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

(2)

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

(3)

Disclosure: No position in Deere

1. http://www.machinefinder.com/ww/en-US/articles/john-deere-dominates-brand-loyalty-among-midwest-farming-base-2192

2. http://www.cnbc.com/2014/10/14/warren-buffetts-stock-pickers-are-crushing-it.html
3. https://www.deere.com/en_US/products/equipment/grain_harvesting/combines/s_series/s690/s690.page

Powder River Basin: Part 2

The Powder River Basin has been one of the most important energy assets for the United States over the last 45 years. But now its future importance appears to be declining. In 2011 coal production peaked at 426.4 million tons but by 2014 had decreased to 381.2 million tons. I believe that further declines in production seem likely as more utility companies are producing energy from natural gas, wind, and solar power. In this second piece I am going to speak briefly to the valuations of some companies that have significant operations in the Powder River Basin. Unsurprisingly, they have all been negatively affected by the declines in coal prices and production.

Black Hills Corporation (WyoDak Mine, BKH)

The WyoDak mine is the longest continuously operated surface mine in the United States. The mine was started by the Homestake Mine Company of Lead, South Dakota and was sold to the Black Hills Corp in 1956. WyoDak is very unique in that it uses a conveyor belt to move the coal out of the mine. As opposed to coal haul trucks like in the rest of the Powder River Basin. The WyoDak mine is also unusual in the fact that not all of the coal is loaded onto trains. Rather it is fed directly to the 335 MW WyoDak Power Plant, which is 20% owned by Black Hills Corp. The other 80% owner of the plant is PacifiCorp, a Berkshire Hathaway Energy subsidiary.

Black Hills Corp owns 16 power plants that generate 841.1 MW in Colorado, Wyoming, and South Dakota. The WyoDak mine represents about 9% of the overall company’s energy production. Utilities are unique businesses in that their rates are regulated by the various utilities commissions of the states they operate in. Because energy use has increased in the past these utilities must expand their operations (capital expenditures). Generally, the state utility commissions allow the utilities to earn about a 10% rate of return on these new investments. Thus, utilities earnings are normally very consistent and easier to predict than some other industries.

In 2014, Black Hills Corp had net income of $129 million or $2.90 per share (in this case net income is a good proxy for earnings). Currently, the stock price is $46.02 for a market cap of $2.06 Billion. Thinking about this as a private investor, I would be accepting an initial return of 6.3%, for a business that will likely grow its earnings by 10% per year in the future. This is not cheap enough to be interesting for me. Now 4 years ago when it was selling for $29, it would have been.

I am not a merger and acquisitions expert but Charlie Munger had an interesting quote at the Daily Journal Meeting in Los Angeles last year.  

“Berkshire will have the biggest utility business in the U.S. in a few years. It will be OK to make 9-10% returns, with 0% float money with interest rates at 0. They (shareholders) will live that it isn’t 12%.”

Given that PacifiCorp already has a business relationship with Black Hills Corp. and Berkshire wants to acquire utilities it would not surprise me to see Black Hills Corp be acquired by Berkshire at some point in the future, albeit probably at a lower stock price.

Cloud Peak Energy (CLD)

Cloud Peak Energy is the only publicly traded, pure play, Powder River Basin mining company. The company was originally part of mining giant Rio Tinto but was spun-off in 2010. In 2014 Cloud Peak operated 3 mines in PRB and sold 87.1 million tons of coal, which accounts for 23% of the production in the basin. The decrease in coal tons sold and coal price has hurt earnings significantly. In 2012 the company had $173 million in net income yet this has decreased to $78 million in 2014. 2015 is looking even worse. The stock price has followed suit decreasing from $20 to $4 (-80%), for a market cap of $240 million.

Predicting the future earnings of Cloud Peak is rather difficult. With coal usage likely in a secular decline the company may continue to struggle in the future. The company looks cheap when looking at past earnings, but for now I have to put this in one in the “too hard basket”.

Union Pacific (UP)

The Union Pacific is one of the two largest Class I railroads in the United States. With the lowest operating ratio, 63.5%, UP is arguably the best managed railroad in the industry. The company derived 18% of its revenues from the coal business in 2014. Coal from the Southern Powder River Basin, including Cloud Peak Energy coal, makes up the majority of this business. In 2015 Burlington Northern Santa Fe, UP’s biggest competitor, had some big issues delivering its customer’s goods on time and lost market share to Union Pacific.

In 2014 I estimate that UP had owner earnings of $4.7 billion or $5.23 per share. With the current stock price of $95.85 we would be accepting an initial return of 5.4%. UP does not interest me at this stock price. Especially when you take into account that the business is operating at a world class level, at some point all businesses make mistakes or run into problems. The coal business also generates some concern because if there is a secular decline then those revenues will have to be made up elsewhere. This year coal carloads are down 7% but revenues are only off 5% because of increased prices. Now, I don’t think Union Pacific will have major problems with its business overall. But, they may struggle to grow the business at an exceptionally high rate like in the past.

Rail Link (Genesee & Wyoming, GWR)

One would think the Union Pacific and Burlington Northern train engineers would just drive their trains right to the coal mines to load the coal, but that is not the case. As I mentioned in the previous post, the engineers stop their trains and hand off the driving responsibilities to the employees of Rail Link. The Rail Link engineers then communicate with the coal loading facility and set the train at the appropriate speed, between .5 and .7 mph, for loading. The coal is then loaded onto the continuously moving train. This process usually takes between one and two hours. Once the coal is loaded, the engineer drives the train to the appropriate spot and hands off the train to the Class I railroad engineers.

The Rail Link coal loading business is only a small part of its parent company, Genesee & Wyoming. For the G&W the non-freight business represents 24% of revenues, which is also split between the company's industrial switching and port operations. The exact numbers for each division are not disclosed. The other 76% of revenues come from the short-line railroad freight business that G&W is known for.

In the last 15 years the G&W has purchased 98 short-line railroads. These are mostly located in the US but they also have operations in Australia and as of very recently Europe. As one might guess, the company has seen spectacular growth in Earnings Per Share. When the company IPO’d in 1996 they had EPS of $.29 and by 2014 EPS had grown to $4.58 for a compounded annual growth rate of 15.6%. This is one of the fastest growing businesses I have seen over a long period of time and obviously the managers have done a great job of managing all of the new acquisitions.

 In 2015 the company has seen revenue and earnings growth take a pause, because their freight coal and coke carloads have declined 34.4% year over year. But they did just acquire Freightliner, a European rail company, which should increase earnings for the year. Once that acquisition is completed I believe that GWR will have normalized owner earnings in the $6.10-$6.60 per share range. Currently the stock price is $75, for an initial return of between 8.1-8.8%. For a fast growing company this is starting to look interesting.

There is an important caveat though. The company’s debt is in term loans which adjust with interest rates and are mostly due 3-5 years from now. If interest rates go higher this could slow growth from the very high rates we have seen in the past. Also, the short term nature of the debt could potentially cause problems if credit is not easy to obtain. Because of this risk I must wait for a lower stock price than what it currently is at. I will admit it is getting close though.

Burlington Northern (Berkshire Hathaway, BRKA, BRKB)

As you can see from the map the BNSF and the Union Pacific have a very similar geographical footprint, mostly the western United States. Not surprisingly, they are very similar companies in size, measured by revenues and net income. The BNSF has a slightly higher mix of coal car loads (+4%) and intermodal car loads (+2%) than UP. While UP moves more chemicals and industrial products (+4%). 

Despite being tough competitors both companies have increased EPS by large amounts over the years. In just the last 4 years, UP increased earnings by 20.1% compounded annually and 108% in total. BNSF increased earnings by 13.3% compounded annually and 65% total during that time. BNSF likely would have been able to boost the EPS numbers more by repurchasing shares, but in 2010 it was purchased by Berkshire Hathaway.

The BNSF contributes 11.7% of revenues and 22.1% of net income for Berkshire and will be a very important asset for years to come. Because of the many operations of Berkshire Hathaway I will wait for another post to analyze the company in its entirety, stay tuned!

The Berkshire Meeting: My Favorite Weekend of the Year

As I sit here reflecting on the past weekend I can’t help but realize how it is by far my favorite weekend of the year. The Berkshire Hathaway Annual Shareholder Meeting brings together such an extraordinary group of people from all around the world. Just this year I saw or talked to Muhtar Kent (CEO of Coke), Larry Van Tuyl (new Berkshire Auto Dealer subsidiary), Carl Ice (CEO of Burlington Northern), Becky Quick, Jean Marie-Eveillard, Bill Gates, and plenty of super talented investors. OK these might not exactly be household names but they are big in the investment and business world. And this is in Omaha, Nebraska no less!

I have found that most investors are kind of lone wolves. We sit in our homes and offices, read voraciously, and think about the world and the businesses we invest in.

Myself with my new international investor friends Anders Heegaard (London) and Peter Sorensen (Copenhagen)

Quite a few of us exchange emails or post on message boards but oftentimes there is not a lot of face to face interaction with our peers. Except for the Berkshire weekend, where we get to meet the faces behind the forum name! This is one of the few places where we can actually talk shop. I’m sure plenty of the people in my social group get bored of me talking about my stocks. But here there are people whose favorite topic of conversation is stocks! 

For example, on Sunday after the Markel meeting I hung out with a couple of investor buddies just talking about what our favorite businesses were, bad investments we’ve made, and hypothetical scenarios. Like could Berkshire and 3G Capital buy Coca-Cola, and then trying to design a deal that worked (it is close by the way). While we were doing this Andrew Ross Sorkin walked by, unfortunately he had to work so we couldn’t pitch him our idea, which I think would make for an interesting Dealbook article. 

The whole weekend is just go-go-go but it is so intellectually stimulating that it doesn’t even matter. Until Sunday night when my body crashes from the lack of sleep, I guess staying up for 22 hours on Saturday will do that.

The Meeting

I always enjoy showing people around Omaha for the first time because I remember the first time I went to the Berkshire Meeting so many years ago. It was such a moving and eye opening experience that I vowed to never miss one again (so far I have been successful).

Myself and my friend Jeremy Saltzberg who was attending the Berkshire Meeting for the first time

Normally, I am content to just get a seat in the Century Link Center and do not get in line terribly early. But this year I decided to get in line a little extra early, at 4:15 am, to get a good spot on the floor and chat with other diehards. For those that have not attended the meeting it starts with a 30 minute movie. Of course Warren Buffett & Charlie Munger are the stars, along with the Berkshire managers, and GEICO’s various mascots (Hump Day Camel and the Gecko). It is rather corny but always good for a laugh. This year the movie featured Ellen DeGeneres, Little Richard, Arnold Schwarzenegger, Jamie Lee Curtis, and was directed by John Landis the director of Animal House and Blues Brothers. The highlight for me was when Buffett challenged Floyd Mayweather to a boxing match. I was impressed by Warren’s trash talking, which unfortunately had to be mostly bleeped out because of profanity. I find an old man swearing to be way too funny!

Following the movie we enter 6 hours of Q&A with a 1 hour break for lunch in the middle. This is what I come for.

Warren Buffett and Charlie Munger

Many of the same questions are asked each year and they normally get similar answers. Warren usually gives long winded answers to good questions and Charlie generally does not add much. His catch phrase is “I have nothing to add”. But when he does add something it is nearly always very blunt, and rather hilarious. And sometimes he will give a long-winded answer, at which you normally realize that was one of the most intelligent things you have ever heard. They banter back and forth quite well and make one heck of a team.

This year there were some great questions about Berkshire’s partnerships with 3G Capital and their acquisitions of Heinz-Kraft. 3G has a history of cutting costs out of businesses, especially in businesses that are not well run. Some people were rather bothered that sometimes the cost cuts involve cutting jobs (normally at corporate headquarters). Buffett responded by saying that no Berkshire company has a policy of employing more people than it needs. And Munger thought if companies allowed themselves to over hire they were moving towards a socialist or communist country. So he chipped in with a quote about the communist USSR: “They pretend to pay us and we pretend to work.”

After a question about Berkshire’s investment in IBM Charlie also chipped in one of his funniest quotes of the day:

“Warren, if people weren’t so often wrong, we wouldn’t be so rich.”

In another exchange Buffett talked about his biggest mistakes being missed opportunities. But he’s never willing to take risks that might endanger the net worth of his partners, the shareholders. They could use more leverage, to which Charlie responded:

“But we would have been sweating at night. It’s crazy to sweat at night.”

Buffett: “Over financial things.”

Munger: “Over financial things.”

Buffett: “Well, we won’t pursue that.”

Another favorite of mine was a question about whether France should abandon the Euro and revert back to the Franc as a currency, and whether the Euro was a good idea or not. To which Charlie gave his best quote of the day:

“I don’t have the faintest idea . . . It’s a flawed system in some ways to put countries that are so different together. You can’t form a business partnership with your frivolous, drunken brother-in-law.”

Buffett: “Everything here is off the record.”

As you can tell Warren and Charlie add a very nice dose of humor to the meeting. During the meeting I couldn’t help but think to myself how much both of them enjoy sharing their wisdom and thoughts on the world. They might not have the titles but they are both teachers.

At the shareholder meeting there is also a convention hall with booths from the various Berkshire companies. Naturally, you can purchase their products such as Dilly Bars from DQ, cowboy boots from Justin, car insurance from GEICO, Fruit of the Loom underwear, books from Bookworm, See’s Candy, and numerous other things. They keep detailed records of how many items are sold at the meeting, and like the meeting itself, the records grow each year.

Wells Fargo Stagecoach, a Berkshire holding, in the convention center that was built in Letcher, SD (REPRESENT!) 
http://www.wsj.com/articles/horse-drawn-carriages-fetch-luxury-car-prices-1430345003

Family

For me, the weekend holds a special place in my heart because it is not all about investing. I always stay a few extra days because a lot of my extended family lives in Omaha. My Grandmother grew up in Omaha and as a child I always loved to hear her stories about growing up. I’ve always enjoyed listening to people’s life stories and when I first read Snowball, a biography on Buffett, I couldn’t help but be reminded of many similarities in her childhood and Buffett’s (they were born just a year apart).

The house my Grandmother grew up in on 44^th and William St.

While most of the weekend is dedicated to investing events I always make time to see as many of my family members as I can. My Great Aunt and Uncle Pat and Peg are always gracious hosts and I really treasure all of my late night conversations with them (maybe that is why I don’t get enough sleep).

                        

                   Pat, Peg, and I                    Pat Enjoying the BNSF Model Train

I also have a number of younger cousins who I enjoy spending time with. They are all intelligent and great kids in their own respects and I cannot wait to see where life takes them!

Megan and I. One of the super talented cousins I mentioned

The Future

Speaking of life and where it takes you, I find myself so grateful that I have stumbled into a life and job that I enjoy so much. And this gets me thinking about what will happen when Warren and Charlie are no longer with us.

What will that mean? Will there still be this Woodstock of Capitalists? Berkshire will no doubt continue to be one of the greatest companies in the world. A true testament to Warren and Charlie's design. But, what will happen with the Annual Meeting? Will it die off, and will these few amazing years I got to enjoy become a distant but extraordinary memory? I do not know, and I really don’t like thinking about it.

But, what I do know is that I will enjoy every moment of how ever many meetings we have left. Because when I am older I know that I will dearly miss these very special days on the first weekend in May.