Company Profile: TransDigm Group

Transdigm LogoTransDigm Group is a leading designer and producer of engineered components that are used in nearly all commercial and military aircraft.  The company was founded in 1993 by Nicholas Howley, who currently serves as Chairman and CEO, and Douglas Peacock who is a member of the Board of Directors.  TransDigm has grown rapidly over the years through acquisitions and organic growth using a private equity-like business model.  Although the company went public in 2006, the business model has not changed.  Since 1993, management has compounded revenue at an annualized rate exceeding 20 percent.  Profitability has grown even more rapidly through margin expansion.

At the outset, it is worth noting that TransDigm uses a highly leveraged capital structure and is not a statistically cheap stock.  The company has negative shareholders’ equity, $8.3 billion in debt, a market capitalization of $12 billion and total enterprise value of approximately $20 billion.  Earnings before interest, financing costs, and income tax was $1.1 billion in fiscal 2015 so the EV/EBIT ratio is quite high at approximately 18x.  However, TransDigm has many interesting characteristics including management’s history of effective capital allocation and the company’s large and growing economic moat.  The company was mentioned in The Outsiders as a contemporary analog for the track record of Capital Cities.  Even if TransDigm shares are not cheap, the business is interesting enough to warrant further study.  It is never a waste of time to examine the track record of a highly successful management team.

Overview

TransDigm specializes in the design, production, and distribution of highly engineered aviation parts and components.  Since its founding in 1993, the company has acquired 56 businesses including 41 since the IPO in 2006.  Six operating units were acquired for a total of $1.6 billion in fiscal 2015 which was the company’s biggest year for acquisition activity up to this point.  Management focuses on capital allocation and allows subsidiaries to operate with a significant amount of autonomy through a decentralized organizational structure.

The key to TransDigm’s economic moat is related to the nature of the aerospace industry.  A typical commercial or military aircraft platform takes many years to develop and can be produced for 20 to 30 years.  The lifespan of an aircraft can be 25 to 30 years so the required component parts can have a product life cycle in excess of 50 years.  Once an aircraft part is incorporated into the design of a new platform, sales are generated to original equipment manufacturers (OEMs) such as Boeing and Airbus.  Aftermarket sales continue for the life of the aircraft.  There is an extensive selection and qualification process for critical parts that often requires FAA certification.

Over 90 percent of the company’s revenues are generated from proprietary products and approximately 75 percent are from products where the company is the only source of supply.  Approximately 54 percent of revenues are from aftermarket sales where the gross margin is significantly higher than from OEM sales.  While the sale of new aircraft tends to be cyclical in nature, aftermarket sales are much more steady and highly correlated with total worldwide revenue passenger miles flown.  Revenue passenger miles has tended to grow at an annual rate of 5 to 6 percent.  Since 1970, revenue passenger miles have doubled every 15 years.  The exhibit below, taken from the company’s February 2016 investor relations presentation (pdf), illustrates the growth of the installed base of commercial aircraft over time as well as the importance of the aftermarket channel.

Commercial Transport Installed Base

The presentation also includes a slide that is quite revealing in terms of TransDigm’s growth prospects as well as the nature of aftermarket parts as a percentage of airline operating expenses:

Commercial Aftermarket

Maintenance only accounts for 9 percent of airline operating expenses but obviously the quality of the components used in maintenance activities is extremely important.  Other than the fact that TransDigm is the single source provider for most of its product lines, airlines have little incentive to “shop around” for a lower bidder given the low cost of replacement parts relative to overall operating expenses.  This provides a great deal of pricing power to TransDigm as well as other aftermarket parts manufacturers. Obviously not all parts are equally critical (a lavatory component is less critical than a fuel pump), but in general, price sensitivity is lower for critical parts especially when the cost of the part is a small component of overall operating expenses.

Operating Results

TransDigm’s overall results since inception have been extremely strong with revenue growing at an annualized rate of 20.1 percent and EBITDA growing at 24.5 percent, as shown in the exhibit below.  When looking at charts like this, it is important to examine whether rapid growth from early years has slowed down more recently but this does not appear to be the case for TransDigm.  In fact, growth rates over the past five years have been roughly in line with the long term trend.

TransDigm Long Term Results

The market has not ignored the strong performance since the 2006 IPO.  Over the past decade, shares have appreciated by over 800 percent.  In addition to share price appreciation, the company has paid a total of $67.50 per share in special dividends.

TransDigm Stock Chart

TransDigm is organized into three reporting segments:

  • The Power & Control segment includes businesses that develop, produce, and distribute components that predominantly provide power or control to the aircraft using a variety of motion control technologies.  Products include items such as pumps, valves, ignition systems, and specialty electric motors and generators. This segment accounted for 49 percent of revenue and 52 percent of EBITDA (as defined by management) in fiscal 2015 (year ended on September 30, 2015).
  • The Airframe segment includes businesses that develop, produce, and distribute components that are used in non-power airframe applications.  Products include items like latching and locking devices, cockpit security components, audio systems, lavatory components, seat belts and safety restraints, and lighting systems. Airframe accounted for 47 percent of revenue and 46 percent of EBITDA in fiscal 2015.
  • The Non-aviation segment targets markets outside the aerospace industry such as seat belts and safety devices for ground transportation, child restraint systems, satellite and space systems, and parts for heavy equipment used in mining and construction. Non-aviation accounted for 4 percent of revenue and 2 percent of EBITDA in fiscal 2015.

The exhibit below shows TransDigm revenue by segment over the past five fiscal years.  The percentage of revenue provided by each segment has not varied dramatically over this time frame despite a significant number of new acquisitions so the mix of business provided by acquisitions has tended to be aligned with the existing mix.

TDG Revenue by Segment

The exhibit below shows segment and total company results over the past five years as well as the first quarter of fiscal 2016.  Management has developed a metric known as “EBITDA as defined” which is used internally to manage the business and evaluate results.  Some of the adjustments, such as the exclusion of stock compensation expense and acquisition related costs, seem suspect for analytical purposes but are probably not meaningful enough to change broad conclusions regarding operating performance:

TDG EBITDA

We can see that Power & Control tends to offer the highest margins, followed closely by Airframe.  Non-aviation, which is a very small part of the company, has significantly lower margins.  A high level look at these figures demonstrates that the company is obviously very profitable and that the business appears to benefit from entrenched economic moats.  Notably, margins have held up well over the period despite several acquisitions.  This indicates that management has been able to successfully find acquisitions that share economic characteristics similar to the existing lineup of business units or has been able to bring up margins after acquisitions.

Approximately two-thirds of revenue in fiscal 2015 came from domestic customers with the rest from direct sales to foreign customers.  Over the past decade, the geographic mix of business has shifted slightly toward foreign customers.  In fiscal 2015, approximately 9 percent of revenue came from businesses acquired over the past fiscal year.  Net income was $444 million in fiscal 2015.  The company’s tax rate has tended to be in the low-mid 30 percent range.

TransDigm’s free cash flow typically exceeds net income.  The business is not capital intensive and there are regular non-cash amortization charges that depress net income relative to operating cash flow.  Additionally, the company believes in using significant equity based compensation.  From fiscal 2004 to 2015 (which encompasses all publicly available data filed with the SEC), the company generated aggregate net income of $2.2 billion and free cash flow of $2.9 billion.

Acquisition History and Capital Structure

TransDigm has been very acquisitive over the years.  Incorporating smaller parts manufacturers into the TransDigm system has been a major factor driving the kind of revenue growth discussed above.  The exhibit below shows all of the acquisitions the company has made over the years:

TDG Acquisitions

The following exhibit aggregates selected data from TransDigm’s publicly available cash flow statements since 2004 and provides a good summary of how management has funded its activities at a very high level:

TDG Selected Sources and Uses of Cash

We can see that the company has used more than its aggregate free cash flow to return capital to shareholders.  Leverage has effectively funded all of the company’s acquisition activity as well as additional return of capital to shareholders.  Leverage is a key component in management’s overall strategy of providing “private equity-like growth” in the value of the stock.  Management targets 15 to 20 percent annualized growth and key performance based compensation is only fully granted if annualized growth reaches 17.5 percent.  The exhibit below shows that TransDigm has historically varied its leverage based on the availability of acquisition candidates as well as the timing of cash return to shareholders:

TDG Leverage History

A leveraged capital structure is a key component of management’s strategy of delivering 15 to 20 percent annualized growth:

TDG Leveraged Growth Model

As of January 2, 2016, the end of the company’s first quarter of fiscal 2016, total debt was $8.3 billion.  Total stockholders’ equity was a negative $964 million and tangible equity was negative $7.1 billion due to the presence of significant goodwill and intangible assets on the balance sheet attributable to past acquisitions.

Despite the fact that the company has negative tangible equity, it is quite clear that economic goodwill is very high.  The evidence of significant economic goodwill is the fact that the company regularly posts high operating margins and generates significant free cash flow.  Tangible equity is not required to operate this business.  Whether one considers the highly leveraged capital structure to be appropriate or not is partly dependent on risk tolerance.  Although the business seems to have all of the characteristics of a steady and growing annuity, and qualitative factors discussed earlier support this viewpoint, negative surprises leave no margin of safety from a balance sheet perspective.  TransDigm has a shareholder constituency that appears to embrace the leveraged capital structure in exchange for higher anticipated returns on their investment.

Boeing’s Push Into Airplane Parts

Earlier this week, The Wall Street Journal reported that Boeing is planning a new push into the airplane parts business. Apparently Boeing’s management has not been oblivious to the high margins enjoyed by parts manufacturers and distributors.  Boeing has the power to grant licenses to suppliers to sell proprietary parts to airline customers.  The company’s effort to gain control over the distribution of aftermarket parts has been ongoing for several years.

There is a risk that manufacturers could be forced to distribute aftermarket parts through Boeing which would take a cut of the revenue.  Assuming that pricing to the end customer stays constant, this would imply margin pressure for parts manufacturers in the aftermarket channel.  Boeing, and other airplane manufacturers, already exert pricing pressure for OEM parts which is why the OEM channel is lower margin than the aftermarket channel.  Parts manufacturers count on higher aftermarket margins to offset the initial cost of design and development.  If the margins for OEM and aftermarket channels eventually converge, it would imply much lower profitability for the parts manufacturers as a group.

The Wall Street Journal included a chart showing the exposure of a number of companies producing aftermarket parts:

WSJ Boeing

It is not clear at this point whether the concerns raised in the Wall Street Journal article will have much of an impact on TransDigm.  The excellent margin characteristics of the aftermarket business have not been a secret in the past and Boeing has wanted a piece of the action for many years.  The characteristics of the economic moat described earlier indicate substantial protection for TransDigm’s profitability. However, over the long run, the risk of Boeing or other airplane manufacturers encroaching on this territory should be kept in mind.

Conclusion

TransDigm has a highly entrenched position in most of its markets and has enjoyed very strong operating results in recent years.  Management has grown the business organically as well as through the aggressive pursuit of acquisitions.  These acquisitions have been funded predominantly with debt and TransDigm has a very leveraged capital structure.  The valuation of the company does not appear to be cheap by conventional measures, although if management is able to continue compounding free cash flow at historical rates, continuing shareholders are likely to be rewarded.

Investors take many different approaches when deciding which companies warrant further study.  Everyone has limited time available for research and it is tempting to focus on companies that are statistically cheap and could be candidates for investment immediately.  However, sometimes limiting the research process to candidates that could be immediately actionable results in not spending time looking at excellent companies that could be candidates at some point in the future.  Assuming that an investor is comfortable with the leveraged business model, it is possible that shares could be attractive during a future market decline.  However, stepping back a bit from the investment process, we should bear in mind that studying great managers with impressive business track records is rarely a waste of time even if it doesn’t lead directly to investment candidates.

Disclosure:  No position in TransDigm Group

Company Profile: C.H. Robinson Worldwide

CH Robinson LogoC.H. Robinson Worldwide is one of the largest global third party logistics companies specializing in offering customers integrated systems and personnel skilled in the efficient movement of goods.  C.H. Robinson operates a capital light business model by purchasing cargo space from trucking firms, railroads, airlines, and ocean shipping lines and reselling space to its customers.  Charles Henry Robinson founded the company in 1905 as a specialty distributor of perishable products.  The company still operates in the produce sourcing business today although it represents a minor percentage of revenues.

In a number of respects, C.H. Robinson’s business model is similar to Expeditors International, profiled earlier this month, but is more focused on domestic shipments transported via trucks and railroads.  In contrast, Expeditors specializes in the international transportation of goods via aircraft and ocean liners.  However, C.H. Robinson has been moving into international freight forwarding in recent years.  The 2012 acquisition of Phoenix International increased the company’s international exposure.  This article takes a look at C.H. Robinson’s business model and recent operating results.

Overview

The basic economic value proposition offered by C.H. Robinson is not that different from what Expeditors International provides.  Customers in need of shipping services can achieve economies of scale by partnering with a third party logistics provider.  Sophisticated information systems optimize the movement of freight and, when multiple customers are involved, C.H. Robinson can consolidate shipments, obtain favorable pricing from carriers, and pass along part of the savings to customers.  In this way, C.H. Robinson earns a margin and customers pay less for transportation services than they would if contracting with shippers directly.

For analytical purposes, is important to look at the company’s net revenue as opposed to total revenue.  Net revenue represents total revenue less purchased transportation services and is the primary indicator of the company’s ability to add value and realize a margin in exchange for providing service to customers. One notable aspect of the company’s performance is that net revenues posted a small increase in 2009 while total revenue fell 12 percent.  This is due to the direct costs of procuring transportation falling along with overall volume and demonstrates skillful management during the recession.  The exhibit below shows total revenue along with the direct costs of revenue.  The difference, shown as the blue area in the chart, represents the company’s net revenue.

CH Robinson Total and Net Revenue 2006-15

The company operates in a single segment but provides a breakdown of net revenue by service line.  The exhibit below shows the company’s net revenue broken down by service line over the past ten years.  The sourcing service line represents the company’s original business of sourcing and transporting fresh produce and perishable goods.  The payment services line was consolidated into transportation starting in 2015.  Figures are in thousands.

CH Robinson Net Revenue 2006-15

Two major acquisitions impacted results in recent years.  In 2012, the company acquired Phoenix International for $560.8 million.  The purpose of this acquisition was to increase C.H. Robinson’s presence and service offerings in international freight forwarding.  The acquisition was made toward the end of 2012 so we can see the additional ocean, air, and customs related net revenue starting in 2013.  On January 1, 2015, the company acquired Freightquote for $398.6 million.  Freightquote is a freight broker specializing in less-than-truckload (LTL) shipments. Most of the increase in the LTL category in 2015 is attributable to this acquisition.

With 74 percent of net revenue attributable to truckload and LTL shipments, it is evident that C.H. Robinson’s mix of business is quite different from Expeditors International which realizes 59 percent of net revenue from air and ocean shipments with the balance from customs brokerage and other services.

Operating Results

C.H. Robinson clearly provides a good value proposition to customers that allows the company to sustain healthy operating margins in a variety of economic environments.  Income from operations was 37.8 percent of net revenue in 2015 while net income was 22.5 percent of net revenue.  There has actually been a slight decline in both operating and net income margins over the past few years which could be attributable to the incorporation of acquisitions.

The exhibit below shows key performance figures over the past decade including productivity data on a per-employee basis.  One interesting aspect to note for C.H. Robinson is that the employee productivity figures appear to be more favorable than the corresponding data for Expeditors International (which are not displayed in the table).  For example, personnel expenses as a percentage of net revenue tends to be in the mid 40 percent range for C.H. Robinson and in the low 50s for Expeditors.  Expeditors has a lower operating margin compared to C.H. Robinson.  It is possible that the difference is attributable to the different mix of business (domestic land-based shipping vs. international ocean/air based shipping).

CH Robinson Selected Operating Data

C.H. Robinson has an enviable record of cash flow generation.  Over the past decade, the company has posted net income of $4.1 billion, cash flow from operations of $4.3 billion, and free cash flow of $3.9 billion.  As we can see from the exhibit below, free cash flow tends to approximate net income over time (figures in thousands).

CH Robinson Cash Flow

Over the past decade, the company has returned $4.3 billion to shareholders in the form of repurchases of $2.5 billion and dividends of $1.8 billion.  This has exceeded free cash flow generation over the period and was partially funded by taking on a modest amount of leverage.  The company has also employed leverage for the cash component of its acquisitions in recent years.  Net cash invested in acquisitions (acquisitions less proceeds from divestitures) was $822 million over the past ten years.

According to a recent investor presentation (pdf), management intends to target the dividend payout ratio to 40-50 percent of net income.  Share repurchases will bring the total cash return to approximately 90 percent of net income annually.  In addition, management is looking for additional strategic acquisitions.  During the Q4 2015 earnings conference call, management indicated that leverage in the range of 1.0-1.5x debt-to-EBITDA will be targeted in the long run leaving room for significant additional debt in the targeted capital structure.

Sustainability of the Moat

C.H. Robinson clearly has a powerful moat that has endured through all kinds of economic conditions.  Perhaps the best evidence of the moat is revealed by examining the company’s record during the 2008-09 recession.  Although total revenue declined in 2009, the company posted a slight net revenue gain.  All of the important performance metrics such as operating margin held up extremely well during the worst economic crisis since the Great Depression.  This is really quite remarkable for a company that is seemingly very exposed to the domestic economy.

In contrast with Expeditors, C.H. Robinson’s moat cannot be primarily attributed to the mechanics and complexity of international trade.  It appears that the moat is primarily protected by the company’s long history with customers and the value added through management of the overall supply chain.  One notable aspect of C.H. Robinson’s business is the extent to which it effectively manages the extreme fragmentation of the U.S. trucking industry.  The exhibit below, taken from the investor presentation mentioned above, shows that the vast majority of trucking firms contracted by C.H. Robinson are extremely small:

Fragmented Trucking Market

Approximately 84 percent of truckload shipments in 2014 were with motor carriers that had fewer than 100 tractors (this figure was 83 percent in 2015).  In 2015, C.H. Robinson worked with 68,000 transportation providers worldwide.  In general, C.H. Robinson represents a very large customer for motor carriers and the company is not dependent on any trucking firm.  The company’s information systems are capable of identifying an appropriate carrier based on the customer’s shipment and coordinating complicated aspects of the shipment with the carrier.  This “middleman” service saves the shipper the hassle of trying to identify and negotiate with an appropriate carrier directly.  Also, the buying power of C.H. Robinson will usually result in lower costs for the shipper.

Switching costs also play a role in the maintenance of the moat.  C.H. Robinson maintains information systems that can be integrated directly into the systems of its customers.  As customer information systems are developed with integral links to C.H. Robinson, the costs of switching the workflow to another carrier increases.  Barring a major disruption, customers have little incentive to “rock the boat” by switching.

C.H. Robinson’s small sourcing business known as Robinson Fresh also enjoys similar economics.  The company has relationships with more than 2,000 growers and transports 120 million cases of fresh produce annually to end customers.  The practical obstacles facing thousands of smaller growers trying to get perishable products to market in a timely manner are very clear.

One potential competitive threat on the horizon could involve Amazon.com. In recent years, Amazon has taken on many of the characteristics of a third party logistics company.  In particular, Amazon now facilitates the sale and transportation of goods between a large number of third party merchants and end customers.  The company has a history of disrupting industries and management has historically not been reluctant to enter adjacent markets with little regard for short term profitability.  A recent article in an supply chain industry publication provides more details regarding the potential threat from Amazon.

Despite the nascent threat from Amazon, it remains likely that C.H. Robinson’s moat will be sustainable.  Although growth through acquisition has inherent risks, growing the scale of its operations should be a priority for management.  As the scale of operations increases, the company should enjoy greater pricing power when negotiating with customers as well as better rates when negotiating with motor carriers, railroads, airlines, and ocean shippers.

Valuation

C.H. Robinson’s business success has not been ignored by investors.  Historically, the stock has not traded at bargain basement levels and shares recently traded at around 21 times 2015 net income.  Market capitalization is approximately $11 billion.  Despite the presence of a moat, the company does not have particularly strong reinvestment opportunities given the capital light business model.  This is implicitly conceded by management given a goal of distributing 90 percent of net income to shareholders.  However, growth through acquisition is possible and management’s goal of diluted earnings per share growth of 7-12 percent could be achievable.  Over the past decade, earnings per share compounded at 9.7 percent.  The current dividend yield is 2.3 percent.

The chart below shows that the shares are much more volatile than the underlying business:

CHRW Price Chart

If C.H. Robinson can compound diluted net income per share at the low end of management’s guidance (7 percent) over the next decade, earnings per share should be close to $7 by the middle of the next decade implying a stock price of around $140 assuming no multiple compression.  After considering the dividend, investors could expect annualized returns in the 9 percent range.

C.H. Robinson appears to be an excellent business available at a reasonable, but not bargain basement, price.  However, as the chart above shows, the stock price is more volatile than the business and occasionally badly overreacts to economic conditions that have not historically harmed the company in any measurable way.  C.H. Robinson deserves a place on a value investor’s watch list for a potential bargain purchase at times when Mr. Market puts the shares on sale.

Addendum:  First Quarter 2016 Results

This article does not incorporate first quarter 2016 results which were released after the market closed on April 26 (slides for the earnings call scheduled for April 27 were also released).  C.H. Robinson posted a total revenue decline of 6.9 percent to $3.07 billion but net revenue increased by 7.3 percent to $563.3 million.  Operating income and net income increased by 9.4 percent and 11.7 percent respectively while diluted earnings per share was up 13.7 percent to $0.83.  Analysts had expected earnings per share of $0.82 so the company “beat” that expectation.  However, total revenue of $3.07 billion fell short of analyst expectations of $3.2 billion sending the shares down around 5 percent in extended after hours trading.  It is not clear whether the company also “missed” net revenue expectations or if market participants noted that net revenue increased 7.3 percent even as total revenue declined.  In any case, as suggested above, market volatility could create opportunities for long term value investors.

Disclosure:  No position in C.H. Robinson Worldwide

Berkshire Hathaway in 2026

The following article originally appeared in the May 2016 issue of The Manual of Ideas which was published on April 20.

Introduction

Berkshire Hathaway Mill - New Bedford, MABerkshire Hathaway’s long history dates back to the nineteenth century but the company was effectively “founded” by Warren Buffett when he assumed control in 1965.  The story of Berkshire’s evolution from a struggling textile manufacturer to the sprawling conglomerate we know today has been well documented and will be scrutinized by students of business for decades to come.  Berkshire is also still a work in progress.  Mr. Buffett remains firmly in charge of the company at age 85 and shareholders could very well continue to benefit from his leadership well into the 2020s.

Over the past 51 years, Berkshire has compounded book value per share at a stunning annualized rate of 19.2 percent and has retained all earnings except for a ten cent per share dividend paid in 1967 and minor repurchases made in recent years.  With a market capitalization of approximately $350 billion, Berkshire is currently the fifth largest company in the United States.  Berkshire was already a very large company ten years ago.  Over the past decade, shareholders’ equity has increased from $91 billion to $256 billion which has been mostly attributable to retention of nearly all earnings.  Net income was over $24 billion in 2015, up from $8.5 billion in 2005.  From 2006 to 2015, book value per share compounded at an annualized rate of 10.1 percent while the stock price compounded at 8.4 percent due to a modest contraction in the price-to-book ratio.

As Berkshire’s capital base continues to grow, it will become increasingly difficult for Mr. Buffett or his successors to redeploy earnings at acceptable rates of return.  If Berkshire compounds book value at 10.1 percent over the next ten years, shareholders’ equity would stand at approximately $670 billion by early 2026 and market capitalization is likely to exceed $1 trillion.  How likely is such an outcome?  In his 2014 letter to shareholders, Mr. Buffett warned that “eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings.”  At that point, Berkshire will have to return cash to shareholders in the form of dividends or share repurchases.

Berkshire Over the Past Decade

Before considering Berkshire’s prospects over the next decade, it is worth examining the evolution of the company over the past ten years.  How did Berkshire compound book value per share at an annualized rate of over 10 percent starting with a capital base that was already very large in 2006?

The property and casualty insurance business has been a major source of Berkshire’s growth since National Indemnity was acquired in 1967.  Through its insurance subsidiaries, Berkshire has been able to benefit from underwriting profits in addition to harvesting returns from investing policyholder “float”. Berkshire’s large holdings of marketable securities have been funded with both shareholders’ equity and policyholder float.  However, Berkshire has never restricted its non-insurance investments to marketable securities.  Starting with the acquisition of See’s Candies in 1973, Berkshire began moving into high quality non-insurance subsidiaries.   As Berkshire grew over the years, Mr. Buffett began a more significant realignment of Berkshire with an emphasis on adding a diverse stream of non-insurance profits.  This trend has accelerated over the past decade as the table below illustrates:

Berkshire EBIT 2006-2015

We can clearly see that pre-tax operating income has shifted dramatically toward non-insurance businesses.  Most obviously, Burlington Northern Santa Fe provided more pre-tax income in 2015 than the consolidated insurance business (underwriting profits and investment income).  In 2006, Berkshire was still four years away from acquiring BNSF.  Berkshire’s collection of operating businesses that are not enumerated in the table also provided more pre-tax income than the insurance group in 2015.

The chart below excludes the impact of realized investment gains, eliminations, and unallocated interest and provides another view of the shift toward non-insurance operations since 2006:Berkshire Pre-Tax Operating Income

We can see that based on this measure, the insurance group’s contribution has fallen from 57 percent of pre-tax income in 2006 to 26 percent in 2015.  The overall trend, although irregular, is quite clear.  The pie chart below illustrates Berkshire’s diverse sources of operating income for 2015.  Berkshire is often referred to as an insurance focused conglomerate.  While this characterization was arguably true in 2006, insurance plays a much less prominent role today.

Berkshire 2015 Pre-Tax Operating Income

Berkshire has added numerous non-insurance operating businesses since 2005 including PacifiCorp, Business Wire, Marmon, Burlington Northern Santa Fe, Lubrizol, NV Energy, Van Tuyl Automotive, and several others including a number of “bolt-on” acquisitions made by Berkshire subsidiaries.  Berkshire’s acquisition of Precision Castparts closed in early 2016.

How did Berkshire go about funding these acquisitions which collectively have transformed the earnings power of the company?  With the notable exception of the Burlington Northern Santa Fe acquisition, which was made partially through the issuance common stock, Berkshire has avoided diluting existing shareholders and has leveraged its free cash flow to fund acquisitions.

Over the past decade, Berkshire posted cumulative net income of $140 billion, cash flow from operations of $200 billion, and free cash flow of $113 billion, which we define as operating cash flow less capital expenditures.  Berkshire invested $62 billion in businesses acquisitions over this period.  In addition, the company allocated $35 billion toward net purchases of equity securities and $34 billion toward the purchase of other investments including financial crisis-era investments in Goldman Sachs and General Electric, as well as more recent investments in Bank of America, Restaurant Brands International, and the Kraft Heinz Company.

It is clear that Berkshire has grown over the past decade primarily through the successful acquisition of several non-insurance subsidiaries utilizing strong cash flow.  These non-insurance subsidiaries will continue to generate significant free cash flow over the next ten years.  It is very likely that the insurance subsidiaries will remain major contributors as well through generation of underwriting profits and investment income.  Insurance results are likely to be quite volatile but, barring a major insurance acquisition, will represent a much less important part of Berkshire ten years from now.

The Next Decade

Berkshire Hathaway has a “high class” problem:  The powerful cash generation capability of the company tends to snowball which makes the task of deploying cash flow more difficult over time.  Berkshire had over $61 billion of cash equivalents at the end of 2015, excluding cash held in the railroad, utility, and financial products groups.  Operating cash flow has averaged over $30 billion during the past three years.  Berkshire can deploy cash in any of the following ways:

  1. Cash can be reinvested within the same operating company in which it is generated.
  2. Cash can be reallocated between operating companies.
  3. New partially or wholly-owned subsidiaries can be acquired (insurance or non-insurance).
  4. Marketable securities can be purchased.
  5. Cash can be returned to shareholders via dividends, repurchases, or both.

If none of the options listed above are taken, cash will continue to build up on the balance sheet over time.  Historically, shareholders have been content to see Berkshire’s cash balance build up since this has provided Mr. Buffett with “ammunition” to opportunistically deploy when the right opportunity presents itself.  Cash flow generated in a given year need not be deployed within the same year but could instead collect on the balance sheet awaiting the emergence of a huge “elephant” sized acquisition that will consume the free cash flow generated over multiple years.  However, until an attractive “elephant” emerges, large amounts of cash on the balance sheet will dampen Berkshire’s overall return on equity and depress the growth of book value per share.

The exhibit below gives a sense of the scale of Berkshire’s “high class problem”.  We can see that retained earnings have ballooned over time.  Berkshire’s retained earnings account stood at $47.7 billion at the end of 2005 and grew to $187.7 billion at the end of 2015.  Another way of looking at this statistic is to note that nearly 75 percent of all earnings Berkshire has retained throughout its long history have come from earnings over the past decade and over 47 percent have been earned over just the past five years.

Berkshire's Shareholders' Equity 1994-2015

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

Is it possible for Berkshire to redeploy over $400 billion within its existing businesses, through acquisitions, or toward marketable securities over the next decade?  Even allowing for the fact that the assumptions made here are necessarily imprecise, it is clear that the capital allocation task at hand over the next ten years will be far more difficult than it has been over the past decade.  Very few publicly traded companies are large enough for Berkshire to purchase a meaningful stake in the stock market.  While there are many companies in the $5-20 billion range that Berkshire states is its preferred acquisition target size, it is likely that much larger acquisitions will be necessary to fully allocate Berkshire’s cash flow in the future.

There is no doubt that Berkshire could deploy over $400 billion over the next decade.  There are always deals to be done, at a sufficiently high price.  However, elevated valuations in public and private markets would make it difficult for Berkshire to acquire businesses that offer incremental returns that will make it possible for Berkshire itself to compound book value at 10 percent going forward.  Opportunistic investments could be made during periods of stress in the financial markets, but perhaps not at a size necessary to absorb all of Berkshire’s available cash.

Conclusion

Berkshire’s management will eventually fail to find enough attractive investment opportunities to intelligently deploy all of the company’s free cash flow.  It is obvious that Berkshire will look like a radically different company in 2026 if it is able to find enough reinvestment opportunities to continue compounding book value at approximately 10 percent annually.  Berkshire would have shareholders equity approaching $700 billion and a market capitalization very likely to exceed $1 trillion.  The composition of Berkshire at that point would look nothing like the company we observe today and even less like the Berkshire of ten years ago.

Achieving this outcome would be a remarkable management accomplishment.  Given Mr. Buffett’s history, if he is able to continue running Berkshire for a majority of the next decade, it would be unwise to rule out this rosy outcome.    However, it seems more likely that Berkshire will begin returning cash to shareholders at some point within the next decade even with Mr. Buffett in charge.  If private and public markets for businesses remain elevated, the probability of cash return over the next several years will be very high.  If valuations plummet, cash return is less likely although still possible.

Mr. Buffett has indicated that Berkshire’s board of directors will consider repurchases as a means of returning cash to shareholders.  Repurchases, if made at levels at or below intrinsic value, can be more efficient than dividends because only shareholders who are voluntarily departing will face tax consequences.  If repurchases cannot be made at prices that make sense, cash dividends will have to be initiated and all shareholders would face the tax consequences.

Berkshire’s current repurchase limit of 120 percent of book value would have to be increased substantially in order to make repurchases of any significant size possible.  Since 120 percent of book value is far below any reasonable assessment of Berkshire’s intrinsic value, it follows that Mr. Buffett and the board of directors would have to agree to increase the repurchase limit in order to return material amounts of cash to shareholders.

Up to this point, the goal of repurchases has been to increase the per-share intrinsic value for continuing shareholders so a low limit makes sense.  Berkshire has not been in a position where it had to return capital to shareholders.  Bargain repurchases will always make sense but when Berkshire has no choice but to return capital, it will have to decide between dividends and repurchases.  At that point, even repurchases at intrinsic value would serve continuing shareholders well because it would spare them from undesirable tax consequences.  Whether an increase in the repurchase limit is something under consideration is perhaps one of the most important questions facing Berkshire shareholders today and a topic worthy of discussion at the upcoming annual meeting.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.