Despite modestly outperforming the S&P 500 year-to-date, Berkshire's (BRK.B,BRK.A) 2016 risks going into the books as a subpar year. During the first six months, book value increased from $256 billion to $263 billion, or an annualized ROE of only 5.5%. The investment portfolio lost several billions in value while its largest mark-to-market investee, WFC, has been embroiled in well publicized criticism. Finally, earnings in the biggest subsidiary, BNSF, are down significantly year-over-year. Investors appear to have more than discounted these disappointments in the share price. Berkshire's market capitalization has decreased by around $20 billion since the end of 2014 despite the fact that book value has increased by $23 billion - a figure that rises to $33 billion if Kraft Heinz (NASDAQ:KHC) shares are marked at fair market value. Additionally, relative to 2014, Berkshire now owns 100% of Precision Castparts (NYSE:PCP) and Duracell, all while increasing cash by $9 billion. This decline in price, simultaneous with an obvious increase in value, has led to a bargain opportunity. I contend that the shares are currently trading at 12x earnings and the market capitalization stands at a $100 billion discount to intrinsic value. Given this discount, I believe Berkshire could create more value through share repurchases than most acquisition scenarios.
It makes sense to get the topic du jour, Wells Fargo (NYSE:WFC), out of the way early. The financial media has breathlessly waited for Buffett's opinion on WFC as if the companies' fates were intertwined. In reality, the investment in WFC has a current value of around $21 billion relative to Berkshire's $592 billion in total assets. If a stock was 3.5% of your portfolio, you would obviously want it to do well but not pull your hair out because it was down 10%. Using this same logic on Berkshire, I want WFC to right the ship and for the share price to recover, however, whether the stock is trading at $35 or $55 in a year has only a marginal impact on my investment thesis.
I also wanted to touch on two accounting topics before diving into valuation. The first is amortization of intangible assets. When Berkshire purchases a company at a premium to book value, which is almost always the case, it needs to account for that premium by recording part of the difference between the acquisition's book value and the purchase price as an intangible asset. Berkshire has been a serial acquirer in recent years and as of June 30th it had intangible assets of $42.3 billion on the balance sheet. $25 billion of those assets are subject to amortization, which means that Berkshire must recognize an expense on its income statement despite the fact that amortization is non-cash and does not accurately depict any business reality. In fact, high-quality companies like Danaher (NYSE:DHR) often, and I believe correctly, adjust this expense when showing investors "non-GAAP" earnings. Last quarter, Berkshire recorded $377 million of amortization expense. This means that Berkshire's pre-tax earnings are lower by around $1.5 billion on an annual basis than would be reported otherwise. While this is negative from an optical perspective because it slows reported earnings and book value growth, it is positive from an intrinsic value standpoint given because the recognition of the expense lowers taxable income and increases cash flow.
The second accounting issue pertains to Berkshire's holdings in Kraft Heinz. Berkshire owns 326 million KHC shares that have a fair value of approximately $29 billion. However, unlike other shareholdings that are marked at fair market value, Berkshire accounts for its KHC shareholdings using the equity method. The difference in the accounting treatment is substantial. While the shares have a fair value of $29 billion, Berkshire only recognizes the investment as an asset with a value $15.75 billion. For perspective, the $13.25 billion difference is only slightly less than what Johnson & Johnson (NYSE:JNJ) earned in all of 2015.
Turning to valuation, I think it is reasonable to expect Berkshire to generate 2017 after-tax earnings somewhere in the realm of $20 billion. This number increases to $25 billion when accounting for profits of Berkshire investees that are retained versus paid out as dividends. The major assumptions are shown below and compared with 2015 (the last full year of reported results) for historical context.
Note that I expect BNSF's 2017 earnings to be well below 2015 as car loadings are still negative on a year-over-year basis. On the bright side, yearly comparisons have improved in recent weeks. Utility earnings should be up modestly, given massive capex into regulated-return markets.
Earnings in the Manufacturing, Service and Retail segment should increase significantly given the inclusion of Precision Castparts and Duracell, which were not part of Berkshire in 2015. Investors should note Berkshire has significant exposure to the oil and gas sector (tank cars, specialty chemicals, cast parts, etc.), so any increase in drilling activity associated with $50+ oil is going to be a tailwind.
Underwriting income is extremely difficult to model, but I would expect modest improvement given GEICO's poor results in 2015. For historical perspective, Berkshire's underwriting income was $2 billion and $1.7 billion in 2013 and 2014, respectively, so $1.5 billion is not particularly heroic.
Note that Berkshire reported $730 million of income from KHC in 2015, but these earnings were almost entirely from preferred stock that was redeemed in 2016. To keep the comparison apples-to-apples, I exclude this from 2015 earnings and use consensus 2017 earnings of $3.91/share on KHC common to arrive at $1.3 billion in equity earnings.
Assuming all of Berkshire's Class A shares were converted to Class B shares, there would be 2.465 billion shares outstanding. $20.6 billion / 2.465 billion shares outstanding = $8.23 in earnings. At the time of writing, Berkshire is trading at $144, or 17.5x 2017 earnings. However, this excludes two major adjustments: i) retained earnings from equity investments and ii) a substantial excess cash position.
Using 2017 consensus estimates for Berkshire's domestic equity holdings as of its most recent 13-F, excluding KHC, I arrive at "look-through" earnings of ~$7.4 billion. The current dividend levels of around $2.6 billion, implies retained earnings at the investees of $4.8 billion. Note that "investment income" in the insurance segment is higher than $2.6 billion because it also includes preferred stock dividends (excluding KHC) and interest income on bonds, all of which totaled $4.6 billion, or $3.7 billion after-tax in 2015. The retained earnings must be taxed. The question is whether they should be taxed using the dividends received deduction rate (~10.5%) or as unrealized gains (~35%). I use the dividends received deduction because I think it more likely than not that Berkshire is a long-term holder and will receive this income in the form of dividends rather than realized gains. Implicit in this treatment is that Berkshire's $72 billion deferred tax liability is dramatically overstated. Including retained earnings, net of taxes, increases Berkshire's total earnings to $24.6 billion, or $9.97/share and reduces the P/E multiple to 14.4x.
The second major adjustment that must be made is to account for the excess cash position. Buffett has stated that Berkshire will always have at least $20 billion of cash on hand to maintain ratings and pay potential catastrophe losses. At the end of the 2nd quarter, Berkshire held $73 billion in total cash, so $53 billion could be considered "excess." Berkshire's free cash flow varies from earnings largely because capital expenditures are materially in excess of depreciation, but this is offset by the fact that utility and railroads are able to defer huge amounts of taxes, insurance float generally increases and the previously mentioned amortization of intangibles. For this reason, I feel that earnings, excluding retained earnings from equity investments, is a reasonable proxy for free cash flow. Assuming this is correct, by my estimates, Berkshire should generate ~$30 billion in free cash flow over the next 6 quarters, leaving YE 2017 of around $103 billion. This means that Berkshire could either i) deploy ~$83 billion of capital in the next 18 months or ii) hold ~$34/share in excess cash. If one assumes that cash simply builds up on the balance sheet and deducts this from the market capitalization, by the end of next year the investor is only paying $110/share for the ongoing business, or 11.1x earnings. Using the 2Q 16 excess cash position of $53 billion, Berkshire is trading at 12.3x earnings.
Some readers may correctly note that I make no allowance for Berkshire's derivative liabilities or common stock warrants (assets) as they roughly offset each other at $4.6 billion and $4.3 billion, respectively. However, the Bank of America (NYSE:BAC) warrants have recently increased in value given the recent share price appreciation, such that the asset is now likely of greater value than the liability.
The question then becomes what is the appropriate multiple for Berkshire. Berkshire has traded at a mean valuation of 1.6x book value over the past 30 years. However, the reasons for this premium have changed over time. Decades ago, Berkshire's premium was largely derived from Buffett's capital allocation acumen. Presently, this premium exists because businesses are held on the asset side of the balance sheet at a huge discount to fair value (e.g. BNSF, KHC) and there are $162 billion of insurance float and deferred income taxes on the liability side whose present value is far lower than the carrying amount.
Berkshire's 2Q book value was $107/share but has probably risen to slightly below $110/share at the end of 3Q due to a combination of operating earnings and the aforementioned Bank of America warrants. A 1.6x multiple on $110 in book value would equate to a share price of $175. Subtracting the estimated $24 in 3Q 16 excess cash per share and applying the previous estimate of $9.97 yields a price to earnings ratio of 15.2x. The S&P 500 is currently trading at 16.2x projected 2017 earnings. By applying the S&P multiple to Berkshire earnings and adding back excess cash, a price of $185 per share is derived, or an intrinsic value of just over $455 billion.
Both the historical book value and S&P multiple on look-through earnings represent common sense ways to value Berkshire. However, the historical book value methodology is somewhat flawed because the difference between book value and intrinsic value should increase over time as businesses held on the balance sheet increase disproportionate to their holding value. On the other hand, the S&P multiple is not perfect either as the broader market can be over or undervalued, or forward earnings estimates can be wrong. Furthermore, although Berkshire is fairly diversified, its earnings streams are not an exact replication of the S&P. Regardless, the fact that both methods triangulate towards a value $100 billion greater than the current market cap, suggests there is a healthy margin for error at the current price.
It is often difficult to know what will be the catalyst for a security price to more closely resemble an efficient price. However, I recently came across an interesting quote from the 1980 Letter to Shareholders.
One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full-frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise."
Given the S&P is trading above 16x earnings and a take-out premium would need to be paid on top of that to acquire the "entire ownership of another enterprise," Berkshire may want to focus on acquiring its own shares at estimated 12x earnings rather than make acquisitions. The last share repurchase occurred in late 2012 at 1.2x book. If my estimate for Q3 book value is correct, Berkshire is now trading at 1.31x book value. However, between 2012 and the present, the composition of the company has changed such that a greater premium to book value still constitutes the same discount to intrinsic value. I calculate that Berkshire's earnings from non-financial assets have increased by over 60% since 2012 while shareholders' equity has only increased by 40%. Therefore, assuming a static return on financial assets (cash, stocks, bonds, etc.), Berkshire's steady-state return on equity should be higher. This dynamic has been masked by the terrible relative performance of KO, IBM, WFC and AXP, increasing cash balances and low bond yields. However, the fact that a lower amount of equity now produces a greater amount of earnings should give comfort to Berkshire's Board if it ever chooses to raise the minimum threshold on the price-to-book level of repurchases.
Buffett certainly understands this math better than I do. He also understands that anytime Berkshire has tried to make open market purchases of its own stock, the shares have quickly increased to above the stated threshold at which they would pay. For these reasons, should Berkshire choose to implement a repurchase authorization, it may make more sense to go the route of an ongoing share program or tender for a large amount of shares in a one-off transaction.
Disclosure: I am/we are long BRK.B.
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.