- BRK’s companies aren’t reliant on Buffett when it comes to their performance.
- Buffett leaving leads to two uncertainties, but the outcome of both are positive.
- The power of BRK lies in the quality of its businesses and huge cash pile. At this point, even an idiot at the helm of BRK would do well.
To keep our karma positive, I’ll write this article under the assumption that Buffett gets an offer from Bill Gates to be the project manager of Microsoft’s (NASDAQ: MSFT) new multi-billion virtual reality Bridge game project. I think something like this could make Buffett leave BRK as I wish him many more decades of health.
The reason why the question about what will happen to BRK after Buffett is raised so often is because of something financial markets hate, and that is uncertainty. Even if the potential outcomes are mostly positive, uncertainty is something that investors don’t like. However, this creates mis-pricing and excellent investing opportunities.
In order to see what could possibly happen to BRK after Buffett, it’s necessary to analyze BRK’s businesses, compare them to their specific sectors, and see whether or how big Buffett’s impact is on their results. What’s also important is to check ownership structure to see who will make the actual decisions after Buffett is no longer there.
I’ll also analyze what would be different for BRK if the new management decides to pay out a dividend.
I wasn’t able to find a concise analysis about what could happen to BRK after Buffett as most analyses focus just on what Buffett has said, so I am very excited to share my analysis with you.
As you probably know, BRK is a conglomerate made up of many different businesses. However, there are some that are more significant, so I’ll look at the specific businesses to see whether they will perform equally well if Buffett goes to work for Microsoft.
Figure 1: BRK’s earnings distribution. Source: BRK.
The question is: does Buffett give any additional value to his companies or are their businesses are pretty sustainable by themselves? A revenue comparison between BNSF and Union Pacific (NYSE: UNP) will give us the answer.
Figure 2: BNSF’s (blue) revenue is perfectly correlated to UNP (yellow). Source: Bloomberg.
The CAPEX spend is also similar between UNP and BNSF.
Figure 3: CAPEX spend for railroads. Source: Bloomberg.
So Buffett’s major contribution to the story is that he was patient to buy BNSF in an economic downturn. Since then, BNSF has returned more than $22 billion to BRK which is an excellent return given the fact that Buffett paid $35 billion back in 2010. Given all this, Buffett’s impact on current businesses isn’t all that relevant. It’s his capital allocation that adds value.
The second largest chunk of BRK’s profit comes from utilities, thus from Berkshire Hathaway Energy (BHE). The best way to see whether Buffett used some direct guru magic touch on earnings is to compare BHE’s earnings with those of other similar operators.
Figure 4: BHE’s revenue and earnings. Source: BRK.
The net after tax margin after accounting for non-controlling interests was 10.6% in 2014, 11.6% in 2015, and 12.8% in 2016. A quick look at competitors’ net margins show that Consolidate Edison (NYSE: ED) had a net margin of 10.8% in 2016, DTE Energy (NYSE: DTE) had a net margin of 9% in 2016, while Duke Energy (NYSE: DUK) had a net profit margin of 9.4%.
The difference in margins comes from the fact that BHE is better capitalized as it retains most of its earnings and doesn’t have to pay a dividend, and is therefore able to reinvest. All of its competitors have significant dividends that increase their interest costs over time and lower their margins. Average percentage of assets financed by debt is around 70% for most of the companies, while it’s only 32% for BHE.
Figure 5: Retained earnings are behind the power of Berkshire Hathaway Energy. Source: BHE.
So the strength and growth of BHE lies in a particular characteristic of BRK which is that if the return on capital is satisfying, it’s better not to pay dividends. With net margins around 10% in the industry after accounting for taxes and interest costs, it’s logical why Buffett and BRK continue to invest in the business by retaining earnings.
Will this change when Buffett leaves? We’ll know the answer to that only when it actually happens, but the only difference would be higher dividends and even more cash for BRK if the new management chooses to pay out retained energy earnings.
The third most significant part of BRK is insurance. However, the story here is again not so much related to Buffett as to Ajit Jain, the man that built BRK’s reinsurance business into one of BRK’s most important operations.
To quote Buffett: “Ajit has probably made a lot more money for Berkshire Hathaway than I have.”
Figure 6: Ajit Jain, the head of BRK’s reinsurance business. Source: The Economic Times.
In addition to the areas of BRK that we have already discussed, there are many other businesses under BRK’s hat.
Figure 7: BRK’s subsidiaries. Source: BRK.
All the above companies were functioning pretty well before BRK got them and thus there is a high probability that they will continue to operate equally if Buffett chooses to take another career path. Thus, the only potential issue that could arise when and if Buffett leaves is future capital allocation. However, there are some pretty strong guidelines that will make the job much easier for the successor.
Figure 8: BRK’s acquisition criteria. Source: BRK.
Additionally, there is another thing that will make things easier for Buffett’s successor. It has been stated publicly by both Buffett and Munger that the aimed return on investment isn’t 20% anymore, but around 10% in the long term, depending on potential growth. This is due to BRK’s size. Store Capital (NYSE: STOR) is a perfect example of such a capital allocation strategy with a lower required return. You can read our article on STOR, and why Buffett bought it, here.
So the task on the shoulders of the person who takes over the helm at BRK isn’t as heavy as it has been for Buffett over the past 53 years, or thus since present management took over.
Ownership & Dividend
As the above is pretty clear, the next most often mentioned uncertainty is if the new management will start paying out a dividend, which isn’t in line with the value creation process explained above. I’ll first look at the ownership structure to see how easy it would be for the owners to vote on a dividend payout.
BRK has two classes of shares, Class B and Class A. Each Class A common share is entitled to one vote per share. Class B common stock possesses dividend and distribution rights equal to one-fifteen-hundredth (1/1,500) of such rights of Class A common stock. Each Class B common share possesses voting rights equivalent to one-ten-thousandth (1/10,000) of the voting rights of a Class A share.
Figure 9: BRK.A and BRK.B difference. Source: BRK.
Thanks to the above difference in the voting structure, Buffett’s 18% stake in BRK allows him 32% of voting rights. Therefore, only an additional 18% of voting rights have to agree with whomever Buffett chooses to vote in his place. Given the loyalty many shareholders show at BRK’s annual shareholder meetings, I find it rather difficult to think that the shareholder long-term value creation policies will change in the future.
However, just for the sake of this article, let’s imagine BRK starts to pay out a dividend and do buybacks as most other S&P 500 companies do.
Dividend & Buybacks
The average S&P 500 company distributes about 100% of earnings to shareholders and is therefore valued with a P/E ratio of around 25 alongside a dividend yield of 2%.
BRK’s net trailing income is $22.5 billion. With 1.644 million shares outstanding (adjusted for A and B) and a market capitalization of $422.3 billion, BRK would need $8.4 billion to pay out a dividend equal to the S&P 500. So, just the cash on BRK’s balance sheet would be enough for BRK to pay out a dividend for the next 11 years.
If BRK spends the remaining available earnings on buybacks, it would have $14.1 billion with which to do so, thus 3.3% of the company. If this happens, BRK would see a significant rise in its stock price as the company would buyback more than 33% of itself over 10 years.
The answer to the question of what will happen to BRK after Buffett is pretty simple, either the company continues to do what it has been doing successfully over the last 52 years, or it changes course and starts doing what all others do.
The first scenario would continue to reward current shareholders who probably own BRK for the long-term shareholder value creation it offers. If dividend and buyback policies change, then BRK’s stock price would go much higher and shareholders who are in it for the long-term value creation would be allowed to exit at a significant premium.
So there is certainly uncertainty about what is going to happen to BRK after Buffett, but the uncertainty is between two positive scenarios for current shareholders. Thus it’s a win-win situation and fears about what is going to happen after Buffett are unfounded.
To finish by quoting Buffett: “If I die tonight, I think the stock would go up tomorrow.”
Figure 10: Buffett on what will happen to BRK. Source: Bloomberg.