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Berkshire Hathaway Underlying Business Value

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You should begin by looking over these consolidated figures:

http://mattpauls.com/berkshire/Balsheet.pdf

http://mattpauls.com/berkshire/INCOMESTMENTa.pdf

http://mattpauls.com/berkshire/Cashflow.pdf

http://mattpauls.com/berkshire/ratios.pdf

Reported earnings and equity are significantly misrepresented.

Investment reports generally include basic financial data and financial ratios, both of which are almost always taken from consolidated financial statements. Much of the time, reasonable conclusions (though of varying quality) can be determined by use of consolidated data, however, this is not always the case. There are plenty of instances where consolidated information is, at times, misleading or otherwise altogether useless. Consolidated information which does not accurately represent a business’s underlying economics is bad information and conclusions drawn therefrom will be equally bad.

Berkshire’s consolidated presentation is not altogether useless. Over time, the annual compounded rate of return of either equity or book value will provide a rough benchmark with which investors may use to measure changes in the value of their respective holdings.To arrive at a reasonable estimate of Berkshire Hathaway’s underlying or intrinsic value, investors must look beyond consolidated figures.

The economics of an insurance business is quite different from a retail or service business. Consolidating these businesses for financial reporting purposes would not properly illustrate the value of each business unit considered separately. Similarly, Berkshire Hathaway on a consolidated basis does not provide a clear picture of what Berkshire is worth as separate business units.

An investor could easily look at berkshire’s numbers and be confused in two very different respects. Both reported earnings and equity are significantly misrepresented and have been for several years. For 2009, Berkshire Hathaway reported earnings of $8 billion, however more accurately earned roughly $5.7 billion, a difference of about $2.3 billion.

Necessary Adjustments

This is not intended to be a complete explanation of Berkshire Hathaway’s intrinsic value, rather, it is meant to provide a clearer understanding of complicating factors and how to adjust them sensibly. In the broader sense, there are two general complications the first of which is the holding company structure of Berkshire Hathaway and the second is related to required accounting standards, primarily with respect to derivative contracts. The organizational chart below provides a general overview of important items discussed.

Overview

There are several potentially confusing adjustments that I make to Berkshire Hathaway which I will describe here in brief and describe in greater detail throughout the remaining discussion.

Berkshire’s investments represent a significant amount of Berkshire’s business value. As reported, investments are broken down into four categories: (i) cash and cash equivalents, (ii) fixed maturity investments, (iii) equities, and (iv) other investments all of which are held by Berkshire’s various insurance companies.

Other investments consist of preferreds, warrants, notes, and other convertible investments specifically interests in Wrigley’s, Goldman Sachs, General Electric, Swiss Re, and Dow Chemical. Also included within other investments are securities reported under the equity method i.e. Burlington Northern Santa Fe. Since the most recent annual filing, Berkshire subsequently acquired the remaining interest of Burlington Northern.

In 2011, Burlington Northern will be placed under “Utilities” for financial reporting purposes. To adjust the 2010 annual report for this, I transfer Berkshire’s 22.5% Burlington Northern holding to the utilities operating unit also adding thereto the $8 billion in cash earmarked by Berkshire Hathaway Inc. That is, a total of about $14.6 billion, $6.6 billion of which is deducted from other investments, leaving about $21 billion.

I do not treat Berkshire’s derivative liabilities as liabilities whatsoever. The primary reason for this is that I believe Buffett to have effectively hedged derivative contract exposures. That is, Buffett received $8.1 billion in derivative premiums (float) most of which came from equity put contracts which provided $5.9 billion. I suggest later that even under the worse case scenario, Buffett should break even on equity put contracts so long as he earns 10.4% annually over the contracts life.

I do not therefore treat Berkshire’s derivatives as liabilities and I either add back or deduct from earnings, respective derivative gains and losses.

Note, these adjustments ultimately do not play a significant role in Berkshire’s underlying value as we are here concerned. It does however add about $9 billion to equity of the finance and financial products business unit. There are other ways to reasonably adjust this, however with the same net effect.

Derivative contracts not designated as a hedge, for example, sold European Style Equity Index Puts (receiving premiums up front) are accounted for by recording premiums as liabilities on the balance sheet. Changes in the fair value of these contracts are adjusted quarterly with changes reflected in the income statement as derivative gains or losses and correspondingly in the balance sheet account as an increase or decrease in derivative contract liabilities. The $8.1 Billion Berkshire initially received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and gains or losses in the “Fair-Value” of “Mark-to-Market” securities are either added or subtracted from earnings in the period of gain or loss, irrespective of actual economic gains or losses. In 2008, Berkshire’s mark-to-market changes in derivative values increased to $14.6 billion and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings. In 2009, Berkshire’s earnings were overstated, recording a pretax gain of $3.624 billion as derivative liabilities fell to $9.269 billion, however, this reduction included what appears to be a real derivative loss of $1.9 billion.

Berkshire’s Derivative liabilities are effectively hedged. Last year I tried to put the derivative contracts into proper context, restated below:

In December 1929 the Dow Jones Industrial Index was at about 370. In 1944, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss. In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion. To break even on this transaction Berkshire Hathaway would need to compound $5.9 billion at about 10%. Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to outlive him-and I expect will exceed the break-even 10%.

[Amendments made in 2009 with respect to certain equity put contracts reduced the strike price by between 29% and 39% and reduced the related contract expiration dates by between 3.5 and 9.5 years. This effectively reduced the annual rate of compounding on these contracts to 8% in order to break even. The remaining contracts were unaltered and remain as they did in 2008.]

If markets are at par with the initial and amended strike prices over the next 14 years, Berkshire will not have made and will not be required to make any payment. Meaning, derivative float will explicitly become equity. In this case, the value of “Equity Put Float” will have definitely compounded well above 15% annually.

What is not discussed, is that these contracts are effectively hedged and the probability of having to actually pay anything is negligible. While Berkshire has the use of between $6 and $8 billion, the balance sheet has shown derivative liabilities of up to $14 billion.

These contracts, though technically, are liabilities should not be considered such insofar as a private investor is concerned. I adjust the income statement from period to period, by either reducing or increasing earnings by the corresponding amount of derivative gains or losses that result from a change in the contract’s fair value. I eliminate derivative liabilities altogether from the balance sheet, since I am of the impression that the contracts are effectively hedged.

That said, investors need to arrive at their own conclusions about the risks involved and may very well wish to keep some or all derivative liabilities on Berkshire’s Books.

Equity Put Contracts	2009 Amendments		Reduced expiration between 3.5 & 9.5 years
			Reduced stricke price between 29% & 35%
$ in millions
			2009		2008
	Derivative liabilities	$	7,309	$	10,022
	Derivative gains/losses		2,713		5,028
	Derivative float		4,900		4,900
	Weighted average expiration		11.5 years		12.5 years
	Contract style		European (paymnet, if any, at expiration only)
Credit Default Swaps
$ in millions
			2009		2008
	Real losses	$	1,900	$	0.542
	Derivative float (approximate)		1,400		3,200
	Weighted average expiration
	High yield indexes		State/Muni		Individual Corporations
	2 years		11 years		3 years

Equity Put Contracts

Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss. The loss in this case is a decline in the general stock market.

Berkshire sold puts and collected premiums of $5.9 billion up front, which Buffett invested. “Derivative premiums,” like insurance premiums, are invested until the contracts expire. These are European style contracts, meaning the seller (Berkshire) is liable only for losses that exist on the expiration date of the contract. The amended contracts have an average weighted expiration of 11.5 years. In the meantime Buffett gets the benefit of the use of this money.

Credit Default Swaps

High Yield Index

Last year I suggested that, of Buffett’s derivative book, these were the most likely to produce a loss. Indeed it appears as though this was the case for 2009 as Berkshire had to pay $1.9 billion in real losses. These contracts now account for approximately $1.1 billion of Buffett’s derivative float.

Individual Companies

Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts. Annually Berkshire receives $93 million for premiums on these contracts. Berkshire was initially liable for 42 corporations. Should any of these companies default on their loans, Berkshire is liable for the decline in the market value of the debt relative to the value of the debt specified in the CDS contract.

Tax Exempt (Muni) Bond Insurance Contracts

Last year I mistakenly reported that premiums for State/Muni contracts would be paid annually. Premiums were received upfront and therefore counter-party risk does not exist. These contracts are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot.

Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years. Berkshire now have total “Derivative Float” of about $6.3 billion primarily from Equity Puts and Credit Default Insurance (high yield index).

Operating units

Berkshire is made up of several separate business units. I like to think of Berkshire in terms of the insurance business and the non-insurance business. Within the non-insurance business there are several subgroups: manufacturing, service, & retail; utilities & energy; and finance & financial products. Within the insurance business group there are two subgroups, the insurance business itself and the investment business.

It may seem a bit strange to separate these two as they are very much related, however, if we look at regulatory capital required for normal insurance operations we find that Berkshire has significant excess capital better treated separate from the insurance business. If we compare Buffett’s stated amount of float which is approximately $62 billion to cash, fixed income securities, and other investments it’s clear that equity investments are not required capital of the insurance business. Therefore I treat equities as separate from the insurance business.

Insurance operation

The value of an insurance company comes from the amount of investable funds it generates. Investable funds can come from underwriting profits, from investment income, or from securities gains. In the simple sense, if insurance premiums are sufficient to cover the losses incurred over the insurable period, the insurer produces an underwriting profit. These profits may be added to surplus, which allows the insurer to write additional business. The amount of business an insurer can write is generally limited to 3 times the insurers surplus, Statutory Accounting Principle’s (SAP) definition for shareholders equity.

As stated above, the amount of business an insurer can write is dependent upon surplus. Investable funds are a combination of surplus and float.

The amount of float depends upon the amount of business written. The amount of business written depends upon the amount of surplus. The amount of surplus depends upon underwriting profit or loss, investment income from interest and dividends, and/or capital gains on investments. The underwriting of insurance policies and the investment of surplus and float are separate operations.

Berkshire Hathaway has, on average, earned underwriting profits. Float at the end of 2009 was $62 billion, up $4 billion from last year. For several reasons not discussed here, most insurers earn underwriting losses. These losses must be made up for with interest income and securities gains. If this does not happen,surplus declines and the amount of business written must also decline.

If a privately owned insurance company owns very attractive securities, but consistently writes at an underwriting loss, then the owner’s equity interest will decline either via liquidating investments or by raising new capital. The key here is that it’s critically important to earn underwriting profit. Berkshire Hathaway’s insurers clearly do this quite well.

It is important to recognize that Berkshire Hathaway’s insurance business holds cash, fixed income securities, and equity securities. Berkshire Hathaway has about $144 billion in cash & cash equivalents, fixed maturity investments, and Equity investments all of which are held within various insurance businesses, primarily by National Indemnity, Columbia Insurance Company, GEICO, GenRe, National Fire and Marine Insurance Company, and Berkshire Hathaway Assurance Company. As of December 31, 2009, $8 billion of this $144 billion was earmarked for the Burlington Northern Santa Fe acquisition and is deducted from the cash account below. Cash and cash equivalents, fixed income securities, and other investments clearly support potential normal insurance underwriting losses, meaning these investments are required for the normal operation of the insurance business, whereas, equity securities are not.

This is very important and a fundamental component of value which must be considered separately.

TOTAL INVESTMENTS		2009			2008				2007			2006
Cash and cash equivalents	$	18,655		$	18,845			$	28,257		$	34,590
Fixed maturity investments		32,331			27,115				28,515			25,272
Equities		56,289			49,073				79,999			61,168
Other		28,780			21,535				-			-
Net investments		136,055			116,568				136,771			121,030
Float		62,000			58,500				58,700			50,887

INVESTMENTS		2009			2008				2007			2006
Net investments	$	136,055			116,568				136,771			121,030
Cash and cash equivalents		18,655		$	18,845			$	28,257		$	34,590
Fixed Securities		32,331			27,115				28,515			25,272
Other Fixed	+	21,200
Total Fixed		53,531

Other investments consist of warrants, preferreds, notes, and similar investment securities-itemized on the following page. Though Burlington Northern Santa Fe is included within other assets (above,) I transfer the $6.6 billion equity securities held by Berkshire to the utilities business for valuation purposes.

OTHER INVESTMENTS – A wonderful lesson in parsimony. If professional investors spent more time thinking, they might recognize a fallacy in the underlying logic that prevents them from holding cash, namely the excuse, “Our investors don’t pay us to do nothing. We have to be fully invested.” The fundamental job of a professional money manager is, or at least should be, to decide when and where to invest. For some reason investors often forget the when. (This has everything to to with knowledge of underlying business value and I am in no way talking about market timing so please don’t confuse the two.) Attractive investments are not always attractively priced. When sensible investments aren’t readily available, the facts and sound logic are clearly telling you to hold cash, and by the way, so too was Warren Buffett. Berkshire Hathaway had more than $40 billion in cash leading up to 2007. As the financial crisis unfolded, Buffett put to work as much as could be invested without overextending the insurance business. Many of these investments are itemized under the line item, Other Investments. Buffett’s other investments were private placements, made at a time of corporate desperation (mid-2008 to mid-2009). Not only did Buffett have the luxury of where and when to invest, he also determined the specific terms under which he invested. (Necessity never made a good bargain.)

	Shares		Cost			Total			Per Share
PREFERREDS, WARRANTS, NOTES
Wrigley’s
2018 notes 11.5′s	-	$	4,400,000,000
Preferreds 5′s	-		2,100,000,000
2013 & 2014 senior notes	-		1,000,000,000
Goldman Sachs
Preferreds 10′s	50,000		5,000,000,000		$	5,500,000,000		$	110,000
Warrants (expire 2013)	43,478,260					5,000,000,000			115,000
General Electric
Preferreds 10′s	30,000		3,000,000,000			3,300,000,000			110,000
Warrants (expire 2013)	134,831,460					3,000,000,000			22.25
SwissRe
12% Cv Perp.	120,000,000		2,700,000,000		CHF	3,000,000,000		CHF	25
Dow Chemical
Preferreds 8.5′s	3,000,000		3,000,000,000						53.72
Net			21,200,000,000
EQUITY INVESTMENTS, GAAP EQUITY METHOD
	Shares		Cost est.
Burlington Northern Santa Fe 22.5%	76,800,000	$	6,600,000,000
Burlington Northern Santa Fe remaining 77.5%	264,500,000		26,500,000,000
Burlington Northern Santa Fe@100%			33,100,000,000
PREFERREDS, WARRANTS, NOTES, BNSF@100% – NET		$	54,300,000,000
PREFERREDS, WARRANTS, NOTES, BNSF@22.5% – NET			27,800,000,000

2008 – Initial Purchases

Wrigley’s

Berkshire bought $4.4 billion fixed income notes yielding 11.5% due 2018 and $2.2 billion cumulative preferred stock which convert into Wrigley’s equity. The preferreds also pay a 5% dividend annually.

Goldman Sachs

Berkshire invested $5 billion in Goldman Sachs preferred stock yielding 10%, however attached thereto, Berkshire also received warrants convertible into 43 million shares of Goldman Sachs equity.

General Electric

Berkshire invested $3 billion in GE, on terms nearly identical to the Goldman deal.

2009 – Additions

Wrigley’s

In addition to Securities purchased in 2008, Berkshire added $1 billion in fixed notes due 2013 & 2014.

SwissRe

Berkshire bought a $2.7 billion fixed income security yielding 12% forever until converted or called (under favorable terms).

Dow Chemical

Finally, Berkshire Invested $3 billion in Dow Chemical convertible preferreds yielding 8.5%.

Berkshire’s insurance float is roughly $62 billion and is largely supported with $32.3 billion fixed maturity securities and $21.2 billion fixed income securities, listed under line item “Other Investments” (less equity in BNSF,) the sum of which comes to $53.5 billion. Berkshire Hathaway’s insurance units also hold a combined $18.6 billion in cash and cash equivalents. Naturally a portion of this cash is available for equity investment to which I arbitrarily assign $8 billion, leaving $10.6 billion with the insurers for the normal course of business. Income earned on fixed investments and cash generated by non-utility subsidiaries contribute to the cash account available for investing operations.

The above steps are useful only to the extent that investors can reasonably estimate how much capital from total investments is required for normal insurance operations, the amount which support float funds. In Berkshire’s case, the value of float (the truly important value in insurance,) commands an economic value in excess of its carrying amount. Meaning, residual capital not required for normal insurance operations should be treated separately for valuation purposes.

The value of float is not easily calculated and will vary from investor to investor, however, I am of the opinion that Berkshire’s float is conservatively worth $78 billion.

Equities

As mentioned above, equities are not an essential part of Berkshire’s insurance regulatory capital. We can therefore separate equity securities from the insurance operation. Equities are itemized below with few exceptions-one of which is BYD. With respect to this discussion, equities are valued at market as of December 31, 2009 ($56,289,000,000).

Security Name	Val ($MM)	Ticker	Pos	% Port	% O/S	Filing Date	Pos Chg	% Pos Chg	Val Chg ($MM)	Market Cap ($MM)	Filing Type
Burlington Northern Santa Fe Corp	34,196.06		341,244,000	40.17	100	13-Feb-14	264,466,971	344.46	26,502.24	34,196.06	13D
Coca-Cola Co	10,544.00	KO-N	200,000,000	12.39	8.68	23-Feb-14	0	0	0	122,161.78	Proxy
Wells Fargo & Co	8,639.19	WFC-N	320,088,385	10.15	6.18	1-Jan-14	6,732,728	2.15	181.72	139,784.77	13F
American Express Co	6,143.27	AXP-N	151,610,700	7.22	12.67	1-Jan-14	0	0	0	45,703.00	13F
Procter & Gamble Co	5,305.33	PG-N	87,503,411	6.23	3.01	1-Jan-14	-8,812,599	-9.15	-534.31	183,802.64	13F
Kraft Foods Inc	3,824.62	KFT-N	138,272,500	4.49	9.35	6-Jan-14	0	0	0	42,058.52	13G
Wal-Mart Stores Inc	2,086.54	WMT-N	39,037,142	2.45	1.02	1-Jan-14	1,200,500	3.17	64.17	206,016.00	13F
Wesco Financial Corp	1,956.16	WSC-A	5,703,087	2.3	80.1	1-Jan-14	0	0	0	2,673.92	13F
ConocoPhillips Co	1,925.92	COP-N	37,711,330	2.26	2.54	1-Jan-14	-19,718,838	-34.34	-1,007.04	71,368.23	13F
Johnson & Johnson	1,747.60	JNJ-N	27,132,467	2.05	0.99	1-Jan-14	-9,782,166	-26.5	-630.07	173,823.30	13F
US Bancorp Del	1,554.08	USB-N	69,039,426	1.83	3.6	1-Jan-14	0	0	0	47,078.93	13F
Moodys Corp	852.63	MCO-N	31,814,610	1	13.44	1-Jan-14	-7,404,702	-18.88	-198.45	6,306.28	13F
Washington Post Co	759.53	WPO-N	1,727,765	0.89	21.7	1-Jan-14	0	0	0	3,407.87	13F
Tesco Plc -Underlying	604.39	TSCO-LN	90,000,000	0.71	1.13	26-Oct-13	0	0	0	50,816.88	UK Registers
Swiss Reinsurance Co – Underlying	527.66	RUKN-VX	11,262,000	0.62	3.04	13-Mar-14	0	0	0	16,682.93	Other Substantial/Declarable
Nike Inc – Class B	504.84	NKE-N	7,641,000	0.59	1.92	1-Jan-14	0	0	0	26,868.43	13F
M & T Bank Corp	449.17	MTB-N	6,715,060	0.53	5.66	1-Jan-14	0	0	0	9,143.79	13F
Costco Wholesale Corp	310.88	COST-O	5,254,000	0.37	1.2	1-Jan-14	0	0	0	26,786.13	13F
USG Corp	239.86	USG-N	17,072,192	0.28	17.19	1-Jan-14	0	0	0	1,338.56	13F
Republic Services Inc	234.7	RSG-N	8,290,500	0.28	2.18	1-Jan-14	4,665,500	128.7	132.08	10,720.89	13F
Nalco Holding Co	229.59	NLC-N	9,000,000	0.27	6.51	1-Jan-14	0	0	0	3,214.42	13F
Symetra Financial Corp	223.59	SYA-N	17,400,000	0.26	14.75	22-Jan-14	17,400,000	100	223.59	1,532.68	13G
Ingersoll-Rand Plc	201.45	IR-N	5,636,600	0.24	1.76	1-Jan-14	-2,146,000	-27.57	-76.7	10,213.12	13F
CarMax Inc	194	KMX-N	8,000,000	0.23	3.59	1-Jan-14	-1,000,000	-11.11	-24.25	4,499.52	13F
Comcast Corp – Cl A Special	192.12	CMCSK-O	12,000,000	0.23	1.57	1-Jan-14	0	0	0	11,850.72	13F
Nestle SA – Dep Rcpt	164.39	NSRGY-5	3,400,000	0.19	0.09	1-Jan-14	0	0	0	181,853.56	13F
Iron Mountain Inc Pa	159.32	IRM-N	7,000,000	0.19	3.44	1-Jan-14	3,627,800	107.58	82.57	5,262.83	13F
Sanofi-Aventis – Dep Rcpt	153.31	SNY-N	3,903,933	0.18	0.15	1-Jan-14	0	0	0	96,660.15	13F
Lowe’s Companies Inc	152.04	LOW-N	6,500,000	0.18	0.45	1-Jan-14	0	0	0	34,592.89	13F
NRG Energy Inc	141.66	NRG-N	6,000,000	0.17	2.29	1-Jan-14	0	0	0	5,719.85	13F
Torchmark Corp	124.11	TMK-N	2,823,879	0.15	3.41	1-Jan-14	0	0	0	3,849.50	13F
Becton Dickinson & Co	118.29	BDX-N	1,500,000	0.14	0.64	1-Jan-14	300,000	25	23.66	18,353.88	13F
General Electric Co	117.68	GE-N	7,777,900	0.14	0.07	1-Jan-14	0	0	0	170,998.77	13F
United Parcel Service Inc	81.99	UPS-N	1,429,200	0.1	0.2	1-Jan-14	0	0	0	41,483.71	13F
Home Depot Inc	79.79	HD-N	2,757,898	0.09	0.16	1-Jan-14	0	0	0	53,052.86	13F
Wellpoint Inc	78.33	WLP-N	1,343,820	0.09	0.3	1-Jan-14	-2,050,393	-60.41	-119.52	27,466.01	13F
Bank of America Corp	75.3	BAC-N	5,000,000	0.09	0.05	1-Jan-14	0	0	0	165,689.84	13F
GlaxoSmithKline Plc – Dep Rcpt	63.82	GSK-N	1,510,500	0.07	0.06	1-Jan-14	0	0	0	95,986.05	13F
Suntrust Banks Inc	48.66	STI-N	2,398,206	0.06	0.48	1-Jan-14	-681,572	-22.13	-13.83	11,889.52	13F
United Health Group Inc	35.81	UNH-N	1,175,000	0.04	0.1	1-Jan-14	-2,225,000	-65.44	-67.82	39,345.89	13F
Gannett Co Inc	32.7	GCI-N	2,202,200	0.04	0.93	1-Jan-14	-1,245,400	-36.12	-18.49	3,595.96	13F
Exxon Mobil Corp	28.76	XOM-N	421,800	0.03	0.01	1-Jan-14	-854,490	-66.95	-58.27	307,573.38	13F
Comdisco Holding Co Inc	15.38	CDCO-U	1,538,377	0.02	38.18	1-Jan-14	0	0	0	34.45	13F
Kromi Logistik AG	4.45	K1R-XE	401,863	0.01	9.74	22-Sep-13	0	0	0	43.74	Other Substantial/Declarable
Travelers Cos Inc	1.36	TRV-N	27,336	0	0.01	1-Jan-14	0	0	0	27,008.86	13F

Insurance business value

		2009			2008
Investing operations (securities at market + excess ins. cash)*	$	64,200		$	58,500
Value of Float		78,000			70,000
Net insurance est.		142,200			128,500
*For the sake of this presentation, 22.5% BNSF equity, $6.6 billion, at cost, transferred to utilities net worth. These holdings were included in investing operations in 2008.

Non-insurance operations

			2009			2008			2007
Manufacturing, Service and Retailing
Pre-tax earnings		$	2,058		$	4,023		$	3,947
Net earnings			1,113			2,283			2,353
Approximate net worth			16,804			17,227			12,112
Finance & Financial Products
Pre-tax earnings		$	781		$	787		$	1,006
Net earnings			494			479			632
Approximate net worth			10,874			6,874			9,658
Utilities & Energy
Net earnings		$	1,071		$	1,704		$	1,114
Approximate net worth			13,963			10,970			8,600
(BNSF earmarked cash & 22.5% equity $14.6b)			28,563			-			-
(BNSF 100% consolidated)			47,963			-			-
Comnbined
Combined net earnings		$	2,678		$	4,466		$	4,099
Combined net worth
22.5% BNSF Pre-merger			56,241			35,071			30,370
100% BNSF Post-merger			75,641			-			-

Non-Insurance Operating Businesses

On the low end of the valuation range, Berkshire’s non-insurance operating businesses are worth their adjusted net worth.

Pre-merger (BNSF) net worth was roughly equal to $56,000,000,000. Post-merger (BNSF) net worth is roughly, $75,000,000,000.

Although, currently suffering from the global economic downturn, I am still of the opinion that Berkshire Hathaway’s non-insurance operating businesses command a liberal premium over basic net worth.

Estimated value of Berkshire Hathaway’s non-insurance operating units sold in private transactions:

BNSF 100% consolidated
$88,000,000,000

BNSF is very capital intensive, why did Berkshire Hathaway buy Burlington Northern? There is literally no close substitute to railroad transportation, a service that is also both needed and desired. Were the industry not subject to price regulation, we would be talking about an economic franchise, but we would also be talking about a clear monopoly subject to anti-trust law. Instead, we have a utility business and as is the case with utility companies, railroads are effectively a regulated monopoly. As the cost of goods increases over time Burlington will pass along their capital costs to customers. However as the cost of oil increases with inflation, the relative attractiveness of rail transport will also increase, but without proportional cost increases. The extremely high fixed costs and similarly high initial investment or replacement costs are gigantic barriers to entry. Utility and railroad businesses alike, have fairly calculable future earning streams, which makes the use of leverage both reasonable and smart.

How much is Burlington Northern worth? Debating whether or not Buffett paid a reasonable price seems to me ridiculous. However, I had calculated BNSF before mention of the merger and as it turns out he appears to have paid what I thought to be his maximum price. (This is also supported by comments made by Buffett about the use of Berkshire Hathaway shares in the acquisition.)

(It is important to recognize that Berkshire Hathaway is enormous in size, limiting the universe of opportunities within which Buffett can invest meaningful amounts of shareholder capital. As the universe gets smaller, so too must overall investment returns, the consequence of an ever- growing huge amount of capital. Berkshire owner expectations should be significantly lower over the next 20 years. That is not to discount Berkshire altogether-owner partners should also expect to earn quite reasonable rates of return over the same period. )

In terms of replacement cost, I’m certain BNSF is worth considerably more than $34 billion. Moreover, I find it hard to believe that anyone wanting to enter this business could acquire enough (connected) real estate to build an equivalent network of roads. The cost would certainly be well in excess of $34 billion. The merger must be considered as a truly long-term investment. Sometime in the future, say 50 years hence, Burlington may very well be a 20% return business. Today it is somewhere between 13% and 15%. It has some, but not excessive leverage.

Though I consider this very much a speculative comment, I am also of the impression that the merger will benefit the utilities operation directly. Mid-American produces significant amounts of its energy production via coal. The Powder River Basin provides 40% of all coal used in the U.S. for electrical power generation. Significant coal bed methane deposits are also located in the Powder River Basin. The Powder River Basin consists of 18 coal mines, from which, 30 states receive approximately 400 million tons of coal every year. According to the U.S. Energy Information Administration, coal from Powder River Basin is significantly less expensive than coal extracted elsewhere in the U.S. selling, for instance, 1/6 the price of Central Appalachian coal. The majority of coal moved from Powder River Basin must first travel 103 miles on a BNSF-Union Pacific jointly owned line. Though partially owned by Union Pacific, the line is primarily owned, and fully operated by, BNSF. There are now a total of four tracks jointly used in the basin by BNSF and UP. Approximately 65 unit trains (115 cars) leave daily, laden with coal.

INSERT TEARSHEET

INSERT COAL IMAGE

Utilities and BNSF

Significant transportation contracts between Mid- American and Burlington Northern expire within 2 years. The new, generally long term contracts, would almost certainly include rate increases chargeable to Mid-American. Given the heavily regulated nature of both of these industries, I am uncertain whether favorable terms are allowable between affiliate companies, however I think it’s fair to assume some benefit will trickle down to the parent company.

The Merger

As of December 31, 2009, Berkshire Hathaway had acquired 76,800,000 shares (22.5%) of Burlington Northern through market share purchases. The weighted cost of these share purchases was approximately $6.6 billion. BNSF shareholders agreed to sell the remaining 77.5% of BNSF to Berkshire Hathaway in a cash and stock deal. The reported value of the transaction was valued at $26.4 billion, or $100 per share, thereby valuing Burlington Northern at approximately $34 billion.

Berkshire acquired the remaining 77.5% of BNSF not already owned. Were this consideration paid strictly with cash, there would be nothing further to discuss, but Berkshire used cash and stock. Meaning, stock, in effect, was used as currency. The underlying value of stock- currency (unlike cash-currency,) may be quite a bit different from its traded market value; generally the important value as far as the seller is concerned. Berkshire Hathaway’s stock-currency traded for about $180 billion at the time of offer. Shares issued in conjunction with the merger amount to approximately 6% of Berkshire Hathaway. That is, 30% of BNSF’s total shares (or 39.9% of BNSF’s shares not already owned) were acquired in exchange for 6% of Berkshire Hathaway’s stock-currency,

when Berkshire was selling for $180 billion. Based upon conservative estimates at the time of offer, Berkshire’s intrinsic value was, roughly $200 billion. The stock- currency used in the transaction adjusted for underlying value, suggests that the total cost of the deal was understated by roughly $1.4 billion. If reference is made to the cost as provided within the merger proxy, adjustment should be made to the value of stock purchased at market, before merger. This number was adjusted up from cost to market which inflated this portion of the acquisition cost, however the increase will come through the income statement in the first quarter. There are many ways to treat this. I take the actual cost to berkshire and add thereto, the cost of undervalued stock-currency.

	% BNSF stock	% BNSF stock			Shares			Total cost			Cost per share
	outstanding	acquired in merger
Stock already owned, at cost	22.5	-			76,800,000		$	6,600,000,000		$	85.94
MERGER OFFER
Acquired with cash	46.7	60.1	(1)		158,400,000			15,800,000,000			99.75
Acquired with stock	30.8	39.9	(1), (2)		105,200,000			12,000,000,000			114.07
Net Acquisition	100.0				340,400,000			34,400,000,000			101.05
(1)	158,400,000 shares represent 46.7% of BNSF total shares outstanding or 60% of BNSF shares
	not already owned; to be acquired.
(2)	Stock-currency value is equivocally 6% of Berkshire Hathaway (i.e. 6% for 30.8%)

Analysis of Multiples at Offer Price. Goldman Sachs calculated and compared various financial multiples and ratios for BNSF based on information that it obtained from BNSF management and estimates from the Institutional Brokers Estimate System (“IBES”):

		As of October 30, 2009			Implied Consideration Value					As of October 30, 2009			Implied
Consideration
Value
Enterprise Value/2010E EBITDA								Enterprise Value/2010E EBITDA
IBES		6.8	x		8.5	x		IBES		6.8	x		8.5	x
2010 Recovery Case		7			8.7			2010 Recovery Case		7			8.7
2011 Recovery Case		7.4			9.3			2011 Recovery Case		7.4			9.3
No Recovery Case		7.6			9.5			No Recovery Case		7.6			9.5
Deeper Recession Case		8			10			Deeper Recession Cas		8			10

ADJUSTED NET WORTH		2009			2008
Net insurance est.	$	142,200		$	128,500
Combined non-insurance operating businesses		75,641			35,071
Conservative value, Berkshire Hathaway inc.		217,841			163,571
NEGOTIATED SALE		2009			2008
Net insurance est.	$	142,200		$	128,500
Combined non-insurance operating businesses		88,000			35,071
Conservative value, Berkshire Hathaway inc.		230,200			163,571

ADJUSTED NET WORTH		2009			2008
Net insurance est.	$	142,200		$	128,500
Combined non-insurance operating businesses		56,241			35,071
Conservative value, Berkshire Hathaway inc.		198,441			163,571