Berkshire looking attractive

Someone e-mailed me an article from Barrons:

With cash pouring in, Warren Buffett's Berkshire Hathaway may do something big this year -- maybe even pay a dividend.


A flush Berkshire Hathaway is in its best shape ever and piling up cash so quickly that it could be sitting on close to $50 billion at its core insurance operation alone by year end, and might even begin paying a dividend. Berkshire's profit recovery, aided by some smart acquisitions and investments by CEO Warren Buffett -- notably its purchase of the Burlington Northern railroad -- has gone largely unrecognized on Wall Street, where Berkshire's Class A shares BRKA, now trading around $121,000, haven't budged in nearly a year. Berkshire's Class B shares (BRKB) trade around $81; each equals 1/1500th of a Class A share.

Berkshire's operating profits are on track to hit a record $12 billion to $13 billion after taxes in 2011, up from an estimated $11 billion in 2010, buoyed by Burlington and many of the company's manufacturing and industrial units, whose earnings fell sharply during the downturn.

Combine that with the likely repayment of some lucrative investments in Goldman Sachs (GS), General Electric (GE) and other companies that Buffett made during the financial crisis, and Berkshire's insurance units could be holding $20 billion more by year end than the $30 billion they had on Sept. 30, 2010. (We focus on cash at Berkshire's insurance operations and not in other divisions because insurance cash is readily available for investment. Other units held about $3 billion in cash.) Berkshire's market value is $200 billion, fifth-largest in the U.S. stock market, behind only ExxonMobil (XOM), Apple (AAPL), Microsoft (MSFT) and Google (GOOG).

The flood of cash could prompt Berkshire to finally start paying a cash dividend in the next 12 to 18 months, particularly if the 80-year-old Buffett is unable to find what he calls an "elephant," or a large acquisition. Locating one could prove difficult, given rising asset and equity values, as well as Buffett's refusal to participate in corporate auctions. Buffett, who declined to comment to Barron's, also hasn't been thrilled by the stock or bond market in the past year, when Berkshire has been a net seller of stocks.

Buffett's fans think Berkshire shares look appealing, trading for a reasonable 1.3 times estimated year-end 2010 book value of $95,000 apiece, and that the stock could surpass its 2007 record of $149,000 within the next 12 months. Book value, or shareholder equity per share, may hit $105,000 by the end of this year, assuming a decent performance by Berkshire's famed equity portfolio, which was an estimated total of $62 billion at year-end 2010. Thus, the shares trade for just 1.15 times projected year-end 2011 book, providing significant downside support.

LONGTIME BERKSHIRE INVESTOR Whitney Tilson of T2 Partners pegs Berkshire's "intrinsic value" around $160,000 a share and sees it surpassing $170,000 by year end. To reach that lofty level, the stock would have to shake off investor concerns about Buffett's longevity and about Berkshire's sheer size. Intrinsic value is the discounted cash flow of Berkshire businesses.

Buffett is in good health, but he may not run Berkshire for much more than another five years -- his actuarial life expectancy is eight years. He probably will keep at it for as long as he can because he loves his job, saying he "tap-dances" to work each day in Omaha and would pay to do it. His pay remains restrained at just $175,000 a year, although his 23% stake in Berkshire is valued at $46 billion. He continues to donate stock annually to the foundation run by Bill and Melinda Gates. Berkshire is due to report its fourth-quarter results in late February.

Wall Street is lukewarm on Berkshire; no analyst has a Buy recommendation on it.

David Rolfe, chief investment officer with Wedgewood Partners in St. Louis, the manager of the new Riverpark/Wedgewood mutual fund, considers that a mistake. "Berkshire's earnings are booming, and the Burlington acquisition looks like a masterstroke, yet the market doesn't give a whit about it," he says. Rolfe sees the stock topping $140,000 this year.

As its adherents regularly note, Berkshire is no longer the insurance and investment outfit it was up until the late 1990s. Insurance and investment income now account for less than half its profit.

Over the years, Berkshire often has traded markedly above its book value, getting a premium for Buffett's incomparable investment skills. The stock has averaged 1.6 times book value in the past 10 years. That premium has melted in recent years, partly reflecting Buffett's advancing age. In fact, Rolfe argues, "There's no Buffett premium in the stock now."

It's true Buffett's successors will face big challenges, both in making investments and in retaining and motivating the managers of the more than 80 businesses under the Berkshire umbrella.

The good news is that they will be sitting astride a cash-spewing conglomerate with annual revenue exceeding $135 billion and some top-notch businesses, including Burlington Northern; Geico, the No 3 U.S. auto insurer; and MidAmerican Energy, a utility conglomerate that owns U.S. and U.K. electric companies and two natural-gas pipelines.

Geico and MidAmerican could each be worth more than $15 billion.

Berkshire's insurance operations also include General Re, a large reinsurer, and the specialty-reinsurance unit run by underwriting genius Ajit Jain. It has made billions for Berkshire over the years by shrewdly handling big-ticket risks like potential damage from hurricanes and earthquakes. (It did, however, suffer losses from BP's Deepwater Horizon disaster in the Gulf of Mexico.)

Berkshire also houses a grab bag of other businesses, including Benjamin Moore, Dairy Queen, Fruit of the Loom and See's Candies.

BUFFETT'S STRATEGY of steadily adding unrelated businesses runs counter to the trend in Corporate America, where companies such as Fortune Brands (FO), ITT (ITT, see Follow-Up), Wendy's/Arby's (WEN) and others are breaking apart to form more manageable businesses and eliminate "conglomerate discounts." Many investors like focused companies. Buffett doesn't buy that idea.

Then there is Berkshire's hands-off approach, with "minimal involvement" by Buffett and Berkshire's tiny corporate staff in the day-to-day activities of its businesses.

Operating units are unfettered by the head office, but this can also let problems fester before they get Buffett's attention. For example, Berkshire's NetJets unit, the leading purveyor of fractional ownership of private jets, overexpanded during the boom years of 2006 to 2008 and got stung when the recession hit, resulting in losses of $711 million in 2009. NetJets was subsequently slimmed down under the leadership of David Sokol, MidAmerican's chairman. It earned $158 million before taxes in 2010's first nine months.

For years, we've speculated Sokol will succeed Buffett as CEO, and he's now the consensus pick. It's less clear who will run Berkshire's investments after Buffett's departure, but one clear possibility is Todd Combs, the little-known money manager that Buffett brought on board last year.

The reality is that the investment role probably won't be so important post-Buffett because some of Berkshire's largest equity holdings -- Coca-Cola (KO), American Express (AXP), Wells Fargo (WFC) and Procter & Gamble (PG) -- are unlikely to be touched, owing in part to large embedded gains. That will leave the chief investment officer with the job of investing the part of Berkshire's annual cash flow that isn't going toward acquisitions and a likely dividend.

Our guess is that the stock will fall 10% whenever Buffett steps down. But it could appreciate substantially before then and resume its ascent in the post-Buffett era, as book value grows and Wall Street gets comfortable with his successors.

The Burlington deal looks like one of Buffett's best, done in November 2009, when the economy was just starting to recover and there was little competition from private-equity or other buyers. Berkshire offered a 33% premium, paying $26.4 billion for the 77.4% of the company that it didn't already own. That initially looked overly generous, at about 20 times then-current estimates of 2010 profits. Yet Burlington's earnings -- and those of the rest of the railroad industry -- surged in 2010 and are expected to increase another 15% or so this year. Burlington could earn $3 billion after taxes in 2011 -- it netted $706 million in the third quarter. So, Berkshire paid only about 11 times projected 2011 profits for Burlington. Burlington probably is worth $40 billion to $45 billion now.

BUFFETT ALSO SCORED with roughly $50 billion of investments made during the 2008-2009 financial crisis. Some are likely to be repaid this year, including $5 billion of 10% preferred stock from Goldman Sachs and $3 billion of 10% preferred from GE. Both companies will pay a 10% premium to get rid of the high-cost preferred. In addition, Berkshire got equity warrants on both stocks. Those on Goldman are worth $2 billion now. Swiss Re, a European reinsurer, just repaid $4 billion to Berkshire from a very lucrative investment by Buffett. These repayments will swell Berkshire's coffers.

Berkshire also holds $7.5 billion of junk debt and preferred issued by Wrigley in connection with the gum maker's purchase by privately held candy giant Mars in 2008. Berkshire's investment income probably will decline because of the investment repayments, but that could be partly offset by higher dividend income on its equity portfolio.

Buffett hasn't paid a dividend on Berkshire shares since he took control in 1965, preferring to invest the company's profits. That's been the right move, given the 6,000-fold increase in Berkshire's stock since then. Buffett's aversion to dividends could change if cash continues to build and he can't find a big acquisition. A dividend also could take some pressure off his successors to invest the company's profits.

Berkshire's initial dividend, whenever it comes, is expected to be modest, at 2% or less.

INVESTORS GENERALLY TAKE a long view and don't pay much attention to Berkshire's quarterly results, but T2's Tilson has said a strong fourth-quarter earnings report next month could act as a catalyst by highlighting the company's earnings power. Tilson called it the "mother of all earnings reports" in a note to MarketWatch, which, like Barron's, is published by Dow Jones.

Profits this year could run at $7,500 to $8,000 per share -- or $12 billion to $13 billion -- up from an estimated $6,700 in 2010. Berkshire trades for about 15 times forward earnings, in line with the Standard & Poor's 500, which is valued at 14 times projected 2011 net. It's rare for Berkshire to trade near a market multiple rather than at a big premium.

Barclays analyst Jay Gelb sees Berkshire's fourth-quarter profit rising 43%, to almost $1,800 per Class A share, boosted by strong gains in manufacturing, Burlington Northern and other divisions. Nonetheless, he carries a Neutral rating on the stock.

One reason for Wall Street's attitude toward the stock: The analysts who cover Berkshire tend to be insurance specialists, and this may color their thinking. That's because conditions in the property-casualty insurance market are tough, with pricing in many segments under pressure.

With little revenue growth and soft pricing, most P&C insurers and reinsurers -- including Travelers (TRV), Chubb (CB) and Ace (ACE) -- trade close to book value. To some P&C analysts, Berkshire therefore looks unexceptional at 1.3 times book.

Yet insurance underwriting is a relatively small part of the company, and Berkshire is on a roll, led by a CEO still at the top of his game. That's why its stock could hit an all-time high this year.