A Closer Look at Markel Ventures

Markel Ventures is a wholly owned subsidiary of Markel Corporation focusing on acquiring companies outside the insurance industry.  Starting with the $14 million acquisition of AMF Bakery Systems in 2005, Markel Ventures has grown into an operation that generated over $1 billion in revenue in 2015 which accounted for nearly 20 percent of Markel’s total revenue.  Although the vast majority of Markel Corporation’s value remains tied to its insurance subsidiaries, Markel Ventures has grown to be a more important part of the overall business.

We have covered Markel on a number of occasions in recent months starting with an overview of the company shortly after shares reached $800 in June 2015.  Although the Markel Ventures operation was discussed, the valuation estimate did not explicitly assign any value to the non-insurance subsidiaries, putting forth the following argument:

We choose to mostly disregard Ventures when assessing Markel’s current value and view the operations as providing additional upside potential in the future – perhaps significant upside potential.  In other words, it might be best to demand Markel Ventures for “free”, meaning that one could demand sufficient value from the insurance and investment operations to justify the price paid for the stock without giving consideration to the additional value potential of Ventures.

Shares have recently been climbing toward the $1,000 level which can be partially attributed to the company’s strong insurance results and book value growth in recent quarters.  However, the expansion of the company’s price-to-book ratio implies that market participants are starting to place more value on Markel as a “mini-Berkshire”.  Insisting on valuing Markel based on the insurance operations alone makes the current price appear to be increasingly stretched.  While changing valuation models in response to a run-up in a stock price is potentially hazardous, so is ignoring an important segment of a company and coming to the wrong conclusion regarding whether the shares continue to offer a reasonable value.  It is clearly past due to take a more serious look at the history and current composition of Markel Ventures.

History of Acquisitions

Although Markel Ventures began operations in 2005, the company took a conservative approach in terms of how quickly to build up its portfolio of non-insurance operations.  After the AMF Bakery Systems acquisition in 2005, the company waited until 2008 to add a second business and did not commit significant capital until the economy was in the midst of the severe economic downturn following the financial crisis of 2008.  Markel Ventures was first discussed in the company’s 2009 letter to shareholders.  Management argued that the criteria for acquisitions was essentially the same as the criteria for stock market investments:

Strategically we believe the ongoing development of Markel Ventures will create value for Markel. All of these companies fit our longstanding investment discipline. As is the case in what we seek in our portfolio of publicly traded businesses, these businesses are profitable, with good returns on capital, they are run by management teams with equal measures of talent and integrity, they will use their profits to either grow their existing business or return the cash to Markel and we acquired them at fair prices.

Ventures was expected to provide opportunities for reinvestment of capital within individual units or elsewhere within Markel.  Additionally, management found it attractive to have a source of earnings and cash flow independent from the insurance business which can provide additional flexibility to deploy cash at the holding company level without undue regulatory scrutiny during stock market downturns.

During the early years, Markel provided very limited data regarding the non-insurance subsidiaries.  Although significantly more detail has been provided over the past several years, some estimations were still required when coming up with a picture of the overall acquisition history.  The data in the following exhibit should be considered a good faith estimate rather than a precise accounting of the acquisition history of Markel Ventures (click on the image for full size):

MKL Ventures History

The bakery businesses have been consolidated into the Markel Food Group and links for the websites of the other subsidiaries can be found on Markel’s website.  Many of the businesses are quite interesting to read about but to keep this article to a reasonable length, we will refer the reader to Markel’s website for further information and proceed to a relatively high level look at the overall Markel Ventures operation based on consolidated information found in Markel’s financial statements.

Balance Sheet

Since 2012, Markel has provided a balance sheet for the Markel Ventures operations.  This is obviously useful for any evaluation of the unit’s overall economic performance and it also serves as a check on the imprecise accounting of the Ventures acquisitions presented above.  The following exhibit shows the balance sheet data for Markel Ventures for the past four years:

Ventures Balance Sheets

It is important to note that the balance sheets for Markel Ventures are fully consolidated into the balance sheets of Markel Corporation, with certain intra-company items eliminated in consolidation.  Although Markel Ventures utilizes debt, we should note that at December 31, 2015, $216.9 million of the $322.4 million of debt was due to other subsidiaries of Markel Corporation and eliminated in consolidation.  Markel Corporation has predominantly funded Markel Ventures using equity, thereby redeploying funds that it generated through the insurance operations over the years.

The non-controlling interests on the balance sheet arise from the fact that Markel Ventures often acquires a majority stake in a company that falls short of complete ownership.  In many cases, the remaining shares of the company are acquired subsequent to the initial transaction at prices that vary with the post-acquisition performance of the unit.  We can see that total capital employed of approximately $900 million is roughly in line with our estimate of the cash Markel Ventures has deployed over the past decade.  Earnings of ventures subsidiaries that are retained within the Markel Ventures organization would increase equity over time.  However, the balance sheets we have access to do not provide enough granularity to isolate changes in equity due to earnings retention versus new investment.

Operating Results

Over the past five years, revenue from Markel Ventures operations has increased rapidly due to the number of new acquisitions that have been made.  The company separates Markel Ventures revenue into manufacturing and non-manufacturing segments.  The exhibit below displays income statement data for the past five years:

Markel Ventures Income Statements

At a surface level, these results are not exactly inspiring to look at.  The overall operating margin has been in the mid-single digits over the past couple of years and net income has been modest relative to the investments made in Markel Ventures to date.  However, for a number of reasons, reported net income is not a particularly good measure of how the businesses have performed to date.  The reader should be very skeptical of this claim since specious “adjustments” to earnings have proliferated like wildfire in recent years.  EBITDA, Adjusted EBITDA, and even more creative measures are usually designed to obfuscate rather than enlighten.

Markel management does provide EBITDA information for Markel Ventures with the rationale explained in detail on pages six to eight of  the 2010 letter to shareholders.  Readers are encouraged to review this information and come to their own conclusions regarding the usefulness of EBITDA when it comes to evaluating Markel Ventures.  From our perspective, the primary use of EBITDA is to evaluate the performance of the business relative to capital employed in a manner that is independent of capital structure and tax policy.  The exhibit below shows the EBITDA information reported by Markel over the past seven years:

Markel Ventures EBITDA

The use of EBITDA, although warranted with the caveats explained by Markel’s management, seems a rather crude measure particularly because depreciation is a very real expense that must be taken into account.  Certain Markel Ventures subsidiaries are more capital intensive than others but we can see that depreciation has become a rather meaningful line item.

We prefer to look at Markel Ventures by starting with the net income line item and then making adjustments that seem appropriate in an effort to understand the true economic earnings of the group of businesses.  There are three major adjustments we have made:

  • Diamond Healthcare Goodwill Impairments.  Over the past two years, there have been goodwill impairments taken to write down the value of Diamond Healthcare.  Although these charges indicate that management may have made errors when deciding how much to pay for Diamond to begin with, they are non-cash charges that obscure the current earnings power of the group as a whole.
  • Cottrell Earn-Out Adjustment.  In 2015, there was a significant charge recorded to account for an increase in the expectation of “earn-outs” to be paid to the former owners of Cottrell.  At the time the Cottrell acquisition was made in 2014, a portion of the amount to be paid to the owners was based on the performance of the business in 2014 and 2015 subsequent to the close of the acquisition.  Markel’s management made an estimate of the amount of this “earn-out” based on their expectation of how Cottrell would perform.  It turned out that Cottrell performed better than anticipated.  As a result, the additional amount owed to the former owners was charged as an “expense” in 2015.  This charge is better looked at as an increase in the purchase price of Cottrell and should logically be attributed to a capital account rather than an expense account.
  • Amortization.  Accounting rules require management to amortize intangible assets over a period of time by recording charges against earnings.  In the 2010 letter to shareholders, management argues that this is not a real economic cost because the value of intangibles should actually be increasing over time rather than shrinking, assuming that intelligent acquisitions were being made and properly managed.  This viewpoint has merit but, in the interests of conservatism, we consider 20 percent of amortization charges to be “real” and 80 percent to be “non-economic”.  Warren Buffett has estimated the non-economic percentage of Berkshire Hathaway’s manufacturing, service, and retail amortization charge to be 80 percent.  While the mix of businesses are obviously different, using the 80 percent approach rather than assuming all amortization is non-economic seems like a conservative adjustment to make.

The exhibit below shows our estimate of “economic earnings” for Markel Ventures based on making the adjustments discussed above and accounting for tax effects.  Note that the tax effect line item may be overstated if amortization and/or goodwill impairments are not deductible for income tax purposes.  However, sufficient information does not appear to exist to make this determination so the adjustment is made in the interests of conservatism.

Markel Ventures Economic Earnings

If the estimate of economic earnings is in the ballpark and recent trends continue, it looks like the ventures operations, in aggregate, are earning around 10 percent on equity.  Obviously, this adjusted figure is far different from the return on equity one would calculate based on reported net income.  However, the adjustments seem quite defensible based on the arguments presented above.

Markel recently reported results for the first quarter of 2016.  Markel Ventures EBITDA was $41.1 million, up from $33.6 million in the first quarter of 2015.  Net income to shareholders was $14.1 million, up from $10.5 million.  Management reported that the increases were primarily due to higher earnings at certain manufacturing operations as well as due to the CapTech acquisition in December 2015.

Valuation

The valuation approach presented in June 2015 explicitly did not account for any value associated with the Markel Ventures operations.  As noted earlier, the assumption was that any value that existed in the ventures operation would be an additional “margin of safety” for investors or could be viewed as a bonus.

Although the vast majority of Markel’s intrinsic value still resides in the insurance business, Markel Ventures has been growing to the point where it should be explicitly considered in the valuation process.  There are a number of approaches that could be used to incorporate Markel Ventures.  The methodology we have chosen, which clearly is not the only “valid” approach, is to segment the insurance and ventures operations as if they were two separate companies.  We estimate the value of each unit and then come up with a sum of the parts to arrive at the total valuation for Markel Corporation.

The valuation of the insurance business is essentially identical to the approach presented in June 2015, except that we have deducted equity attributable to the ventures operations from the estimate of insurance equity.  We assume that Markel posts a 100 percent combined ratio over the next five years and deploys its investments at various rates of return.  We then come up with a terminal price-to-book value for the insurance business only to estimate the market’s assessment of the business in five years.  This valuation is then discounted to estimate today’s present value of the insurance subsidiaries.

The Markel Ventures valuation model simply estimates 2016 “economic earnings” and applies an earnings multiple ranging from 16 to 20 to arrive at an estimate of current intrinsic value.  One can debate both the estimate of economic earnings and the multiple selected but a good “reality check” is that the estimated valuation falls within a plausible range given the cash that Markel has invested into these businesses over the past decade.

The exhibit below presents the valuation exercise for Markel Corporation as described above:

Markel Valuation

The overall valuation of Markel Corporation is simply the sum of the parts divided by shares outstanding at March 31, 2016.  Taking the base case estimate, we arrive at a valuation of $909 per share, with $825 per share attributed to insurance operations and $84 per share attributed to Markel Ventures.  Although this baseline estimate is materially higher than what we would estimate if Markel Ventures were totally ignored, it is still substantially below where Markel has traded recently.

Markel has a very strong track record, as we have pointed out in past articles, and the current share price might very well prove to be justified based on future events.  Nevertheless, it is always prudent to estimate the value of a business based on sound principles that are not subject to changes designed to “justify” a recent price advance.  At the same time, valuation methodologies cannot remain so fixed as to fail to respond to material changes in the underlying business. Markel Ventures has clearly reached the point where shareholders must estimate its value in some manner.  The method above is one of many ways to do so.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel Corporation.

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

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.