Sector

Financial Services

Background

Chris Bloomstran is the President and CIO of Semper Augustus. We cover the specific elements that make Berkshire special, what it has taught the world about float, and why it's unlikely any business can replicate Berkshire's success.

Cover

Date

June 29, 2022

Episode Number

63

Berkshire Hathaway Business Breakdown

Background / Overview

Berkshire Hathaway, originally a textile company acquired by Warren Buffett in 1965, has transformed into one of the world's largest conglomerates, with over $900 billion in assets. Headquartered in Omaha, Nebraska, it operates as a holding company with a diverse portfolio spanning insurance, energy, railroads, manufacturing, services, and retail. Its evolution from a failing textile business to a global powerhouse reflects Buffett’s ability to pivot and capitalize on opportunities, particularly through the acquisition of National Indemnity in 1967, which introduced the insurance float model that became central to its success. With approximately 400,000 employees across its subsidiaries, Berkshire is a compounder, leveraging permanent capital to acquire and retain high-quality businesses.

Ownership / Fundraising / Valuation

Berkshire is publicly traded, with Buffett and Charlie Munger as key figures, though no specific ownership changes or fundraising events are detailed in the transcript. The company’s market capitalization is approximately $600 billion, trading at 1.3 times book value, significantly lower than its peak of nearly 3 times book value in the late 1990s. It has never raised new equity capital in the markets, instead using its stock for acquisitions (e.g., General Re in 1998) when valuations are high and repurchasing shares ($60 billion in recent years) when trading at a discount to intrinsic value. Valuation is attractive, with an 8.3% earnings yield based on $50 billion in economic earnings, suggesting a 12x earnings multiple.

Key Products / Services / Value Proposition

Berkshire’s value proposition lies in its ability to generate and reinvest permanent capital at high returns, underpinned by disciplined capital allocation and a fortress balance sheet. Its major segments include:

1. Insurance: Generates $70 billion in premiums, producing $150 billion in float, which is invested in a $320 billion stock portfolio and $22 billion in bonds. The underwriting discipline and massive surplus capital ($300 billion statutory surplus) enable consistent profitability.
2. Energy: MidAmerican Energy and other utilities generate $4 billion in profits, reinvesting all earnings into renewable energy (wind, solar) and pipelines, benefiting from regulated returns and tax subsidies.
3. Railroad: Burlington Northern Santa Fe (BNSF) generates $7 billion in profits, with stable economics due to its duopoly-like position in Western U.S. rail transport.
4. Manufacturing, Service, Retail (MSR): A diverse group generating $150 billion in revenue and $11 billion in profits, including businesses like Precision Castparts and Marmon.
5. Investment Portfolio: A $320 billion stock portfolio, with significant holdings in Apple ($100 billion+), Chevron, and Occidental Petroleum, yielding $5.5 billion in dividends and $21 billion in look-through earnings.

Segments and Revenue Model

Berkshire’s revenue model is multifaceted, with each segment contributing distinct cash flows:

• Insurance: Generates $70 billion in premiums across Geico ($40 billion), BH Primary ($13 billion), and reinsurance ($20 billion). Float ($150 billion) is invested in equities, yielding dividends and retained earnings.
• Energy: Earns regulated returns on equity capital, reinvesting all $4 billion in profits into renewable energy and pipelines.
• Railroad: Generates $7 billion in profits from freight transport, with all earnings upstreamed to the parent.
• MSR: Produces $150 billion in revenue and $11 billion in profits from diverse businesses, with profits sent to Omaha for redeployment.
• Investments: Yields $5.5 billion in dividends and $21 billion in look-through earnings from a $320 billion stock portfolio.

Splits and Mix

• Segment Mix (Revenue): Insurance ($70 billion), MSR ($150 billion), with energy and railroad contributing smaller but significant portions.
• Segment Mix (EBITDA): Insurance ($3.5 billion, 5% margin), energy ($4 billion), railroad ($7 billion), MSR ($11 billion), investments ($21 billion look-through).
• Geo Mix: Primarily U.S.-focused, with energy and railroad assets concentrated in the Midwest and West. Insurance and MSR have global exposure.
• Customer Mix: Diverse, ranging from individual auto insurance customers (Geico) to industrial clients (MSR) and regulated utilities.
• Historical Shifts: Insurance’s contribution to profits has declined from dominant to less than 50%, with energy and railroad growing in importance. The stock portfolio’s value has shifted due to market fluctuations (down 20% in the year discussed).

KPIs

• Premium Growth: Stable at $70 billion, with disciplined underwriting limiting growth in unprofitable markets.
• Float Growth: $150 billion, growing steadily due to retained premiums.
• ROE: 10-12%, driven by investment portfolio returns and operating businesses.
• Earnings Yield: 8.3% on $50 billion economic earnings, indicating undervaluation.
• Capex: Energy invests heavily in renewables ($18 billion ongoing), while railroad capex has declined from 2x to 1.5x depreciation.

Headline Financials

• Revenue Trajectory: Stable, driven by insurance premiums ($70 billion), MSR ($150 billion), and steady contributions from energy and railroad. No specific CAGR provided, but historical book value growth was 29% from 1965-1998.
• EBITDA: $50 billion in economic earnings, with $3.5 billion from insurance underwriting, $4 billion from energy, $7 billion from railroad, $11 billion from MSR, and $21 billion from investments. Margin ~20% (estimated).
• FCF: MSR generates $11 billion, with energy and railroad reinvesting or upstreaming profits. No specific group-level FCF figure provided.

Value Chain Position

Berkshire operates across multiple value chains:

• Insurance: Midstream, underwriting policies and investing float. Go-to-market (GTM) via direct channels (Geico) and broker networks (reinsurance).
• Energy: Upstream (power generation) and midstream (distribution), with a regulated monopoly model.
• Railroad: Midstream, transporting freight with a duopoly-like position.
• MSR: Varies, from manufacturing (upstream) to retail (downstream).
• Investments: Passive ownership, leveraging float to hold equity stakes.

Competitive advantage stems from surplus capital, underwriting discipline, and regulated returns in energy/railroad. GTM strategies are segment-specific, with insurance relying on brand (Geico) and relationships (reinsurance), while energy and railroad benefit from regulatory barriers.

Customers and Suppliers

• Customers: Diverse, including individual auto insurance buyers, industrial clients, and utility ratepayers. No single customer dominates.
• Suppliers: Varied, with energy relying on equipment providers for renewables and MSR sourcing raw materials. Berkshire’s scale provides bargaining power.

Pricing

• Insurance: Premiums set by market dynamics and state regulators (Geico). Reinsurance pricing is disciplined, avoiding unprofitable business.
• Energy: Regulated returns on equity capital, ensuring stable pricing.
• Railroad: Contract-based, tied to freight demand and economic activity.
• MSR: Varies by business, from commodity pricing to branded retail.

Pricing power is limited in insurance due to competition, but Berkshire’s discipline avoids price wars. Energy and railroad benefit from regulatory or structural pricing stability.

Bottoms-Up Drivers

Revenue Model & Drivers

• Insurance: $70 billion in premiums, driven by volume (policies written) and pricing (premium rates). Geico competes on price and brand, while reinsurance leverages relationships and discipline. Float ($150 billion) generates investment income ($21 billion look-through earnings).
• Energy: $4 billion in profits from regulated returns on $40 billion in equity capital. Volume driven by population growth and renewable adoption; pricing fixed by regulators.
• Railroad: $7 billion in profits from freight transport. Volume tied to GDP; pricing contract-based.
• MSR: $150 billion in revenue from diverse businesses. Volume and pricing vary by market.
• Investments: $5.5 billion in dividends and $21 billion in look-through earnings from $320 billion portfolio. Driven by stock selection and market performance.

Key Drivers:

• Pricing: Insurance pricing is competitive but disciplined; energy/railroad pricing is stable due to regulation or contracts.
• Volume: Insurance volume stable, energy/railroad tied to economic growth, MSR varies.
• Mix: Shift from insurance to energy/railroad reduces reliance on volatile underwriting profits.

Cost Structure & Drivers

• Variable Costs: Insurance losses ($40 billion annually), energy fuel costs, railroad operating expenses, MSR production costs. Driven by claims frequency, inflation, and input prices.
• Fixed Costs: Insurance overhead, energy/railroad infrastructure maintenance, MSR facilities. High fixed costs in energy/railroad provide operating leverage.
• Cost Analysis:
• Insurance: Losses ~57% of premiums, with remainder as overhead. 5% underwriting margin.
• Energy: High capex ($18 billion ongoing), low variable costs.
• Railroad: Maintenance capex ~1.5x depreciation, high fixed costs.
• MSR: Varies, with blended high single-digit ROE.
• EBITDA Margin: ~20% (estimated), driven by operating leverage in energy/railroad and investment income.

FCF Drivers

• Net Income: $50 billion economic earnings, offset by minimal interest expense ($110 billion debt at 3%, offset by underwriting profits).
• Capex: Energy ($18 billion ongoing), railroad (~1.5x depreciation), MSR varies. High capital intensity in energy/railroad.
• NWC: Minimal impact, with insurance float acting as negative working capital.
• FCF: $11 billion from MSR, with energy/railroad reinvesting profits.

Capital Deployment

• M&A: Strategic acquisitions (e.g., Allegheny for $11.6 billion, BNSF for $35 billion) at attractive multiples (7x earnings for Allegheny). Focus on durable businesses.
• Buybacks: $60 billion in recent years, executed at discounts to intrinsic value.
• Organic Growth: Energy reinvests all profits; railroad and MSR upstream profits for redeployment.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Insurance: Global property-casualty market ~$300 billion in premiums. Berkshire writes 7% of reinsurance volume with 40% of surplus capital. Growth driven by demand for coverage, tempered by competition.
• Energy: U.S. utility market growing with renewable adoption. Berkshire’s $35 billion in wind/solar investments position it as a leader.
• Railroad: Freight market tied to GDP, with stable demand in Western U.S.
• MSR: Diverse markets, with growth varying by segment.

Market Structure

• Insurance: Fragmented, with Berkshire as the largest and most disciplined player. Competitors (Swiss Re, Munich Re) lack surplus capital and discipline.
• Energy: Regulated monopolies, with Berkshire’s utilities dominant in Midwest/West.
• Railroad: Duopoly with Union Pacific, high barriers to entry.
• MSR: Varies, with some segments (e.g., housing) cyclical.

Competitive Positioning

Berkshire’s moat is its fortress balance sheet, underwriting discipline, and ability to reinvest at 10-12% returns. It avoids price wars in insurance, benefits from regulated returns in energy/railroad, and selects durable businesses in MSR and investments.

Hamilton’s 7 Powers Analysis

1. Economies of Scale: Massive surplus capital ($300 billion) in insurance allows Berkshire to retain premiums and invest in equities, unlike competitors.
2. Network Effects: Limited, but insurance relationships and brand (Geico) create stickiness.
3. Branding: Geico’s brand drives customer acquisition; Buffett’s reputation attracts deal flow.
4. Counter-Positioning: Berkshire’s discipline (e.g., avoiding unprofitable premiums) contrasts with competitors’ growth-at-all-costs approach.
5. Cornered Resource: Buffett’s capital allocation expertise and surplus capital are unique.
6. Process Power: Underwriting discipline and conservative accounting ensure durability.
7. Switching Costs: High in energy/railroad due to regulatory barriers; moderate in insurance due to brand loyalty.

Strategic Logic

Berkshire’s strategy focuses on retaining profits and reinvesting at high returns. It avoids overpaying for acquisitions, leverages tax-advantaged investments (e.g., renewables), and maintains a conservative balance sheet. The shift from insurance to energy/railroad reduces volatility, while buybacks enhance per-share value.

Unique Dynamics and Key Takeaways

Berkshire’s business model is unique due to:

• Float Leverage: $150 billion in float, invested in a $320 billion stock portfolio, generates $21 billion in look-through earnings, far exceeding competitors’ bond-heavy portfolios.
• Underwriting Discipline: Berkshire’s willingness to shrink premiums by 30-50% in unprofitable markets contrasts with competitors’ reckless growth, ensuring consistent profitability.
• Surplus Capital: $300 billion in statutory surplus (40% of global reinsurance) provides a fortress balance sheet, eliminating the need for recapitalization.
• Diversified Earnings: Insurance contributes less than 50% of profits, with energy ($4 billion), railroad ($7 billion), and MSR ($11 billion) providing stable cash flows.
• Capital Allocation: Buffett’s ability to pivot (e.g., from textiles to insurance, then energy/railroad) and reinvest at 10-12% returns is unmatched. Acquisitions like Allegheny enhance profitability by leveraging Berkshire’s balance sheet.
• Tax Efficiency: Investments in renewables and strategic deals (e.g., Occidental preferred) benefit from tax subsidies, enhancing returns.
• Cultural Discipline: No stock options, low executive pay, and a shareholder-focused culture ensure rational capital allocation.

Critical Insights:

• The insurance float model, while central historically, is less critical today as diversified earnings streams reduce reliance on underwriting profits.
• Competitors’ inability to replicate Berkshire’s discipline and surplus capital creates a widening moat, compounded over decades.
• Mistakes (e.g., Precision Castparts write-down) are absorbed by the fortress balance sheet, becoming rounding errors.
• Valuation at 12x earnings and 1.3x book value suggests undervaluation relative to intrinsic value, driven by durable, predictable earnings.

Conclusion

Berkshire Hathaway’s success lies in its ability to generate permanent capital through insurance float, reinvest at high returns across diversified segments, and maintain unmatched discipline. Its fortress balance sheet, underwriting conservatism, and strategic acquisitions create a compounding machine that is difficult to replicate. The shift toward energy and railroad, coupled with a $320 billion stock portfolio, ensures durability, while buybacks and tax-efficient investments enhance shareholder value. Despite its size, Berkshire remains a compelling investment at an 8.3% earnings yield, with a culture and structure that will outlive its legendary leaders.