Warren Buffett, the famed investor and CEO of Berkshire Hathaway Inc. (NYSE:BRK.B), recently announced that a bearish viewpoint will be presented at the upcoming annual meeting. While it’s not clear what kind of evidence this bear analyst will offer, it does look like there are some compelling reasons to be pessimistic on the stock.
One reason is that the company looks a bit too expensive. Berkshire’s consolidated intrinsic value, or estimated cash earnings multiplied by a capitalization factor, seems lower than the market price even after using standard multipliers and applying some generous assumptions. Another rationale is the company’s advancing risk profile. This increasing tolerance of risk seems to have created the chance for an unsettling financial disturbance, which may be an unfamiliar event to long-time shareholders, much more likely.
Here is the detail behind these factors.
Berkshire’s Overly Enthusiastic Market Price
Berkshire Hathaway Inc. (NYSE:BRK.B) is a highly diversified conglomerate involved in many different industries. The company’s five major business components are Insurance & Finance, BNSF Railroads, Utilities, Other Operating, and a Portfolio of Stock Holdings. By combining the intrinsic value of each, we can get a total consolidated fair value estimate.
Berkshire’s Insurance & Finance business is mostly influenced by the auto insurer GEICO and various reinsurance operations. Investment gains and income generate most of the profits. Estimating this unit’s average cash earnings at around $6.1 billion, which includes a higher than average $3.4 billion pre-tax investment and derivative gain, intrinsic value comes in around $85.4 billion based on a multiplier of 14x.
The BNSF business is the company’s railroad operations. Based on revenues of around $21 billion and adjusted earnings of $3.8 billion with a capitalization multiplier of 12x, this division looks to have a fair value of about $45.6 billion.
Berkshire Hathaway Inc. (NYSE:BRK.B)’s Utilities segment is greatly influenced by subsidiaries PacifiCorp and MidAmerican Energy. With average cash earnings of around $1.54 billion from $11.7 billion in revenues, intrinsic value is around $16.9 billion after applying an 11x multiplier.
The Other Operating business segment is made up of a wide range of firms. Chemical company Lubrizol and the diversified units of its Marmon entity have a significant pull on the segment. Based on total combined sales of $83.3 billion and an average adjusted earnings amount of around $3.5 billion, using a 12x multiplier results in a reasonable business value of $42.0 billion.
Berkshire also had an equities portfolio of roughly $86.5 billion at the end of 2012. Though an expected annualized gain was included in the Insurance and Finance segment, assuming an additional 8% pre-tax return on the portfolio, or roughly $4.1 billion after-tax at a 12x capitalization rate, adds about $49.2 billion of fair worth.
Combining these component fair values results in a consolidated amount of around $239.1 billion. Assuming 2.48 billion in equivalent “B” shares and without a conglomerate discount (which is probably necessary as I discuss in an earlier post) and acknowledging a generous value to the equity portfolio, Berkshire’s total “B” share equivalent fair value looks to be in the $96 a share area.
Berkshire’s Increasing Risk Profile
In my earlier post, the Heinz transaction seemed to exemplify Berkshire’s increased exposure to risk. The leveraged nature of the buyout and the company’s increased participation in “sweetheart” deals indicate that a valuation risk adjustment, beyond the typical conglomerate application, is probably warranted.
The transformation of Berkshire’s investing methodology looks to be another example of an acceptance of increased risk. One of Mr. Buffett’s aphorism’s is that a good investment has business fundamentals so solid that one should be able to hold it comfortably for five years even if the markets were closed during that period. It looks like two of Berkshire Hathaway Inc. (NYSE:BRK.B)’s major non-Buffett initiated stakes, DIRECTV (NASDAQ:DTV) and DaVita HealthCare Partners Inc (NYSE:DVA), don’t come close to meeting that measure.
DIRECTV is a provider of digital television in the United States and Latin America. It has 20.1 million subscribers in the U.S. and 12.4 million in Latin America. This company faces a number of operating risks. In the U.S., it faces threats from the burgeoning use of video over the Internet and increased competition from cable/telecom TV providers. These circumstances have resulted in domestic subscriber stagnation, growing only 4% over the last three years.
