Why Warren Buffett Could Buy Berkshire Hathaway Shares At The Current Level Soon (Hint: Tax Reform)

| About: Berkshire Hathaway (BRK.A)

Summary

Berkshire is a prime beneficiary of the tax reform and its book value could increase by 18% to $147 per B share in Q4.

Berkshire's earnings and book value growth rate will also increase by around 20% with a lower tax rate.

As a result, Buffet could increase the buyback threshold from 1.2x to 1.44x book value or $212 per share, significantly above the current share price.

Why I Believe Berkshire Hathaway (NYSE:BRK.B) Itself is in Buffett’s Buy Zone after the Tax Reform

The article addresses the following points:

Question 1: What is the impact of the tax reform on Berkshire Hathaway’s book value?

Question 2: Where does Berkshire trade compared to this estimated book value?

Question 3: Why I believe Buffett is likely to increase his buyback level from 1.2x book value.

Appendix: What are the other impacts of the tax reform on Berkshire?

Question 1: What is the impact of the tax reform on Berkshire's book value?

  1. Berkshire has accumulated large deferred tax liabilities of $86.6bn (of Sep-30th, 10-Q p.3). They mainly come from unrealized capital gains and accelerated depreciation schedules for tax purposes. For example: Berkshire has not yet paid any taxes on the $15.3bn unrealized capital gains on its investment in Coke (annual report 2016, page 21). However, Berkshire added a corresponding $5.5bn liability for taxes not yet due on its balance sheet (annual report 2016, page 66) that offset 35% of the appreciation in the Coca-Cola (NYSE:KO) share price. As the tax rate is reduced, the deferred tax liability will come down and boost the book value. If and when the federal tax rate goes down from 35% to 20%, the deferred tax liability will decrease by 42% (of $86.6bn). This will boost book value by $36bn or 11.7%.
  2. The investment portfolio is marked to market from an accounting standpoint (apart from Kraft Heinz). Berkshire’s portfolio consists of many names that are high beneficiaries from the tax reform, notably as financials are over 40% of his equity portfolio (led by Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and American Express (NYSE:AXP)). Apple (NASDAQ:AAPL), 12% of his equity portfolio, is also a large beneficiary as they will be able to repatriate and distribute their $269bn cash pile (31% of market cap) to shareholder after paying a preferential tax rate (in addition to significant earnings benefits, as they accrue US tax rate for about half their foreign earnings, source: Bernstein). So far in Q4 his portfolio contributes to another 3% of book value gain (net of the new tax rate; source: Bloomberg).
  3. Operating businesses will generate earnings in Q4 that will add to book value. Berkshire’s equity holdings are likely to rise somewhat further as the tax reform is confirmed. Both factors together could lead to another c.3% of book value gain in Q4.

Conclusion: Berkshire is a prime beneficiary of the tax reform. The book value per B share was at $124.96 as of the end of Q3. Based on the factors above, the book value could reach around $147 at the end of the year assuming a 20% federal tax rate.

Question 2: Where does Berkshire trade compared to this estimated book value?

We have derived a book value of $147 on a mark-to-market basis with a 20% tax rate for the end of Q4. This would leave the stock trading on 1.32x book value. To put this number in perspective:

  1. 1.32x is just 10% over the level at which Buffett would buy it back aggressively. From the 2013 letter to shareholders: “We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.”
  2. 1.32x leaves significant upside to intrinsic value. Whilst no precise number exists, Whitney Tilson has estimated the intrinsic value per A share at $295,969 at YE2016 (source: presentation, page 12). This would represent 1.72x the book value of $172,108 (source: 2016 annual letter). The current 1.32x multiple leaves 30% upside to fair value.
  3. It also leaves 5% upside to the 5-year average price to book value multiple of 1.39x (source: Bloomberg). This is at a time where the S&P500 is 6% trading above its historical valuation level: 16.9x 12-month forward P/E vs 16.0x 5-year average (source: Bloomberg). (this 16.9x multiple gives credit to an 8% earnings upgrade for the tax reform, source: JP Morgan)

Conclusion: Based on the estimated increase in book value in Q4 thanks to the proposed tax reform, the shares could have significant upside to historical trading levels or to intrinsic value.

Question 3: Why I believe Buffett is likely to increase his buyback level from 1.2x book value

  1. Tax rate impact on investment portfolio: going forward, 80% of the gains in Berkshire’s equity holdings will accrue to the book value as just 20% of the gains will be offset by a deferred tax liability (compared to a 35% deferred tax liability under current law). Ceteris paribus, book value growth thanks to the investment portfolio will accelerate by 23% going forward (80% divided by 65% minus 1). This is a big enough difference that Buffett adds a note on the first page of his letter to shareholders: "If a corporation such as Berkshire were simply to have owned the S&P 500 and accrued the appropriate taxes, its results would have lagged the S&P 500 in years when that index showed a positive return, but would have exceeded the S&P 500 in years when the index showed a negative return. Over the years, the tax costs would have caused the aggregate lag to be substantial."
  2. The operating businesses will also be large beneficiaries from a lower corporate tax rate as they are mostly ((i)) domestic facing and (ii) full taxpayers. Around 80-90% of the revenues and profitability are from the U.S. (annual report 2016, note 23). Businesses like Geico and BNSF should see an over 20% increase in after-tax earnings as they are likely accruing c.the full federal tax rate. Only the utility businesses (c.s10% of the earnings of the operating businesses) will not see significant earnings gain over time as they will need to pass the tax cuts on to their customers. Excluding the foreign and regulated earnings, an estimated 75% of the operating businesses will benefit from the tax rate reduction from 35% to 20%. For these businesses the post-tax earnings increase should be around 23% as 80% of pre-tax earnings (1 minus the proposed 20% tax rate) will be retained compared to 65% previously (1 minus the existing 35% tax rate). As this 23% benefit accrues to 75% of the operating businesses, this should lead to a 17% increase in post-tax operating earnings.
  3. The intrinsic value is roughly split into 57% investment portfolio and 43% operating earnings (source: Whitney Tilson, ibid). If the investment portfolio’s contribution to book value growth increases by 23% and the operating businesses’ contribution to book value growth increases by 17%, this leaves just over 20% improvement in the rate of book value growth (everything else kept constant).
  4. With a book value growing 20% faster, Buffett could be willing to pay 20% more for the book value (leaving exact math aside for another time). That would increase the buyback threshold from 1.2x book value to 1.44x book value. At the new $147 book value, this would increase the buyback threshold to $212 per share or 9% above last Thursday’s close.
  5. Berkshire is generally trading significantly above the buyback level (last five year average was 16%, see above). This would bring the shares to $245 or 26% higher.
  6. Buffett has $100bn in cash and based on the recent rally he is unlikely to put a large part of this into use in the immediate future. He might have raised the buyback threshold next year even without tax reform.

Conclusion: In addition to a large book value increase, the tax reform could lead Buffett to increase his buyback level up to 1.44x book value. This would leave the shares currently trading in Buffett’s buy zone.

Appendix: What are the other impacts of the tax reform on Berkshire?

  • Both the Senate and the House bills propose to expand bonus depreciation into full expensing. Berkshire has been spending around $15bn per year over the last three year on capex (almost twice the depreciation and amortization, source annual report 2016). Full expensing will improve Berkshire’s cash flows.
  • The tax cuts will help the economy in general. Goldman estimates the economic benefit at 0.3% in 2018 and 2019. This will benefit the economically sensitive businesses of Berkshire (notably its industrial and retail businesses).
  • The tax cuts will also help the Federal Reserve in its normalization of interest rates. With a close to $100bn cash pile and significant part of the equity portfolio invested in banks, Berkshire will significantly benefit from it.
  • The hurdle to selling underperforming stocks will be lower. Whilst Buffett generally sticks to his holdings for the long-term, he sometimes sells stocks with large capital gains as businesses change (for example Washington Post or Procter & Gamble). A lower tax rate will facilitate the monetization of such stocks with large unrealized capital gains.
  • Berkshire sits on an unrealized capital gain of $11.1bn on its Kraft Heinz (KHC) investment that is not reflected on its balance sheet as the investment is equity accounted (Berkshire and 3G own just over 50% of the shares). Kraft Heinz is well known to have an acquisitive strategy as it notably tried to buy Unilever earlier in 2017. If and when Kraft Heinz proceeds with its next large acquisition it is likely that Berkshire will change the accounting for its investment to mark it to market like other equity holdings. This will provide a $8.9bn boost to book value at current share price and proposed 20% tax rate (rather than $7.2bn at the existing 35% tax rate) or around 3% of the current book value.

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.

Additional disclosure: - The article deals with the proposed tax reform in the US. The tax reform has been adopted by the House and by the Senate but still needs to be reconciled and signed into law by the President. There is no guarantee that this will happen (though Goldman Sachs assigns a 90% chance it becomes into law by year-end). - The article is based on Berkshire’s closing price of $194.56 as of Friday Dec 1st. - The author and funds co-managed by the author are long Berkshire Hathaway shares. - The author is neither an accountant nor a tax expert. You are advised to take professional advice on these matters. - The author and funds managed by the author intend to actively trade the stock in the next three days (buy or sell or both).

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Property & Casualty Insurance
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here