- Berkshire is 15%-19% Undervalued Relative to its Intrinsic Value.
- Warren Buffett is Still an Investing Genius.
- Whitney Tilson is Still Bullish on Berkshire.
- Berkshire Generated Solid Performance From its Industrial & End-User Products Manufacturing Operations.
Investors should accumulate share of Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) on the dips. I believe that Berkshire's share price is 15% undervalued relative to my fair intrinsic value of its shares. Berkshire's share price trading at a 38% premium to its Q1 2014 book value and I believe it should be trading at a 60%-80% premium to its book value. As Berkshire's share price is well over the 1.2X book value that Buffett has targeted for share repurchases, I do not see Berkshire buying back shares unless its P/B drops by ~15%.
Sources: Morningstar Direct and My Estimates
Berkshire Hathaway will not repeat the 19.8% returns it enjoyed from 1964-2011 for the following reasons:
- Berkshire's size: Berkshire is a $314.6B company. It is no longer an upstart taking on the establishment. By virtue of its size, it is the establishment
- Berkshire has already bought up many of the most desirable investment opportunities in the marketplace. However, Berkshire should continue to generate solid growth and performance due to its mix of high quality businesses that it owns as well as its well-regarded portfolio of marketable securities.
I agree with hedge fund manager and Buffett disciple Whitney Tilson that there is still upside in Berkshire Hathaway's shares. I believe that there is 15% upside in Berkshire and he believes that there is 30% upside in Berkshire (as of March 1 and 19% as of May 2). Here is the updated valuation model Tilson used to value Berkshire's shares:
- Tilson valued Berkshire's pre-tax earnings stream (excluding investment income) at a P/E multiple of 10X, up from 8X last year (I still use 8X myself).
- Tilson excluded 50% of the earnings from Berkshire's insurance businesses for purposes of conservatism.
- Tilson added up all of Berkshire Hathaway's gross cash and investments per share (excluding the impact of manufactured housing and other real estate loans originated or purchased).
- Tilson then divided that sum by Berkshire's weighted average outstanding Class A share equivalents.
Sources: Whitney Tilson and My Estimates
My previous articles on Berkshire discussed its acquisitions announced in 2013. Berkshire also announced that Berkshire Hathaway Energy entered into a Share Purchase Agreement to acquire 100% of AltaLink, L.P., an indirect wholly-owned subsidiary of SNC-Lavalin Group Inc. for an estimated cash purchase price of C$3.2B (~US$2.9B). AltaLink is a Calgary-based regulated transmission-only business. Berkshire's management expends to fund this acquisition with a combination of cash and new Berkshire Hathaway Energy senior unsecured debt.
Burlington Northern Santa Fe
BNSF's growth trajectory has been slowing down lately. BNSF's revenues in FY 2013 increased by 5.66% in comparison to FY 2012's revenues but only grew by 3.08% in Q1 2014. BNSF's revenue growth reflected 2% growth in revenues per car/unit and a 1% increase in cars/units handled ("volume"). Q1 2014 revenue growth was due to stable volume for consumer products ($1.7B in revenue) and volume growth for industrial products ($1.4B in revenues, 5% growth), coal (($1.2B in revenues, 1% growth) and agricultural products (7% growth).
Source: BNSF's SEC Filings
Although BNSF is not the only railroad with capacity problems, it had to lease and buy new locomotives by the hundreds as well as hire new crews. BNSF expects traffic to normalize by April but it will continue to face capacity challenges in 2014. Severe weather conditions and service-related challenges, particularly in the Northern U.S service territory, negatively affected BNSF's revenues and earnings (7.3% decline in its after-tax earnings). Together, these factors reduced operating efficiencies and gave rise to higher costs for service recovery. Nevertheless, we expect that BNSF's revenues and earnings over the remainder of 2014 will equal or exceed its 2013 earnings. In addition, BNSF's planned capital investments and new employee hiring in 2014 will expand capacity and allow it to maintain high service levels in the future.
Source: BNSF's SEC Filings
Berkshire Manufacturing, Service and Retailing
Berkshire's Manufacturing, Service and Retailing businesses' revenue grew by 1.9% in Q1 2014 versus Q1 2013 and reached a total of $22.5B. McLane Company's reported revenues declined by 3% year-over-year during the quarter. McLane operates on a 52/53 week fiscal year and McLane's Q1 2014 period was one week shorter than Q1 2013. Berkshire's collection of manufacturing businesses grew by 5.9% and its operating income increased by 12.66%. Forest River RVs generated 17% revenue growth and 52% operating income growth on the strength of increased unit sales and lower materials costs. Berkshire's apparel businesses generated 20.7% pre-tax earnings growth due to expense reductions while Iscar's operating earnings grew 39% and Lubrizol's pre-tax profits were roughly unchanged from the prior year.
Source: Berkshire's Q1 2014 Report
Berkshire Finance and Financial Products
Berkshire's Manufactured Housing and Finance (Clayton Homes) earnings were $416M for FY 2013, an increase of $161 million (63%) compared to FY 2012. Clayton Homes followed up its strong performance in FY 2013 by growing its earnings by 62% in Q1 2014. FY 2013 and Q1 2014 benefited from lower loan loss provisions and an increase in net interest income as the result of lower interest expenses. The reduction in interest income on Clayton Homes' loan portfolio was more than offset by lower interest expense due to a decline in average borrowings and lower interest rates. Clayton Homes' results in FY 2013 benefited from a 9% increase in units sold.
Furniture/Transportation equipment leasing's pre-tax earnings increased $32M (14%) in Q1 2014 versus Q1 2013. The increases primarily reflected 10% growth in lease revenues, reflecting increased units on lease and higher lease rates.
Investment and Derivative Pre-Tax Gains/Losses were $1.37B in gains for Q1 2014 versus $1.71B of gains in Q1 2013. Investment gains realized in Q1 2014 included $949M from the exchange of shares of Phillips 66 common stock for 100% of the common stock of a specialty chemical products subsidiary of Phillips 66. In Q1 2014, Berkshire's equity index put option contracts produced losses of $132M compared to gains of $1.25B in Q1 2013. In 2014, the losses were due to lower interest rate assumptions. In 2013, the gains reflected higher equity prices and the favorable foreign currency exchange rate movements from effects of a stronger U.S. Dollar. In the first quarter, Berkshire's credit default contract generated a pre-tax gain of $373M in 2014 and a loss of $14M in 2013. Berkshire's credit default contract exposure currently relates to municipality/state issuers.
Berkshire's Insurance Operations
GEICO enjoyed strong performance in Q1 2014. GEICO generated solid 11% revenue growth on the strength of 7.2% growth in polices-in-force and increased premiums per policy. GEICO's underwriting expenses increased and losses and loss adjustment expenses at a slower rate than revenues resulting in a 120bp decline as a percentage of premiums earned. This resulted in GEICO's pre-tax underwriting gain increasing by $87M year-over-year.
General Re's revenues grew by 6% but its underwriting profit declined by 16% as improved underwriting from its property insurance operations was not enough to offset underwriting losses incurred in its workers' compensation operations and its life/health operations.
Berkshire Hathaway Reinsurance Group's Q1 2014 revenue declined by 27.7% year-over-year and all of its units saw pre-tax profit declines year-over-year. This division saw its pre-tax income decline by 81% due to the following factors:
- The absence of a $235M gain associated with the Swiss Re quota-share contract, which largely related to decreased estimated ultimate liabilities for prior years' losses.
- A $271M decline in net foreign exchange gains from its other multi-line property/casualty and its life and annuity operations.
- The absence of a $255M gain associated with amendments to the SRLHA contract.
Berkshire Hathaway Primary Group is the smallest division of Berkshire Hathaway's insurance operations. Premiums earned in the first quarter by BH Primary aggregated $953M in Q1 2014 and $713M in Q1 2013. BHPG's primary insurers produced underwriting gains of $99M in Q1 2014 versus $54M in Q1 2013.
Berkshire Hathaway Insurance's Net Investment Income decreased by 10% in Q1 2014 as this quarter did not include interest from the Wrigley 11.45% subordinated notes ($4.4 billion par). Partially offsetting its interest declines were increased dividends on its equity investments.
In conclusion, Berkshire Hathaway's share price is undervalued by 15% relative to its fair intrinsic value and its business units continue to generate steady profit growth. Investors should view Berkshire Hathaway as diversification away from traditional stocks and bonds as well as being able to utilize a high-quality asset manager to gain access to private equity businesses that are not leveraged to the hill in order to pay dividends and debt service to the private equity owners and lenders. Berkshire Hathaway's continued ability to increase its book value on a recurring basis is impressive and as it continues to do so, the investment community will recognize the value of Berkshire's shares. Berkshire has set an implicit floor price for its shares through its December 2012 buyback and that it is adapt at sheltering its income from the taxman. Although Berkshire will not be able to enjoy the 19.8% compounded annual growth it enjoyed from 1964-2011, Berkshire's future total return should be able to exceed that of the S&P due to its strong portfolio of diversified businesses.
Source: Berkshire's Q1 2014 Report
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.