Company annual reports typically contain a letter from the CEO or Chairman. Many of these letters are boring and filled with half truths. There is one exception: Warren Buffet's annual letter to Berkshire Hathaway shareholders. His letters are eagerly awaited by the financial community because they are funny and insightful, Web site logisticsviewpoints.com reports.
His most recent letter came out at the end of February. He did not say as much as I was hoping for about his rationale for investing in Burlington Northern Santa Fe (BNSF), one of North America's largest railroads. But he did say some interesting things. Here are some excerpts from Buffett's letter:
"In earlier days, Charlie [i.e., his long time partner Charlie Munger] and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations are met -- and we believe that they will be -- Berkshire's ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead.
"Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant.
"We see a "social compact" existing between the public and our railroad business, just as is the case with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to the compact should -- and we believe will -- understand the benefit of behaving in a way that encourages good behavior by the other. It is inconceivable that our country will realize anything close to its full economic potential without it possessing first-class electricity and railroad systems. We will do our part to see that they exist.
"In the future, BNSF results will be included in this "regulated utility" section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens -- yes, tens -- of billions of dollars of incremental equity capital.
"Our blockbuster deal with BNSF required us to issue about 95,000 Berkshire shares that amounted to 6.1 percent of those previously outstanding. Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy. The reason for our distaste is simple. If we wouldn't dream of selling Berkshire in its entirety at the current market price, why in the world should we "sell" a significant part of the company at that same inadequate price by issuing our stock in a merger?
"If shares of a prospective acquirer are selling below their intrinsic value, it's impossible for that buyer to make a sensible deal in an all-stock deal. You simply can't exchange an undervalued stock for a fully-valued one without hurting your shareholders. Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 114 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6 percent of A & B's combined assets and A's shareholders will own 44.4 percent. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.
"In the end, Charlie and I decided that the disadvantage of paying 30 percent of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term...But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting."
I found the latter section particularly interesting. As an industry analyst covering the software market, I've listened to a fair number of calls where the CEO explains why they have purchased another software company. It is not unusual for them to say that they believed the company they acquired was undervalued. I don't recall ever hearing the reverse, that their company was undervalued, which would make a good argument against an acquisition.
(The preceding article by Steve Banker appeared on the Web site logisticsviewpoints.com on March 15, 2010.)
