Wednesday, April 10, 2013

Berkshire's Regulated, Capital-Intensive Businesses

Berkshire Hathaway (BRKa) has two large operations, BNSF and MidAmerican, that, due to their capital-intensiveness, are quite different from most of their other businesses. From Warren Buffett's latest Berkshire shareholder letter:

 "A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each business has earning power that even under terrible conditions amply covers its interest requirements."

BNSF and MidAmerican combined earned $ 4.84 billion ($ 4.7 applicable to Berkshire) in 2012.

Some things that were also highlighted about these two businesses in the letter:

BNSF carries roughly 15% of all inter-city freight and, in fact, the railroad moves more ton-miles of goods than anyone else (truck, rail, water, air, or pipeline).

BNSF carries a ton of cargo roughly 500 miles on a gallon of diesel fuel. Trucks use about four times as much.

MidAmerican's utilities serve ten states. Only one other utility in the U.S. serves more. The utility accounts for 6% of the U.S. wind generation and ~ 14% of solar-generation capacity.

These projects are huge commitments of capital for Berkshire. The renewable energy investments will have cost Berkshire $13 billion once completed. In the letter, Buffett says they "relish" these investments as long as they promise at least reasonable returns.

"...on that front, we put a large amount of trust in future regulation.

Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investment in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.

Our managers must think today of what the country will need far down the road. Energy and transportation projects can take many years to come to fruition; a growing country simply can’t afford to get behind the curve."

Buffett added this about infrastructure:

"Whatever you may have heard about our country's crumbling infrastructure in no way applies to BNSF or railroads generally. America's rail system has never been in better shape, a consequence of huge investments by the industry. We are not, however, resting on our laurels: BNSF will spend about $4 billion on the railroad in 2013, roughly double its depreciation charge and more than any railroad has spent in a single year."

In total, Berkshire invested $9.8 billion on plant and equipment in 2012 across all of its businesses (19% higher than the previous year and 88% of it in the United States). They should spend even more on plant and equipment in 2013.

Now, consider if going forward -- and I've covered this in previous posts -- Warren Buffett were paid just the 2% portion of the 2 and 20 compensation structure that's often used by the hedge fund industry. A structure that's commonly used even if there are many variations to it.
(2 and 20: 2% of assets under management plus 20% of the profits usually above a certain level.)

If so, Buffett would be paid, give or take, $ 3.6 billion (again, for just the 2% portion multiplied by the roughly $ 180 billion in Berkshire investments) over the next year instead of the $ 100,000 per year he's been getting paid for a very long time.* Over the long haul those incremental funds would either have to come out of the company's earnings (and, even for a company the size of Berkshire, that'd be a real hit to earnings) or that $ 9.8 billion (and growing) of plant and equipment.
(Over the short run they could borrow, of course, to fund the huge new compensation cost but that's obviously a nonsensical use of debt.)

Either way, over time, it would have a meaningful immediate negative impact on Berkshire's intrinsic value (mostly due to reduced earnings capacity now, of course, but also due to having less incremental capital to allocate over time) and lots of likely quite useful infrastructure wouldn't be built by the company (though the money paid to Buffett would surely flow into the economy in other ways over time).**

Certain types of assets require capital not only in meaningful amounts, but also enough investors with the patience, discipline, and willingness to provide funding with the long-term in mind. Big financial scale focused on outcomes that require longer time frames to come to fruition. There's a price paid for short-termism and excessive frictional costs. Maybe if there was more wise capital development, fewer casino-like activities (bets on near-term price movements), and reduced frictional costs (Jeremy Grantham once said when fees are raised "we actually raid the balance sheet") we'd end up with better long-term outcomes. More actual wealth creating activities instead of less than zero-sum -- at least in the aggregate due to the frictional costs if not fund by fund -- activities. I'm certainly in that camp even if I realize that fixing the problem will be difficult at best.

Obviously, these fees are currently what the market will pay for these investment services but there are and have been important economic consequences to the norms as they've evolved over time. Tough to measure precisely, but real and hardly ideal. I certainly can't blame anyone whose able to get these kinds of fees for high performance. That doesn't mean that, in its current form, it's a wonderful system in totality.

There's also the hidden cost of the brain drain by the way. Lots of engineering and scientific talent "distracted".
(Can't say I really blame them either. They're just going where the money currently is.)

No one can know whether a bridge or something else useful wasn't built because of the current flaws. Counterfactuals are a tough sell for a good reason. I've focused on Berkshire's capital intensive businesses as one example but this issue clearly doesn't just apply to infrastructure. Most really useful innovations and hard to solve problems require patient capital of all kinds, allocated wisely, and in meaningful quantities.
(There continues to be no shortage of incredibly dynamic and innovative capacities around the world. That hasn't changed. I'm merely suggesting that the way some parts of the financial system currently operates is one real factor that puts unnecessary wind in the face of that dynamism.)

The bulk of Berkshire's intrinsic value comes from their investments (stocks, bonds, cash and equivalents) funded, in part, by low cost insurance float, earnings from the non-insurance businesses plus, as explained on page 104-105 of the 2012 annual report, the quality of future capital allocation. The quality of what will be done with the funds over time might be difficult to estimate but it's no less real. Each must be considered to make a reasonable judgment of intrinsic value:

"This 'what-will-they-do-with-the-money' factor must always be evaluated along with the 'what-do-we-have-now' calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton." - From Page 105 of the 2012 Annual Report (initially seen in the letter of the 2010 Annual Report)

To that I'd add the frictional cost of the capital allocation. Buffett doesn't need to mention frictional costs in his intrinsic value calculation because Berkshire is, at its core, built to minimize these costs. I mean, I think it's more than fair to say that the frictional costs at Berkshire are very low compared to the assets being managed and compared to just about any other investment vehicle.***

At least it is for now.

If those frictional costs were to become materially higher down the road, the intrinsic value of Berkshire -- or any other business/investment vehicle for that matter -- would plainly be reduced.
(Berkshire's frictional costs seem certain to become somewhat higher in the future but likely not enough to matter much. Materially higher frictional costs would seem to be a stretch considering the company's culture and the way it is structured.)

It certainly couldn't hurt the world if more long-term oriented capital allocation, done at some scale, with more modest system-wide frictional costs was encouraged. Those that manage large amounts of money but generally make shorter term bets -- especially if done for rather lucrative fees -- are playing an entirely different game. Whether one thinks, as I do, that both speculation and investment (and I realize sometimes the line between the two seem blurred) are necessary for a healthy system, the proportion still matters. As does the cost. As it stands, the frictional costs and the proportion of actual long-term capital allocation compared to short-term bets on price action seem far from being at healthy or optimal levels.

Not all what's loosely often described as capital allocation is created equal. If something at least directionally closer to the Berkshire model (and that doesn't require literally entering the insurance business) were to become the norm it wouldn't be a bad thing at all.

Adam

Long position in BRKb established at much lower than recent prices

* 2% of the more than $ 180 billion in Berkshire investments does exclude all the operating businesses. Of course, he'd get paid much more if he were to also get the 20% of investment-related profits. Oh, and then there's the operating businesses with nearly 300,000 employees that earn, give or take, $ 10 billion per year (that number excludes Berkshire's investment related returns). I mean, some pay for those additional responsibilities wouldn't seem unreasonable...

Buffett's wealth over the past 40 plus years has come almost exclusively from appreciation of his Berkshire shares not from fees paid for the privilege of his investing skills (though he was certainly paid fees before he shut down the partnerships back in the 60s). The capital he put at risk inside Berkshire long ago is the primary basis of his substantial wealth. For his enti
re time as CEO his salary hasn't exceeded $ 100,000 (it was at one time less than $ 100,000). As in previous years, he received no stock, stock options, or bonuses last year but Berkshire does cover his security costs.
** It's still, at least, a "detour" along the way to the funds becoming a more long-term oriented capital investment. Of course, since in this hypothetical instance it would be in the hands of Warren Buffett, those funds seems rather likely to be put to good use sooner than later.
*** An apples-to-apples comparison to hedge fund frictional costs would also include all the operating costs of Berkshire's corporate office (though much of those costs are presumably related to the operating businesses Berkshire owns outright) and related (including the costs associated with the two investment managers). Consider how small these costs are in the context of Berkshire's assets overall. The difference in frictional costs is still measured in orders of magnitude compared to a typical hedge fund. So let's not split hairs. This difference, I think, speaks for itself.
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