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Regulated or Capital-Intensive Business ROE at Berkshire


Shane
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Just did some quick calculations:

 

In the 2015 annual report, the combined companies (BHE + BNSF) earned net income of about $6.38B.  I can look at the consolidated balance sheet and see that the equity invested in this business is about $92.3B ($165B - $72.7B).  This results in an ROE of 5%!  This seems much too low.

 

Does anyone have an idea of how to explain this?  Union Pacific earns an ROE of >20% right now and has averaged in the high teens over the past 10 years.  WAS BNSF able to earn a high ROE before it was acquired?  Debt levels are comparable between the two companies.  If this math is correct, we don't want any incremental capital invested in this business.  I am referring to BNSF as it makes up the bulk of this business, please feel free to dissect things further.

 

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just some thoughts:

-Was it equity or equity+ float?

 

I would assume just equity, but does it matter?  Float is becoming less important for Berkshire and any dollar invested at such a low ROE is destroying value

 

-Case of skate where the puck will be or where it's at?

 

Looking back, BNSF has never been a high ROE business while Union Pacific has consistently earned higher returns

 

-Will the competitor's ROE go down while Berkshire's go up?

 

Maybe?  Doesn't look like BNSF ever really had a high ROE

 

-Replacement cost?

 

What about it?  Not sure I follow?

 

I owned a stock with 5% ROE, it did NOT do well :)

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Replacement cost as in value of the franchise. Yes, owning the major utility in an entire group of States is hard to replicate. You're the only one. With railroad, you are one of very few. So one would accept lower return for the privilege of owning those cash-flows. But 5%? That's too low even if you had the only cash cow in town.

 

One more question - Special niche or larger area? Maybe I make 20% on 1 million and you make 5% on 50 billion. Is it a case of parking large sums somewhere?

 

Another question - a play on future inflation?

 

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There's "Income taxes, principally deferred" liability of 63B that is not attached to any segment.

 

Assigning 20B of that to Railroad, Utilities and Energy segment would reduce its equity to ~72B and raise your ROE to 8.8%. Assigning more, would increase ROE even more.

 

I don't know what is the right amount of this liability for Railroad, Utilities and Energy segment.

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I am on my phone so won't go to trouble of posting links, but both BNSF and BE file separate 10-K's and q's. You can use those to compare to peers. They are generally doing just fine and boast decent ROE's and ROTE's (Berkshire has obviously acquired these at premiums to boom so goodwill will increase equity and decrease ROE relative to peers, ceteris peribus); since UNP has never been acquire it will obviously have lower equity so it's ROE will be higher.

 

Edit: by "doing just fine", I don't mean to imply all is well as obviously rail and utilities both have challenges, just that there is nothing glaringly wrong or Berkshire specific

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Page 73 of the annual report shows identifiable assets of $67 and $74 bil at BNSF and BHE respectively. Included in these amounts are $15 and $9 bil of goodwill. So $140 - $24 = $116 bil and assume $70 bil of liabilities (most of which is $57 bil of debt on which they pay 5%), I estimate tangible equity of say $50 bil. On $6.3 bil of GAAP income that's low double digit after-tax ROE.

 

We can argue about whether BNSF is under-earning or not but I think big picture these are businesses where you can allocate billions of incremental capital every year and expect to earn reasonable regulated rates of return which probably isn't the worst thing for a company of BRK's size

 

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As Benjamin just said, I think there is a focus on what can be done with incremental capital, which I think is in the high single digit to low double digit range.

 

Also, wasn't there a giant thread on the ROEs of BHE and BNSF 6 months or a year ago?

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Here's an example of the type of ROE they shoot for at the utility.  There is a significant time lag before the ROE's are earned and actual cash taxes factor into it of course.  To a certain degree, I also believe the utility is under-earning as a sort of marketing strategy to regulators so approval will come for large future acquisitions in this space.  Going forward, warren is happy to make an almost guaranteed 8-12% perpetually in this rate environment and can live with locking in these returns "permanently" on that capital.  Not a way to get rich - Berkshire is already rich.

 

http://www.utilitydive.com/news/midamerican-energy-reaches-settlement-to-move-2-gw-wind-farm-forward/423385/

 

edit: hadn't seen benjamin1978's post before typing.  i agree with him/her

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Fair points being made looking at ROTE.  Some more calculations below:

 

Total segment assets of $165m - $24.2m goodwill - $3.4m cash - $73m in liabilities = $64M in tangible equity = ~10% ROTE.  I take out cash just to see if it would match up with the 'identifiable assets' number listed elsewhere.  Similar to the results achieved by benjamin1978.  I'm a little too detail oriented to take any company (even Berkshire) at their word on identifiable assets and am still not sure what they omit. 

 

My conclusion, Warren's thesis is to overpay slightly today for a lifetime of 9-11% returns on incremental capital going forward.  Additionally, there might be some arbitrage because cost of capital for BNSF under BRK might be lower than when it was independent.  Maybe one day they can strive to achieve the much higher returns that peers are making.  I understand the rational, but I was hoping for something a little more impressive when I embarked on the analysis.  Glad I posted on the board.  Thanks for the input.  Let me know if you disagree.

 

 

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If you do what thepupil pointed out and look at the SEC filings for standalone BHE and BNSF (which they submit for the public debt) you actually get to about 17% and 12% returns on tangible equity for the two companies respectively. Links to the filings below.

 

Why are you so conclusive that Buffett "overpays" for these deals? Back in 2009 when BNSF was acquired many pundits came out and screamed that it's not a value investment, he's overpaying etc., but fast forward today the business is earning 2x what it did back then despite meaningful decline in coal related offtake etc. So I think it's been a very shrewd investment and I can make a similar argument for BHE

 

https://www.sec.gov/Archives/edgar/data/71180/000108131616000023/bhe123115form10-kcombined.htm#se3a2c4834e07497c84774767598ef848

 

https://www.sec.gov/Archives/edgar/data/15511/000001551116000027/bnsfrailway-12312015x10xk.htm

 

 

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I found this quote from Buffett in 2012:

 

"Farms, real estate, and many businesses such as Coca-Cola  KO -0.05% , IBM  IBM -0.46% , and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets."

 

http://fortune.com/2012/02/09/warren-buffett-why-stocks-beat-gold-and-bonds/

 

I think he's saying that these capital intensive industries are not the best, but they beat gold and cash and as has been pointed out can deploy lots of that depreciating cash.

 

I'm trying to wrap my mind though around quality of businesses. Is he suggesting that large margins and pricing power involve things like low labour costs, royalty income streams, established relationships where you can raise prices without investing much. There are many products/services that don't have large capital requirements but you can't raise prices. Presumably you invest even there to brute force sell more or something. It's interesting to think about.

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That is a different point, thanks for bringing it up. I like the quote but I think there's some distinction between a capital intensive business like US Steel and a capital intensive but regulated utility like BHE though where your contractual returns actually have a built-in inflation adjuster. To some extent that is a form of protective / capped pricing power if you will. Whereas cash, yes forget it.

 

Also, while utilities are capital intensive, you'd be surprised that they actually have pretty low maintenance capex. In Berkshire's case their capex is high because they're growing the regulated asset base and any incremental spending over depreciation just gets added to the RAB. Profits next year will be based on RAB multiplied by the regulated rate of return.

 

Is it like See's Candy where you don't even have to spend any capital to grow? Not at all, especially if you consider the fact a box of Toffee-ettes these days will set you back about $22 after-tax before considering the additional distribution cut that third-party POSs can levy on you. But on the flip side, there's only so much scale in that business

 

Utilities’ Profit Recipe: Spend More

https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwjS2dDD8J3OAhUElh4KHVCsD-cQFgglMAE&url=http%3A%2F%2Fwww.wsj.com%2Farticles%2Futilities-profit-recipe-spend-more-1429567463&usg=AFQjCNHNBY_icNu9q79_5vgXTIlVer4rZw&sig2=I-gzhdGUHP6-qItEhvgDXw&bvm=bv.128617741,d.dmo

 

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If you do what thepupil pointed out and look at the SEC filings for standalone BHE and BNSF (which they submit for the public debt) you actually get to about 17% and 12% returns on tangible equity for the two companies respectively. Links to the filings below.

 

Why are you so conclusive that Buffett "overpays" for these deals? Back in 2009 when BNSF was acquired many pundits came out and screamed that it's not a value investment, he's overpaying etc., but fast forward today the business is earning 2x what it did back then despite meaningful decline in coal related offtake etc. So I think it's been a very shrewd investment and I can make a similar argument for BHE

 

https://www.sec.gov/Archives/edgar/data/71180/000108131616000023/bhe123115form10-kcombined.htm#se3a2c4834e07497c84774767598ef848

 

https://www.sec.gov/Archives/edgar/data/15511/000001551116000027/bnsfrailway-12312015x10xk.htm

 

Why am I conclusive? - My point was really that he is accepting a low return on his investment in the short term (including goodwill), but is counting on a long runway of solid incremental returns on capital to dilute that out over time.  So earnings doubled, but the return on his investment (again, including goodwill) doesn't seem to be very attractive.  That figure will improve as the goodwill is diluted by more incremental capital invested over depreciation in the future.  Does this make sense?

 

I need to work on these filings tonight, it is interesting to me that the ratios can vary that widely depending on the filing.  A 17% ROE would completely change my analysis, but would totally confuse me given our other calculations!

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BNSF Railway is owned by BNSF LLC. You can find their 10K here.

 

http://www.bnsf.com/about-bnsf/financial-information/form-10-k-filings/#%23subtabs-1

 

Looking at 10K. BNSF LLC has equity of $34.5 billion and net income of $4.3 billion. So ROE looks much better when you consider LLC which owns 100% of BNSF Railways.

 

My point was really that he is accepting a low return on his investment in the short term (including goodwill), but is counting on a long runway of solid incremental returns on capital to dilute that out over time.

 

Return on investment from Berkshire perspective are quite different as you need to factor in initial cash outlay, dividends received, value of the company currently and discount rate.

 

I have developed model to calculate returns on generated based on above assumptions. Returns will vary based on discount rate applied and terminal values but there is sensitivity table to show possible impact. Berkshire actually financed this deal with 10 billion in shares, 8 billion with cash on hand and 8 billion debt. So leveraged returns are even better.

 

With various assumptions we can see that investment is already generated $30-50 billion (range since final value of BNSF is not available) above initial investment of $26.5 billion.

BNSF_returns.xlsx

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Nice. What about the bils they put into it via capex? playing devil's advocate here

 

BNSF Railway is owned by BNSF LLC. You can find their 10K here.

 

http://www.bnsf.com/about-bnsf/financial-information/form-10-k-filings/#%23subtabs-1

 

Looking at 10K. BNSF LLC has equity of $34.5 billion and net income of $4.3 billion. So ROE looks much better when you consider LLC which owns 100% of BNSF Railways.

 

My point was really that he is accepting a low return on his investment in the short term (including goodwill), but is counting on a long runway of solid incremental returns on capital to dilute that out over time.

 

Return on investment from Berkshire perspective are quite different as you need to factor in initial cash outlay, dividends received, value of the company currently and discount rate.

 

I have developed model to calculate returns on generated based on above assumptions. Returns will vary based on discount rate applied and terminal values but there is sensitivity table to show possible impact. Berkshire actually financed this deal with 10 billion in shares, 8 billion with cash on hand and 8 billion debt. So leveraged returns are even better.

 

With various assumptions we can see that investment is already generated $30-50 billion (range since final value of BNSF is not available) above initial investment of $26.5 billion.

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Valueinvesting101 - thanks for this, very helpful!

 

Benjamin1978 - I agree here.  Since Berkshire owns all of BNSF, the return on his investment must include the additional investments made in the company via capex.

 

It now seems to me the easiest way to get a feel for the return on Berkshire's investment is to just look at the ROE of BNSF LLC.  Not bad at all.

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