Tuesday, April 28, 2009

Buffett on Economic Goodwill: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1983 Berkshire Hathaway (BRKa) shareholder letter:

"To see how it [accounting Goodwill] differs from economic reality, let's look at an example close at hand. We'll round some figures, and greatly oversimplify, to make the example easier to follow.

Blue Chip Stamps bought See's early in 1972 for $25 million, at which time See's had about $8 million of net tangible assets. This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See's was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.

Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See's – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.


Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."

I believe this is the essential point that Buffett was making about Coca-Cola in this new Fortune Magazine interview. Coca-Cola earns approximately $ 7 billion after tax on GAAP tangible common equity of $ 8 billion. Do you think TCE maybe does not reflect Coca-Cola's value? Even common equity (which includes accounting Goodwill and other intangibles) comes up woefully short of correctly reflecting Coca-Cola's value.

The consumer franchise that Coca-Cola has built produces economic Goodwill that you will not find on the balance sheet.

This is a limitation of accounting...nothing more.

The better banks have similar consumer franchises and some are low cost producer's (i.e. able to obtain cheaper deposits) resulting in economic Goodwill that will not be found on the balance sheet. Simple measures like TCE ignore this economic value and can easily understate (and in some cases overstate) a bank's health. The current dialogue on the banks largely misses this reality.

The regulators, of course, can do whatever they want. It just doesn't necessarily mean that forcing a capital raise on a bank makes economic sense. Hey, some banks certainly need capital but that's not because of low TCE. It's because they lack earning power relative to the quality of their assets.

Kraft is a more crazy example since they reliably produce $ 2.5 billion of annual cash earnings with (according to GAAP) TCE of $ -18 billion (Yes negative. Quick...bring in the regulators...they are bankrupt). Yet a conservative capitalized economic value of Kraft today is north of $ +30 billion.

So either accounting has its limits or, using the Kraft example, we live in a world where someone will pay you $ 18 billion to take a likely to grow perpetuity of $ 2.5 billion in future annualized cash earnings off their hands.

Adam

Long BRKb
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