Wednesday, May 4, 2016

An Elephant For Berkshire, or Rather a Deere

Warren Buffett took his Elephant Gun out once last year with the purchase of Precision Castparts and there might be an opportunity to do so again soon with one of the worlds most iconic brands, John Deere. Deere & Company (DE) is absolutely the type of business that Buffett would consider for Berkshire Hathaway. It has few competitors and is easily the best business in its industry. In the United States, farmers by far prefer John Deere green to the other competitors AGCO and CNH Global (1).

Having this wonderful brand allows Deere to not just sell more tractors and equipment, but to sell them at a higher price. This is evident when you compare the average gross margins over the last 5 years. 
  • Deere = 25%
  • AGCO=21%
  • CNH = 18%
If this isn't the kind of moat Buffett is looking for then I don't know what is.
Since Deere sells most of its products to commodity producers it is a cyclical business. But, farmers and construction companies can only wait so long to replace their equipment. This causes Deere to have lumpy earnings but Buffett historically has had no problem with this if he is getting a great business. Deere is no doubt in one of those lumpy periods right now as revenues and earnings are down around 30% since 2013 when grain prices were much higher. 

Deere helps many of its customers finance their equipment. Since 2010 Deere has seen its loan portfolio grow from $17.6 billion to $24 billion. In 2002 its loan portfolio was just $9 billion. Because of its stronger financial position, there is an argument to be made that Deere would benefit from being part of Berkshire Hathaway. 

The farming industry has been going through dramatic changes in recent years seeing larger and more sophisticated equipment. Many of the functions such as planting, driving a grain cart, and harvesting are now automated. It is very possible that 10 years from now a person is not required to physically operate the equipment. Because Deere has much higher margins and profits than it's competitors it will be able to allocate more money to developing these technologies, thereby increasing the massive moat it already has.

John Deere Self-Driving Equipment (CBS Special)

Normally I prefer using owner earnings to figure out the earning power for the business but for Deere that is rather difficult. Deere finances a lot of their customers equipment themselves. This causes much of Deere's cash from operations to flow into these leases. For Deere I actually consider earnings per share (EPS) to be a good proxy for the company's earning power. Below is a graph showing Deere's EPS from 1998-2015.

Berkshire recently purchased Precision Castparts, an aerospace parts supplier, for $32 billion. PCP was making about $1.6 billion at the time of the purchase. This means Buffett paid 20 times earnings or accepted a 5% earnings yield on this investment. PCP is nearly certain to have higher earnings in the future as it is a fantastic business and I think this stretched the limits of how high Buffett is willing to pay up for a great business.

The idea to purchase Precision Castparts for Berkshire came from one of the new investment managers, Todd Combs. Todd first bought PCP for his Berkshire investment portfolio in the 3rd quarter of 2012. Just before the 4th of July in 2015 Mark Donegan, the PCP CEO, stopped by Berkshire to meet with Todd and at the end of the meeting Buffett stopped in to chat. He was very impressed by Donegan and asked Todd Combs to see if the board of PCP would be receptive to an offer from Berkshire. Buffett has committed to never doing a hostile takeover so this is very important. The board was receptive, Berkshire made their $235 per share offer, and they accepted the offer.

In interviews Buffett makes it seem like he didn't really follow the company that closely but I would say that is extremely unlikely. Though he allows Todd and Ted to make their own investment decisions I'm sure he keeps up with the businesses they own as that is his favorite hobby! Once Buffett realized how good Donegan was as a manager I think it was an easy decision for him to make an offer.

Todd and Ted


Berkshire currently owns a $1.9 billion position in Deere. Todd and Ted manage $9 billion for the company so this would make it a 21% position for one of these managers. I think it very possible that a situation similar to Precision CastParts could happen if Deere's board of directors is open to an offer. If they are not it is a non-starter and Buffett won't pursue a deal any further.

Because of Deere's cyclicality I don't believe Buffett would pay the high premium he did for PCP. But I think it is reasonable that he would accept a 7% earnings yield vs 5% for Precision Castparts. With earnings of $5.77 in 2015 this means Buffett would be willing to pay around $82 ($26 Billion) to purchase the whole business. Right now that is where the stock is trading so it is unlikely that there is a deal to be made as the board would want a premium to the stock price. If the price were to decline to $70 or less I think it is very possible for the wheels to get turning on Berkshire making an offer.

Berkshire Hathaway currently has about $43 billion in cash on it's balance sheet. $23 billion of that can be used for a deal as Buffett has said he will never go below $20 billion. With a market cap of $26 billion, Deere is the right size for Berkshire to be able to handle comfortably with a small debt issuance or waiting a few more months for cash to pour into Omaha.

Right now there is probably not a deal to be made for Berkshire purchasing Deere, but it is getting close! In summary:
  1. Deere is a great business with a strong moat and is almost certain to be making more money in 10 years.
  2. If the Deere board is open to it, Berkshire might make an offer.
  3. I don't believe an offer would be for much more than $82 so the stock probably has to trade down to around $70 for a period of time before one would be made.

John Deere S690


Disclosure: No position in Deere



Saturday, March 26, 2016

Berkshire Hathaway Investment Analysis

Right now I am not finding a lot of very interesting, or cheap, investment ideas. Most companies are valued pretty fairly, or appear over-priced to me. But one big exception is Berkshire Hathaway. It has so many high quality businesses with great long-term prospects that it should really be priced higher than it is. I have talked about this with my clients, as it is currently the largest position in our investment portfolios. Below is what I wrote them about Berkshire in 2014, but the numbers have been updated for 2015.

Berkshire Hathaway (BRK-B)

It should be of no big surprise that Berkshire would end up in the portfolio at some point. Warren Buffett, with help from Charlie Munger, has the best long-term track record of anyone in the investment business. Berkshire has grown book value at 19.2% compounded over the last 51 years, or a total of 798,981%. To put this in different terms, Warren Buffett and his BPL partnership bought their first shares in Berkshire for $7.50. Those same shares are now worth $210,530.

Obviously Berkshire has had a fantastic past, but what we care about is the future. The businesses are best described in Warren Buffett’s annual letter to shareholders, which can be found at I think that the 2014 letter was his best by far, as he talked about the history of Berkshire and what him and Charlie think the future holds. I will give a brief description of the businesses below.

The Insurance business is what has fueled Berkshire’s massive growth over the years. It is represented by Berkshire Hathaway Reinsurance, GEICO, Gen Re, and Berkshire Hathaway Primary Insurance Group (a collection of insurance business). If these insurance businesses generate more premiums than claims in a given year then they essentially are able to hold large amounts of money for free. This is called float, of which Berkshire has about $88 billion. Berkshire then invests as much of this money as it can, in common stocks or wholly owned businesses. In 2015 the Insurance group contributed about $1.8 billion in underwriting profit or about 7% of earnings for Berkshire. This does not count the earnings from the float which are much more.

The next largest business is the Burlington Northern Railroad which contributes about 22% of my estimate of Berkshire’s owner earnings (profits) in 2015. The BNSF operates one of the largest rail networks in North America, mostly in the western United States. Since it was purchased in 2010 by Berkshire it has seen its earnings grow dramatically from about $2.2 billion to $4.9 billion last year. This will be an extremely important asset for Berkshire for many years.

Berkshire Hathaway Energy is one of the biggest energy companies in the United States. BHE is an owner of power companies in Oregon, Utah, Nevada, and Iowa. This is a business that provides about 10% returns to Berkshire that is almost guaranteed to be around many years in the future. Charlie Munger believes that BHE will become the largest power company in the US in a few years. The energy business contributed earnings of $2.2 billion or 9% of earnings.

The last part of Berkshire is a large collection of businesses that sells everything from cowboy boots, to chocolate, Dilly Bars, and industrial parts. Most of these companies enjoy strong positions in their markets and have bright prospects for the future.

Berkshire is a very unique company to value because of its large common stock portfolio, $112 billion at year end. What is unique is that all of these companies are essentially minority interests in businesses that Berkshire owns. But, the only “earnings” from these businesses that show up on Berkshire’s financial statements are the dividends that are paid. Thus, Berkshire has a large amount of what Buffett calls “look-through earnings”, essentially all of Berkshire’s portion of the earnings that aren’t paid as dividends. Some of the companies that Berkshire owns in it's common stock portfolio are Wells Fargo, American Express, US Bancorp, IBM, John Deere, IBM, and Coca-Cola.

To figure out the look-through earnings for Berkshire’s investments I calculated the owner earnings attributable to Berkshire for each company it owns stock in. Then subtracted out the dividends paid to Berkshire. After these calculations I found that Berkshire has about $5.7 billion of earnings that are not reflected on its financial statements.

In 2015 Berkshire generated $32.7 billion in cash and had to spend about $9.2 billion in capital to maintain its various businesses. If we add in the “look- through earnings” Berkshire made about $29.3 billion or $11.87 per B share. In 2009 this figure was about $6.15 and in 2004 $3.65, meaning that Berkshire has been doubling earnings about every 5 or 6 years.

In addition, Warren Buffett has said that he will not allow Berkshire to have less than $20 billion in cash. Berkshire currently has $61 billion. $22 Billion of which will be used to purchase Precision Cast Parts. This leaves us with $19 billion in excess cash that will be invested at some point, providing future streams of earnings. I will break this down into easier per share numbers below.

Class B Per Share figures for 2015:

Owner earnings= $11.87
Excess cash     = $7.78
Current price    = $140

We will subtract the cash from the stock price because that money will generate future investment returns for us. We do not know when this will be, but we can all but guarantee that it will happen because of who is running the company.

Effective Price=$132.22
Effective Initial Rate of Return= $11.87/$132.22 = 9.0%

If we owned Berkshire as our own private business, we would be buying a business that has recently doubled earnings each of the past 5 years that is managed by the investor with the best long term track record. If earnings continue to grow, a highly likely proposition, then intrinsic value will likely grow at a similar rate. In a world where not very much looks interesting, I believe this represents a great investment.

If Berkshire doubles earnings again in 6 years it will be making around $22 per share. If we get that same initial return of 9% that we are getting now that would value the company at around $244 giving us a 12.3% average return. Because of the high quality of the businesses and its managers I believe Berkshire deserves a higher price in relation to it's earnings than 9%. If that happens we would get even better returns.

Fortunately, it is not just me that thinks Berkshire is cheap! Warren has said that he will only buyback stock when it is "significantly undervalued" and for Berkshire he will buyback stock at 1.2 times book value. Currently 1.2 times book value per B share is $125.89 and very recently the stock price was trading close to that. We are a bit about above that now at $140 or 1.33 times book value. When the stock is trading close to where Warren thinks its cheap, it probably is. 

This is not to be taken as investment advice, but is for informational purposes only. I am not making a recommendation to purchase shares in Berkshire Hathaway. Please do your own research.