Is Burlington a Game-Changer for Berkshire?

Brett Horn: Hello. I'm Brett Horn, the associate director of equity research here at Morningstar. We've got Berkshire Hathaway's annual income up this weekend. So, I invited Bill Bergman, our analyst who covers Berkshire for us, in to talk about what we might expect to hear from them.

Thanks for joining us.

Bill Bergman: Hi, Brett. Nice to be here.

Horn: We talked about a couple of topics. One topic I'd like to hit is this operational hits. Buffett draws a lot of press for his trades and his investments, but Berkshire Hathaway is a large operating company. They have got a lot of businesses that are some very exotic, some very pedestrian.

One thing in reading his letter this year, I was actually surprised to hear was, he was talking about how they're actually attracted to capital-intensive businesses at this point. Now, given our philosophy, that maybe raises a little bit of a flag. All else equal, as capital goes up, ROICs come down, returns to shareholders and value creation would come down.

Is that something you're worried about?

Bergman: Well, I don't know if "worried" is the right word, Brett. But, it is something that is a reality, I think, for Berkshire at this stage in its development.

It has a long history of acquiring firms at a relatively good price, and compounding returns over time for shareholders of Berkshire in ways that haven't been replicated elsewhere in our corporate universe.

But having said that, yes, the size of the firm and its cash position, as well as it capital structure, are making the firm more attractive as a merger partner for capital-intensive businesses. This was exhibited by the Burlington Northern acquisition.

One attraction for the Burlington Northern acquisition for Berkshire shareholders, as well as Burlington Northern, may be the marriage...you have a capital intensive business in the form of Berkshire within Burlington Northern. But you have a low-cost of capital at Berkshire Hathaway in ways that it may be good for both entities.

Horn: Is Burlington really a game-changer for Berkshire? Is it just one more business under the umbrella? Or how do you view that?

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Bergman: Well, it is a game-changer in terms of the size of the transaction. I think it really is fundamental. We don't have pro forma statements yet. They're going to me very different, just because of the size of this transaction, I think. It's going to be an important material mover, in terms of the book value per share.

One issue, going forward here, is looking at the change in the book value per share at Berkshire in the year ahead. And whether or not this acquisition, thinking about the contribution of this acquisition, once it's added to the book value numbers for Berkshire Hathaway. That's how big this transaction is.

It makes sense to be thinking about how big it is, relative to the actual... Berkshire likes to look at the change in book value per share as an indicator of the economic growth for the shareholders during the year ahead. But there's going to be some interesting issues associated with this transaction.

Horn: I guess, keeping on Burlington, one other section that caught my eye in the annual letter was... maybe apology is the wrong word, but he felt the need to explain why they paid partly with stock, and drew out that this is not something historically that they've done. It seemed like maybe he had a little bit of misgivings about that, or at least felt the need that he had to explain why they did that.

Is that a flag for you at all, that kind of change?

Bergman: It was a flag initially, and I've thought about it. I think, over time, the fact that they are willing to pay stock at this price is something that may reflect actually the value of Berkshire Hathaway's stock to the Burlington Northern shareholders.

The ways that the shares were split as a consequence of reducing the tax consequence of the transaction for the Burlington Northern shareholders. I think that was part of the overall attractiveness of that $100 per share consideration, which is something that actually is probably viewed, I think, at least neutral or better for Berkshire Hathaway shareholders.

Horn: And I guess, going back to the existing businesses, we know Berkshire is known for, generally, as a financial institution. But, the reality is, in terms of the contribution, there's quite a range of businesses under the Berkshire umbrella, and a lot of them are very economically sensitive.

What do you see if we do get into an economic recovery this year? What does that mean for Berkshire's results?

Bergman: It is easy to think about Berkshire Hathaway as a mutual fund. A lot of people think about that. But, no, it's a collection of real, honest-to-goodness, bricks-and-mortar businesses. At least half the fair value, perhaps, are these operating subsidiaries, which are in a wide variety of industries, many of them very economically sensitive.

Firms I'm just thinking of: Forest River, a manufacturer of RVs--consumer discretionary spending to the max.

Horn: RVs are not necessarily something that you think about when you think about Berkshire Hathaway.

Bergman: RVs. Acme Brick, you don't think about bricks as something that's in Warren Buffett's portfolio, but it is. It's a brick manufacturer that's very sensitive to trends in housing and residential construction.

You've got Shaw Industries, a maker of flooring systems and carpeting. That's very sensitive to housing. There are others, a variety of different... the furniture companies that are within the Berkshire operating subsidiaries, and Iscar Metalworking, a metalworking company that's very sensitive.

A large swath of those operating subsidiaries are very sensitive to the economy, and they've been dragging results in recent years. That may be turning in ways that, if we combine a good insurance year and a good investment year for Berkshire with a recovery that looks to be developing in those operating subsidiaries, we've got a pretty good increase in book value per share this year.

Horn: Well, on that note of optimism, we'll end it there. Thanks for joining me, Bill.

Bergman: Good. Nice to be here.

Horn: I'm Brett Horn for Morningstar. Thanks for joining us.