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Is Berkshire Undervalued Today?

Greggory Warren, CFA
Susan Dziubinski

Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Berkshire Hathaway's annual meeting is this weekend. I'm here with Gregg Warren, a senior analyst at Morningstar, who covers Berkshire, to talk about whether the stock is attractive today. Gregg, thank you for joining us.

Gregg Warren: Thanks for having me.

Dziubinski: So, let's start out with your take on the operating business today. What's happening there, what's firing on all cylinders, and what maybe isn't working as well?

Warren: The problem right now is we won't know first-quarter earnings until the weekend of the meeting because they don't release the earnings until then, so we're basically forced to fall back on end-of-the-year results, which overall weren't that bad. From an operating perspective, most of the businesses are doing fairly well. There were some headline issues with the Kraft Heinz impairment, plus the fourth-quarter sell-off in the equity markets impacted the equity investment portfolios. So, barring those, when you look at the operating business, it's pretty good. I mean, if we look at the insurance business, which is about 38% of our overall fair value estimate--good, solid results from Geico. They've pulled back from what was an aggressive push for market share, took some pricing, reduced underwriting overall, and their operating profitability's looking better than it has in a long time--again, back to more normalized levels. On the reinsurance front, pricing has been an issue in that business, but they seem to continue to find ways to find business, and overall they're trying to run it just basically flat, keep it in the black. They've had some headwinds the past couple of years just because of catastrophe losses, but overall they're doing a good job there. And then the primary group business continues to outperform, it's really the crown jewel within that portfolio. 

When we look at the railroad business, it's about 22% of our fair value estimate, a good solid year overall. Beat their closest peer, Union Pacific, on a lot of different measures, from volumes to revenue, but they still are trailing them from a profitability perspective, and this is kind of a concern for us. We've seen some moves within the industry to adopt precision railroading, and Union Pacific is the latest one to adopt this one. As we look out over the next five to 10 years, our concern is that if they don't get on board, Union Pacific could start using this as a competitive wedge. But, overall, it was a good year for them. Expectation is we'll continue to see some good results from them. On the energy business, it's usually sort of a beacon of stability, it's about 8% of our fair value estimate, nothing too exciting happens there. The only time we have any sort of major moves is when they do an acquisition, but overall, a good, solid year from that business. 

And then we look at the MSR segment, which is manufacturing, service, and retailing. That's about 32% of our fair value estimate right now. It's gotten larger because they folded up the finance and finiancial products business into there. At the end of the day, it's a big black box, though. It's really opaque, Berkshire does not give us a lot of details. What we do know is Clayton Homes, ISCAR, Lubrizol, Precision Castparts, and Marmon are the five biggest contributors there. They're about 60% of pretax profits overall. So, we can get a general sense of where things are going directionally, but when we look at how results ended up last year, it's about in line with our expectations, sort of mid-single-digit growth on the revenue line, 8% pretax margins, so overall, it was a pretty good result from them, barring the issues we saw with the equity investment portfolio. And with Kraft Heinz, we do include that as more of the equity investment portfolio than actually a operating company.

Dziubinski: Now, we assign Berkshire a wide moat. Do you see those competitive advantages improving? Do you see any threats to those competitive advantages? How does the moat look today?

Warren: Our moat trend for the firm overall is actually stable. So, we don't really see anything positive or negative on an overall basis. With our trend, it's sort of like our moat and our fair values overall. We're doing a sum of the parts. We're breaking down the different businesses. We're looking at the competitive advantages, sort of the threats and the weaknesses that are impacting the businesses. And we look at insurance, I mean, overall, good, solid advantaged businesses. Geico's in a great spot. Direct sell is growing much, much faster than the rest of the industry, and it's a much better position to be in. On the reinsurance side of the business, pricing is terrible, that's a known-known for that business. Berkshire's unique, though, relative to its peers, because it tells its underwriters, if you can't find a good business that's reasonable for the risk we're taking on, don't underwrite it. So, they can sit on their hands when the pricing isn't appropriate. And then, when we look at the business, overall, you can have situations like Geico did for a couple years there, where they could take advantage of the entire book of business, the larger insurance business, and then the larger business that is Berkshire, to go out and be aggressive, taking some market share, run some losses in order to do that, which they did for almost four or five quarters. Because the offset within the rest of the organization is going to help them to do that. 

With BNSF, which we talked about just a little bit there, everything's good right now, but my concern is longer term. If Union Pacific gets in a point where their spread in operating profitability widens out even further than it is now, they could eventually start taking price and use that as a competitive wedge. And that's where we worry about it because that's its most direct competitor in the western part of the United States. On the utilities business, it's really what Berkshire Energy is, which is sort of an almost private company operating underneath the Berkshire umbrella. The biggest advantage they have relative to public peers is that they don't have to pay out 60% to 70% of their earnings as a dividend every year. So, that's capital they can throw back into the business. In the past 10 years, that's all gone toward wind power and solar power. They've driven down the cost basis on that so dramatically that it's put them at a huge competitive advantage relative to a lot of peers within the areas in which they operate. So, from that perspective, that's a huge advantage, nothing really changing there. 

And then with the MSR segment, again, that's a more difficult one to really sort of peg because there is just not a whole lot of clarity within the business operations themselves. But, again, we know the five major players in there, we know what's going on with those businesses, so directionally things seem to be fairly stable right now. But we do keep an eye on that because, again, there will be times when one or two players, or some of the smaller players, will face competitive pressures, but depending on the size, it may or may not have an impact on the business overall.

Dziubinski: And then, lastly, how about Morningstar's fair value estimate today on Berkshire? Does it look undervalued, overvalued, fairly valued?

Warren: Our fair value is $360,000 on the Class As, it's $240 on the Class Bs. The shares right now are trading about a 10% discount to that, so it's not a huge margin of safety, but in the way in which we look at things, for a medium uncertainty firm, that is enough to start to putting capital to work in the business. Now, that said, I'd wait for prices lower than this. Berkshire's traditionally traded about 1.4 to 1.45 times book value per share. There seems to be a ceiling at about 1.6 times, so it never really gets past that, and I think part of that is because the concerns about Buffett, and will he pass away tomorrow, next week, next year? But then, they also have never really gotten below 1.25 times book value per share. Now, part of that was because Buffett has sort of built a floor under the stock at 1.2 times book value. But since he's taken that threshold off, it's still really not driven down that far. Ideally, I would look for prices between, say, 1.25 and 1.35 times book value, which seems to be the prices that Buffet's looking at because that seemed to be where he was buying stock in the fourth quarter overall.

Dziubinski: Interesting. Gregg, thank you so much for your time today.

Warren: Thanks for having me.

Dziubinski: For Morningstar.com, I'm Susan Dziubinski.