No. of Recommendations: 24
The esteemed Greg Warren’s and his thoughts on BRK valuation…more weekend reading. Enjoy!
It's a good summary, but to my mind, it doesn't adequately address what worries me, i.e. the concerns that Buffett himself has raised regarding regulators and their effects on the profitability of the railroad and, particularly, the energy utility. Here's what they say:
BHE also contended with an increase in energy operating expenses, including increases in estimated pretax loss accruals by PacifiCorp for wildfires (net of expected insurance recoveries) of $1.6 billion during 2023, plus higher interest expense and lower electric utility margin year over year.
We view this as a blip in BHE’s overall results. We continue to believe ongoing constructive rate-case outcomes will lead to EBITDA growth in an average 5%-6% range annually over the next five years for its regulated US utilities, even as it ramps up growth and operating capital expenditures.
And here's what Buffett said about the utilities (the worst parts bolded by me, and there are lots of 'em):
Our second and even more severe earnings disappointment last year occurred at BHE. Most of its large electric-utility businesses, as well as its extensive gas pipelines, performed about as expected. But the regulatory climate in a few states has raised the specter of zero profitability or even bankruptcy (an actual outcome at California’s largest utility and a current threat in Hawaii). In such jurisdictions, it is difficult to project both earnings and asset values in what was once regarded as among the most stable industries in America.
For more than a century, electric utilities raised huge sums to finance their growth through a state-by-state promise of a fixed return on equity (sometimes with a small bonus for superior performance). With this approach, massive investments were made for capacity that would likely be required a few years down the road.
With this model employed by both private and public-power systems, the lights stayed on, even if population growth or industrial demand exceeded expectations. The “margin of safety” approach seemed sensible to regulators, investors and the public. Now, the fixed-but-satisfactory return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread. Climate change adds to their worries. Underground transmission may be required but who, a few decades ago, wanted to pay the staggering costs for such construction?
At Berkshire, we have made a best estimate for the amount of losses that have occurred. These costs arose from forest fires, whose frequency and intensity have increased – and will likely continue to increase – if convective storms become more frequent.
It will be many years until we know the final tally from BHE’s forest-fire losses and can intelligently make decisions about the desirability of future investments in vulnerable western states. It remains to be seen whether the regulatory environment will change elsewhere.
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, but both that company and Berkshire itself are structured to survive negative surprises. We regularly get these in our insurance business, where our basic product is risk assumption, and they will occur elsewhere. Berkshire can sustain financial surprises but we will not knowingly throw good money after bad.
Whatever the case at Berkshire, 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. Nebraska made this choice in the 1930s and there are many public-power operations throughout the country. Eventually, voters, taxpayers and users will decide which model they prefer.
When the dust settles, America’s power needs and the consequent capital expenditure will be staggering. 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.
I have seen several assessments of Buffett's letter, the Morningstar one above, and also those by Tilson and Rationalwalk, and to my mind, none of them take these things very seriously; they all reassure us that Berkshire's sources of operating income are diverse, and when one is doing badly, like the utilities and railroad last year, others pick up the slack, insurance being the slack picker-upper this year. But Berkshire will not always have such favourable underwriting results, and I think it is legitimate to ask whether the utilities can really still be relied on to pick up the slack in future years, given Buffett's comments.
dtb
