Deconstructing Buffett

February 28, 2010
BusinessWeek cover story on Warren Buffett, she explains the hidden upside:

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Alice Schroeder has two interesting takes on Berkshire Hathaway’s acquisition of Burlington Northern. In her BusinessWeek cover story on Warren Buffett, she explains the hidden upside:

Buffett always likes a sweetener, and Burlington gives him one in the form of information. He learns about wallboard demand from USG and consumer-credit trends from American Express, but Rose has called the railroad a kaleidoscope of the economy. Rail traffic patterns are a window on commodity, wholesale, consumer, and international trade flows. Buffett is adding this kaleidoscope to what his other CEOs tell him about the “reset of the consumer” to a lower level of spending. They feed him data from Berkshire’s portfolio of companies—sales of building materials, jewelry, furniture, real estate, credit, fractional jets, vacuum cleaners, fabricated steel, newspaper ad lineage, and other products and services. He may now command as much information about the state of the U.S. economy as anyone, including the Federal Reserve—and probably gets his faster.

This makes sense — and it might also provide a hint as to whom Buffett will choose to succeed him as chief investment officer. He’ll want a data hound, someone who can leverage the huge amounts of information that the Berkshire conglomerate provides.

On her blog, Schroeder then adds that she’s disappointed in the way that Buffett is going to hide BNSF’s earnings in his annual reports:

Berkshire has been growing less transparent year by year. Now it is going to combine BNI with its utlity segment for financial reporting next year. Buffett made the argument for combining them (regulated, high capex etc.), but the result is less transparency. BNI is in the transportation business. If being a regulated and capital intensive business is what creates an operating segment for financial reporting, the insurance businesses would also be combined with Mid-American.

Schroeder gives good accounting reasons why BNSF should not be lumped in with the utilities, adding, wearing her CPA hat, that “this is not the spirit of the rules” and that “this is pretty annoying”.

Meanwhile, in his annual letter to shareholders, Buffett does a pretty weak job of responding to Jeff Matthews’s criticism of his decision to pay for BNSF in large part using BRK’s own stock. Or, to put it another way, he actually spends a lot of time and space laying out Matthews’s criticism in his trademark ultra-lucid manner. And then he tries to answer his own criticisms thusly:

In the end, Charlie and I decided that the disadvantage of paying 30% 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. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. 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.

This can essentially be boiled down to two words: “trust me”. Which is maybe sensible, given that trusting in Buffett is exactly what he’s been asking his shareholders to do for decades. But the letter does make it seem that it’s a lot easier to argue against the BNSF acquisition than it is to argue for it.

For me, however, the weirdest part of the letter is where he talks about Clayton Homes, the manufacturer of modular and mobile homes which famously was giving away a free can of pork and beans with every house bought. Clayton doesn’t live in the category of “Manufacturing, Service and Retailing Operations”, where you might suspect it would be found; instead, it’s part of “Finance and Financial Products”, since the real business here isn’t selling homes so much as it’s selling the financing to buy them.

As Buffett explains:

Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 5 1⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan.

Wow, sounds like a great business! Rather than see its financing profits competed away in a commoditized mortgage market, Clayton essentially has a monopoly on providing financing on its homes, and can lend out money at rates much higher than prevailing mortgage rates.

But weirdly, Buffett seems to be unhappy about this:

Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.

Really, Warren? I’d like to see some numbers on this, because I always thought that the great thing about being Berkshire Hathaway, even without a triple-A credit rating, was that you could borrow at a rate approaching that available to government agencies. What’s the spread on Berkshire debt over agency debt? When Berkshire recently borrowed $8 billion, it paid between 2bp and 43bp over Libor on the floating-rate bonds, and between 63bp and 93bp over Treasuries on the fixed-rate bonds. In comparison, agency debt recently narrowed all the way to 66bp over Treasuries, albeit at longer maturities.

In any case, I’d say that the funding advantage that agencies have over Berkshire will be no more than about 50bp, while the financing rates that Clayton’s buyers are paying to Berkshire are, by Buffett’s estimation, about 375bp more than those offered by Frannie. And remember here that Buffett is adamant that Clayton’s buyers are good credit risks, and that “Clayton’s delinquencies and defaults remain reasonable and will not cause us significant problems”.

If you take his words at face value, then, Buffett is saying that Clayton’s buyers are no less creditworthy than buyers of site-built homes. So something over 300bp of the spread that Clayton is charging over other mortgage providers should be pure gravy for Clayton and Berkshire. I’m sure that Buffett would love Clayton to be able to sell more homes than it’s doing right now, but if you remember that Clayton is basically in the business of finance more than it is in the business of manufacturing, I can’t quite see what Buffett is complaining about. Sure, he could sell more mobile homes if you could get conventional mortgages on them. But then he’d lose all of his financing profits, and I’m sure he wouldn’t want that.


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