This morning, Berkshire Hathaway (BRK-B) released its annual report detailing the conglomerate’s 2009 earnings, as well as Chairman Warren Buffett’s 2009 letter to shareholders.  There wasn’t anything completely unexpected in either of these, though there were some subtle changes in the letter.

Earnings

Let’s first do a brief review of Berkshire’s 2009 earnings, which by and large, were fine.  In aggregate, Berkshire’s book value per share climbed 19.8% this year after declining 9.6% last year, though this rebound was less than the 26.5% increase in the S&P 500 total return index last year.  Berkshire’s book value now stands at $84,487 per class A share.

Insurance continues to be the engine that drives most of Berkshire’s earnings, and all of Berkshire’s insurance businesses produced underwriting profits this year.  Auto-insurer Geico and multi-line reinsurer General Re were the biggest contributors to this segment’s profitability, with the Berkshire Hathaway Reinsurance Group also pumping in about $350 million in profit, which is good, but down from the $1.3 and $1.4 billion of the prior two years, respectively.  After a strong start in 2008, Berkshire’s municipal bond insurance arm’s growth was essentially non-existent, which is likely consistent with Berkshire being stripped of its AAA rating in the last year. 

All of Berkshire’s insurance businesses provide float—insurance premiums collected but not yet paid as claims—to invest over time, and the float from these operations now amounts to $62 billion.  Berkshire’s investment income of $4 billion was up from 2008 thanks to Berkshire’s investments in the higher yielding preferred stocks of Goldman Sachs (GS), General Electric (GE), Dow Chemical (DOW), Swiss Re, and Wrigley.  These preferred stock investments are surely better than the effective zero percent interest this capital would be earning if it were still in cash.

Berkshire’s other big area, utilities, also performed satisfactorily, though thanks to lower demand from a weak economy, this group’s earnings were down from the prior year.  That said, Berkshire’s utility earnings are fairly consistent given that these businesses are guaranteed a certain return on capital by regulators.  In addition, since Berkshire’s new purchase of the Burlington Northern Santa Fe railroad is also a business that is guaranteed returns on capital by regulators, it will also be included in this segment.  In some ways the railroad business is very akin to the utilities business in that it is highly regulated, returns are regulated, and each of the businesses also requires large amounts of capital expenditures.  That said--and as Buffett pointed out in the letter--the railroad business tends to be more cyclical, thanks in part to its more direct ties to the economy, than the utilities businesses.

Berkshire’s operating businesses produced the weakest results of any of the segments.  This wasn’t unexpected at all, given that many of them are tied directly to the consumer and the housing industry, in particular.  In fact, Berkshire’s Clayton Homes unit, Acme Brick, Shaw (carpet manufacturer), Home Services of America (real estate brokerage), Berkadia Commercial Mortgage (mortgage originator), and Johns Manville, to name a few, have their fate tied to the residential housing market in the US.  And until this segment of the economy recovers, these businesses will continue to face headwinds.  One bright spot in this segment was food distributor McLane, where profit continued to growth despite the weak economic environment.  It also appears that after suffering more than a $700 million loss in 2008, NetJets might break-even or turn a profit in 2010.

Shareholder Letter

One change in Chairman Warren Buffett’s shareholder letter was that it was more of a review of Berkshire’s vast array of businesses—and the praising of certain managers—rather than an opportunity for him to lecture or inform his readers of his thoughts on a particular part of the economy or aspect of business.  In fact, over the last couple of years he seems to have reserved his thought pieces more for New York Times op-ed articles or television appearances, rather than the shareholder letter, preferring to have that more focused on Berkshire.  In my opinion, this was probably tacitly done to ease the transition to an eventual successor, making the letter more about Berkshire’s businesses than Buffett’s viewpoints, thereby helping to solidify the Berkshire brand.

While that seemed to be the overriding theme I took away from the letter, there were also a couple items of note, in my opinion.  Buffett spent time discussing the disadvantages of size for investing and Berkshire, as well as for companies in general.  Buffett continued to inform his readers that given the copious amounts of capital that Berkshire generates and the conglomerate’s already large size, it will be impossible for Berkshire to deliver the rates of return over the next several years that it generated for shareholders during the last 45 years.  This is nothing new, but just another gentle reminder that size is inversely correlated to returns when thinking about investments.  What’s more, he more deeply explained that despite Berkshire’s large size, it’s decentralized operating structure should continue to allow the conglomerate to operate more efficiently and nimbly than its other large company peers.  The reasoning for this of course is not new, but that pushing decision-making down to the folks on the ground, generally makes for better decisions and gives these managers a more owner-oriented focus, which is vastly different from the layers of bureaucracy that plague most large organizations.

In the one or two areas that Buffett did deviate from talking about Berkshire, he took aim at CEOs who were able to walk away and profit in spite of their companies failing and costing shareholders and the government billions of dollars.  He explicitly stated that while CEOs have had the opportunity for many rewards as part of their employment, they certainly need some “meaningful sticks” to keep their behavior in check.  Buffett also took aim at those CEOs and directors who use stock as a currency for making an acquisition.  I think this comment was in part to further explain his thinking in using some of Berkshire stock to complete the Burlington Northern deal, as well as possibly taking a tacit jab at Berkshire holding Kraft (KFT), which issued in Buffett’s view undervalued stock to purchase Cadbury earlier this year.

You might also be interested to that I recently made an appearance on Fox Business News, which I have linked here.  This blog was also recently mentioned in a New York Times article linked here, and an Associated Press article linked here.

Please do send me any questions or comments you may have.

Justin

Copyright © 2010 Buffettologist.com

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business.  This content is intended solely for the entertainment of the reader, and the author.

A colleague of mine, Matt Nellans, and I have been discussing Berkshire Hathaway’s (BRK-B) proposed acquisition of Burlington Northern Santa Fe (BNI).  And to put it mildly, the Burlington purchase is very different from most other acquisitions Berkshire Chairman Warren Buffett has ever completed.  In order to complete the deal, Buffett is issuing debt, giving up some of Berkshire stock, splitting Berkshire stock, and paying top dollar to acquire the railroad company—all of which are actions that are very uncharacteristic of the Berkshire Chairman.

Let’s first look at Burlington and ask why would Buffett want the railroad company.  To begin, the competitive dynamics of the railroad business have improved over the last several decades.  Consolidation in the industry, improved efficiencies in transporting via rail, and higher fuel prices have all made railroads a more efficient means of transporting goods compared to using trucking companies.  Furthermore, Burlington’s footprint is over the western states of the country.  In simple terms, goods and materials are shipped via boat from Asia and arrive into the country in Long Beach or Oakland, and then need to be transported long distances to Dallas, Chicago, New York or elsewhere.  Who better to transport these goods than Burlington?  My colleague Matt puts it even more succinctly, when he refers to the United States as a human body, and posits that Burlington is the proverbial circulatory system of the western states of the country.  The body simply can’t function without its circulatory system running at full steam.

Buffett is also noted for wanting to acquire or make investments in businesses that are shielded from competition.  He has typically used the moat and castle analogy to illustrate this concept, preferring businesses that have a wide moat around their franchises.  In Burlington, if someone wanted to install a new railroad in the western states, not only would they need billions and billions and billions of dollars for the labor and materials, but they would also need government approval, rights of way agreements, and significant land holdings on which to place their rail.  Furthermore, they would then need to build additional infrastructure around their rail, acquire shipping contracts, purchase equipment, purchase fuel, and the list goes on.  Thus, Burlington is shielded from competition by not only the high fixed costs of starting a new railroad, but also by government.  And as Matt points out, Burlington is guaranteed a decent return on capital by law, making it even more difficult for someone to penetrate its business.  To be sure, the moat around Burlington is wide.

If we then examine the way Berkshire is financing the deal, it perhaps illuminates other factors in Buffett’s thinking.  While Berkshire has issued debt in the past, it has typically been done to finance loan portfolios, and as Matt points out, the durations have been matched.  In Buffett’s New York Times op-ed pieces he has further warned about the risks of price increases, or inflation, coming at some point in the future. And if he truly believes that inflation is a major risk, it would make sense to issue debt—some of it fixed rate--to finance the deal, as the burden of those debt payments would decline over time if inflation were to heat-up.  In addition, any capital expenditures that Burlington makes today will be cheaper than they would in the future if inflation were to heat-up.  Finally, as Matt pointed out to me, since Burlington is guaranteed a decent return on capital, it may be shielded from future inflationary pressures since it would be able to pass on price increases to keep earning its return.  Think of this as utility type earnings.

All of these characteristics--including the inflationary ones--may explain why Berkshire was willing to pay-up so much to buy Burlington.  Not only could one argue that the absolute price of the acquisition was on the higher side, but Buffett himself indicated that in his view he was using modestly undervalued stock as currency to complete the deal.  Furthermore, given Buffett’s historical views on stock splits, it seems odd that he would agree to one now unless he really wanted to bring Burlington into the Berkshire umbrella.  Given all of this, Matt probably put it best, when he said that not only is Buffett’s purchase of Burlington an all-in bet on the United States, but so is it an all-in bet on future inflation.

Please do send me any questions or comments you may have, and my thanks to Matt Nellans for his contributions to this article.

You might also be interested to know that this blog was featured in a Crain’s article, which I have linked here.

Justin

Copyright © 2010 Buffettologist.com

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business.  This content is intended solely for the entertainment of the reader, and the author.