S&P's Decision to Downgrade Berkshire Is Hard to Understand

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Includes: BRK.A, BRK.B
by: The Rational Walk

Standard & Poor’s has downgraded its long-term counterparty credit rating on Berkshire Hathaway (NYSE:BRK.A) to AA+ from AAA. The action also lowered the financial strength rating on Berkshire’s insurance operations to AA+. The ratings were removed from Standard & Poor’s credit watch and now have a stable outlook. Standard & Poor’s action comes only weeks before Berkshire Hathaway is set to release results for 2009 which will almost certainly indicate that book value ended the year at a record high.

Standard & Poor’s initially established a negative outlook on Berkshire’s AAA credit rating last March but reaffirmed the AAA rating at the time. In November, Standard & Poor’s placed Berkshire Hathaway on credit watch citing liquidity concerns related to the Burlington Northern acquisition.

“Risk Tolerances Have Increased”

Here are a few excerpts from Standard & Poor’s press release (free registration required):

“The rating actions are based on our view that Berkshire’s overall capital adequacy, as well as that of its insurance operations, has weakened to levels no longer consistent with a ‘AAA’ rating and is not expected to return to extremely strong levels in the near term,” said Mr. Iten. “Furthermore, we expect that the consolidated liquidity position of BRK will be reduced from extremely strong historical levels as a result of the acquisition.”

As capital adequacy and liquidity levels have declined, investment risk remains very high in our view, compounding the need for extremely strong capital and liquidity given potential investment volatility. A key concern is that BRK’s risk tolerances appear to have increased, yet we believe they remain ill defined while the organization increases in complexity.

It is not clear how Berkshire’s level of risk tolerance has increased as a result of the Burlington transaction. While one can debate whether the transaction will add value for shareholders, our prior analysis of Burlington clearly indicates that the company generates significant free cash flow which is more than sufficient to service the incremental debt issued by Berkshire. Warren Buffett has also indicated that the company plans to pay down the new debt within three years which is noted in S&P’s press release.

Succession Planning Concerns

Standard & Poor’s repeats the familiar concern regarding Berkshire’s succession planning issues:

Uncertainty surrounding management succession and management structure, corporate culture, and business strategy following an eventual transition of the company’s leadership from current CEO Warren Buffett is an ongoing concern. This, in our view, is only partially mitigated by a board-approved succession plan and the experienced management teams in place at the operating companies, given Mr. Buffett’s strong and positive influence on all aspects of operations at Berkshire.

It is hard to understand exactly what would satisfy critics of Berkshire’s succession planning short of Warren Buffett formally naming a successor. We have previously discussed why management succession concerns at Berkshire are misguided. It is also not as if Berkshire lacks talented managers such as David Sokol who are clearly capable of running the company if necessary.

Revisiting S&P Concerns from March 2009

Finally, it is worth noting that the concerns raised by Standard & Poor’s in March when the outlook was first lowered no longer apply. At that time, Standard & Poor’s analyst John Iten cited concerns over Berkshire’s level of statutory capital due to the decline in the market value of the company’s equity investments. In fact, Mr. Item specifically stated that if Berkshire’s equity investments were to recover, the negative outlook could be revised to stable at the AAA level:

If the value of the group’s substantial equity investment holdings were to stabilize or improve during this period, or if it appears that the group will be able to rebuild its capital position back to a level commensurate with the current ratings within a reasonable period of time (typically one to two years) through earnings or other means, we could revise the outlook back to stable.

With Berkshire’s book value almost certainly at a record high at the end of 2009, it is difficult to understand Standard & Poor’s decision Thursday. While it is true that Berkshire has used a significant amount of cash and debt to finance the Burlington transaction, the company is certainly in a much more solid position today than in March 2009 when S&P reaffirmed the company’s AAA rating.

Disclosure: The author owns shares of Berkshire Hathaway.