Charlie Munger’s annual letter to shareholders of Wesco Financial Corporation was published last week. Wesco Financial is a publicly traded company that is 80 percent owned by Berkshire Hathaway. Charlie Munger is Berkshire Hathaway’s longtime Vice Chairman and also serves as Chairman and President of Wesco Financial. Mr. Munger’s annual letter does not attract nearly as much attention as Warren Buffett’s letter to Berkshire shareholders (discussed last month) but nonetheless provides notable insights worthy of extended discussion.
Overview
Mr. Munger makes reference to Wesco’s 10-K report which was released in early March and should be reviewed in conjunction with the financial information provided in the letter. Wesco reported operating income of $54.1 million for 2009 which is down from $77.6 million in the prior year. While insurance underwriting produced a $7.2 million profit for 2009 compared to a $2.9 million loss in the prior year, investment income dropped to $55.8 million compared to $64.3 million in 2008.
In Wesco’s non-insurance operations, CORT’s business has been “melting away” faster than management can fix it as demonstrated by a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008. Precision Steel produced a $648,000 loss in 2009 compared to a $842,000 profit in 2008 as its business was “pounded by the Great Recession”. Another factor leading to lower reported results for 2009 was a $6.2 million after-tax write down of the carrying value of a condominium development that was completed on land adjacent to Wesco’s headquarters in Pasadena.
Insurance
Wesco engages in the reinsurance business through its Wes-FIC subsidiary and provides various types of insurance coverage to the banking industry through its Kansas Bankers subsidiary.
Since the beginning of 2008, Wes-FIC’s business has been dominated by Wesco’s participation in Berkshire Hathaway’s reinsurance contract with Swiss Re. Wes-FIC has assumed 10 percent of Berkshire’s 20 percent quota-share reinsurance of Swiss Re which means that Wes-FIC has assumed 2 percent of essentially all of Swiss Re’s property-casualty risks incepting over the five year period starting on January 1, 2008. This business accounted for the vast majority of earned premiums in 2009 and generated $10.4 million in underwriting profits. In addition to Wes-FIC’s participation in the Swiss Re contract, the business is exposed to various risks associated with the aviation industry.
Kansas Bankers Surety Company is engaged in providing various types of insurance coverage to the banking industry. As we discussed last year, Kansas Bankers made a decision to exit the deposit guarantee bond business and this process continued in 2009. As a result of shrinking the deposit guarantee bond business, Kansas Bankers experienced a significant decline in earned premiums and posted a $3.2 million underwriting loss for the year. Mr. Munger reports that the aggregate face value of outstanding deposit guarantee bonds has declined to $33 million insuring ten institutions which is down sharply from $9.7 billion insuring 1,671 institutions when the exit from this line of business commenced in 2008.
We continue to note that management’s actions have demonstrated an unusual level of underwriting discipline by rejecting risks that are perceived as inadequately priced even at the expense of a painful reduction in premium volume and near term underwriting losses as overhead expenses failed to shrink in line with earned premiums. This is the type of underwriting discipline that we discuss extensively in our 2010 Berkshire Hathaway Briefing Book and has led to sustained levels of underwriting profitability at National Indemnity and other Berkshire insurance operations over very long periods of time. There are few businesses that are willing to voluntarily shrink in the short run in order to preserve capital required for opportunities in the future which is one reason many insurers fail to achieve underwriting profits in the long run.
CORT Gets “Hammered”
Mr. Munger pulls no punches when discussing the poor performance at CORT which posted a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008. While CORT’s revenues only declined to $380 million in 2009 compared to $410 million in 2008, the revenue decline was much more severe when one excludes the impact of acquisitions. On a “core revenues” basis, CORT experienced nearly a 20 percent decline in 2009. Mr. Munger expects “disappointing profits” for 2009:
Under Wesco’s ownership, CORT has continuously undertaken to improve its competitive position. With several websites, principally, www.cort.com and www.apartmentsearch. com, professionals in more than 80 domestic metropolitan markets, affiliates servicing more than 50 countries, almost twenty-one thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT is better positioned than previously to benefit from an economic turnaround if it occurs in due course. Near term, we expect more of the difficult business conditions of the recent past, but we do not expect another operating loss at CORT in 2010. Instead, we expect disappointing profits.
Precision Steel Gets “Pounded”
Precision Steel experienced a significant decline in revenues with $38.4 million for 2009 compared to $60.9 million for 2008. In terms of pounds sold, Precision Steel is only shipping half the annual volume compared to the number of pounds shipped thirty years ago when the company was acquired by Wesco. The main factor responsible for this downturn is that Precision Steel’s traditional customers have been moving production outside the United States and management has been unable to compensate for these competitive losses as well as for the impact of the recession:
Apart from the recessionary-caused weakness, the general and ongoing decline in Precision Steel’s physical volume is a serious reverse, not likely to disappear in some “bounce back” effect once the economy recovers.
Straight Talk
Although Mr. Munger’s letter cannot be characterized as upbeat, it is notably more positive than last year’s letter when he referred to the economy as being in the midst of “the worst economic disaster since the Great Depression.” But at a more general level, it is hard to not appreciate Mr. Munger’s willingness to deliver bad news to shareholders in a direct and candid way. For every CEO who is willing to do this, there are dozens who prefer to invent reasons and explanations that strain credulity and attempt to shift blame to others. For another example of a straight forward document that delivers the required information in a candid manner, please read Wesco Financial’s 2010 Proxy Statement which was also released late last week.
Disclosure: The author does not directly own shares of Wesco Financial. The author owns shares of Berkshire Hathaway, 80 percent owner of Wesco, and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.