Research as of 03 May 2013Estimates as of 01 May 2013Pricing data through 09 May 2013Rating updated as of 09 May 2013
Analyst's Perspective 01 May 2013
Our two biggest concerns about Berkshire Hathawaycontinue to be the firm's ability to grow the business (givenits current size and the need to consistently find deals thatnot only add value but also are large enough to bemeaningful) and the company's planning for the day whenWarren Buffett no longer runs the show. While Berkshirehas shown an ability to put money to work, it will need tofind larger acquisitions, or increase the number of deals itdoes in any given year, in order to move the needle. Theother major issue facing Berkshire is the continued lack ofclarity that investors have into the firm's succession plans.While Buffett did acknowledge this past year that thecompany's board has a CEO candidate selected (and twobackups at the ready), it has done little, in our view, to quellinvestor concerns about the impact that Buffett's ultimatedeparture will have on the firm.
Key Investment Considerations
Berkshire Hathaway is a holding company with a wide collection ofsubsidiaries engaged in a number of diverse business activities. The firm'score business is insurance, run primarily through GEICO (auto insurance),General Re (reinsurance), Berkshire Hathaway Reinsurance, and BerkshireHathaway Primary Group. The company's other businesses are a collectionof finance, manufacturing, and retailing operations, along with railroads,utilities, and energy distributors.
Profile
Vital Statistics
Valuation Summary and Forecasts
Financial Summary and Forecasts
The primary analyst covering this companydoes not own its stock.
Currency amounts expressed with "$" are inU.S. dollars (USD) unless otherwise denoted.
Source for forecasts in the data tables above: Morningstar EstimatesAnalyst Note: Financial Statements refelct Insurance segment information only, EPS reflectsconsolidated operations.
(USD Mil)
Contents
Analyst's Perspective
Key Investment Considerations
Morningstar Analysis
Analyst Note
Thesis
Valuation, Growth and Profitability
Scenario Analysis
Economic Moat
Moat Trend
Bulls Say/Bears Say
Credit Analysis
Financial Health
Capital Structure
Enterprise Risk
Management & Ownership
Analyst Note Archive
Additional Information
Morningstar Analyst Forecasts
Comparable Company Analysis
Methodology for Valuing Companies
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3 Berkshire's reported book value at the end of 2012 was$114,718 per Class A equivalent share, representing a14.4% increase year over year.
3 While acquisitions and shrewd capital allocation havenearly tripled the firm's book value per share over thepast decade, we think it will be difficult for Berkshire toreplicate that kind of performance longer term.
3 Even though the firm's future results are unlikely to beas good as past results, the moats surrounding thebusinesses that Buffett has collected over the yearsshould allow for ongoing excess returns.
Berkshire's biggesthurdle will be itsability to find dealsthat add value andare large enough tobe meaningful.
Morningstar Analysis
Berkshire Comes Out of the Gate Strong in 2013; Book
Value Per Class A Share Rises to $120,525 03 May 2013
Ahead of its annual meeting this weekend, wide-moat ratedBerkshire Hathaway BRK.A BRK.B released results for thefirst quarter of 2013 that were much stronger than thosefrom the year-ago period. First-quarter revenue increased15% year over year to $43.9 billion on improved operatingresults from each of its operating segments. With expensesrising at a much slower rate than revenue, and most of thegains from investments and derivatives falling straightdown to the bottom line, Berkshire reported a 49% increasein pretax earnings (to $5.0 billion) and a 51% increase innet earnings (to $4.8 billion). Stripping out the impact ofinvestments and derivatives, operating earnings increased42% to $3.8 billion. Net earnings per Class A equivalentshare were $2,977.
Book value per Class A equivalent share at the end of thefirst quarter was $120,525--up 13% year over year and upmore than 5% over the fourth quarter of 2012. This in linewith our expectations, which had called for Berkshire's bookvalue per share to increase to at least $118,000 per ClassA share (or $79 per Class B share) during the period. Thecompany also closed out the first quarter with $49.1 billionin cash on its books, up from $47.0 billion at the end of lastyear. It should be noted, though, that $12.1 billion of thattotal is slated for the Heinz HNZ deal, which receivedshareholder approval at the end of April, and is expected toclose sometime this summer. It should also be noted thatWarren Buffett tends to prefer to keep around $20 billionon hand as a backstop for its insurance business.
Unlike the fourth quarter of 2012, Berkshire did not buy backany shares during the first quarter of 2013. For those whomay not recall, the company repurchased 9,475 Class Ashares and 606,499 Class B shares for $1.3 billion inDecember of last year after increasing the threshold forshare repurchases from 1.1 to 1.2 times book value. WithBerkshire's book value per Class A share at $120,525 per
Class A share (or $80 per Class B share) at the end of themost recent period, Buffett would now be willing to step inand buy back stock at prices up to $144,630 per Class Ashare (or $96 per Class B share), implying a floor on thecompany's shares that is 10%-15% below today's currentprices.
Looking more closely at the firm's operating businesses, asubstantial portion of the gains in Berkshire's operatingearnings came from higher levels of profitability in itsinsurance subsidiaries (a portion of which was due to theelimination of certain charges, as well as the inclusion ofone-time gains, relative to the year-ago period). Totalunderwriting income for the insurance businesses overalljumped to $901 million during the first quarter of 2013 from$54 million during the prior-year period. Berkshire HathawayReinsurance Group, or BHRG, and, to a lesser extent, GEICO,were responsible for much of the turnaround in profitability,with General Re also seeing a slight improvement year overyear.
Similar to the first quarter of last year, the insurance industryoverall benefited from a relatively quiet period, during whichthere were essentially no major storms or catastrophelosses. As a consequence, profit margins for most insurerswere very strong. What helped Berkshire out even more,though, was the fact that the firm's insurance results weredepressed last year by a number of one-time charges thathave reversed in the current period, further boosting alreadystrong underwriting results. Specifically, foreign exchangelosses on reinsurance contracts, which cost the company$146 million last year, provided it with a $223 milliontailwind this year. Additionally, BHRG reported a $255million one-time gain due to amendments to life reinsurancecontracts. It should also be noted that during the first quarterof 2012 insurance companies were forced to change theaccounting treatment for some of their deferred expenses,which caused a one-time drop in profits. This change wasparticularly notable at GEICO and was responsible for a
substantial portion of its year-over-year improvement.
Earned premium growth of 14% across the insurance groupwas very strong and was led by gains at GEICO (10%) andBHRG (35%). More specifically, GEICO continued not onlyto woo business from competitors, but also grow policiesin force, or PIF, while raising prices. The premium growth atBHRG was also notable, as the subsidiary wrote a newreinsurance contract during the period, and may be writingbusiness more aggressively as the commercial insurancepricing market improves. Increased volume in the firm'scatastrophe operations--where Berkshire admitted it hassignificantly more capacity to write business if pricingimproves--and its other multiline property/casualtysegment were notable as well. It should be noted, though,that premiums in this business will decline as we moveforward given that the quota-share agreement with SwissRe recently expired. That said, Berkshire did pick up somenew business during the quarter, assuming the variableannuity book of Cigna CI, which further boosted premiums.With life insurance companies looking to shed legacyliabilities, we believe there may be more of these runoffreinsurance blocks available should Berkshire have an
appetite for them.
Much as they have the last couple of years, Berkshire's non-insurance operations continue to be a source of stability forthe firm, reporting a 12% increase in operating earningsyear over year during the first quarter. Burlington NorthernSanta Fe, or BNSF, which continues to be one of the largestcontributors to pretax earnings at Berkshire outside of itsinsurance operations, reported a 16% increase in pretaxearnings during the first quarter, as increased rail volumesand higher average revenue per car/unit led to a 6% increasein revenue, with operating expenses increasing just 2%when compared with the first quarter of 2012. Berkshirealso reported solid results for MidAmerican Energy Holdings(MEHC), which saw its top-line increase 8%, and pretaxearnings rise 10%, primarily due to higher pricing andvolumes, and lower expense overall, during the quarter.
With regards to Berkshire's manufacturing, service andretail, or MSR, operations, which include both Marmon andMcLane, the group overall saw a 17% increase in revenue,but only a 3% increase in pretax earnings, when comparedwith the first quarter of 2012. Marmon, which has been astandout performer over much of the last three years, hit abit of a speed bump during the period, with revenuedeclining 4%, and pretax profits falling 1%, most of whichwas tied to declining commodity prices during the firstquarter. This was offset some by better results at McLane,which reported a 34% increase in revenue, and a 29%increase in pretax earnings, spurred on by acquisitions andthe addition of new customers during the first quarter of2013. Revenue from Berkshire's other MSR operations rose7%, with pretax earnings rising at a much slower rate of2%, when compared with the prior-year period. As forBerkshire's finance and financial products division, whichincludes Clayton Homes (manufactured housing andfinance) and CORT Business Services (furniture rental), thesegment saw revenue decline year over year, but still
reported a 4% increase in pretax earnings.Thesis 01 May 2013
Berkshire Hathaway's economic moat has been built on thefirm's record of acquiring and managing a portfolio ofbusinesses with enduring competitive advantages.Whether through direct ownership of individual companiesor via significant stock holdings, famed value investorWarren Buffett has typically looked to acquire firms thathave consistent earnings power, generate above-averagereturns on capital, have little to no debt, and have solidmanagement teams. Once purchased, these businessestend to remain in Berkshire's portfolio, with sales occurringrarely. Buffett strives to raise capital as cheaply as possibleto support Berkshire's ongoing investments and measuresthe success of the portfolio by per-share growth in intrinsicvalue. Given the current size of the firm's operations, thebiggest hurdle facing Berkshire will be its ability toconsistently find deals that not only add value but also arelarge enough to be meaningful. The other major issue facingthe company is the longevity of Buffett and managingpartner Charlie Munger, both of whom are octogenarians.
Berkshire's most important business continues to be itsinsurance operations. Not only do they contribute ameaningful amount of the firm's pre-tax earnings, but theyalso generate low-cost float (the temporary cash holdingsarising from premiums being collected well in advance offuture claims), which has been a major source of fundingfor investments. Berkshire underwrites insurance throughthree main units: GEICO, General Re, and BerkshireHathaway Reinsurance. GEICO, the third-largest autoinsurer in the United States, relies on direct selling toconsumers, a model that provides it with cost advantagesover some of its competitors. While this practice hasbecome more common, GEICO was a pioneer in the channeland continues to generate solid underwriting profits andnegative cost of float for Berkshire.
The firm's two other main insurance businesses are bothreinsurers. For a premium, these subsidiaries will assumeall or part of an insurance or reinsurance policy written byanother insurance company. General Re is one of the largestreinsurers in the world based on premium volume andshareholder capital, while Berkshire Hathaway Reinsurance'sclaim to fame is its ability to take on large amounts ofsuper-catastrophe underwriting, which covers events liketerrorism and natural catastrophes. These unique policiesoften contain large tail risks that few companies (other thanBerkshire, with its strong balance sheet) have the capacityto endure. When priced appropriately, though, these typesof transactions can generate favorable long-term returns oncapital for the firm.
Berkshire's non-insurance operations encompass a widearray of businesses, including Burlington Northern Santa Fe(railroad), MidAmerican Energy (energy generation anddistribution), McLane (food distribution), Marmon(manufacturing), Shaw Industries (carpeting), BenjaminMoore (paint), Fruit of the Loom (apparel), Dairy Queen(restaurant), and See's Candies (food retail). Of the morethan 70 non-insurance businesses in its portfolio, the twolargest contributors to Berkshire's pre-tax earnings areBNSF, which the firm acquired in full in February 2010, andMidAmerican, in which Berkshire maintains a 90% stake,having initially added the company to its holdings more thana decade ago.
Buffett's shift into such debt-heavy, capital-intensivebusinesses as railroads and utilities is a marked departurefrom many of Berkshire's past investments, which havetended to require less capital investment and have had littleto no debt on the books. While running railroads and utilitiesrequires massive reinvestment, Berkshire acquired thesebusinesses because they can earn decent returns onincremental investments, ensuring that the large amountsof cash generated by the firm's other operating businesses
are reinvested in value-creating projects. And whileBerkshire does consolidate the debt of these twosubsidiaries on its own balance sheet, the firm guaranteesnone of it.
All of Berkshire's operating businesses are managed on adecentralized basis, eliminating the need for layers ofmanagement control and pushing responsibility down to thesubsidiary level, where managers are empowered to maketheir own decisions. This leaves Buffett free to focus oncapital allocation decisions and managing the investmentsin Berkshire's portfolio--two things that he has beenextremely adept at doing over the past 40-plus years. Whilewe could argue that Buffett is not the sole reason forBerkshire's success, he has been (and continues to be) acritical element in the firm's competitive positioning. In ourview, Buffett's ultimate departure would cause the firm tolose some of the significant advantages that come fromhaving a capital allocator of his caliber at the helm.
Valuation, Growth and Profitability 01 May 2013
We've increased our fair value estimate for BerkshireHathaway's Class B shares to $125 per share from $117after updating our valuation model to account for changesin our assumptions about the firm's revenue, profitability,and cash flows since our last update. Our new fair valueestimate is equivalent to 1.6 times Berkshire's reported bookvalue per Class B share of $76 at the end of 2012. Duringthe last decade, Berkshire's Class B shares have traded ina range of 1.1 to 1.7 times book value, with a median valueof 1.4 times.
Our fair value estimate for Berkshire is derived using asum-of-the-parts methodology, which values the differentpieces of the company's portfolio separately, then combinesthem to arrive at a total value for the firm. We estimate thatBerkshire's insurance operations are worth $65 per Class Bshare, slightly higher than our previous valuation due to an
improved outlook for premium growth and underwritingprofits in our explicit five-year forecast. We have not,however, altered our view on the firm's investment income,which remains depressed because of the historicallylow-yield environment.
We estimate that Berkshire's railroad, utilities, and energyoperations, which are the next largest contributors to pretaxincome, are worth $31 per Class B share, also higher thanour previous forecast, due to the strength we continue tosee at BNSF, as well as the ongoing operating improvementsand long-term investments being made at MidAmerican.While these subsidiaries are capital intensive in nature, wefeel that they can continue to earn decent returns onincremental investments longer term.
With regard to Berkshire's other non-insurance subsidiaries,we believe the manufacturing, service, and retailingoperations are worth $24 per Class B share, somewhathigher than our previous estimate, owing to the ongoingimprovements that continue to be seen in revenue andoperating profits throughout the division, even in the faceof a slower than expected recovery in the U.S. economy.Finally, we believe that Berkshire's finance and financialproducts division is worth $5 per Class B share, higher thanour previous estimate owing to the changes that a morestable housing market are having on its operations.
Scenario Analysis
Our downside case leads to a fair value estimate of $87 perClass B share. This scenario assumes that Berkshire'sinsurance segment does not perform as strongly as weproject in our base case, with any improvements in thebusiness taking several years to materialize. It also assumesthat the improvements in Berkshire's manufacturing,service, and retailing operations stall after posting morethan two years of solid growth in revenue and profitability.On top of that, our downside cases assumes a far less
prosperous outlook for Berkshire's railroad, utilities, andenergy division, with a moribund recovery in the U.S.economy and significantly higher fuel costs affecting theresults for these more economically sensitive businesses.
In our upside case, which results in a fair value estimate of$169 per Class B share, we assume that Berkshire'sinsurance segment performs much more strongly than weare projecting in our base case, with premium growth andunderwriting profits exceeding our expectations throughoutour five-year forecast. This scenario also assumes a morerobust recovery in the U.S. economy in the near term, withBerkshire's two main non-insurance segments--manufacturing,service, and retailing and railroad, utilities, and energy--notonly holding on to revenue and profitability gains that havebeen made since the 2008-09 financial crisis, but alsopicking up pace over the next several years.
Economic Moat
Berkshire's wide economic moat is more than just a sum ofits parts. That said, the parts that make up the whole arefairly moaty in their own regard. The company's mostimportant business continues to be its insurance operations.Not only do they contribute a fair amount of its pretaxearnings, but they also generate low-cost float (thetemporary cash holdings that arise from premiums beingcollected well in advance of future claims)--a major sourceof funding for Berkshire's investments. That said, we do notbelieve the insurance industry itself is all that conducive tothe development of sustainable economic moats. Even withall of the advantages Berkshire has with its own operations,it insurance businesses--composed primarily of propertyand casualty insurance and reinsurance--benefit from nomore than a narrow economic moat. While much can bemade of Buffett's investment abilities, represented by themore or less "permanent" stock investment portfolio thatexists within Berkshire's insurance operations, our belief isthat insurance companies create durable competitive
advantages only through insurance profitability, achievedthrough superior underwriting abilities and/or some sort ofcost advantage.
Of the more than 70 noninsurance businesses that make upBerkshire's remaining collection of operating subsidiaries,Burlington Northern Santa Fe and MidAmerican EnergyHoldings Company are the next two largest contributors toBerkshire's pretax earnings (and collectively account foraround one-fourth of our fair value estimate for the firm).The most interesting thing about these two businesses isthat neither one was a major contributor to Berkshire'searnings a decade ago, with Buffett's shift into suchdebt-heavy, capital-intensive businesses as railroads andutilities representing a marked departure from many of hisother investments, which have tended to require lessongoing capital investment and have had little to no debton their books. Buffett entered into these businesses,despite the fact that they would require massive amountsof capital reinvestment, because they could earn decentreturns on incremental investments longer term.
With BNSF, which was acquired in full by Berkshire inFebruary 2010, the firm picked up a Class I railroad operator,which is an industry designation for a large operator withan extensive system of interconnected rails, yards,terminals, and expansive fleets of motive power and rollingstock. We believe that Class I railroads benefit from colossalbarriers to entry because of their established, practicallyimpossible-to-replicate networks of rights-of-way andcontinuously welded steel rail. Also, rail customers havefew choices and thus wield limited buyer power,highlighting the fact that most railroads operate as aduopoly in most markets, and that some may even be amonopoly supplier to the end client in many cases. Evenwith these positive attributes, railroads earn returns thatare around their cost of capital, limiting their economicmoats to narrow, and we believe BNSF is no exception.
As for MEHC, which Berkshire built up through investmentsin MidAmerican Energy (supplanting a 76% equity staketaken in early 2000 with additional purchases that haveraised its interest up to 89.8%) and PacifiCorp (acquired byMEHC in full during 2005), we think the business overall isendowed with a narrow economic moat. While MEHC haspicked up some pipeline assets, which can have wide-moatcharacteristics, the majority of its revenue and profitability(and ongoing capital investment) continues to be driven byits two main regulated utilities--MidAmerican Energy andPacifiCorp. Regulated utilities have had, in our view, a moredifficult time establishing more than a narrow moat aroundtheir businesses, even with their difficult-to-replicatenetworks of power generation, transmission, anddistribution, given that their returns are ultimately set bystate and federal regulators.
While Berkshire's manufacturing, service and retailingoperations are the next-largest contributor to pretaxearnings (and our overall value for the firm), they comprisea wide array of businesses operating in more than a handfulof different industries. Unlike BNSF and MEHC, both ofwhich file annual and quarterly reports with the Securitiesand Exchange Commission, there is little financialinformation available on the firms operating in this segment.Given Buffett's penchant for acquiring companies that haveconsistent earnings power, generate above-average returnson capital, have little to no debt, and have solid managementteams, we believe these businesses are collectivelyendowed with a narrow economic moat. The same couldalso be said for Berkshire's finance and financial productsegment, which includes Clayton Homes (manufacturedhousing and finance) and CORT Business Services (furniturerental). While the disruption caused by the financial crisisand the collapse of the housing market may have affectedthese businesses, much like it did some of Berkshire's othersubsidiaries--like Benjamin Moore, Shaw, Acme, and Johns
Manville--there are still some moaty characteristics in thesesubsidiaries
With Buffett running Berkshire on a decentralized basis, themanagers of these operating subsidiaries are empoweredto make their own business decisions. In most cases, thesemanagers are the same individuals who originally sold theirfirms to Buffett, leaving them with a vested interest in thebusinesses they are running, such that barring a trulydisruptive event in their industries these firms are likely tocontinue to have the same advantages that attracted Buffettto them in the first place. That does not mean that therewon't be firms within Berkshire whose competitiveadvantages diminish (exemplified most ironically by thetextile manufacturer that Berkshire Hathaway derives itsown name from)--it's just that the large collection of moatyfirms that reside in Berkshire's noninsurance/railroad/utilityoperations is more likely to maintain a narrow moat inaggregate, even as a few firms along the way succumb tochanging competitive dynamics in their industries..
Adding up all of the firm's operating subsidiaries leavesBerkshire with a fairly solid narrow economic moat aroundits operations. What has traditionally put it over the top, inour view, has been the company's ability to take the excesscash flows generated by these different businesses (as wellas the float that is provided by its insurance operations) andinvest them back into projects that have tended to earn morethan their cost of capital. While a company's managementteam by itself is not sufficient, in our view, to create aneconomic moat, it can add to, as well as detract from, thecompetitive advantages that may exist for a firm. InBerkshire's case, Buffett and Munger have been integral tothe company's success over the past 40-plus years. Theirability to take the cash generated by Berkshire's variousoperations and consistently invest it back into projects thathave on average earned more than the firm's cost of capitalhas, in our view, elevated Berkshire from its solid narrow
moat foundation to one that is endowed with a wideeconomic moat.
Moat Trend
While we expect Berkshire to have sufficient enoughcompetitive advantages in the near to medium term tomaintain its wide economic moat, we think that the trendhas turned decidedly more negative over the last decade.The sheer size of Berkshire's operations, the nature of someof its more recent acquisitions (of more debt-heavy,capital-intensive businesses), and the ultimate longevity ofBuffett and Munger, who have been integral to thecompany's success, will all play a role in determining howlong Berkshire will continue to generate outsize returns.
While acquisitions and shrewd capital allocation havenearly tripled the firm's book value per share over the pastdecade, we think it will be difficult for Berkshire to replicatethat kind of performance longer term, even with Buffett atthe helm. That's not to say that Berkshire can't continue toput money to work in value-creating projects, much as it hasdone the past several years, it's just that the huge sums ofcapital that the firm now manages will ultimately limit itsability to generate outsize returns. In our view, the natureof Berkshire's major investments over the past decade,which have included moves into capital-intensivebusinesses like railroads and utilities, will continue to limitoverall returns, even as these investments generate valuefor the firm. Much of this is due to the fact that the returnsfor some of these businesses are affected not only by thecapital-intensive nature of their operations, but in the caseof MidAmerican by the state and federal regulators who setand monitor the rates and returns for the utilities. We'reinclined to believe that future investments will skew towardcapital-intensive businesses, like BNSF and MEHC, if onlybecause these types of deals help to reduce the numbercapital allocation decisions that will need to be made infuture periods (by individuals other than Warren Buffett in
a post-Buffett world).
We also believe the mix shift that has taken place inBerkshire's portfolio has effectively raised its cost of capital.The firm's foray into debt-heavy, capital-intensivebusinesses like BNSF and MEHC has been a markeddeparture from its traditional practice of running itsoperating companies and making ongoing investmentswithout relying too much on debt. While parent companydebt at Berkshire remains relatively low, at around $8 billionat the end of 2012 (most of which is tied to its 2010 purchaseof BNSF), the firm reported consolidated debt of close to$63 billion, more than half of which was coming from BNSFand MEHC. This debt tends to be issued by these twosubsidiaries directly and is not explicitly guaranteed byBerkshire. While there is bound to be some discount givento these firm's as a result of Berkshire being the ultimatebackstop for their operations, much of their cost of debt istied to their operations (as well as their assets, which areoften times pledged to secure their debt). As such,Berkshire's cost of funding these operations tends to bemuch higher than it would be if the firm financed thesebusinesses directly with the low- to no-cost capital providedby its insurance operations.
It should also be noted that Berkshire's insurance float isunlikely to grow much from its current levels. Buffett hasnoted on several occasions that Berkshire already has an"outsized amount relative to (its) premium volume," andgrowth in the company's float has averaged around 4% overthe past five years, compared with a 6% rate of growth overthe past decade. Also of note was the fact that Berkshire'sfloat of $73 billion at the end of the fourth quarter of 2012was up less than 4% year over year. With much of the growthin the firm's float having come from retroactive insurance,as BHRG has struck deals to take on responsibility for eventsthat have already occurred, there is a limit to how muchgrowth is really left out there for Berkshire to tap. So with
the firm potentially hitting a ceiling on the amount of low-to no-cost capital that it can generate longer term and itsoverall cost of borrowing being influenced more and moreby the debt-heavy, capital-intensive businesses that it hasbeen acquiring, we expect the firm's adjusted cost of capitalto continue moving upward, all while its returns are trendingdownward as a result of its size and capital allocationdecisions.
With Buffett celebrating his 83rd birthday this comingAugust, and Munger turning 89 at the beginning of 2013,the biggest unknown for investors is whether Berkshire willbe able to replace the significant competitive advantagesthat have come from having capital allocators of this caliber,with the knowledge and connections they've acquired overthe years, at the helm once they are no longer running theshow. Buffett continues to note that the job of the next CEOat Berkshire will be to act as capital allocator in chief, withhis two newest lieutenants--Ted Weschler and ToddCombs--responsible for managing the company'sinvestment portfolio. While admitting that his successor islikely to do things differently than he has, Buffett believesthat this person would have the ability to do the same typeof deals that Berkshire has become known for, noting thatthe firm's ability to find and close deals requiring financialsecurity (such as those executed during the financial crisis)were not due to Buffett's reputation, but were achievedbecause of Berkshire's unique ability to move quickly andhave excess cash available even in the most dire ofsituations.
Although we'd like to believe that Buffett's successors willbe able to extract the same advantages from Berkshire'soperations that he has over the years, those responsible forallocating capital after Buffett departs will have theirreturns constrained not only by the size of the firm'soperations, but by the investment decisions that were madelong before they took the helm. At this point, we think that
Buffett has already laid claim to some of the firm's futurecash flows by buying up capital-intensive businesses likeBNSF and MEHC, which are expected to require a significantamount of reinvestment over the next 10-20 years. We alsoexpect him to continue to acquire these types of businessesin the near-to-medium term, which means that investorsshould expect lower returns from Berkshire in the futurethan they have seen in the past, a problem that will onlygrow in magnitude as the company becomes even larger.Additionally, we believe that the chorus of shareholders thathave called for the institution of a dividend in the past willonly increase in size and din once Buffett is gone, furtherconstraining the amount of capital that the next CEO has towork with longer term.
3 Book value per share, which is the best proxy formeasuring changes in Berkshire's intrinsic value,increased at a compound annual rate of 19.7% from1965 to 2012, compared with a 9.4% total return forthe S&P 500 TR Index.
3 Berkshire's long-term record has also been fairlyconsistent, with the company reporting annualdeclines in book value per share in only two years:2001 and 2008.
3 At the end of the fourth quarter of 2012, Berkshire had$73 billion in float from its insurance operations. Thecost of float, as represented by the ratio ofunderwriting gain or loss to average float, has beennegative for the past ten years, as Berkshire'sinsurance operations generated underwriting gains ineach period.
3 A strong balance sheet allowed the firm to take fulladvantage of opportunities in the months leading upto and following the collapse of the credit and equitymarkets in 2008, making lucrative investments inGoldman Sachs, General Electric, Swiss Re, DowChemical and Wrigley.
3 That same balance sheet strength allowed Buffett toextend a $5 billion lifeline to Bank of America during2011, with Berkshire receiving 50,000 shares of thebank's preferred stock (with a 6% annual dividend)and warrants to purchase 700 million shares of Bankof America common stock at an exercise price of $7.14per share (which may be exercised in whole or in partat any time before September 2021).
3 Given the current size of its operations, the biggesthurdle facing Berkshire will be its ability toconsistently find deals that not only add value but alsoare large enough to be meaningful.
3 The other major issue facing the firm is the longevityof chairman and CEO Buffett and managing partnerMunger, both of whom are octogenarians.
3 Investments made in Goldman Sachs, GeneralElectric, Swiss Re, Dow Chemical and Wrigley haveeither been repaid or are in the process of being paidoff, negatively affecting investment income andleaving Berkshire in the position of having to reinvestthe proceeds in less lucrative offerings.
3 Berkshire's insurance business faces highlycompetitive and cyclical markets and occasionally willproduce large losses. It also has highly uncertainliabilities, including potential asbestos claims, whichmight ultimately cost more than the firm has stated.
3 Berkshire is a large conglomerate, and its reportedresults are complicated by the firm's size and frequentacquisitions. This makes our fair value estimate moreuncertain and subject to estimation error.
Adjusted Balance Sheet Surplus 73,819Total Profitability Available for Debt Service 29,133Total Projected Surplus 102,952Debt Balance 9,777Total Debt Service 12,337Debt Cushion 8.3
Business Risk ScoreFinancial Risk Score Debt Cushion ScoreDistance to Default ScoreCredit Rating —
Business Risk Summary(USD Mil)
Credit Analysis
Financial Risk Summary
Debt Cushion Summary
Credit Rating Pillars
Financial Health
Berkshire's financial strength was tested by the collapse ofthe credit and equity markets in 2008, which ultimately ledto the company losing its AAA credit rating in 2009. Thatsaid, Berkshire remains one of the most financially soundcompanies we cover, with the firm managing its risk throughdiversification and a conservative capital position. WhileBerkshire does not pay a dividend, the firm did initiate ashare-repurchase program during the third quarter of 2011that allowed management to buy back both Class A andClass B shares at prices no higher than a 10% premium tothe firm's most recently reported book value per share.Berkshire altered the terms of the share-repurchaseprogram during the fourth quarter of 2012, with the boardnow authorizing the firm to repurchase Class A and Class Bshares at prices no higher than a 20% premium to the firm'smost recently reported book value per share (which stoodat $114,718 per Class A share--or $76 per Class B share--atthe end of the fourth quarter of 2012).
Capital Structure
Berkshire's strong balance sheet and liquidity are among itsmost enduring competitive advantages. The company'sinsurance operations are well capitalized and highly liquid,carrying greater levels of equity and cash relative to otherinsurers, which we believe should offset potential losses.The firm generates large amounts of free cash flow from itsoperations and maintains significant levels of cash on itsbalance sheet, which amounted to $47 billion at the end ofthe fourth quarter of 2012. That said, Buffett does like tokeep at least $20 billion in cash on hand as a backstop forthe insurance business.Berkshire generally seeks to run itsoperating companies and make ongoing investmentswithout an overreliance on debt. In instances when it isnecessary to issue debt, Berkshire strives to do it on along-term, fixed-rate basis. While consolidated debt levelshave risen significantly over the past five years, much of itis tied to two of the firm's non-insurance subsidiaries--MidAmerican
Energy and BNSF--and is not explicitly guaranteed byBerkshire. That said, substantially all of these twosubsidiaries' assets can be pledged or encumbered tosupport or otherwise secure the debt.It should be noted,though, that Berkshire benefits from an extremely low costof capital, given the float that is provided by its insuranceoperations. Collecting insurance premiums well in advanceof any potential future claims provides Berkshire with plentyof low-to-no-cost capital that can be used to fund itsinvestment activities. While most property and casualtyinsurers generate float, Berkshire tends to outstrip its peerson an absolute basis, as well as in relation to premiumvolume. About three fourths of Berkshire's float tends tocome from its reinsurance operations, which are able tounderwrite policies that contain large tail risks that fewcompanies (other than Berkshire, with its strong balancesheet) have the capacity to endure. In most years, the firm'sinsurance operations generate negative cost of float, whichis a direct result of these same operations generating a netunderwriting gain. In effect, the company is being paid tohold on to other people's money in those years when itgenerates negative cost of float. It is also interesting to notethat Berkshire has seen solid growth in its float, even as itsticks to a fairly rigorous underwriting discipline. The firm'sfloat, which was $73 billion at the end of 2012, has risenfrom $59 billion in 2007 and $42 billion a decade ago. Thatsaid, Berkshire's insurance float is unlikely to grow muchfrom current levels. With much of the growth in the firm'sfloat having come from retroactive insurance, as BHRG hasstruck deals to take on responsibility for events that havealready occurred, there is a limit to how much growth isreally available.Berkshire does not pay a dividend on itsshares. In the third quarter of 2011, the company did,however, authorize a share-repurchase program aimed atbuying back Class A and B shares at prices no higher thana 10% premium to the firm's most recently reported bookvalue per share. Berkshire altered the terms of theshare-repurchase program during the fourth quarter of 2012,
with the board now authorizing the firm to repurchase ClassA and Class B shares at prices no higher than a 20% premiumto the firm's most recently reported book value per share(which stood at $114,718 per Class A share--or $76 per ClassB share--at the end of the fourth quarter of 2012). WhileBerkshire has been vague about how much it would spendon share repurchases, Buffett has noted on severaloccasions that stock repurchases would not be made if theyreduced the firm's consolidated cash balance below $20billion.Berkshire spent $67 million on share repurchasesduring 2011, purchasing 98 Class A shares (for about $10million) and a little over 800,000 Class B Shares (for around$57 million) during the last four months of that year. Aftermaking no share repurchases during the first three quartersof 2012, the company bought back 9,200 of its Class A sharesfrom the estate of a longtime shareholder (for a total costof $1.2 billion, or $131,000 per Class A share) after raisingthe price limit for share repurchases to 120% of book value.We continue to believe that Buffett has succeeded increating a floor under Berkshire's stock price, as investorswill now be expecting him to buy back shares at prices below120% of the firm's reported book value. We believe thatabsent more lucrative investment opportunities, this wouldbe a good use of shareholder capital.
Enterprise Risk
Berkshire is exposed to large potential losses through itsinsurance operations. While the company believes itssuper-catastrophe underwriting will generate solidlong-term results, the volatility of this particular line ofbusiness, which can subject the firm to especially largelosses, could be high. That said, Berkshire maintains muchhigher capital levels than almost all other insurers, whichwe believe helps to mitigate some of the risk. Several ofthe firm's key businesses--insurance, energy generation anddistribution, and rail transport--operate in industries thatare subject to higher degrees of regulatory oversight, whichcould have an impact on future business combinations and
the setting of rates charged to customers. Berkshire also isexposed to foreign currency, equity price, and credit defaultrisk through its various investments and operatingcompanies. The firm's derivative contracts, in particular, canaffect Berkshire's earnings and capital position, especiallyduring volatile markets, given that they are recorded at fairvalue and, therefore, are periodically updated to record thechanges in the value of these contracts. Many of the firm'snon-insurance operations, meanwhile, are exposed to thecyclicality of the economy, with results typically sufferingduring economic slowdowns and recessions. The companyis also heavily dependent upon two key employees, Buffettand Munger, for almost all of its investment and capitalallocation decisions. With both men now in their 80s, it hasbecome increasingly likely that our valuation horizon willend up exceeding their expected life spans, with theexpectation being that investment returns andcapital-allocation quality will deteriorate under newmanagement. The 2011 departure of David Sokol, who manyhad assumed would be Berkshire's next CEO, has raisedserious questions as well about the firm's internal controlsand, to some extent, tarnished its legacy of strong ethicalbehavior.
SSgA S&P 500 Index Strategy 0.47 1.09 10,954 31 Mar 2012Longleaf Partners Q 0.12 2.99 2,926 30 Jun 2012IVA Worldwide A QQ 0.05 1.02 1,106 30 Jun 2012Janus Contrarian D QQ 0.03 2.09 634 30 Jun 2012BlackRock CDN US Equity Idx Hdg Non-Tax QQQ 0.02 1.16 564 31 Aug 2012
Top 5 Sellers
Undrly L&G Pen PMC Consensus Idx — 0.08 -6,677 31 Mar 2012Undrly L&G Pen PMC Glb Eq 60:40 Idx — 0.08 -6,675 31 Mar 2012Undrly L&G Pen PMC Oversea Consensus Idx — 0.20 -3,356 31 Mar 2012Undrly L&G Pen PMC World Ex UK Eq Idx 0.02 0.33 -2,794 31 Mar 2012Mellon Cap EB Stock Index Fund QQQ 0.03 1.10 -286 31 Mar 2012
Stewardship: 01 May 2013
Management & Ownership
Management Activity
Fund Ownership
Institutional Transactions
*Represents the date on which the owner’s name, position, and common shares held were reported by the holder or issuer.
Warren Buffett has been chairman and CEO of BerkshireHathaway since 1970. Charlie Munger has served as vicechairman since 1978. Berkshire has two classes of commonstock, with Class B shares holding 1/1,500th of the economicrights of Class A shares and only 1/10,000th of the votingrights. Buffett is Berkshire's largest shareholder, with a 35%voting stake and 21% economic interest in the firm. He hasbeen a strong steward of investor capital, consistentlyaligning his own interests with those of shareholders, andBerkshire's economic moat is derived primarily from thesuccess that he has had in melding the firm's financialstrength and underwriting ability with his own investmentacumen. Buffett's stewardship allowed Berkshire toincrease its book value per share at a compound annual rateof 19.7% from 1965 to 2012, compared with a 9.4% totalreturn for the S&P 500 Index.
This makes it even more important that Buffett's legacyremains intact once he no longer runs the firm. Successionwas not formally addressed by Berkshire until 2005, whenthe firm noted that Buffett's three main jobs--chairman,chief executive, and chief investment officer--wouldprobably be handled by one chairman (expected to be hisson, Howard Buffett), one CEO (with one candidate alreadyidentified but not revealed), and three or more external hires(reporting to directly to the CEO) to manage the investmentportfolio. While we have gained a little more clarity aboutthe plan for the investment side of the business, with ToddCombs and Ted Weschler likely to be the only outside hiresbrought in to take responsibility for the investment portfolio,questions linger over who will step into the CEO role. In ourview, whoever steps into Buffett's role as chief executiveis going to feel more pressure from shareholders andanalysts than Buffett has ever been subjected to. As such,the real long-term question for investors is whether or notthe individual that succeeds him can replace the significantadvantages that have come from having an investor ofBuffett's caliber, with the knowledge and connections he
Warrants Issued During Financial Crisis 26 Mar 2013
In a less-than-surprising move, Berkshire Hathaway BRK.ABRK.B and Goldman Sachs GS announced today that thetwo companies have amended the terms of the warrantsthat were issued to Berkshire as part of the $5 billion lifelinethat Warren Buffett extended to Goldman at the height ofthe financial crisis. As part of the original agreement,Berkshire received 50,000 shares of Goldman's preferredstock (with a 10% coupon) and warrants to purchase43,478,260 shares of the company's common stock (at anexercise price of $115 at any time until Oct. 1, 2013). Underthe amended agreement, Goldman will deliver to Berkshirea number of shares of its common stock that is equivalentto the difference between the average closing price overthe 10 trading days preceding Oct. 1, 2013, and the exerciseprice of $115 for the warrants. Such that if the average priceof Goldman's common stock during that 10-day period endedup being $150 per share (similar to what it has been overthe last 10 trading days), then Berkshire would receivearound 10.1 million shares (worth just over $1.5 billion at aprice of $150 per share). Add this to the $1.8 billion thatBuffett made from the preferred shares, which includes allof the dividends and premiums that Berkshire receivedbefore Goldman finally redeemed those shares in April 2011,and the Oracle of Omaha is already sitting on a more than$3 billion return on his initial investment. Once the warrantconversion is completed, Buffett intends to hold on to theGoldman shares, which would likely rank in the company'stop 15 equity holdings, and add to its collection of other bigfinancial services holdings--which includes Wells FargoWFC , American Express AXP , and US Bancorp USB .
Buffett's 2012 Shareholder Letter Reveals Thoughts on
Dividends, Acquisitions, and Other Topics 04 Mar 2013
After looking more closely at wide-moat-rated BerkshireHathaway's BRK.A / BRK.B 2012 annual report and Warren
Buffett's annual letter to shareholders, which were releasedlate last week, we found a number of items worth noting,with the most important for investors being, in our view, thecommentary surrounding the company's capital allocationdecisions--specifically those related to ongoing investments,acquisitions, and the likelihood of a dividend for Berkshire'sshareholders.
Acquisitions are an integral part of the company's businessmodel and, unsurprisingly, Buffett dedicated a sizableportion of his comments to this theme. While Buffett notedhis disappointment with not finding a large acquisitionduring 2012, this was quickly remedied by the Heinz HNZdeal last month, which will consume about USD 12 billionof Berkshire's cash, roughly equivalent to the earnings thefirm generated last year. The investment is undoubtedlylarge, but the fact that it only used one year's worth ofBerkshire's cash underscores the challenge the firm faces--namely that its ever-increasing size will make acquisitionsthat meet Buffett's investment criteria, while also beingboth meaningful and sensible, much more difficult to find.
This obstacle is complicated by the historically low interestrate environment, which causes the cash held by Berkshireto earn next to nothing for shareholders. Not unexpectedly,Buffett remains opposed to paying a dividend, preferring (inorder) internal reinvestment, acquisitions, and sharerepurchases (at prices materially below intrinsic value) asthe main uses for cash. He did, however, lay out his thinkingon dividends, illustrating the potential drawbacks toshareholders of a firm that pays a dividend as opposed tofollowing a "sell-off" approach.
Buffett's argument makes sense to us, in that firms don'thave to pay dividends when they have profitable internalopportunities. The math behind his argument breaks down,though, when a firm is unable to find incrementalinvestments that yield returns in excess of its cost of capital.
Eventually Berkshire will reach this threshold, and only timewill tell if Buffett will then admit that a dividend is justified.
Looking more closely at the firm's internal investments,Berkshire spent a record USD 9.8 billion on plant andequipment in 2012, which was 19% more than it spentduring 2011 (which, at USD 8.2 billion, was its previoushigh). Buffett expects spending levels to remain elevatedthis year, with Berkshire likely to set yet another record forcapital expenditures. Specifically, he noted that BurlingtonNorthern Santa Fe will spend about USD 4 billion on itsrailroad infrastructure during 2013, roughly double itsannual depreciation charge and more than any railroad hasspent in a single year. Meanwhile, in its annual report,MidAmerican Energy Holdings forecast more than USD 4billion in capital expenditures for its operations, putting totalcapital spending for just these two subsidiaries at close toUSD 9 billion.
While Buffett failed to land a major acquisition during 2012,the managers of Berkshire's subsidiaries did far better,spending about USD 2.3 billion for 26 companies that weremelded into existing businesses, representing a record yearfor bolt-on acquisitions for the firm. Where Buffett seemedto have some influence, though, was in the company'songoing purchase of newspapers, with Berkshire acquiring28 daily newspapers at a cost of USD 344 million since thestart of the fourth quarter of 2011. This activity included theextension of financing to Media General, which wasstruggling with a heavy debt load, during the second quarterof last year, a deal that also had Berkshire acquiringnewspapers from the firm for USD 142 million, and pickingup warrants that gave it the right to purchase a 19.9% stakein Media General. We now know that Ted Weschler washeavily involved in this deal, which was conducted intandem with his main responsibilities as an investmentmanager.
On that note, Buffett also mentioned increasedresponsibilities for his two key lieutenants, Weschler andTodd Combs. After noting during the third quarter of 2012that the two managers would be working with a "bank" ofabout USD 4 billion each--up from USD 1.75 billion each atthe end of 2011 and USD 2.75 billion each at the end of thefirst quarter of 2012--Buffett revealed that Berkshireincreased the funds managed by the two men to USD 5billion each (with some of this emanating from the pensionfunds of Berkshire's subsidiaries). As we have noted in thepast, this willingness on Buffett's part to not only increasethe amount each manager has to work with, but also sellsome of his own legacy holdings in order to fund theirportfolios, speaks volumes about how much faith he has inWeschler and Combs.
We only wish that he would be more forthcoming aboutsuccession planning, which has become an increasinglyimportant topic for shareholders. While Buffett did heappraise on Ajit Jain (who runs Berkshire HathawayReinsurance Group), Tad Montross (the head of General Ge),Tony Nicely (GEICO's CEO), Matt Rose (chief executive atBNSF), and Greg Abel (who runs MEHC), we're still no closerto knowing which, if any, of these men will succeed Buffettas chief executive when the time comes. While weappreciate the pressures that may come from naming asuccessor too soon, we would like Buffett to be a bit moretransparent on this front. We believe that a transitionalperiod where a replacement takes on something akin to aCOO role might alleviate shareholder concerns and helpfacilitate a smooth transition.
And finally, Buffett included commentary regarding hisviews on the intrinsic value of Berkshire. As usual, Buffettdid not directly detail how he values the firm, but ratherprovided a few hints for investors with his highlighting theeconomics of Berkshire's insurance float along with histypical breakout of the per-share investments from earnings
of the noninsurance businesses. For our thoughts on howbest to value the firm, see our Feb. 19 presentation "What'sthe Best Way to Value Berkshire Hathaway?" whichexamines the numerous methods for calculating thecompany's intrinsic value, including a discussion of our sum-of-the-parts approach (based more on a discounted cashflow methodology, which we think more adequatelycaptures the complex cash flows of Berkshire's businesses).Berkshire's 2012 Book Value Gain Falls Short of S&P 500;
Buffett Still Not Open to a Dividend 01 Mar 2013
Wide-moat rated Berkshire Hathaway's BRK.A BRK.Bfourth-quarter earnings wrapped up a year in whichacquisitions and ongoing improvements in the firm's non-insurance businesses contributed to what was a year ofimproving results for its insurance operations. Aftertaxoperating earnings increased 6% year over year during thefourth quarter, contributing to a 17% increase in earningsduring 2012. Including the impact from investment andderivative gains, the firm reported a 49% increase in fourth-quarter net earnings, contributing to a 45% increase in netearnings for the full year.
Berkshire's book value per Class A equivalent share at theend of 2012 was USD 114,214--up 14% year over year. Whilea result like that would normally be seen as a positive, itwas only the ninth time in the last 48 years Berkshire'spercentage increase in its book value was less than that forthe S&P 500 Total Return Index. Warren Buffett did go onto note in his annual letter to shareholders that in eight ofthose nine years the index posted gains of more than 15%.
Berkshire closed out the fourth quarter with close to USD47 billion in cash on its books, down from USD 48 billion atthe end of the third quarter. That said, the company didspend more than USD 1 billion on share repurchases, anearly equal amount on business acquisitions, and close toUSD 3 billion on capital expenditures during the fourthquarter, so we're not going to fret too much about the
decline. If anything, we've become concerned about thegrowing cash hoard the last couple of years.
As such, we were encouraged to see Buffett putting moremoney to work this year, with the Heinz HNZ deal knockingmore than USD 12 billion off the total. This leaves Berkshirewith about USD 15 billion in need of investment, with USD20 billion left over as a cash backstop for the insuranceoperations. Forget any talk of a dividend, though, as Buffettmade it clear in his letter that the priorities for cash willremain (in this order): capital expenditures, acquisitions, andshare repurchases. The payment of a dividend will only beconsidered once it no longer makes sense for Berkshire tobe putting money back into the business and the market-price premium for Berkshire's stock is too high to warrantshare repurchases.
Looking more closely at the firm's operating businesses, allof Berkshire's insurance operations (save for BerkshireHathaway Primary Group) posted underwriting losses duringthe last quarter of the year, albeit not of very largemagnitudes, and primarily related to claims from HurricaneSandy. At USD 725 million aftertax, the aggregate figure isslightly better than we would have initially guessed,especially given the firm's exposure to catastrophes andsuper-catastrophes in its reinsurance operations, but thequarterly underwriting performance at GEICO wassomewhat surprising given results from close competitors.Even with the concentrated losses Berkshire experiencedduring the fourth quarter, catastrophe claims were actuallydown significantly for the full-year. A combination of lossesfrom the Japanese earthquake/tsunami, earthquakes inNew Zealand, an elevated number of severe tornadoes inthe U.S., and widespread flooding in Thailand caused 2011to be a very difficult year for both Berkshire and the globalinsurance industry. Consequently, the firm's full-yearunderwriting income actually rose more than sixfold to USD1.0 billion in 2012 when compared to last year's results.
Offsetting a fourth-quarter underwriting loss, growth atGEICO was relatively robust as toward the end of the yeargains in earned premiums accelerated--growing by nearly10% in the quarter and 9% for the full year. Gains in policies,as the company continues to take share, were primarilyresponsible. At the same time, GEICO was able to raiseprices, which accounted for most of the remainder ofpremium growth. Berkshire's auto insurance subsidiarycontinues to increase in importance as its other insurancebusinesses have grown at a much slower rate, contributingmore than 40% of pretax underwriting profits during 2012.That said, top-line growth at Berkshire's reinsuranceoperations, which tends to be lumpier in nature, was up yearover year at both BHRG and General Re. With regards to netinvestment income, which is an important driver ofinsurance profitability, it continued to decline in both thefourth quarter and full year. While Berkshire invests a sizableportion of its aggregate portfolio in equity securities in orderto maximize total returns, its fixed income securities are notimmune to the effects of a historically low interest rateenvironment. We expect this trend to persist for as long asinterest rates remain depressed, with the firm forced to rolllarger and larger portions of its investment book into loweryielding securities.
Much as they have the last couple of years, Berkshire's non-insurance operations continue to be a source of stability forthe firm, reporting a 2% increase in operating earnings yearover year during the fourth quarter, contributing to a 16%increase for these businesses for all of 2012. While thefirm's annual results were distorted somewhat by the timingof the Lubrizol acquisition (which closed in mid-September2011), this should not detract from many of the positivethings going on with these operations. BNSF, whichcontinues to be one of the largest contributors to earningsat Berkshire outside of its insurance operations, reported a13% increase in aftertax earnings during 2012, as increased
rail volumes and higher average revenue per car/unit led toa 7% increase in revenue, with operating expensesincreasing just 4% when compared with 2011. Berkshirealso reported fairly solid results for MidAmerican, whichsaw its top line increase 4% despite seeing an 8% declinein revenue at MEC, as much stronger results from PacifiCorpmore than compensated for the shortfall. Aftertax earningsattributable to Berkshire increased 10%, which was a vastimprovement over 2011 results.
With regards to the manufacturing, service, and retailoperations, which include Lubrizol, the group overall saw a15% increase in revenue during 2012, which translated intoa 22% increase in aftertax earnings. The company reporteda solid year from McLane, which benefited from acquisitionsmade during 2012, with full-year revenue increasing 12%and pretax earnings up 9% at the wholesale distributor.While the same could also be said for Marmon, whichbenefited from several bolt-on acquisitions during the year,the firm continues to focus more heavily on higher-marginsectors that focus on niche markets, leading to a 4%increase in full-year revenue and a 15% improvement inpretax earnings. Aided by the Lubrizol acquisition,Berkshire's other manufacturing segment recorded a 26%increase in full-year revenue and a 38% improvement inpretax earnings (no doubt aided by the 19% operatingmargins provided by Lubrizol). While Berkshire's otherservice segment had stronger top-line results, with revenueincreasing 10% during 2012, pretax earnings declined 1%year over year. Meanwhile, the firm's retailing operationsreported a 4% increase in revenue and a 2% gain in pretaxearnings. As for Berkshire's finance and financial productsdivision, which includes Clayton Homes (manufacturedhousing and finance) and CORT Business Services (furniturerental), the segment had a fairly good year as well, withrevenue up 2% and aftertax earnings increasing 8% yearover year.
It should also be noted that while Berkshire did notrepurchase any shares through the first nine months of 2012,the firm spent USD 1.3 billion during the fourth quarterbuying back 9,475 Class A shares and 606,499 Class Bshares, most of which were bought from the estate of alongtime shareholder. We continue to believe that Berkshirehas effectively created a floor under the company's stockprice by announcing that it would buy back both Class A andClass B shares at prices up to 120% of reported book value,which stood at USD 114,214 per Class A share (and USD 76per Class B share) at the end of the fourth quarter of 2012.This means that Buffett would be willing to step in and buyback the company's common stock at prices up to USD137,000 per Class A share (and USD 91 per Class B share),although we're more likely to see repurchases in the USD125,600-137,000 range for Class A shares (and USD 84-91per Class B share), which is the range between the old pricelimit (of 1.1 times book value) and the new one.Equity Portfolio and Heinz Deal could Signify a Shift in
Berkshire's Approach to Investments 19 Feb 2013
With wide-moat-rated Berkshire Hathaway's BRK.A BRK.B fourth-quarter earnings and annual report set to bereleased this coming weekend, and the company not onlyannouncing its investment in Heinz HNZ last week but alsofiling its form 13-F (which details its equity holdings), wewanted to mull over some of the thoughts we've had aboutsome of Berkshire's more recent capital allocation decisionsthat may not have made their way into our initial takes.
With regards to the equity portfolio, which was worth morethan $75 billion at the end of 2012, Warren Buffett continuesto have an outsized influence, but has shown signs of cedingmore and more control to his two lieutenants--Todd Combsand Ted Weschler--noted by the fact that both DirecTV DTVand DaVita DVA have worked their way into the top 10holdings. While both men are now working with a "bank"of about $4 billion each, equivalent to what Lou Simpsonworked with during his time at Geico, we continue to expect
that level to go higher in the near term.
We also believe that Buffett has the two managers involvedin some of Berkshire's nontraditional investments, like itsdeal with Media General last year, and wouldn't besurprised to learn that they worked on the Heinz deal with3G Capital. While we still don't expect to make any materialchanges to our valuation of Berkshire as a result of the Heinztransaction, as Buffett is basically replacing some of thehigher-yielding investments procured during the financialcrisis with this deal, we do think that it could signify a bigchange in how Berkshire approaches investments in thefuture.
We continue to view the Heinz transaction, which requiresan outlay of $12 billion from Berkshire, as a situation whereBuffett has lent his name (and capital) to a transaction thatwas put together by a private-equity firm in return for a 9%yield on two-thirds of his investment and the potential forupside longer term via Heinz's operations (which Berkshirewill have no hand in running). With Buffett having more cashthan he knows what to do with, and Combs and Weschlerlikely to have an even greater influence on investmentsgoing forward, we believe that the Heinz deal could end upbeing the first of many unique investments that Berkshireends up putting together.
Berkshire Sells More Legacy Holdings; Heinz Purchase
Ends Up being Bigger News Than 4Q Buys 15 Feb 2013
Berkshire Hathaway's BRK.A BRK.B fourth-quarter 13-Ffiling, which details the firm's equity holdings, continued toshow evidence of the primary theme we've believed woulddrive portfolio movements over the near term. Ever sinceBerkshire appointed Ted Weschler and Todd Combs asinvestment managers, the firm has been fairly active aboutselling legacy positions as part of an ongoing process toraise capital for the two managers to invest.
The biggest sale during the period involved 28.8 millionshares of Kraft Foods Group KRFT , which, by our estimatesraised around $1.1 billion for the firm. At a little more than$75 million at the end of last year, Kraft is now one of thesmallest holdings in Berkshire's equity portfolio, and we'dbe surprised if the shares remained there much longer. Asfor the other sales during the period, Berkshire sold offanother 165,000 shares of Johnson & Johnson JNJ ,whittling its stake in the health-care firm down to less than$23 million at the end of the year. Much like with Kraft, weexpect Johnson & Johnson to continue to be a source ofcash for the managers at Berkshire. The only other saleduring the fourth quarter involved Lee Enterprise LEE , whichis now the smallest holding in Berkshire's equity portfolio.
Looking at the purchases during the quarter, Warren Buffettcommitted another $585 million to Wells Fargo WFC , whichis now Berkshire's largest holding (at 20% of the total equityportfolio). DaVita DVA , General Motors GM , and DIRECTVDTV all saw more than $200 million in additional capitalallocated to them as well during the period, with DaVita andDIRECTV both firmly placed as top 10 holdings at Berkshireat the end of the year. As for the other purchases duringthe quarter, the firm increased its stakes in IBM IBM , Wal-Mart WMT , Liberty Media LMCAV , Precision CastpartsPCP , and National Oilwell Varco NOV , but the buys wererelatively small compared with Berkshire's holdings in thesestocks. While there was a more meaningful purchase ofWabco Holdings WBC , and new money purchases of ArcherDaniels Midland ADM and VeriSign VRSN , thesetransactions paled in comparison with the company's $12.2billion investment in Heinz HNZ announced yesterday.
Buffett Bags Elephant With Purchase of Heinz; Joint
Nature of Deal and Valuation Raise Questions 14 Feb 2013
Wide-moat-rated Berkshire Hathaway BRK.A BRK.B
announced this morning that it has agreed to acquirepackaged foods firm Heinz HNZ in a $28 billion deal thathas been put together in conjunction with 3G Capital, aBrazilian private equity firm. Early indications are thatBerkshire and 3G Capital will be putting up most of the cashportion of the deal (equal to $23.2 billion), with WarrenBuffett noting that Berkshire and 3G Capital will each bedirecting $4 billion toward the joint buyout, with Berkshirealso paying $8 billion for preferred shares. The rest of thecash portion of the deal will be covered by debt financing.
Our gut reaction to the deal, which involves Berkshireactually partnering with a private equity firm, is that Buffetthas once again lent his name (and capital) to a transactionin return for a somewhat higher yield (in this case preferredstock with a 9% coupon). That said, at $72.50 per share, theacquisition represents a nearly 30% premium to ouranalyst's fair value estimate (of $56 per share) for Heinz anda 20% premium to Wednesday's closing price for the shares.While this is a classic Buffett type of name, similar to otherconsumer goods firms--like Coca-Cola KO and Gillette--that have found their way into Berkshire's portfolio over theyears, we are a little concerned about the valuation (at justover 12 times our adjusted fiscal 2014 EBITDA estimate)and need more concrete details about the terms of thetransaction to determine the full impact on Berkshire. Thatsaid, Berkshire came into 2013 with well over $40 billion incash that was earning next to nothing, so engineering a dealwhere two thirds of the investment is guaranteed to yield9% is money well spent.
Berkshire Warms Up to Heinz With an Ore-Right Buyout
14 Feb 2013
The packaged food industry has been ripe for value-enhancing transactions--both marriages and divorces--forquite some time. To that end, H.J. Heinz HNZ announcedthis morning that it is to be acquired by Berkshire Hathaway
BRK.A BRK.B and 3G Capital in a $28 billion deal ($72.50per share), valuing the company just north of 12 times ouradjusted fiscal 2014 EBITDA estimate, roughly in line withtransaction multiples for other recent takeovers in consumerpackaged goods. Our initial take is that this is a fabulousdeal for Heinz shareholders, representing a nearly 30%premium to our $56 fair value estimate and a 20% premiumto Wednesday's closing price. We are putting Heinz underreview and intend to raise our fair value estimate to thetakeout price, as we don't anticipate any roadblocks to thedeal's completion.
We've long regarded Heinz--the most global of the U.S.-based packaged food firms--as maintaining broadcompetitive advantages, deriving from its expansive globalscale and the brand strength inherent in its refocusedproduct portfolio, resulting in our narrow economic moatrating. It appears that Warren Buffett shares our take. TheHeinz brand, which is on an array of products from ketchupto baked beans to baby food, is a $4.5 billion globalpowerhouse, accounting for about 40% of the firm's totalrevenue, and Heinz's top 15 brands (each of which resultsin more than $100 million in annual sales) drive about 70%of revenue every year. In addition, Heinz generates aboatload of cash--free cash flow averaged nearly 10% ofsales annually over the past five years--and we bet thatBerkshire found this to be quite attractive.
Heinz has been challenged in North America, with problemsthat go beyond the macro headwinds plaguing its peers. Forinstance, the Ore-Ida brand has faced an onslaught ofissues, stemming from aggressive competition from private-label offerings and product innovation that has failed toexcite consumers. But we've been encouraged bymanagement's focus on driving further efficiencies andreinvesting in its brands, which we think will ensure itscompetitive advantages remain intact over the longer term.
Berkshire Assumes Cigna's Annuity Liabilities 04 Feb
2013
Cigna Corporation CI has announced that BerkshireHathaway BRK.A BRK.B , through Berkshire Hathaway LifeInsurance Company of Nebraska (a subsidiary of NationalIndemnity Company), will reinsure Cigna's Run-offGuaranteed Minimum Death Benefits (VADBe) andGuaranteed Minimum Income Benefits (GMIB) businesses.Under the terms of the agreement, Berkshire will assume100% of Cigna's exposure up to $4 billion of future VADBeand GMIB claims, which is significantly in excess of currentprojections of future claims for this business, in return for$100 million in cash, investment assets worthapproximately $1.8 billion, and an estimated $300 milliontax benefit.
While this is not the first time that Berkshire has engagedin these kinds of transactions, it has been more than twoyears since we've seen anything of this nature withannuities, with the firm's 2010 deal with Swiss Re Life &Health America standing out the most. While the companyhas noted in the past that transactions like this represent agood long-term deal for shareholders, it should be notedthese types of liabilities are notoriously long-tailed and theultimate estimation of losses is very difficult to predict. Thatsaid, Berkshire is likely to have gotten a good deal whenassuming these liabilities as insurers are under pressure toshed legacy annuity reserves in order to both clear upreported financials and reduce market tail risk. Given thesepressures, there may be more of these deals in the marketfor Berkshire to consider. After all, the long-tail nature ofthe liabilities does, however, mean that Warren Buffett caninvest the $1.9 billion that Berkshire is receiving until theseclaims are ultimately due. That being said, Berkshire alreadycame into 2013 with a relatively large amount of cash(around $40 billion-plus by our calculations) sitting on itsbalance sheet.
Berkshire Buys Back Shares, Increases Price Limit for
Share Repurchases to 1.2 Times Book Value 12 Dec 2012
In yet another surprising move from the Oracle of Omaha,Berkshire Hathaway BRK.A BRK.B announced Wednesdaythat it had repurchased 9,200 of its Class A shares from theestate of a longtime shareholder (for a total cost of $1.2billion, or $131,000 per Class A share) and was raising theprice limit for share repurchases to 120% of book value.This follows the announcement in late September 2011 thatthe board of directors had authorized its first ever share-repurchase program, which was designed to buy back ClassA and B shares at prices no higher than a 10% premium tothe firm's most recent book value per share. WithBerkshire's shares and book value improving in value sincethat time, the firm has not had much of an opportunity tobuy back shares, purchasing 98 Class A shares (for about$10.5 million) and a little over 800,000 Class B Shares (foraround $57 million) during the last four months of 2011 andmaking no share repurchases during the first nine monthsof 2012.
With Berkshire's board of directors increasing the price atwhich the firm will consider repurchasing its own shares to1.2 times its most recent book value, Warren Buffett is nowauthorized to buy back shares at prices below $134,062 perClass A share (and $89.37 per Class B share) compared withthe previous limit, which would only have allowed to thefirm to repurchase shares below $122,890 per Class A share(and $81.92 per Class B share). While the shift in the pricelimit seems a bit fortuitous, given that Berkshire was facedwith the prospect of having the estate of a longtimeshareholder potentially dump $1.2 billion worth of stock intothe open market, and the raising of the threshold allowsBuffett to buy all of the shares under the auspices of theshare-repurchase program, it does provide benefits to bothparties. For the seller, it provides a single transaction at a
single price for shares that have traditionally not been veryliquid. For Berkshire, it provides the opportunity to retire9,200 Class A shares, which have 10,000 times the votingpower of Class B shares, at what looks to have beensomething close to the going market price. We would alsoassume that the transaction costs for both parties werelower than they would have been had the shares been sold/bought in the open market.
Berkshire Sells More Legacy Holdings in 3Q; Trading
Activity Picks Up With Buffett's Two Lieutenants 14 Nov
2012
Berkshire Hathaway's BRK.A BRK.B third-quarter 13-Ffiling, which details the firm's equity holdings, continued toshow evidence of the primary theme that we expect to driveportfolio movements over the near- to medium-term. WithBerkshire's appointment of Ted Weschler and Todd Combsas lieutenants to Warren Buffett, the company has beenactive over the last several quarters selling legacy positionsand in the process raising capital for the two managers toinvest. While a fair amount of the buying activity of late hasbeen initiated by Buffett--with his favorite target continuingto be Wells Fargo WFC --we have seen plenty of tradingactivity on the part of Weschler and Combs. And whileBuffett did make a point during the third quarter of notingthat each of these two managers would be working with a"bank" of around $4 billion each (exclusive of any gains/losses on capital that has already been put to work)--up from$1.75 billion each at the end of last year and $2.75 billioneach at the end of the first quarter--we think that this amountcould rise even higher in the near term, given the amountof selling that has taken place in the portfolio.
Some of the most notable moves in the most recent quarterwere sales of legacy positions that can be tied directly toBuffett. Among these were significant sales of shares ofJohnson & Johnson JNJ , General Electric GE , United
Parcel Service UPS , and Kraft Foods. With regards toJohnson & Johnson, which Berkshire has been selling fairlyregularly over the last year, the firm eliminated another 9.8million shares (equivalent to 95% of the shares that the firmheld at the end of the second quarter and worth more than$680 million based on today's closing price for the stock).At this point, Berkshire holds less than 500,000 shares ofthe health-care firm, and we would not be surprised if thefirm eliminated this holding completely before the end ofthe year (given that it is now one of the smallest positionsin Berkshire's equity portfolio). As for General Electric,which we've always ascribed to Lou Simpson, the firmreduced its stake in the company by close to 90% duringthe third quarter, with less than $15 million left invested inthe conglomerate at the end of the period. UPS receivedsimilar treatment, with Berkshire eliminating 77% of itsstake in the firm, which at less than $5 million was thesecond-smallest holding in the insurer's portfolio.Meanwhile, the sale of half of its Kraft position wasintriguing in that Buffett initiated the trade before thepackaged foods giant was set to spin off its groceryoperations, Kraft Foods Group KRFT , and rename itself asMondelez International MDLZ , which retained global snackfood operations. Having sold off close to 80% of its sharesin Kraft over the last several years, we expect Berkshire tocontinue to whittle down this stake (which is still a top 10holding at more than $1.2 billion at the end of the thirdquarter), much like they have with Johnson & Johnson.
Other sales of legacy positions during the quarter includedConocoPhillips COP , which was reduced by 16% (or 4.7million shares), Procter & Gamble PG , which was trimmedby more than 10% (with 6.8 million shares sold), and USBancorp USB , which saw a less than 10% reduction(equivalent to 4.7 million shares). While not quite what wewould consider to be a legacy position, it was interestingto see Berkshire sell about two thirds of its stake in LeeEnterprises LEE , given that the insurer had really only
started to build a position in the firm this year. That said,the stock has doubled since the start of the year, partlybecause Berkshire was taking a stake in the firm, so thiscould be a move to book some gains, which would meanthat this was likely a Combs holdings as opposed to a Buffettpurchase (which is what we had originally believed it to be).Combs was also likely behind the sales of CVS CaremarkCVS , Dollar General DG , and Visa V , all of which werebeen built up over the last year or so. With the first twoholdings, he eliminated the positions from the portfolio, withCVS up 25% in the year leading up to the start of the thirdquarter, and Dollar General up more than 60%. Combs alsotook advantage of the 45% runup in Visa's stock price toeliminate about one quarter of his stake in the firm. As forthe other sales in the portfolio, Berkshire reduced its stakein Verisk Analytics VRSK , and finally eliminated its positionof Ingersoll-Rand IR .
Looking more closely at the purchases, Buffett was likelybehind the additional purchases of shares of Wells Fargoand International Business Machines IBM . Buffett hasthrown money at Wells Fargo in eight of the last ninecalendar quarters, with Berkshire now holding a $14.5billion stake in the bank. As for IBM, the purchase was muchsmaller, with Berkshire adding another 870,000 sharesduring the third quarter, leaving the insurer with just over$14 billion invested in the technology giant at the end ofthe third quarter. The rest of the purchases during the periodwere initiated, in our view, by Weschler and Combs, withthe former likely behind the purchases of shares of DIRECTVGroup DTV , DaVita DVA , Viacom VIAB , and Media GeneralMEG , given his penchant for media stocks, while the latterwas likely behind increased stakes in Bank of New YorkMellon BK , National Oilwell Varco NOV , and GeneralMotors GM , as well as new money purchases of Deere DE, Precision Castparts PCP , and Wabco Holdings WBC . Thatsaid, this is pure speculation on our part. Unless we are tolddirectly the purchases and sales made by respective
Cost of Equity % 10.0Average Forward ROE %, 5 Yr % 5.3Average Forward ROE %, 5 Yr, Excluding Goodwill % 6.2Long-Run Tax Rate % 30.0Stage 2 Net Income Growth Rate % 4.5Stage 2 Incremental ROE % 13.0Perpetuity Year 20
USD MilFirm Value
(%)Per Share
Value
Present Value Stage I 41,494 13.7 25,265.28Present Value Stage II 61,802 20.4 37,630.50Present Value of the Perpetuity 44,875 14.8 27,323.89Equity Value, Sub-Total 148,172 90,219.68
Other Adjustments 154,641 51.1 94,158.55Total Equity Value 302,813 187,499.64
Projected Shares Outstanding 2
Fair Value per Share 125.00
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Key Valuation Drivers
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Additional estimates and scenarios available for download at http://select.morningstar.com.
Comparable Company AnalysisThese companies are chosen by the analyst and the data are shown by nearest calendar year in descending market capitalization order.
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Profitability Analysis
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Price/Earnings Price/Book Price/Tangible Book Price/Earned Premium Dividend Yield %
ROE % ROE Without Goodwill % Return on Assets % Combined Ratio % Profit Margin %
The Morningstar Rating for stocks identifies companies trad-
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We assign three moat ratings—none, narrow, or wide—as
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Morningstar Research Methodology for Valuing Companies
Analyst conducts company and industry research:
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Channel checks
Trade-show visits
Industry and company reports and journals
Conference calls
Management andsite visits
3
3
3
3
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3
Strength of competitive advantage is rated: None, Narrow, or Wide
Advantages that confer an economic moat:
High Switching Costs (Microsoft)
Cost advantage (Wal-Mart)
Intangible assets(Johnson & Johnson)
Network Effect(Mastercard)
Efficient Scale(Lockheed Martin)
Analyst considers past financial resultsand focuses on competitive position and future prospects to forecast future cash flows.
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QQQQQQQQQQQQQQQ
Fundamental Analysis
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@Morningstar 2013. All Rights Reserved. Morningstar's Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization(“NRSRO”). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are providedsolely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwiserequired by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property ofMorningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
Page 30 of 33
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perpetuity formula. In deciding on the rate at which to dis-
count future cash flows, we ignore stock-price volatility.
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ing into account fundamental factors such as the diversity of
revenue sources and the firm’s fixed cost structure.
We also employ a number of other tools to augment our valu-
ation process, including scenario analysis, where we assess
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model three to five scenarios for each company we cover,
stress-testing the model and examining the distribution of
resulting fair values.
The Morningstar Uncertainty Rating captures the range of
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nancial leverage, and any other contingent events that may
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ment of management's stewardship of shareholder capital,
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@Morningstar 2013. All Rights Reserved. Morningstar's Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization(“NRSRO”). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are providedsolely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwiserequired by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property ofMorningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
Page 31 of 33
Morningstar Corporate Credit Rating
3 Offers a proprietary measure of the credit qual-ity of companies on our coverage list.
3 Encapsulates our in-depth modeling and quantitative work in one letter grade.
3 Allows investors to rank companies by each of the four underlying com- ponents of our credit ratings, including both analyst-driven and quantitative measures.
3 Provides access to all the underlying forecasts that go into the rating, available through our insti-tutional service.
MethodologyWe feel it’s important to perform credit analysis through different lenses—qualitative and quantitative, as well as fundamental and market-driven. We therefore evaluate each company in four broad categories.
Business RiskKey components of the business risk score include the Morningstar Economic Moat™ Rating and the Morningstar Uncertainty Rating. However, it also takes into consideration some insurance-specific factors: regulatory environment, the level and volatility of underwriting profitability, and overall level of underwriting risk.
Financial RiskThis score is a quantitative assessment of an insurer’s credit health based on three components: reserves leverage, financial leverage, and an investment portfolio sensitivity analysis. For this final measure, we estimate a one-standard deviation loss rate for each asset class in the company’ investment portfolio to assess the relative risk level of the investment portfolio and the balance sheet
3
3
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3
PurposeThe Morningstar Corporate Credit Rating measures the ability of a firm to satisfy its debt and debt-like obligations. The higher the rating, the less likely we think the company is to default on these obligations.
The Morningstar Corporate Credit Rating builds on the modeling expertise of our securities research team. For each company, we publish:
Five years of detailed pro-forma financial statements
Annual estimates of free cash flow
Annual forecasts of return on invested capital
Scenario analyses, including upside and downside cases
Forecasts of leverage, coverage, and liquidity ratios for five years
Estimates of off balance sheet liabilities
These forecasts are key inputs into the Morningstar Corporate Credit Rating and are available to subscribers at select.morningstar.com.
Morningstar’s Credit Methodology for Insurance
Morningstar Research Methodology for Determining Corporate Credit Ratings
Competitive Analysis
Cash-Flow Forecasts
ScenarioAnalysis
Quantitative Checks
RatingCommittee
AAA
BBBC
D
BB
BCC
CCC
Analyst conducts company and industry research:
• Management interviews• Conference calls• Trade show visits• Competitor, supplier, distributor, and customer interviews• Assign Economic Moat™ Rating
Analyst considers company financial statements and competitive dynamics to forecast future free cash flows to the firm.
Analyst derives estimate of Debt Cushion.
Analysts run bull and bear cases through the model to derive alternate estimates of enterprise value.
Based on compet- itive analysis, cash-flow fore- casts, and scenario analysis, the analyst assigns Business Risk.
We gauge a firm’s health using quantitative tools supported by our own backtesting and academic research.
• Distance to Default
Senior personnel review each company to determine the appropriate final credit rating.
AAA Extremely Low Default Risk AA Very Low Default Risk A Low Default Risk BBB Moderate Default Risk
BB Above Average Default Risk B High Default Risk CCC Currently Very High Default Risk CC Currently Extreme Default Risk
C Imminent Payment Default D Payment Default
UR Under Review UR+ Positive Credit Implication UR- Negative Credit Implication
AAA
@Morningstar 2013. All Rights Reserved. Morningstar's Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization(“NRSRO”). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are providedsolely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwiserequired by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property ofMorningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
Page 32 of 33
Overall Credit RatingThe four component ratings roll up into a single prelim-inary credit rating. To determine the final credit rating, a credit committee of at least five senior research per-sonnel reviews each preliminary rating.
We review credit ratings on a regular basis and as events warrant. Any change in rating must be approved by the Credit Rating Committee.
Investor AccessMorningstar Corporate Credit Ratings are available on Morningstar.com. Our credit research, including detailed cash-flow models that contain all of the components of the Morningstar Corporate Credit Rating, is available to subscribers at select.morningstar.com.
leverage to potential investment losses.
Debt CushionOur debt cushion score is a corollary to the Cash Flow Cushion™ concept in the general credit rating methodology, measuring the insurer’s ability to cover its debt load and future interest payments with its balance sheet surplus and future profitability. We believe the debt cushion is a fairly robust measure as it is forward-looking and not only takes into account both earnings power and leverage, but also allows the components to be dissected and analyzed..
Distance to DefaultMorningstar’s quantitative Distance to Default measure ranks companies on the likelihood that they will tumble into financial distress. The measure is a linear model of the percentile of a firm’s leverage (ratio of Enterprise Value to Market Value), the percentile of a firm’s equity volatility relative to the rest of the universe and the interaction of these two percentiles. This is a proxy methodology for the common definition of Distance to Default which relies on option-based pricing models. The proxy has the benefit of increased breadth of coverage, greater simplicity of calculation, and more predictive power.
For each of these four categories, we assign a score, which we then translate into a descriptive rating along the scale of Very Good / Good / Fair / Poor / Very Poor.
Morningstar Corporate Credit Rating
Morningstar’s Credit Methodology for Insurance
@Morningstar 2013. All Rights Reserved. Morningstar's Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization(“NRSRO”). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are providedsolely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwiserequired by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property ofMorningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
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