The Future Of Berkshire's Float, Part II: 'Naked Credits' From Precision Castparts

| About: Berkshire Hathaway, (BRK.B)
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Summary

Buffett generates balance sheet leverage through insurance float and deferred tax liabilities.

The latest annual report reveals a new source of quasi-permanent deferred tax float.

Asset write-ups of Indefinite-lived intangibles result in long-term deferment of tax liabilities known as "naked credits.".

These were created via acquisition fair-value adjustments in the Precision Castparts and Duracell acquisitions.

The release of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) 2016 Annual Report has revealed some new insights - in particular new sources of leverage. While Buffett is a great investor, much of the value created within Berkshire to date is attributed to his capital structure - which takes advantage of low-cost leverage through the use of insurance "float." More recently, we have seen the rapid rise of a secondary source of "float" in deferred tax liabilities (DTLs).

I previously wrote on this topic, drawing attention to how Buffett uses the capital-intensive businesses to drive long-term DTLs accompanying fixed assets. I recommend reading the initial article first as background, as this followup aims to extend some of the ideas presented in the initial article.

Deferred taxes Are a Source of Float That Are Growing Rapidly

Why are we focusing on deferred taxes? This excerpt from the Owners' Manual (emphasis mine) highlights why:

Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and 'float,' ... Both of these funding sources have grown rapidly and now total about $168 billion.

Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest… Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt - an ability to have more assets working for us - but saddle us with none of its drawbacks. - Warren Buffett

As at 2016, Berkshire had a total of $168bn of "float" consisting of $91bn from insurance and $77bn from DTLs. The share of DTLs has risen from 20% in 2004 to 46% in 2016 (note that insurance float is higher post balance date given an additional $9.8bn via the AIG deal, taking insurance float >$100bn). As the level of insurance float matures over time, it likely that DTLs will overtake insurance float in the long term.

(Source: authors analysis, company reports)

Deferred Tax Liabilities

Deferred taxes liabilities arise on the balance sheet from temporary differences between taxes that will come due in the future and taxes paid today. Accounting rules require this difference to be recognized as a liability and therefore a deduction in calculating net worth. The deferral of this tax payment acts as a source of quasi-float, generating a return without cost, until it is due to be paid.

DTLs are not as intuitive to understand as insurance float which are readily thought of as "temporary inflows" versus DTLs which are essentially "deferred outflows." In each instance both insurance float and DTLs have an NPV which deems it more like an asset than the stated balance sheet liability values. Insurance float has greater flexibility in terms of investment options versus DTLs which are tied to specific assets.

The key types of deferred tax liability for Berkshire are:

  • Unrealized investment gains: This is a familiar source of DTL, essentially deferring capital gains tax on listed investments given Buffett's reluctance to sell certain equity holdings. They act as a free loan from the government which doesn't have to be repaid until the investment is sold/realized.
  • Fixed assets (PP&E): In my previous article, I discussed how the mismatch in depreciation schedules between book accounting and tax accounting of capital assets can give rise to DTLs. Capital intensive businesses such as the railroad and energy business have long-life slowly depreciating assets which give rise to these long-term DTLs. For more background on this, please read my previous article (linked to above).
  • Intangible assets: This is a new source of DTL for Berkshire which is the main thrust of this analysis. And it was driven primarily by the $32.7bn Precision Castparts acquisition, and to a lesser extent Duracell.

The chart below shows the composition of the above deferred tax liabilities - with around $11.3bn related to these new "intangible assets," which was a sizable $8.5bn step-up from 2015. Deferred taxes have been becoming of increasing importance over the last 7 years, and the composition is changing.

(Source: authors analysis, company accounts)

Precision Castparts Intangibles Are Revalued Significantly on Acquisition

Buffett does not directly explain how and why these new Intangible related DTLs work. However, a good place to start looking is usually acquisitions made during the year:

  • On Jan. 29, 2016, Berkshire acquired Precision Castparts Corp. (NYSE:PCP) for $32.7bn. PCP is a diversified manufacturer of complex metal components and products. It serves the aerospace, power and general industrial markets.
  • On Feb. 29, 2016, Berkshire acquired the Duracell business from Procter & Gamble (NYSE:PG) in exchange for PG shares worth $4.2bn. Duracell is a leading manufacturer of high-performance alkaline batteries and is an innovator in wireless charging technologies.

Related to these acquisitions were a number of balance sheet adjustments:

During the fourth quarter of 2016, Berkshire revised the previously reported acquisition date fair values of certain identified assets and liabilities of PCP and Duracell, which primarily resulted in decreases in the amounts of identified intangible assets and deferred income tax liabilities, offset by increases in the amounts of goodwill. These revisions were immaterial to our Consolidated Financial Statements. Goodwill from these acquisitions is not amortizable for income tax purposes. The fair values of identified assets acquired and liabilities assumed and residual goodwill of PCP and Duracell at their respective acquisition dates are summarized as follows (in millions).

(Source: annual report)

For the subsequent analysis I will mostly focus on Precision Castparts (and largely ignore Duracell) to make things a little simpler to follow, and because it is the larger PCP acquisition which is driving most of the change, and Duracell to a smaller extent.

We can see below the fair-value adjusted balance sheet for Precision Castparts, noting that of the $32.7bn acquisition price, there was $16bn of goodwill, $23.5bn of intangibles and $7.5bn of DTL. If we then compare the adjusted balance sheet to what Precision Castparts reported in their last 10-Q prior to being acquired we can see some very large upward adjustments that have been made. Of the ~$21bn premium paid to book value, there was asset revisions of +$9bn allocated to goodwill and +$20bn to intangibles, and a +$6.6bn increase to the deferred tax liability. So the question is what is going on here, and what do these purchase allocations mean?

(Source: authors analysis, company accounts)

Goodwill adjustments are ordinarily expected when making acquisitions. The acquirer pays a premium to book-value and the premium gets booked as goodwill. Right? Not quite, and the sheer size of intangible fair-value adjustments and DTLs does raise some curiosity.

So to see what's happened we can take a look at the composition of Precision Castparts Intangibles prior to being acquired by Berkshire, which we can find in their 10-Q. This highlights Precision Castparts view of their own acquired intangibles. There is roughly $4bn worth:

  • Amortizable intangibles: $0.5bn primarily related to long-term customer relationships.
  • Unamortizable intangibles: $0.7bn related to tradenames and $2.7bn related to long-term customer relationships

There is not really much to speak of here at first glance. Other than identifying some various types of intangible assets, the values in the books are not overly significant, and perhaps easily glossed over to an unsuspecting analyst. What is important here is the categories (amortizable/un-amortizable, trade names/customer relationships, etc.) and how they appear unimportant given their relatively small carrying amounts on PCP's books.

(Source: annual report)

If we now have a look at Berkshire's Note 11 in the Annual Report we see quite significant changes year-on-year for various other intangibles primarily as a result of the inclusion of these acquisitions and the fair-value adjustments of PCP + Duracell. There was around a $2.3bn increase in trademarks and trade names and $22bn increase in customer relationships - similar categories to the ones we glossed over for PCP prior to being acquired.

(Source: annual report)

The note to the table provides the necessary color (emphasis mine):

Intangible assets with indefinite lives as of December 31, 2016 and 2015 were $18.7bn and $3.0bn million, respectively [a $15.7bn increase]. Other intangible assets at December 31, 2016 included assets of PCC and Duracell of approximately $24.8 billion, which included approximately $13.6 billion in customer relationships and $2.3 billion in trade names that were determined to have indefinite lives.

So we can clearly see the purchase accounting adjustments coming through in Berkshires book via the intangibles disclosures. Although slightly messy to interpolate, the key points here are that 1) PCP's intangibles were significantly undervalued in its own books, and 2) Buffett subsequently revalued them on acquisition allocating oversized amounts of his purchase cost to customer relationships which have indefinite life. These provide important clues into PCP's moat and what Todd Combs probably saw in the business (who brought the deal the Buffett).

Why Are Indefinite-Lived Intangibles Important?

Typically intangibles attract an amortization charge until they are fully written off. Buffett alludes to the fact amortization can result in fully written off intangibles that still provide economic benefit in the annual letter:

Eventually amortization charges fully write off the related asset. When that happens - most often at the 15-year mark - the GAAP earnings we report will increase without any true improvement in the underlying economics of Berkshire's business. (My gift to my successor.)

However, this is a little misdirected as Buffett seems to be alluding to intangible assets with finite life, those with indefinite life are different. Indefinite-lived assets do not typically attract an amortization charge. Instead, they are periodically tested for impairment. It is therefore interesting that Buffett revalued a large part of Precision Castparts intangibles as having indefinite life and as such is unlikely to attract any ongoing amortization charge.

How Do Intangible Asset Writeups Create DTLs?

Acquisition accounting adjustments resulting in DTLs is nothing new. The purchase price needs to be allocated somewhere and the revaluation of assets is usually accompanied by a DTL, reflecting expected future tax payments.

In allocating the purchase price: DTL = tax rate * (fair value - tax basis)

This is easily reconciled for PCP. The assets (excluding goodwill) were revalued upwards a net $18.6bn and at a 35% tax rate equates to an expected increase of $6.5bn in DTLs (vs. recorded $6.6bn - close enough).

This sort of DTL would arise from any upward revaluation of the purchased assets, not just intangible assets. So what's so great about the Precision Castparts DTLs?

Naked Credits

It is the nature of these DTLs that makes it novel. While the Intangibles are largely indefinite-lived, they will likely never be amortized or written off, so this brings into question will the accompanying deferred tax liability ever be paid? Probably not… Therefore, the DTLs related to indefinite-lived intangible assets could well be a permanent fixture of the balance sheet - and hence good quality float.

DTLs for indefinite-lived intangible assets are known as "naked credits." In addition to the other types of DTLs we have identified, perhaps we will see greater use of these naked credits in future acquisitions. It is a very clever strategy identifying Precision Castparts' value (customer relationship moats) and coupling this with smart accounting and structuring (reclassifying them as indefinite-lived) resulting in the benefits of float through quasi-permanent deferral of taxes. Had the purchase cost been allocated differently (to upward revision of finite-life assets) this would also have resulted in a DTL, but would wind down over time as taxes are paid - a subtle but financially important difference.

So the fact is using indefinite-lived assets makes the NPV of the accompanying DTL greater than it would otherwise be. Is Buffett just being a little too cheeky with his fair-value purchase adjustments here?

In any case, the last few years we have seen an evolution in the use of float from insurance and unrealized capital gains to fixed asset DTLs and now DTLs related to indefinite-lived intangibles. It would appear identifying new and novel sources of float is part and parcel of Berkshires DNA and the impact of this on Berkshires leveraged capital structure should allow it to benefit from this for many years.

Disclosure: I/we 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.