Much analysis has been lavished on understanding Berkshire Hathaway (BRK) and its future. As an aid, Warren Buffett outlines the historical growth rates in per share investments and in per share earnings in the BRK 2005 Annual Report.
For the last forty years, the growth rate in per share investments has been 28.0% compared to the much lower growth rate of 17.2% in per share earnings. However, the past ten years has had a serious reversal as per share investments have grown at 13.0% while per share earnings have grown at 30.2%. Despite Mr. Buffett's desire to move both measures of value at the higher rates, the likelihood is that future returns will resemble the lower rates.
The dramatic increase in earnings has accompanied the change from a publicly traded portfolio of stocks to a privately held portfolio of businesses. In the publicly traded portfolio, earnings of the stocks did not show up in the earnings per share calculation. For example, 1995's per share earnings figure is $175 while the per share investment is $21,817, giving an incredibly low earnings yield of 0.8%! Currently, 2005's per share earnings figure is $2,441 while the per share investment is $74,129, giving a much higher earnings yield of 3.3%.
Thursday, March 30, 2006
Wednesday, March 29, 2006
Nonsense Decisions
Arthur J. Gallagher & Co. (AJG)'s 2005 results demonstrates, once again, the value of common sense in business decisions. AJG is one of the "Big Four" in the insurance brokerage business; Marsh, Aon and Willis are the others. The insurance brokerage business is a "creamer," as premium increases drives higher commissions without additional capital requirements. With such a business paying a 4.3% dividend yield, what's not to like?
AJG is having significant challenges with its synthetic fuel investments. AJG committed to various energy and low-income housing investments in order to pay less taxes. The results have been far worse than simply poor investment returns. Last year, AJG settled a lawsuit in synthetic coal licensing technology for over $130 million, after a Utah jury returned a verdict against AJG for $175 million. To provide scale, $175 million is roughly what AJG was expected to earn for the year.
AJG commented in its 2005 annual report that the verdict was "totally unexpected." Of course. There is little understanding that an insurance brokerage firm would bring to a synthetic fuel investment legal issue. Common sense dictates that AJG focus its efforts on its wonderful insurance brokerage business and pay the resulting taxes.
AJG is having significant challenges with its synthetic fuel investments. AJG committed to various energy and low-income housing investments in order to pay less taxes. The results have been far worse than simply poor investment returns. Last year, AJG settled a lawsuit in synthetic coal licensing technology for over $130 million, after a Utah jury returned a verdict against AJG for $175 million. To provide scale, $175 million is roughly what AJG was expected to earn for the year.
AJG commented in its 2005 annual report that the verdict was "totally unexpected." Of course. There is little understanding that an insurance brokerage firm would bring to a synthetic fuel investment legal issue. Common sense dictates that AJG focus its efforts on its wonderful insurance brokerage business and pay the resulting taxes.
Tuesday, March 14, 2006
More Bank Robbery
In a recent post, http://www.scottsrandombits.blogspot.com/2006/01/ridiculous-compensation.html, I highlighted the best way to get rich: "get a good safe job with a corporation...hold it hostage for money." Wallace D. Malone, Jr. exemplified this with his $135 million payoff for handing of $14 billion SouthTrust over to Wachovia, amounting to a 1% seller's fee. Now, less than two months later, fees appear to have gone up.
North Fork Bankcorp (NFB) CEO John Kanas will receive about $185 million for handing $14 billion NFB over to Capital One Financial Corp. (COF), amounting to a 1.5% seller's fee. In today's WSJ, CEO Kanas called it "an egregious amount of money, " but defended it since it monetized a life's work. As he puts it, "It's not like I flew in here on a private jet three years ago and prettied up the company and then booted it out of here."
From his comments, it appears that his $5 million plus annual compensation (for at least the past three years, according to the latest proxy) has not appropriately compensated him - entitling him to finally get paid. When asked about plans for his proceeds, he volunteered that he "intends to use a portion of the money to replace his Dodge pickup" and will "try to get more of that money into a charity if we can." (My italics). I guess he's not making any charitable commitments until he knows how much that pickup replacement will cost.
North Fork Bankcorp (NFB) CEO John Kanas will receive about $185 million for handing $14 billion NFB over to Capital One Financial Corp. (COF), amounting to a 1.5% seller's fee. In today's WSJ, CEO Kanas called it "an egregious amount of money, " but defended it since it monetized a life's work. As he puts it, "It's not like I flew in here on a private jet three years ago and prettied up the company and then booted it out of here."
From his comments, it appears that his $5 million plus annual compensation (for at least the past three years, according to the latest proxy) has not appropriately compensated him - entitling him to finally get paid. When asked about plans for his proceeds, he volunteered that he "intends to use a portion of the money to replace his Dodge pickup" and will "try to get more of that money into a charity if we can." (My italics). I guess he's not making any charitable commitments until he knows how much that pickup replacement will cost.
Friday, March 10, 2006
Spring Cleaning (of the Mind)
Every spring, I get to do some mental housecleaning from reading the witty, but sober words of my hero - Warren Buffett. Recently, a friend commented that all our heroes let us down. I replied that mine hasn't.
The 2005 Berkshire Hathaway (BRK) annual report had its usual share of good humor and business insights. In rereading old BRK reports, I have noticed a pattern. In commenting on large scale issues, such as inflation or interest rates, I have found his outlooks as prone to inaccuracy as the rest of us. However, on issues of narrower scope, he has an amazing record.
So when he criticized the derivatives business, I sat up in my chair. He writes "We lost $104 million pre-tax in our continuing attempt to exit Gen Re's derivative operation. Our aggregate losses since we began this endeavor total $404 million." His words warrant some reflection and, probably, alarm.
BRK purchased Gen Re on December 21, 1998. Gen Re has a subsidiary that operates as a dealer in the swap and derivatives market. I have prepared the following chart to highlight the derivatives issue as it develops for BRK since the time of the Gen Re purchase:
...........# Of "Derivative"..Remaining.....Mlns of $
Year ........Mentions .........Contracts....... Losses
1998 ............0
1999 ............0
2000 ...........11
2001 ...........16........................ 23,218
2002 ..........53.........................14,384...............$173
2003 ..........32..........................7,580................$ 99
2004 ..........25..........................2,890................$ 28
2005 ..........63.............................741................$104
Mr. Buffett admitted that he did not understand the depth of the Gen Re derivatives problem. His initial idea was to just sell that part of the business, but, he found that derivatives are like Hell - easier to get into than out of.
For the novice reader, let me explain. Derivatives are contracts designed to transfer a specific risk for a certain period of time. For example, I might want to transfer the risk of my shipping company going broke to someone who may view that company as creditworthy. We could use a contract to accomplish this, called a "derivative" because it derives its value from something else - here the supplier's financial situation.
Because such contracts are so specific, they are mostly illiquid. This lack of liquidity creates enormous latitude for valuation. Since there is no ready market for the contract I have listed as an example, both the buyer and the seller (in this case, me) could estimate the contract's value. Human nature being what it is, both sides will typically find a method to value it a profit.
Mr. Buffett found that the listed values did not equal those he really found in the marketplace. By 2002, BRK had worked on selling these contracts for four years, managing to reduce the number of such contracts to 14,384 from 23,218 while realizing a loss of $173 million (in effect, paying someone else to take those contracts). In the 2002 annual report, Mr. Buffett reflected this frustration, describing derivatives as "time bombs" and "financial weapons of mass destruction." This is strident language for someone not prone to emotional overstatement.
Three years years later, (economically, very good ones) he reports that, despite continuing his best efforts, losses have piled up and are not over yet. BRK still holds 741 contracts. Clearly, these contracts are exit-challenged.
If this astute investor (arguably the best) is unable to extricate himself from derivative issues, how do the rest of us avoid getting in?
Some clues may be provided by this year's annual report. We have to assume that his current investment decisions reflect his desire to avoid "derivative" problems. However, Mr. Buffett increased BRK's ownership of Wells Fargo (WFC) from 56.448 million shares in 2004 to 95.092 million shares in 2005. A quick survey of the 2004 WFC annual report reveals heavy use of derivatives, mentioning them 106 times. Why wouldn't he avoid such exposure?
As we saw from the example above, there are basically three types of derivative users: sellers - who want risk transferred, buyers - who want to take on risk and brokers - who get paid to match sellers and buyers. The use of derivatives is very similar to insurance - both are contracts designed to transfer risk. Since WFC is a heavy user of derivatives, but almost exclusively to transfer the risks away, Mr. Buffett views them positively. Are there areas that would be mean greater risk?
Here a clue may be in Mr. Buffett's comparison of derivative contract issuance to providing reinsurance. Basically, Gen Re used derivative contracts as another line of reinsurance. In fact, a review of other reinsurance company annual reports reveal "unhedged" uses of derivatives, meaning that reinsurance companies take on risk and income is the equivalent of insurance premiums. Interestingly, the mention of "derivatives" is much lower (between 5 and 25 times). Other insurers are more complex.
Most insurers use derivatives as WFC does - as a hedge. However, AIG uses them both ways. AIG makes a distinction between its operations that use derivatives in a hedging sense and those that don't. AIGFP, a subsidiary, would qualify as a candidate for some of these derivative-related problems pointed out by Mr. Buffett.
Finally, the brokerage houses are the most complex, but not necessarily the most risky. The mention of "derivatives" moves to a new high - as many as 265 mentions in the annual report of J.P. Morgan Chase (JPM). However, analysis of these mentions shows some positives and negatives. While the exposure is much higher, the exposure is as a broker, not as the taker of a risk. By having a such a high level of derivatives (notionally $41 trillion), there is greater systemic risk, although not as much company or contract specific risk.
From the 2005 annual report, good "spring cleaning" would avoid whereever derivatives increase risk (and income), but to include those areas where derivatives reduce risk.
The 2005 Berkshire Hathaway (BRK) annual report had its usual share of good humor and business insights. In rereading old BRK reports, I have noticed a pattern. In commenting on large scale issues, such as inflation or interest rates, I have found his outlooks as prone to inaccuracy as the rest of us. However, on issues of narrower scope, he has an amazing record.
So when he criticized the derivatives business, I sat up in my chair. He writes "We lost $104 million pre-tax in our continuing attempt to exit Gen Re's derivative operation. Our aggregate losses since we began this endeavor total $404 million." His words warrant some reflection and, probably, alarm.
BRK purchased Gen Re on December 21, 1998. Gen Re has a subsidiary that operates as a dealer in the swap and derivatives market. I have prepared the following chart to highlight the derivatives issue as it develops for BRK since the time of the Gen Re purchase:
...........# Of "Derivative"..Remaining.....Mlns of $
Year ........Mentions .........Contracts....... Losses
1998 ............0
1999 ............0
2000 ...........11
2001 ...........16........................ 23,218
2002 ..........53.........................14,384...............$173
2003 ..........32..........................7,580................$ 99
2004 ..........25..........................2,890................$ 28
2005 ..........63.............................741................$104
Mr. Buffett admitted that he did not understand the depth of the Gen Re derivatives problem. His initial idea was to just sell that part of the business, but, he found that derivatives are like Hell - easier to get into than out of.
For the novice reader, let me explain. Derivatives are contracts designed to transfer a specific risk for a certain period of time. For example, I might want to transfer the risk of my shipping company going broke to someone who may view that company as creditworthy. We could use a contract to accomplish this, called a "derivative" because it derives its value from something else - here the supplier's financial situation.
Because such contracts are so specific, they are mostly illiquid. This lack of liquidity creates enormous latitude for valuation. Since there is no ready market for the contract I have listed as an example, both the buyer and the seller (in this case, me) could estimate the contract's value. Human nature being what it is, both sides will typically find a method to value it a profit.
Mr. Buffett found that the listed values did not equal those he really found in the marketplace. By 2002, BRK had worked on selling these contracts for four years, managing to reduce the number of such contracts to 14,384 from 23,218 while realizing a loss of $173 million (in effect, paying someone else to take those contracts). In the 2002 annual report, Mr. Buffett reflected this frustration, describing derivatives as "time bombs" and "financial weapons of mass destruction." This is strident language for someone not prone to emotional overstatement.
Three years years later, (economically, very good ones) he reports that, despite continuing his best efforts, losses have piled up and are not over yet. BRK still holds 741 contracts. Clearly, these contracts are exit-challenged.
If this astute investor (arguably the best) is unable to extricate himself from derivative issues, how do the rest of us avoid getting in?
Some clues may be provided by this year's annual report. We have to assume that his current investment decisions reflect his desire to avoid "derivative" problems. However, Mr. Buffett increased BRK's ownership of Wells Fargo (WFC) from 56.448 million shares in 2004 to 95.092 million shares in 2005. A quick survey of the 2004 WFC annual report reveals heavy use of derivatives, mentioning them 106 times. Why wouldn't he avoid such exposure?
As we saw from the example above, there are basically three types of derivative users: sellers - who want risk transferred, buyers - who want to take on risk and brokers - who get paid to match sellers and buyers. The use of derivatives is very similar to insurance - both are contracts designed to transfer risk. Since WFC is a heavy user of derivatives, but almost exclusively to transfer the risks away, Mr. Buffett views them positively. Are there areas that would be mean greater risk?
Here a clue may be in Mr. Buffett's comparison of derivative contract issuance to providing reinsurance. Basically, Gen Re used derivative contracts as another line of reinsurance. In fact, a review of other reinsurance company annual reports reveal "unhedged" uses of derivatives, meaning that reinsurance companies take on risk and income is the equivalent of insurance premiums. Interestingly, the mention of "derivatives" is much lower (between 5 and 25 times). Other insurers are more complex.
Most insurers use derivatives as WFC does - as a hedge. However, AIG uses them both ways. AIG makes a distinction between its operations that use derivatives in a hedging sense and those that don't. AIGFP, a subsidiary, would qualify as a candidate for some of these derivative-related problems pointed out by Mr. Buffett.
Finally, the brokerage houses are the most complex, but not necessarily the most risky. The mention of "derivatives" moves to a new high - as many as 265 mentions in the annual report of J.P. Morgan Chase (JPM). However, analysis of these mentions shows some positives and negatives. While the exposure is much higher, the exposure is as a broker, not as the taker of a risk. By having a such a high level of derivatives (notionally $41 trillion), there is greater systemic risk, although not as much company or contract specific risk.
From the 2005 annual report, good "spring cleaning" would avoid whereever derivatives increase risk (and income), but to include those areas where derivatives reduce risk.
Wednesday, March 8, 2006
Future of Newspapers, II
In an earlier post, I tried to evaluate the future of newspapers. The latest reports show newspapers headed in the same direction as computers: miniturization. WSJ managing editor Paul Steiger announced at the Yale Club that each page of the Wall Street Journal will be 20% smaller when a redesign is completed later this year. Perhaps this is a gradual process designed to culminate in us reading the paper on our cell phones. However, given the age of newspaper's primary readership, it does seem a little unfair to begin providing smaller papers rather than larger print.
CA's Great Year outside Stock Market
CA recently announced the completion of a $375 million enterprise application acquisition. This purchase completes CA's capital allocation "triangle," made up of acquisitions, dividends and share repurchases. For FY2006 (ending March 2006), CA will likely generate $1 billion of cash flow to be allocated to the above acquisition, $100 million paid out in dividends and $600 million of share repurchases.
On top of a renovating accounting systems and settling various legal actions against the company, CA turned in a strong, solid year. To have such capital-generating ability beyond the ordinary demands of a competitive world might cause some investment excitement. Not here. In January 2005, CA was trading at $31 and now trades at $27. What's more, Citigroup, one of the major investment banking firms, just discontinued coverage as a result of an analyst's departure.
On top of a renovating accounting systems and settling various legal actions against the company, CA turned in a strong, solid year. To have such capital-generating ability beyond the ordinary demands of a competitive world might cause some investment excitement. Not here. In January 2005, CA was trading at $31 and now trades at $27. What's more, Citigroup, one of the major investment banking firms, just discontinued coverage as a result of an analyst's departure.
The Empire (Intel) Strikes Back
The past twelve months have been strange ones for the Intel and AMD rivalry. Dominant Intel's stock has dropped from nearly $30 per share to about $20, while AMD's has moved from $15 to about $40 per share. What's going on?
AMD has taken a couple of points of market share, creating a sense that Intel's dominance eroding. Even computer manufacturers who have only used Intel chips are evaluating a move to AMD. Today's WSJ reports Intel's response.
Three new chips will be introduced in late 2006. Its new program is called Core microarchitecture, designed to increase performance while reducing power consumption. This is important because electricity savings has been a major selling point of the AMD's highly competitive Opteron chip.
All three chips are "dual core" chips, meaning that there are two microprocessors on one chip. The resultant chips increase performance by as much as 80% while cutting power consumption by as much as 30%. Boosting this framework, Intel is expected to move to a "quad core" chip in 2007. Intel CEO Ortellini says employees were "energized."
(Note to Brooke: How many other company names can be formed from the letters of their CEO's last name?)
AMD has taken a couple of points of market share, creating a sense that Intel's dominance eroding. Even computer manufacturers who have only used Intel chips are evaluating a move to AMD. Today's WSJ reports Intel's response.
Three new chips will be introduced in late 2006. Its new program is called Core microarchitecture, designed to increase performance while reducing power consumption. This is important because electricity savings has been a major selling point of the AMD's highly competitive Opteron chip.
All three chips are "dual core" chips, meaning that there are two microprocessors on one chip. The resultant chips increase performance by as much as 80% while cutting power consumption by as much as 30%. Boosting this framework, Intel is expected to move to a "quad core" chip in 2007. Intel CEO Ortellini says employees were "energized."
(Note to Brooke: How many other company names can be formed from the letters of their CEO's last name?)
Monday, March 6, 2006
Latest Auto Parts Manufacturer Bankruptcy
Dana (DCN) is the fourth multibillion dollar auto parts manufacturer in the past year to declare bankruptcy, following on the heels of Delphi, Tower and Collins & Aikman. The news not only points out the worsening troubles for the automotive sector, but reminds me again of those three all-important words: "margin of safety."
In October 2005, Delphi filed for bankruptcy, causing auto part manufacturing stocks to plummet. DCN fell from $10 to under $6. DCN has been the dominant axle manufacturer for years, actually having introduced the automotive universal joint in 1904. DCN is not simply domestic either, with 175 plants in 28 countries.
So, in 2005, it appeared with just 50% of its historical profitability, DCN's stock would be worth about $16, a significant rise from the $6 it was trading at. Other good omens were Lord Abbett's 11% ownership of the company, Capital Research's (American Funds) 10% and Gabelli's 7%. These three well respected managers had all gotten in at much higher prices. But the stock lost its appeal after a review of its financials. Why?
To sum it up in one word: debt. DCN sells almost $10 billion of axles per year and has generated about $300 million of operating profit, even in the recent lean years. However, the interest costs have run about $250 million, narrowing DCN's flexibility to $50 million. So any business blip could create a potential cash problem. That business blip showed up in the squeeze of a slowing economy accompanied by rising material prices.
In October 2005, Delphi filed for bankruptcy, causing auto part manufacturing stocks to plummet. DCN fell from $10 to under $6. DCN has been the dominant axle manufacturer for years, actually having introduced the automotive universal joint in 1904. DCN is not simply domestic either, with 175 plants in 28 countries.
So, in 2005, it appeared with just 50% of its historical profitability, DCN's stock would be worth about $16, a significant rise from the $6 it was trading at. Other good omens were Lord Abbett's 11% ownership of the company, Capital Research's (American Funds) 10% and Gabelli's 7%. These three well respected managers had all gotten in at much higher prices. But the stock lost its appeal after a review of its financials. Why?
To sum it up in one word: debt. DCN sells almost $10 billion of axles per year and has generated about $300 million of operating profit, even in the recent lean years. However, the interest costs have run about $250 million, narrowing DCN's flexibility to $50 million. So any business blip could create a potential cash problem. That business blip showed up in the squeeze of a slowing economy accompanied by rising material prices.
Private Equity Deal in Education
Continuing the trend of private equity deals taking out public companies, Providence Equity Partners and Goldman Sachs announced the purchase of Education Management (EDMC) for $3.4 billion.
EDMC is a for-profit university, taking advantage of the rising costs of traditional universities. Two weeks ago, I tried to disguise my shock when my son Ross showed me the annual sticker price for his college of choice: $46,800. (Paying for college for children is like paying for an engagement ring - there are some things you just do, regardless of the cost.)
EDMC is the third largest for-profit, behind Apollo Group (APOL) and Career Education (CECO). The latest buyout seems similar to most of the recent deals I've studied: a 16% premium over the latest stock price.
As a footnote for the more financially minded, EDMC had 2005 sales of $1 billion with a 10% net of $100 million. In contrast APOL had 2005 sales of $2.2 billion with 20% net of $440 million. The purchase price of EDMC, offered by the new owners, implies a comparable (ave. of sales and net profit multiples) purchase price for APOL of at least $10.6 billion or about $60 per share.
EDMC is a for-profit university, taking advantage of the rising costs of traditional universities. Two weeks ago, I tried to disguise my shock when my son Ross showed me the annual sticker price for his college of choice: $46,800. (Paying for college for children is like paying for an engagement ring - there are some things you just do, regardless of the cost.)
EDMC is the third largest for-profit, behind Apollo Group (APOL) and Career Education (CECO). The latest buyout seems similar to most of the recent deals I've studied: a 16% premium over the latest stock price.
As a footnote for the more financially minded, EDMC had 2005 sales of $1 billion with a 10% net of $100 million. In contrast APOL had 2005 sales of $2.2 billion with 20% net of $440 million. The purchase price of EDMC, offered by the new owners, implies a comparable (ave. of sales and net profit multiples) purchase price for APOL of at least $10.6 billion or about $60 per share.
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