as the sum of five groves of businesses:

1. Non-insurance Wholly Owned

2. Marketable Equities

3. Equity Method Investments

4. Cash & Equivalents

5. Insurance

1. Non-insurance Wholly Owned

Berkshire’s non-insurance businesses include the BNSF railroad, Berkshire Hathaway Energy, and its collection of manufacturing, service, and retailing (MS&R) businesses. I value these based on comparable public market multiples.

Berkshire’s largest non-insurance business is the BNSF railroad. BNSF is similarly positioned and capitalized as Union Pacific, which trades for 24x earnings and 19x EV/EBIT. Berkshire’s utilities and energy business is above-average, but I conservatively value it at an 18x PE multiple versus the Dow Jones Utility Average Index’s 20x forward PE. The MS&R group includes a variety of businesses like Precision Castparts, McLean, Nebraska Furniture Mart, Dairy Queen, Borsheims, and See’s Candy. Some of the larger businesses in this category have struggled recently, so I assign a moderately below-market multiple of 15x.

Marked to market, this group is collectively worth $300 billion or $125 per share. This is Berkshire’s most important grove beyond insurance as it accounts for over half of Berkshire’s current market value.

2. Marketable Equities

Apple has come to dominate Berkshire’s stock portfolio. As of 8/18/20 it’s worth $113 billion or over half of Berkshire’s portfolio. Berkshire’s next largest positions are Bank of America, Coca-Cola, and American Express. Collectively the top four positions are 73% of Berkshire’s portfolio, which is remarkably concentrated. Buffett has long preached that investors should concentrate on their best ideas instead of spreading their capital across more mediocre ideas. He certainly practices what he preaches.

Note: I exclude Kraft Heinz and account for it using the equity method.

On a look-through basis, Berkshire’s marketable equities earned $9.5 billion over the last twelve months and $10.3 billion in 2019 which amount to about $4 per share. They are the second largest grove at Berkshire.

3. Equity Method Securities

Berkshire uses the equity method of accounting when it owns enough of a company to exert “considerable influence” but does not own the entire company. Equity method investments include 26.6% of Kraft Heinz, 50% of Berkadia, 38.6% of Pilot Flying J, and 50% of Electric Transmission Texas. I value these at their carrying value. They are a relatively minor component of Berkshire and contribute only $7 per share of value.

4. Cash and Equivalents

Berkshire’s fortress balance sheet comes from its cash hoard. Most of this is held at Berkshires reinsurance units. The vast majority of Berkshire’s cash is in T-Bills which yield virtually nothing today. This has reduced earnings by a few billion versus 2019 when rates were higher. Buffett views T-Bills as a free option on opportunities to redeploy the capital into higher return investments. If he were to “reach for yield” he could marginally increase short-term earnings today but wouldn’t be able to capitalize if attractive prices materialize down the road. He’s playing the long game which has always served Berkshire shareholders well.

5. Insurance

Insurance is the engine which keeps Berkshire going. Insurance companies accept policy payments up front, pay out claims down the road, and invest the “float” in between. Historically Berkshire has underwritten policies at a 2% margin which means this float costs -2%. Float is currently $131 billion, up $2 billion since the end of 2019. Year-to-date underwriting has produced a $1.5 billion profit.

It’s impossible to delineate where Berkshire’s insurance operations end and the rest begins because many of Berkshire’s other assets are financed by its float. To be conservative and avoid double counting, I don’t add any value for Berkshire’s insurance operations since it funds the assets I’ve already valued.

The Sum of The Parts

Summing the five groves suggests Berkshire is worth about $700 billion or $293 per share. The book value method suggests shares are worth about $284, which is remarkably similar. In 2019 I valued Berkshire between $276-298 using similar methods, which suggests little change to intrinsic value despite the upheaval in the 2020. This steadiness speaks to Berkshire’s resilience.

If Berkshire compounds at 7% for the next five years, intrinsic value will rise to $410 by the end of 2025. This is about double the current stock price and doesn’t seem too far fetched as Berkshire currently earns a little over 8% on its equity.

While I don’t think Berkshire has the best growth prospects in the market, I do think it is one of the safest equities in the market. I try to look down before I look up, and with that in mind I like Berkshire’s potential return profile today.

Beyond The Sum of The Parts

Bronze is an alloy of 90% copper and 10% tin. Copper has a hardness of 3.0 on the Mohs scale while tin has a hardness of 1.5. So, you might expect Bronze to have a hardness of 2.8, the weighted average of the two. But it doesn’t. It’s much stronger. Bronze has a hardness of 6.0! Iron, for context, has a hardness of 5.5. Copper and tin aren’t found geographically close to each other, so it took awhile for cavemen to discover this phenomenon. When they did, it ushered Europe out of the Stone Age and into the Bronze Age.

When I heard about this from Peter Kaufman I thought of Berkshire Hathaway. Berkshire has combined things not usually found together, such as reinsurance and railroads and utilities, and in doing so has created a whole that is much stronger than the sum of its parts.

Insurance, like utilities and rails, is a highly regulated industry and the regulators love Berkshire. They allow Berkshire to invest a disproportionate amount of its float into businesses as opposed to lower-return bonds because they understand that Berkshire’s earnings power at its railroad and utilities virtually ensure it will always be able to meet its insurance obligations. Berkshire also writes far less premium relative to its capital than almost any peer. This advantage allows Berkshire to earn higher investment returns than any other insurance company. Unlike bronze, I’m not suggesting Buffett’s “discovery” will usher in the next epoch of western civilization. I am suggesting that Berkshire’s structure deserves a premium rather than a conglomerate discount.

How much of a premium is difficult to say. My $700 billion valuation doesn’t ascribe Berkshire’s insurance units any value beyond their assets, which is too low. They at least deserve a premium for their underwriting profits, but a 2% margin on earned premiums of $63 billion capitalized at 10x only adds $13 billion or $5 per share. They also deserve a premium for gathering low-cost float that can fund purchases of marketable securities and wholly owned businesses.

Although GAAP requires Berkshire to carry float as a liability, Buffett has said it’s almost as good as equity since, at least at Berkshire, it is enduring. And because of Berkshire’s unusual earnings power and Fort Knox balance sheet, it can use that float to buy things other insurers cannot, making it particularly valuable even when rates are low.

Berkshire’s $131 billion of float has grown at a 18.5% CAGR since 1967. It’s doubled over the last ten years, growing at a 7% CAGR. If it doubles again by 2030 and costs -2%, what’s the value to shareholders? Something on the order of $172 billion or $72 per share — $131 billion of assets purchased with the float plus $41 billion of collective (un-discounted) underwriting profits.

Now it’s far from guaranteed that float doubles again. Buffett has been saying for a while that float won’t grow much, but the results have proved him wrong. I wouldn’t buy Berkshire if the thesis hinged on growing float at 7%, but fortunately it doesn’t. With shares at $210, Berkshire could double over the next five years if the gap to intrinsic value (excluding float) closes and intrinsic value compounds at 7%. If there is no re-rating, then the stock should compound at 7%, which wouldn’t be the end of the world. But, Berkshire is historically cheap right now at 1.2x book value, so some re-rating seems likely. In the meantime, shareholders can sleep well knowing they’re protected by one of the world’s strongest balance sheets.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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