by Will Ashworth | May 17, 2013 9:27 am
Less than two weeks after Berkshire Hathaway’s (BRK.A, BRK.B) annual meeting in Omaha, Standard & Poor’s downgraded its credit rating by one notch to double-A, citing an over reliance on dividends from its insurance operations.
One of the main reasons Buffett started investing in insurance companies in the first place is the investable cash — known as float — they produce. That hasn’t changed.
The S&P downgrade has to do with the fact a state insurance regulator has the authority to reject dividend payments made by an insurance company and must approve any payout that’s deemed extraordinary. Berkshire Hathaway received $6.8 billion in dividend payments from subsidiaries in 2012, 80% of which were from National Indemnity Corp. — Buffett’s umbrella insurance business.
Does that mean you should avoid the stock? I’ll look at three pros and three cons of owning Berkshire Hathaway under S&P’s new rating criteria.
Economic Rebound: Kase Capital’s Whitney Tilson recently made a presentation outlining the investment merits of Berkshire Hathaway’s stock. In it, he reminds investors that Buffett’s non-insurance businesses have soared thanks to Burlington Northern Santa Fe (BNI) and the economic rebound. In 2012, BRK’s non-insurance operating income was $14 billion — more than double the operating income for its insurance operations. So, although its non-insurance businesses accounted for 70% of BRK’s operating income, Standard and Poor’s is focusing on what the subsidiaries have chosen to pass along. In the span of five years to the end of 2012, BRK’s insurance float has grown from $59 billion in 2007 to $73 billion. The difference of $14 billion invested at 1% is an additional $140 million. That adds up fast.
Operating Business: Leaning on Tilson once more, his presentation reminds us that BRK is more of an operating company today than it is an investment business. Using four, 10-year time increments from 1970 through 2010, Tilson points out that in the ten years ending in 2010, BRK’s compounded annual increase in per-share investments grew by 6.6%. Meanwhile, in the same 10-year period, BRK’s compounded annual increase in per-share pre-tax earnings grew by 20.5%. It’s clear that, although investment managers Todd Combs and Ted Weschler were important hires, they’re not the critical component to its future. And the next CEO will have to be good at operating businesses because he or she will own a ton of them.
Cash: Although having almost $75 billion in cash to invest is a good problem to have, an even better quandary is generating $1 billion each month in free cash flow. Standard and Poor’s cutting of the holding company’s credit rating one notch does little to slow this cash-generating monster. As long as the operating businesses continue to grow, the nature of S&P’s move is speculative at best. The rating agency reminded investors that BRK’s insurance subsidiaries have the best credit ratings of any insurer. It appears they were trying to make headlines on a slow news day. Anyone who can borrow $500 million at 4.3% over the next 30 years must be doing something right.
Size Does Matter: Buffett admitted to short-seller Doug Kass at the annual meeting that BRK can’t do as well as it has in the past because it’s a much bigger beast. Charlie Munger then suggested, however, that BRK will be the exception to the rule that big companies become slovenly. I have no idea where it will end up but, if the DaVita (DVA) situation is any indication (it agreed to stop at 25% ownership of the company), it’s becoming increasingly difficult to swing a big stick when you’re the elephant in the room.
Private Equity: Buffett almost must stop getting into bed with too many private equity firms, who often are about financial engineering rather than business building. Sure, the Heinz (HNZ) deal provides BRK with a good operating partner in 3G Capital as well as a nice preferred share paying 9%. And I think Jorge Paulo Lemann is one of the finest private equity investors anywhere (I recently read a book about InBev‘s purchase of Anheuser-Busch [BUD] ). But great deals like that don’t come around very often. BRK must do more of its own deals like Burlington Northern.
Eight More Notches: Finally, the biggest problem with the cut isn’t the move from AA+ to AA, but rather the negative outlook, which brings into play the possibility of future cuts. Eight more and Berkshire Hathaway gains junk status. Although Standard and Poor’s doesn’t like Buffett, I doubt it would be able to come up with enough reasons to keep cutting. Nonetheless, any additional cuts could hurt its ability to secure inexpensive funding.
Even if Doug Kass was my father, I’d respectfully have to disagree with his shorting of Berkshire Hathaway. Long term, the intrinsic value of stock is well above today’s prices. It’s definitely a buy with or without the rating cut.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.
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