Stocks To Power Lines, The Evolution Of Berkshire Hathaway

Summary

• Berkshire Hathaway is shifting its focus towards infrastructure due to the difficulty of outperforming the public equity markets with its large capital base.
• The returns generated by Berkshire's Railroads, Utilities, and Energy business will significantly impact the growth rate of the company.
• Regulatory issues and wildfire liabilities pose risks to Berkshire's infrastructure investments, but a negotiated solution and resolution are likely.

From its humble beginnings as a New England textile mill, Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) has compounded shareholders equity rapidly and evolved into a global insurance behemoth with interests in many of America’s best companies. The evolution does not stop though.

Berkshire has outgrown the markets for years and now only a few companies, public or private, are large enough to significantly impact its performance and those that do are scrutinised meticulously by armies of analysts. Outsmarting the markets consistently becomes practically impossible when operating with such large sums of capital. Big and profitable acquisitions will mostly come about during periods of market distress but these will be few and far between and might not be enough to employ all the cash produced by Berkshire.

Faced with this challenge, Warren Buffett, Berkshire's Chairman, made the strategic decision to shift towards private asset markets. Rather than just acquiring and passively holding well-managed businesses, Berkshire now takes a more active role in building and operating infrastructure. This move makes sense for Berkshire as the infrastructure industry requires substantial capital, features large-scale projects, and offers relatively predictable returns.

However, infrastructure investments typically yield lower profits compared to Berkshire's earlier acquisitions. Some investors worry that this shift may slow down Berkshire's growth, especially compared to the rapidly expanding and highly profitable US tech companies dominating a third of the S&P500. Many are questioning whether it's still worthwhile to hold BRK shares as the company transitions towards infrastructure.

In this article, we delve deeper into the current challenges and performance of Berkshire's Railroads, Utilities, and Energy businesses to assess whether BRK can maintain its competitiveness against the S&P500, as it has done over the past six decades.

This article expands on our previous research on the valuation, as well as the management transition challenges of Berkshire Hathaway. Our assessment indicates that the company is currently fairly valued, suggesting that future stock returns will hinge on its growth prospects. Effective management and capital allocation are the linchpins of this growth. In this article, we delve into one of Berkshire's primary capital investment strategies.

Low but dependable returns

The future growth of BRK will heavily rely on the returns generated by its Railroads, Utilities, and Energy businesses. This is because Berkshire is expected to allocate a larger portion of its retained earnings towards infrastructure projects. When earnings are reinvested, the return on that capital dictates the growth rate of Berkshire's book value, which in turn drives stock appreciation.

However, regulated infrastructure businesses typically yield modest returns. As a result, the growth of Berkshire Hathaway's book value and stock price is likely to slow down significantly. Gone are the days when Mr. Buffett could reinvest all retained earnings into high-return, capital-light acquisitions, resulting in 20% book value growth. Instead, the Railroads, Utilities, and Energy businesses have been generating average returns on equity of only 8-9%.

Here's a summary of the financial performance of Berkshire's infrastructure division:

Berkshire Hathaway financial statements

These moderate returns can seem appealing in a low-interest-rate environment. When long-term Treasuries offer only 2-3% returns, the 8-9% returns on infrastructure investments appears relatively attractive, especially if they are perceived to be as safe as Treasuries. However, this assumption doesn't always hold true.

Wildfire liabilities and regulatory uncertainty

One significant concern is wildfire liabilities and regulatory uncertainty. Last year, the Railroads, Utilities, and Energy business saw a decline in profits due to increasing provisions for wildfire liabilities. Initial estimates suggest damages exceeding $8 billion, but these figures could fluctuate depending on court rulings regarding non-material damage severity.

While Berkshire possesses the financial strength to cover these damages, a more pressing issue is the structural decline in returns on power sector investments. Utilities are essentially forced to carry out wildfire risk mitigation activities, despite not being paid for them, to avoid being held liable for potential damages. Costs associated with activities like vegetation management or installing underground power lines can significantly reduce returns below the allowed rates.

Regulation poses the greatest risk for utility-like businesses, as regulators determine which costs can be included in rate cases. Systemic issues within the regulatory framework could render an infrastructure investment strategy obsolete, depriving Berkshire of a prime opportunity to deploy capital with an attractive risk/return balance.

In his latest shareholders letter, Mr Buffett candidly outlined the significant issues that the Railroads, Utilities and Energy business is facing.

Now, the fixed-but-satisfactory- return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread <…> Other electric utilities may face survival problems resembling those of Pacific Gas and Electric and Hawaiian Electric. A confiscatory resolution of our present problems would obviously be a negative for BHE <…> the final result for the utility industry may be ominous: Certain utilities might no longer attract the savings of American citizens and will be forced to adopt the public-power model.

I did not anticipate or even consider the adverse developments in regulatory returns and, along with Berkshire’s two partners at BHE, I made a costly mistake in not doing so.”

A potentially costly mistake

Mr Buffett has acknowledged misjudging the risk/return balance in the utility business. Initially, investors were concerned about Berkshire allocating capital to a sector with limited return potential. However, it has become evident that the returns may be even lower than anticipated. Last year, the return on equity from the infrastructure business plummeted to 5.2%, while long-term Treasury rates rose to 4-5%. If these low equity returns persist, the current infrastructure investment plans may no longer be feasible.

This presents a significant challenge for Berkshire Hathaway, as the existing capital deployment strategy took years to develop and scale. Greg Abel, CEO of Berkshire Hathaway Energy, is poised to assume the role of chairman after Mr Buffett's departure. It may be too late for the current chairman to devise alternative strategic directions and groom new leaders. Berkshire will have to play with the cards that it has.

Assuming that the regulatory climate remains challenging and that a significant share of retained earnings of the group will continue being poured into the Utilities and Energy business, Berkshire would most likely underperform the S&P500 in the coming years.

Regulatory issues are likely to be resolved

The issues can be addressed and a negotiated solution can be reached and we believe that eventually it will be reached. In the worst case, Berkshire can refocus efforts on more friendly states. The carbon mitigation targets will not be achieved without wind and solar generation and capital is needed to build and connect additional renewable generation capacity. Energy research firm Wood Mackenzie estimates that it would cost $4.5 trillion to convert the entire U.S. power grid to 100 per cent renewable energy. Decarbonisation will hardly be achieved without the capital or the expertise of private operators.

We interpret the transparent discussion of challenges facing Western utilities as a preemptive message to regulators ahead of upcoming rate case negotiations. Berkshire is unwilling to accept diminished returns and is prepared to withdraw capital if a satisfactory resolution cannot be reached. Utilities must present a credible threat to have their concerns addressed in negotiations.

With its diverse portfolio, Berkshire Hathaway possesses the credibility to redirect funds to states with more favourable regulatory climates or alternative sectors within the conglomerate. We are confident that Mr. Buffett or his team would identify more lucrative investment opportunities than unprofitable utilities. Nonetheless, it would be mutually beneficial for both the country and the utilities industry to find a negotiated solution and implement slight increases in electricity rates in affected states.

Under normalised conditions, infrastructure investments offer a viable alternative to public equity markets, particularly considering the current earnings yields of most stocks. Additionally, the industry requires substantial capital, a need that Berkshire Hathaway is well-positioned to meet if offered appropriate rates of return. We trust that rationality will prevail, allowing Berkshire to continue its investments in power infrastructure.

Infrastructure could help outperform the S&P500

Concerns among Berkshire observers frequently revolve around the potential slowdown caused by low-return infrastructure investments, leading to challenges in surpassing returns generated by broader US stock market indices, which have significant exposure to some very profitable sectors. However, we believe this concern may not necessarily hold true.

In his recent shareholder letter, Mr. Buffett highlighted the remarkable performance of his long-term strategic holdings, American Express (AXP) and Coca-Cola (KO). These companies are lauded for their robust competitive positions and high returns on invested capital, but these businesses are already mature and do not have the opportunities to deploy capital effectively at these impressive returns.

Investing in a highly profitable yet mature business, which cannot efficiently redeploy capital and trades at a high earnings multiple, is likely to yield mediocre returns for shareholders. Berkshire's investments in Coca-Cola and American Express, for example, have generated Total Shareholder Returns of 7-10% over the last 10 years.

Total Shareholder's Return of selected companies:

TIKR.com data

The 11-14% normalised returns, generated on tangible capital investments (RoTE) in the Railroad, Utilities and Energy business do not look all that bad in comparison to these equity returns.

Well-operated (…and regulated) utilities and railroads should be able to generate mid-teen returns on tangible equity over longer periods. The heavy investment that Berkshire undertakes also tends to have a front-loaded cost structure and therefore growth projects reduce profitability in the early years. Profitability should improve to the levels of less aggressive industry peers as growth decelerates.

The table below sets out rates of return in some comparable infrastructure businesses:

TIKR.com data

Earnings on infrastructure investments are also expected to be a lot less volatile than on equities. Mr Buffett probably expected organic infrastructure investments within acquired infrastructure franchises to produce superior risk-adjusted returns compared to the stock market. This explains why he would choose to build the Railroad, Utilities and Energy business instead of just pouring money into the S&P 500. The benefits of the low-risk nature of infrastructure investments are not necessarily evident in booming markets, though they will shine during a market downturn when corporate earnings in cyclical sectors decline.

As was pointed out, the infrastructure businesses are currently facing issues. Margins in railroads “could and should” be improved and the regulatory climate for some energy utilities seems to be deteriorating. Once these issues are resolved, Berkshire will have a reliable growth engine capable of delivering investment returns greater than those commonly found in the equity markets.

Infrastructure is a growth engine

Berkshire Hathaway Energy alone plans to spend close to $6 billion per annum on growth capital investments. This spending will be supplemented by bolt-on acquisitions, such as the recent $3.3 billion deal to take over the Cove Point LNG facility. It seems that Mr Buffett is not the only one in possession of an elephant gun within Berkshire Hathaway. As pointed out in the latest BHE investor presentation:

Berkshire Hathaway Energy and its subsidiaries will spend approximately $27.2 billion from 2022-2024 for growth and operating capital expenditures, which primarily consist of new renewable generation project expansions, repowering of existing wind facilities, and electric transmission and distribution capital expenditures.”

The corporate structure of Berkshire Hathaway makes the infrastructure investment even more profitable. Berkshire has grown as fast as it has by funding acquisitions with float (unpaid insurance liabilities) from its sprawling insurance operation. Berkshire will continue following the same playbook and a significant share of infrastructure investment will be funded through the growth of Berkshires’ insurance float. Ajit Jain, the Vice-Chairman of Insurance Operations will deliver the cost-free capital and Mr Able will deploy it. The increasing float will amplify and improve returns in the infrastructure sector.

Conclusions

Considering all factors, it appears probable that Berkshire stock will at least remain competitive with broader stock market index trackers like the S&P 500. However, returns are not assured. Achieving outperformance would depend on a robust operating performance and the successful resolution of regulatory challenges in the utilities sector. Berkshire Hathaway Energy holds a strong bargaining position, and we anticipate a mutually beneficial agreement can be reached with regulators. Even if the situation in California and Oregon does not improve, Berkshire maintains a robust balance sheet to absorb losses and possesses alternative business areas where funds can be redirected.

Risk factors

1. Regulatory uncertainty could make it increasingly difficult to deploy funds in the power utilities space at a reasonable return.
2. Poor operating performance.