Reasons To Be Bearish On Berkshire Hathaway
Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Warren Buffett, the famed investor and CEO of Berkshire Hathaway (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 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'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's major non-Buffett initiated stakes, DIRECTV (NASDAQ: DTV) and Davita Healthcare (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.
Its Latin American focus faces other risks. The company has been pushing this business, growing it from 15% of revenues in 2010 to 20% in 2012, but it is exposed to potential economic and political turbulence. As the company's product is priced at a premium in relatively poor countries, economic difficulties can easily disrupt growth plans. Political instability and unexpected regulation are also well-recognized problems in countries like Venezuela and Argentina, which DIRECTV relies on.
Given the rapid change in the fundamentals of DIRECTV's domestic market and the potential lack of stability in its Latin American operations, anticipating what the business might look like in five years seems very problematic.
Davita has its own fundamental risks. The company is a medical service provider operating a U.S-based dialysis business that accounts for roughly 68% of revenue. Davita expanded its offering with a mostly debt-financed $4 billion acquisition of Healthcare Partners, a medical provider and physician organization, in late 2012.
Besides healthcare regulatory issues, the company faces significant government based payment risk. With over 66% of their dialysis revenue coming from government entities and 60% of Healthcare Partners reimbursement from senior care, Davita looks highly reliant on administratively mandated fees.
It would seem that looking five years out, with governmental budget issues and an increasing healthcare burden, the company's reimbursement environment appears murky at best.
DIRECTV and Davita are not necessarily bad investments, but their large position in Berkshire’s portfolio seems to indicate that the scope of acceptable equity risk has been expanded.
There are reasons to be bearish on Berkshire stock, and its optimistic valuation and increased risk profile may be the most persuasive. Though finding a pessimistic view is rare, investors may find it prudent to at least consider any potential downside.
Bob Chandler has a short position in Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!