Berkshire Hathaway: Warren Buffett Has Work With GEICO, BNSF, And Especially BHE
“Who is John Galt?” – the first line of Ayn Rand’s influential cultish novel Atlas Shrugged
The 2023 Shareholder Letter accompanying Berkshire Hathaway’s (NYSE:BRK.A)(NYSE:BRK.B) Annual Report needs to be read at least twice. It starts with a thoughtful homage to his close friend Charlie Munger, to whom he gives credit as the architect of Berkshire Hathaway, then goes on to the major business of summarizing the present and future of Berkshire written as if to explain things to his younger sister Bertie, who has, of course, done well in Berkshire stock. Bertie is a good proxy for the typical Berkshire shareholders, as she is highly intelligent if largely innocent as to finance and the detailed workings of Berkshire. Overall, it’s an optimistic letter, at least on the surface, assuring “Bertie” that everything at Berk is under control and the company is virtually assured of doing well for many years into the future.
A second reading of the Shareholder Letter with pauses to read a few sections two or three times is much less sanguine. At least three of Berkshire’s major businesses require some attention from Buffett himself: GEICO, BNSF, and Berkshire Hathaway Energy. The need to solve problems in these units is heightened by the fact it’s a time when other major assets are unlikely to provide leadership for reasons beyond the control of Buffett and Berkshire. As Buffett explained in the Letter, it’s not currently a good moment to be hunting for assets to buy which would be transformative at a company as large as Berkshire. He sees none on the market. Much of the problem derives from Berkshire’s past success, which has made it become so large that it takes a giant acquisition to “move the needle.”
Lurking in the background, there is a previously unasked question concerning the investment model of buying capital-intensive highly-regulated businesses such as railroads and particularly utilities. With the exception of Apple (AAPL), these businesses have constituted most of the acquisitions which “moved the needle” over the past two and a half decades. Stated briefly, the question is whether Berkshire should trust the implied “guarantee” from regulatory entities that they will fulfill their side of the bargain by delivering the due reward for Berkshire Hathaway Energy’s huge effort and expenditures on infrastructure.
You can be fairly sure that this kind of troubleshooting is one of WEB’s least favorite activities. He has often stated that one of his qualifications for a potential acquisition is that it have a good management already in place because Berkshire is unable to provide one. That comes with Berkshire’s extreme decentralization, in which its various units run themselves while sending cash back to Omaha where Buffett manages asset allocation. That’s clearly Buffett’s preferred design, but it cannot escape the occasional need for the CEO to step up and deal in a hands-on way with a problem in one of the operating businesses.
At times Buffett has done the job himself, as in 1991 when he assumed control to rescue Salomon Brothers (in which Berkshire had a 12% interest) from the risk of bankruptcy when it was threatened with being disqualified as a primary Treasury dealer. He has also at times used a designated troubleshooter as in 2011 when he appointed his then-presumed successor David Sokol to fix the problems at Berkshire subsidiary NetJets. The simplest of the three current problems, GEICO, may or may not be halfway to a needed fix under the focused guidance of overall insurance leader Ajit Jain who runs the insurance side of Berkshire.
Has GEICO Been Completely And Permanently Fixed?
GEICO, initially Government Employees Insurance Company with clients who were mostly federal employees and military, has swung to extremes despite major growth periods which made Buffett call it his “favorite child”. One might argue that it was a spoiled child because from the beginning its clientele were a selected population who generally were highly responsible and had good habits so that they had far fewer vehicle accidents than the general population. A little known fact which I wrote about here, is that legendary value investor and Buffett mentor Ben Graham drew the larger part of his long-term performance from a large GEICO position originally purchased in 1948 for $712,500 and sold 25 years later for $400 million, making it a 500 bagger.
Ultimately, GEICO, the favorite child, became the “spoiled child” making the mistake of trying to grow faster by writing insurance outside of its specialty using the tagline “many more qualified” to go for “growth, growth, growth.” (These and quotes to follow are sourced from Alice Schroeder’s biography of Buffett The Snowball, pp 430 ff.) The stock price ultimately fell from $62 per share to $2. “I looked again at GEICO and was startled by a few rule of thumb calculations about loss reserves,” Buffett said at the time. “It was clear in a sixty-second examination that the company was far under-reserved and the situation was getting worse.” The inflation roaring at the time didn’t help. Several board members had lost their personal fortunes in the debacle, the son of the founder died by a drug overdose (a presumed suicide), and previous management was thrown out. What fixed it starting in 1976 was an emergency rate increase, some help from regulators fearing a systemic disaster, and a drastic reining in of costs. Buffett snapped up GEICO stock during the crisis and bought the remaining part of GEICO for cash in 1996.
The unfolding of a crisis at GEICO in 2021/2022 has some marked similarities to the crisis in 1976. GEICO had been gradually losing ground to Progressive (PGR) thanks to the head start PGR had with pricing which used telematics to model driver behavior, but the crisis did not become obvious until its combined ratio jumped from 96.7 in 2021 to 104.8 in 2022 (numbers under 100 meaning more money came in via new premiums than went out with payments). This produced a $1.9 billion underwriting loss. It was in part the same problem of poorly selected customers which led to the crisis in 1975/6 but complicated by Progressive’s superior technology and masked at first by the fact that GEICO was reported along with Berkshire’s PC insurance businesses which had only the random occasional bad year. GEICO was not a publicly traded company making regular reports that would set off alarm bells and drive down the stock price as happened in 1976. Here’s what I wrote in a mid-year analysis of Berkshire:
The real question is whether GEICO is in the process of a true turnaround after years of losing market share to Progressive which had a head start in the use of telematics to evaluate driver behavior. A fairly blunt element of GEICO’s response has been sacrificing volume for higher profit margins which you may have noticed in the reduced frequency of its ads. It also was a good year for GEICO thanks to it being a pure vehicle insurance company much less exposed than its competitors to weather catastrophes. It’s important to remember that one year isn’t enough to declare victory.”
Now that we have full-year results for 2023, much of what we see is encouraging, with GEICO having returned to profitability. The combined ratio improved greatly, going from the 104.8 in 2022 to 90.7 in 2023 while it swung from the $1.9B operating loss of 2022 to a $3.6B operating profit for 2023. There were, however, less encouraging numbers to consider as much of the positive result stemmed from cost cutting, especially in the area of advertising, perhaps generating the 9.8% loss of customers, bad customers, perhaps, although a nearly 10% loss of customers is not generally a happy event for a business. It cannot in any case be done repeatedly without giving rise to other problems. This is especially true as its major competitor Progressive was enjoying a 9% increase in policies with a 22% increase in premiums.
Is it too early to proclaim GEICO “fixed”? In this SA News piece, Ajit Jain, who runs all Berkshire’s insurance businesses, suggested that while GEICO has returned to profitability, a return to growth might not occur until 2025. As to the question about the completeness and permanence of the GEICO fix, one can think of the return to profitability in 2023 as Phase One and increasing future volume as a Phase Two yet to unfold. We will know the answer in the fullness of time. Buffett will be happy to leave this in Ajit Jain’s skilled and steady hands.
What’s Up With BNSF?
BNSF had a bad year. There’s no other way to put it. Revenues saw an annual drop of 6.9% while operating earnings fell almost 15% from $5.9 billion to $5.1 billion. It was also a bad year for the other major railroads, although BNSF was the worst performer once again in terms of profit margins. Five numbers flesh out the longer perspective on BNSF. Its purchase price in 2010 was $26.5 billion, and it has spent $22 billion above depreciation on capital improvement since then. That’s a number about which Buffett seems both proud and regretful, having said in the past that maintenance spending should not greatly exceed depreciation. The balance sheet now values BNSF assets at $70 billion. In his shareholder letter discussing Berkshire’s four Family Jewels, Buffett said that BNSF and Apple had roughly the same value, which was then about $144B for Apple. In the 2023 letter, Buffett suggests that the replacement cost of BNSF is about $500 billion.
That last number may reinforce the idea that railroads have an impenetrable moat, but it really says little in terms of future cash flow which will make its way to shareholders. That $500 billion number frames BNSF by its heroic past as if saying that the U.S. military had 10 million human beings in uniform over the course of WWII as it helped liberate the world from Fascism. As for BNSF’s margins, Buffett said this:
Though BNSF carries more freight and spends more on capital expenditures than any of the five other major North American railroads, its profit margins have slipped relative to all five since our purchase. I believe that our vast service territory is second to none and that therefore our margin comparisons can and should improve.
Does this mean that BNSF doesn’t contribute to Berkshire’s future growth? Not at all. It continues to throw off lots of cash, which plays an important role in Berkshire’s growth. The level of revenue and earnings growth in larger railroads is relatively flat and inflation including higher wage costs over the past year probably made its lack of growth look worse than it was. It would be good, nevertheless, to fix the profit margin thing. The major problem is that there is no single and obvious explanation as to why BNSF should have had lower profit margins since its acquisition than its four major competitors. Without a full understanding of that, it’s hard to see a path to fixing it. Figuring out the cause of its persistently trailing profit margins is an essential first step and may require an outside view, at least more outside than those engaged in day to day management.
Buffett himself may be it. He is the closest to a railroad man in Berkshire’s senior management, having had a fascination with trains going back to his childhood. He knows the difficulties of railroad work, which he discusses in the shareholder letter. He can certainly see the way inflation and labor costs expanded the revenue decline and contributed to the steep decline in the bottom line. Making a hard decision on capital expenditures exceeding depreciation by $22 billion falls into CEO territory and is one of the things Buffett has always done well if sometimes reluctantly (a past example: his reluctant decision to stop trying after several efforts to establish See’s Candy on the East Coast where tastes in candy appear to differ from taste on the West Coast). Whether he is the hands-on fixer or has a specific individual in mind, the profit margin thing is very much on his plate.
BHE’s PacifiCorp Raises The Biggest Question
The problems mounting with PacifiCorp raise a question that is larger than PacifiCorp or Berkshire Hathaway Energy as a whole. For several years, BHE has been celebrated as Berkshire’s fastest growing operating business, but now that status has been called into question. PacifiCorp has been blamed and found guilty in Oregon for fires from a windstorm that killed several people and destroyed homes. A few days ago, a second court decision found PacifiCorp guilty, raising to $42 million the current judgments against the company with prospects for ultimate judgments in the billions. Was PacifiCorp correctly held responsible? It’s hard to judge from a distance. What’s clear is that Berkshire Hathaway is a company with deep pockets but very few voters in California or Oregon, while public sentiment is what makes for judges.
There’s a more important question, however, that festers in the background. In his 2020 Shareholder Letter Buffett discussed a massive project begun in 2006 and expected to be complete in 2030, during which time BHE would return no cash to Berkshire headquarters while carrying out the task of connecting power sources to places where power is needed. Here’s a part of what he wrote:
The advent of renewable energy made our project a societal necessity. Historically, the coal-based generation of electricity that long prevailed was located close to huge centers of population. The best sites for the new world of wind and solar generation, however, are often in remote areas. When BHE assessed the situation in 2006, it was no secret that a huge investment in western transmission lines had to be made. Very few companies or governmental entities, however, were in a financial position to raise their hand after they tallied the project’s cost.
BHE’s decision to proceed, it should be noted, was based upon its trust in America’s political, economic and judicial systems. Billions of dollars needed to be invested before meaningful revenue would flow. Transmission lines had to cross the borders of states and other jurisdictions, each with its own rules and constituencies. BHE would also need to deal with hundreds of landowners and execute complicated contracts with both the suppliers that generated renewable power and the far-away utilities that would distribute the electricity to their customers. Competing interests and defenders of the old order, along with unrealistic visionaries desiring an instantly-new world, had to be brought on board. Both surprises and delays were certain. Equally certain, however, was the fact that BHE had the managerial talent, the institutional commitment and the financial wherewithal to fulfill its promises.
As it turned out, the biggest surprise has been the fact that a number of political regimes in Western states have begun to repudiate their promises. Buffett’s tone when writing about this situation in the 2023 Letter reflects a muted outrage. My own response when reading his more optimistic account in the 2020 Shareholder Letter was skeptical at the time. If I had heard about the PacifiCorp project in back in 2006, I would have moved heaven and earth to question whether the honesty and fairness of Western states and their “political, economic, and judicial systems” could be relied upon over 25 years.
In his 2023 Letter, Buffett clearly feels that the good faith of the political, economic, and judicial systems is in serious doubt. The entire premise of buying capital-intensive, highly-regulated businesses has been called into question. If regulators cannot be relied upon to meet their obligations and compensate those businesses in accord with their commitments, utilities could well slide back into the status of high risk/low return investments. Working out a full understanding of this problem and coming up with the best response to it is probably the most important task on Buffett’s plate.
It starts with the comment in the 2023 Shareholder Letter that “Berkshire can sustain financial surprises, but we will not knowingly throw good money after bad,” Meanwhile the set aside for liabilities in the PacifiCorp case have been increased by $2 billion to $2.4 billion with reason to fear that the number will continue to increase from the several class actions suit. As I suggested in this piece published on August 15, 2023, it may be time to ask whether it has “ceased to be worth the trouble and risk of doing business there.” By there I meant mainly the Western states, with particular reference to California and Oregon. I thought quite a bit before leaving that sentence in my article.
Getting out of California and Oregon may sound like a fairly draconic suggestion, but Buffett’s tone in the 2023 Shareholder Letter and his mention of states that have gone to public energy in the past suggest that turning PacifiCorp over to the public or declaring bankruptcy might ultimately be the most prudent approach to building a wall against future litigation risks. If it comes to that, Buffett might well decide to put his reputation on the line and deal with his sense of betrayal honestly with the moral authority his name brings rather than leave his successors to thrash it out.
The John Galt epigram above is unfortunately not a joke. (Please note, by the way, that while I appreciate some Ayn Rand’s views, I am no ideologue.) Jeff Bezos and Elon Musk have both personally left California, with Musk having this to say about it to CNBC in 2020:
…it’s worth noting that Tesla is the last car company still manufacturing cars in California. SpaceX is the last aerospace company still doing significant manufacturing in California,” …There used to be over a dozen car plants in California. And California used to be the center of aerospace manufacturing! My companies are the last two left…That’s a very important point to make.”
Lesser known Silicon Valley leaders have also departed California in droves. What I sense in Buffett is not merely a matter of crass materialism concerning taxes, but the feeling that capitalism and the creative energies it releases are not appreciated in California and other Western states. Who better than Buffett, with his lifetime credit of honesty and straightforward thinking, to make this point emphatically for the people and leaders of West Coast states.
To get out of California and Oregon by one of the actions suggested above would be a last resort, but it’s hard to think of a better alternative which doesn’t leave financial outcomes hanging. As Buffett’s quote suggests, there is no going back and undoing past decisions, but one should usually cut losses as soon as possible to salvage the maximum amount. Who knows? Courts and regulators may get the message.
Berkshire Has Challenges But Is Still A Buy
The fact that Berkshire is a conglomerate with many parts is both a source of risks and a defense against major problems with any one unit. The other two large units of Berkshire – Apple and the $167 billion cash position – create issues which need to be considered, but nothing over which Buffett and Berkshire have real control. Fortunately, the problems are of a modest scale. Apple might best be described – my informed opinion from a distance – as a very large and highly successful company with a strong brand which has matured into a middle age with slower growth and more challenges. One challenge worth noting is China, particularly as a market for Apple products, and Apple really has little control over the outcome.
On the other hand, Apple will probably continue to grow sporadically unless a new product kicks it back into rapid growth. Meanwhile, Apple will continue to be generous with shareholders, including Berkshire, and much of its generosity will likely continue to be in the form of share buybacks. There’s not a lot Buffett can do about any of this, but that’s not necessarily a problem he hasn’t foreseen. He can’t sell because a very high percentage of his capital tied down in Apple consists of embedded capital gains, over 80% at present market prices, meaning that if he sold, the IRS would take a huge chunk of Berkshire’s capital in taxes. The models for Apple’s future are probably Coca-Cola (KO) and American Express (AXP) with their annually increasing dividend and buyback yields, except on a much larger scale. Like KO and AXP, Apple is likely to have growth spurts from time to time. That’s the realist’s view.
The other potential looming problem would come with the moment the Fed decided to cut short-term interest rates. T Bill rates close to 5.5% have provided a wonderful return on the $167 billion of cash with zero risk. It wouldn’t be too bad if short term T Bill rates dropped to, say, 4%, although that would clip about $2 billion off of current cash yields. Anything much beyond that would return Berkshire to the position it was in for much of the period after 2010 until Buffett saw the possibility of loading up on a then-underpriced Apple. For much of that decade, he was in the same place as retirement investors, forced to wrestle with poor returns on cash. The same suppression of rates by the Fed made it extremely difficult to find a large acquisition or a publicly traded stock he could buy on a large scale. Thus, the greatest asset allocator in history live under constant time pressure, which probably played some part in the decision to buy Precision Castparts, one of his rare major mistakes.
The real problem with less robust growth in Apple and the potential pressure of lower rates is that they are a contextual aspect of the problems with GEICO, BNSF, and BHE. All three large wholly owned subsidiaries are needed to generate some growth or at least a waterfall of free cash flow. Without their contribution, growth at Berkshire will be slower. Over the longer term, Berkshire’s Return on Equity seems likely to be 10-12 percent, near its five-year average of 10.88% rather than the one year 18%.
This 10-12 ROE is an important number when it comes to Buffett’s one other investment option if T-Bill rates decline. With Price to Book Value around 1.60-1.65 the yield to stock price (1.6-1.65 times common equity) would be 6-7%, not wonderful but not so bad if Buffett compares this yield from the company he knows best to all the other options. Buffett has demonstrated with the recent decline in dollar volume of buybacks that he is not enthusiastic about buying back shares at those prices but if the available yields elsewhere should fall – another factor not under his control – an assured long-term yield to buybacks of 6-7%, though not accretive in improving internal return, might be a persuasive way of returning capital to shareholders without generating a windfall to the IRS.
Articles keep suggesting that Berkshire will begin paying a dividend after Buffett retires, but I doubt it. Most Berkshire shareholders, myself among them, would feel the same way about dividends as the Strasbourg goose feels about having nutrients ground down its throat. Of course, the numbers change a bit for the worse if the State of the Union proposal to jump the buyback tax from 1% to 4% actually comes to pass, but maybe the investment community will notice the trend and stand up to fight it.
Summary
It’s unusual for the SA site to give a higher Quant Ranking to Berkshire than I do. The reason is simple. Berkshire is besieged by at least one problem, which seems worse to me than it does to the market. In the end, I believe that Buffett will deal with it in the best way possible – perhaps building a fence around PacifiCorp, perhaps some other creative solution I haven’t thought of. The Quant Rating is currently Strong Buy. I see Berkshire as selling at fair value, give or take. If you don’t already own enough of it, it’s a Buy.