Berkshire Hathaway (BALANCE

SHEET)
Jana Vembunarayanan / December 30, 2013

I own class B (BRK.B) shares of Berkshire Hathaway. In 2013 I had the privilege to
attend the shareholders meeting and I wrote about my experience here. In this post I am
writing about my understanding of Berkshires business, management and its valuation.

Business
Warren Buffett wrote in 1999 in the annual letter to shareholders, To understand
Berkshire, therefore, it is necessary that you understand how to evaluate an
insurance company. The key determinants are: (1) the amount of float that the
business generates; (2) its cost; and (3) most critical of all, the long-term outlook for
both of these factors.

Let us start with the balance sheet. Berkshires balance sheet as of Sep 30th 2013 can be
found here. I annotated the balance sheet with few questions that came to my mind.
A. Insurance and other businesses has $35.33 billion. Why does it need a lot of cash?
B. Equity and Fixed maturity investments from all its business segments comes to
$163.34 billion. Where are they invested?
C. $91.09 billion is invested in Property, Plant and Equipment. Is this a capital intensive
business?
D. Does the company pay any interest for the liability of $76.48 billion?
E. Can the company service the debt of $40.01 billion without any problems?
F. Why does the company defer the income tax of $50.85 billion. How long can they
do?

Berkshire is a holding company headquartered in Omaha, Nebraska, that oversees and

manages a number of subsidiary companies. Warren Buffett is the Chairman
 and CEO of the company and Charlie Munger is the Vice Chairman of the company. Its
has five major business operations.

1. Insurance
2. Railroad and Utilities
3. Manufacturing, Service and Retailing
4. Investments
5. Finance and Financial Products

Let us look at each business operation in detail and in the process we will get all the 6
questions answered.

1. Insurance

A car cannot run without an engine. Likewise there is no Berkshire without its insurance
business. Hence it is important to understand the insurance business. The two key
concepts about insurance is float and its cost. In 2002 shareholder letter Buffett
explained about it.

To begin with, float is money we hold but dont own. In an insurance operation, float
arises because premiums are received before losses are paid, an interval that sometimes
extends over many years. During that time, the insurer invests the money. This pleasant
activity typically carries with it a downside: The premiums that an insurer takes in
usually do not cover the losses and expenses it eventually must pay. That leaves it
running an underwriting loss, which is the cost of float. An insurance business has
value if its cost of float over time is less than the cost the company would otherwise
incur to obtain funds. But the business is a lemon if its cost of float is higher than
market rates for money. Moreover, the downward trend of interest rates in recent years
has transformed underwriting losses that formerly were tolerable into burdens that
move insurance businesses deeply into the lemon category.

"...[W]e have calculated our float which we generate in large amounts relative to
our premium volume by [my formatting]:

[A]dding net loss reserves, loss adjustment reserves, funds held under reinsurance
assumed and unearned premium reserves, and then
[S]ubtracting insurance-related receivables, prepaid acquisition costs, prepaid taxes
and deferred charges applicable to assumed reinsurance."

Let us look Berkshires float and underwriting profit/loss in 2002, 2007 and 2012.
When we look at the changes over 5 year period we can clearly see the picture (contrast
effect).

Float (in Underwriting Profit/Loss

Year
Millions) (in Millions)
2002 41,224 -411
2007 58,698 3,374
2012 73,125 1,625
In 11 years the float has grown at an annualized rate of 5.35%. In 2002 the cost of the
float was 1% which is lesser than the market interest rate. In 2007 and 2012 the cost of
the float is negative i.e. it had an underwriting profit. This is like having the cake and
also eating it. In 2012 letter he wrote

If our premiums exceed the total of our expenses and eventual losses, we register an
underwriting profit that adds to the investment income our float produces. When such a
profit is earned, we enjoy the use of free money and, better yet, get paid for holding it.
Thats like your taking out a loan and having the bank pay you interest.

As of 2012, Berkshire has been operating with an underwriting profit for 10 consecutive
years. What about other insurance companies? Their results are terrible. State Farm is
the largest insurer and a well run company had underwriting loss in 8 out of 11 years
ending in 2011. The lollapalooza combination that is working in Berkshires insurance
business are

1. Huge float that is growing with time.

2. Zero or very low cost for the float.
3. The float is in the hands of Buffett who is the worlds best capital allocator. He
uses this float to purchase other companies which in turn produces earnings
which are then used for buying other companies. This feedback loop is
happening at Berkshire for a very long time.

Now let us answer one of the questions that I had.

D. Does the company pay any interest for the liability of $76.48 billion?

This liability is the float. Hence the answer is no. In fact Berkshire is being paid
(underwriting profit) for holding the float.
In banking business negative black swans proliferate a lot. Taleb writes

If you are in banking and lending, surprise outcomes are likely to be negative for you.
You lend, and in the best of circumstances you get your loan back but you may lose all
of your money if the borrower defaults. In the event that the borrower enjoys great
financial success, he is not likely to offer you an additional dividend.

Insurance business is different than banking. But the risks are similar. What if an
unforeseen disaster like 9/11 happens and the loss incurred is several times more than
the premiums collected? Buffett understands about the improbable and his insurance
operations underwrite polices with extreme discipline.

If our insurance operations are to generate low-cost float over time, they must: (a)
underwrite with unwavering discipline; (b) reserve conservatively; and (c) avoid an
aggregation of exposures that would allow a supposedly impossible incident to
threaten their solvency.

Now let us answer the second question that I had

A. Insurance and other businesses has $35.33 billion. Why does it need a lot of
cash?

One reason for holding a lot of cash is to purchase quality business, if available at the
right price. The other reason is margin of safety. Even if the worst of disaster happens
he wants Berkshire to be solvent. Remember too-big-fail in 2009 when banks were
bailed out by the government. He does not want to be in that situation.

There are 4 major insurance divisions and they engage in primary insurance and
reinsurance of property/casualty, life and health risks.

1. GEICO Is the low-cost auto insurer. It follows direct response methods in

which customers apply for coverage via telephone or Internet. This helps it to
save a lot of money and pass on the benefits to the customers. Low-cost is a
huge moat. Tony Nicely runs this business and he joined GEICO when he was
18 years old. He is with GEICO for the last 52 years.
2. General Re It is a reinsurer offering property and casualty and life and health
coverages worldwide. Reinsurer assume risks of other insurer and reinsurers.
Tad Montross runs this business.
3. Berkshire Hathaway Reinsurance Group (BHRG) It is a reinsurer
offering coverage for major catastrophes. Buffett refers to catastrophes as super-
cats. Ajit Jain runs this business. In 2012, 47.6% ($34.82 billion) of the total
float ($73.12 billion) came from this group. On 2008 this division had 31
employees and even today this number should be very low. What is the moat for
BHRG? Major catastrophes can cause damages in the order of billions. Most of
the insurance companies will go bankrupt if they need to pay out loses in
billions. Hence they go to a reinsurer for cover. If you are an insurer which
reinsurer will you go to? You will go to someone who will have money when
the disaster happens. The only one out there with money to protect when the
disaster happens is Berkshire. This is a huge moat.
 4. Other Primary It consists of wide varieties of independently managed
insurance business.

Given below is the float and underwriting profit/loss for each division in 2002, 2007
and 2012

In Millons 2002 2007 2012

Underwriting Underwriting Underwriting
Float Float Float
Profit/Loss Profit/Loss Profit/Loss
BHRG 13,396 53423,009 55534,821 304
General Re 22,207 -139323,692 1,42720,128 355
GEICO 4,678 416 7,768 1,11311,578 680
Other
943 32 4,229 279 6,598 286
Primary
Total 41,224 -41158,698 3,37473,125 1,625

As you can see BHRG float has grown at an annualized rate of 9.07% on a huge float
base. No wonder why Buffett writes in his letter If you see Ajit at our annual
meeting, bow deeply.

2. Railroad and Utilities

For any country to prosper, it needs to have first class infrastructure. Railroad and
Electricity are the two main infrastructure items. Berkshire owns both of them.
Burlington Northern Santa Fe (BNSF) moves freight on railroad tracks. MidAmerican
supplies electricity to millions of customers. Both of these business require a massive
amount of capital to operate. Also the capital expenditure requirements are very high.
Then why did Buffett buy them? Buffett believes that regulators in their self interest
(incentive caused bias) will give capital providers with a decent return on capital.

Our confidence is justified both by our past experience and by the knowledge that
society will forever need massive investment in both transportation and energy. It is in
the self-interest of governments to treat capital providers in a manner that will ensure
the continued flow of funds to essential projects. And it is in our self-interest to conduct
our operations in a manner that earns the approval of our regulators and the people
they represent.

The moat for both the business are (1) Highly regulated, (2) Huge amounts of capital
needs to be employed, and. (3) Decent returns on capital. Now we can answer the 3rd
question that I had.

C. $91.09 billion is invested in Property, Plant and Equipment. Is this a capital

intensive business?

Yes. BNSF and MidAmerican are capital intensive business. $53.58 billion in BNSF
and $56.21 in MidAmerican with accumulated depreciation of $18.70 billion comes
to total investment of $91.09 billion.

BNSF

In America 42% of all inter-city freight is moved on railroad tracks. Of which BNSF
moves 37%, which means BNSF moves 15% (0.42 * 0.37) of all inter-city freight in the
US. Moving freight on rail is both environment friendly and energy efficient. In 2010,
BNSF moved each ton of freight it carried a record 500 miles on a single gallon of
diesel fuel. Thats three times more fuel-efficient than trucking. This is a huge cost
advantage for companies and it is another moat. Matt Rose manages the operations at
BNSF. Since Berkshire acquired BNSF in 2009 all the data comparisons are going to be
from 2010, 2011 and 2012.

(In Millions) 2010 2011 2012

Operating Earnings 4495 5310 6000
Interest 507 560 623
Interest Coverage 8.87 9.48 9.63

MidAmerican

Berkshire started its acquisition of MidAmerican in 1999 and in 2012 it owned 89.8%
of MidAmerican. Today it serves electricity to customers in 10 states. It also accounts
for 6% of the countrys wind generation. Three projects are under construction, when
completed it will own about 14% of U.S. solar generation capacity. Greg Abel manages
the operations at MidAmerican.

(In Millions) 2010 2011 2012

Operating Earnings 1,862 1,982 1,958
Interest 353 336 314
Interest Coverage 5.27 5.90 6.24
Now we can answer my 4th question.

E. Can the company service the debt of $40.01 billion without any problems?

Yes it can. BNSF has an average interest coverage of 9.33 and MidAmerican has an
average coverage of 5.80. Should I be concerned with MidAmerican as it only has a
cover of 5.80? No. Remember it is in utility business and hence it is recession proof.
People need electricity all the times. BNSF business is cyclical as companies move less
freight during recession. Hence a coverage of 9.33 has a good margin of safety built in.
On top of this, Berkshire does not guarantee any debt or other borrowings of BNSF,
MidAmerican or their subsidiaries. So as a shareholder we should not be concerned.

Let us take a look at Berkshire return on the capital deployed in BNSF and
MidAmerican. I got the capital deployed by subtracting goodwill and liabilities from
assets. Why did I subtract goodwill? Imagine a company which has assets of $100
generating $25 in pre-tax income. If you want to buy the company you will pay
more than $100. Why would the owner sell you the business that is generating 25%
returns at the cost of assets? You need to pay more so that he will have an
incentive to sell. If you pay $125 for the company the extra $25 is the goodwill.
Hence I removed the goodwill to see the true earning potential of the asset. Why
did I subtract liabilities? Some of the liabilities will have cost in the form of interest
payment. Pre-tax earnings is arrived after subtracting the interest. Hence I have
removed the liability.

(In Millions) 2010 2011 2012

Pre-Tax Earnings 5150 6400 7021
Capital Deployed 49,528 51,725 54,426
Return on Capital 10.39% 12.37% 12.90%

3. Manufacturing, Service and Retailing

Buffett and Munger acquire businesses that are (1) Easy to understand (2) Have durable
moat (3) Run by able and honest management and (4) Fairly priced. Over the years they
have purchased several companies which met their criteria. Some of them are Marmon,
McLane Company, Sees Candies, Fruit of the Loom, and, Nebraska Furniture Mart.
You can look at the full list here. Given below are the total assets deployed in this
segment along with the pre-tax earnings for 2008, 2010, and 2012. Since Berkshire
acquired 64% of Marmon in 2008 hence I am using 2008 as the base year for
comparison. For arriving at capital deployed I subtracted goodwill and liabilities from
the assets. Most of the business will have less capital expenditure. Hence some portion
of their earnings can be used to buy more businesses.

(In Millions) 2008 2010 2012

Pre-tax earnings 4023 4274 6131
Capital Deployed 14264 14574 22640
Return on Capital 28.20% 29.32% 27.08%

4. Investments

Now it is time to answer my 5th question

B. Equity and Fixed maturity investments from all its business segments comes to
$163.34 billion. Where are they invested?

The investments are made into three different groups. The value of all these investments
are marked-to-market. As of Sep 30th 2013 whatever price these securities are selling
for is reflected in the balance sheet.

1. Fixed Maturity Investments $29.54 billion is invested in Treasuries,

Corporate, State and Municipal bonds, Mortgage Backed Securities, and,
Foreign Government bonds.
2. Equities $106.76 billion is invested in equities of publicly traded companies.
Of which 55%($58.71 billion) is invested in the shares of four companies
(highly concentrated). The companies are American Express, Coca-Cola, IBM,
and, Wells Fargo. The same four criteria used for acquiring companies is applied
here.
3. Other Investments $29 billion is invested in this category. This includes
preferred stock and warrants in Wrigley, Dow Chemical Company, Bank of
America and H.J. Heinz Holding Corporation. $12.05 billion is invested in
Heinz which was done in June 2013.

Most of the investments are managed by Buffett. Todd Combs (2010) and Ted
Weschler (2011) joined Berkshire to manage the investment portfolio. As of 2012 they
both managed $5 billion each. Both are smart and honest and have beat S & P 500 in
2012 by double digit margins. They will be managing the entire investment portfolio
after Buffett and Munger.

Now it is time to answer my final question.

F. Why does the company defer the income tax of $50.85 billion. How long can
they do?

Let us see what Buffett thinks about this. In the owner manual he writes

Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that
allow us to safely own far more assets than our equity capital alone would permit:
deferred taxes and float, the funds of others that our insurance business holds
because it receives premiums before needing to pay out losses. Both of these funding
sources have grown rapidly and now total about $117 billion. Better yet, this funding to
date has often been cost-free. Deferred tax liabilities bear no interest. And as long as
we can break even in our insurance underwriting the cost of the float developed from
that operation is zero. Neither item, of course, is equity; these are real liabilities. But
they are liabilities without covenants or due dates attached to them. In effect, they give
us the benefit of debt an ability to have more assets working for us but saddle us
with none of its drawbacks.

Imagine you purchased one share of a company for $100. After one year the value
of the share is $200. If you sell the investments you will pay taxes on capital gains
for $100 ($200 $100) at say 15%. The tax comes to $15 which is the deferred tax
liability if you hold the investment. By not selling you get an interest free loan of
$15 from the government which is put into use.
To make this concept very clear let us assume that you invested $1 in 1980 and
every year the investment doubles. You held onto it for 10 years. Let us call this
strategy as buy-and-hold. At the end of 10 years you have a gain of $512 and a
total deferred tax of $76.80.

Deferred
Year Amount
Tax (15%)
1980 1
1981 2 0.15
1982 4 0.30
1983 8 0.60
1984 16 1.20
1985 32 2.40
1986 64 4.80
1987 128 9.60
1988 256 19.20
1989 512 38.40

Now consider another scenario. The investment doubles every year and at the end
of each year you sell your holding at 15% tax. You did this for 10 years. You made
253.83 just half of what you made in buy-and-hold. Also the total taxes paid to the
government is $44.62. In the buy-and-hold case the deferred tax comes to $76.65.
Even the government got benefited in the buy-and-hold strategy. Why? This is the
power of compound interest. You let the deferred tax liability compound. Buffett
has been doing the buy-and-hold strategy for a very long time. In the process he
did not pay taxes to the government and this comes to $50.85 billion. As long as
Berkshire holds these companies it need to not pay any taxes. Buy right and sit
tight.

Tax at
Year Amount
15%
1980 1.00
1981 1.85 0.15
1982 3.42 0.28
1983 6.33 0.51
1984 11.71 0.95
1985 21.67 1.76
1986 40.09 3.25
1987 74.17 6.01
1988 137.21 11.12
1989 253.83 20.58

Given below are the investment market value of Berkshire in 2002, 2007, 2012, and,
2013.

2013 (9
(In Billions) 2002 2007 2012
months)
Investments Market
87.35 106.57 139.76 163.34
Value
5. Finance and Financial Products

This is a small segment of Berkshire. There are 2 rental companies. CORT rents
furnitures and XTRA rents trailers. Clayton Homes is the countrys leading producer
of manufactured homes and it also services mortgage loans. In 2012 it serviced 332,000
mortgages, totaling $13.7 billion. Remember the financial crisis of 2008? Lots of people
defaulted on their loans and several banks went bust in the process. Clayton Homes
lends money for people to buy their homes. How did their loans perform? It was very
stable. How did they achieve this? Clayton gave mortgages by lending money to people
with manageable debt-to-income ratio. Buffett wrote about this in 2010 letter.

If home buyers throughout the country had behaved like our buyers, America would not
have had the crisis that it did. Our approach was simply to get a meaningful down-
payment and gear fixed monthly payments to a sensible percentage of income. This
policy kept Clayton solvent and also kept buyers in their homes.

Net loss as a
Year percentage of
average loans
2006 1.53%
2007 1.27%
2008 1.17%
2009 1.86%
2010 1.72%

In 2012 this segment had a pre-tax earnings of $848 million.

We have looked at all the 5 business segments of Berkshire. Let us look at the net
earnings and book value in 2002, 2007, 2012, and 2013 (9 months). In 11+ years book
value has grown by 11.32% and net earnings grew by 11.72%.
 2013(9
(In Billions) 2002 2007 2012
months)
Net Earnings 4.28 13.21 14.82 14.48
Book Value 64.03 120.73 187.65 208.38

Management
Berkshire management is able, open, honest, and, shareholder friendly. Buffett has
explained 13 owner-related business principles here. By reading this we can understand
about Berkshire management. In that principle no 9 is

We feel noble intentions should be checked periodically against results. We test the
wisdom of retaining earnings by assessing whether retention, over time, delivers
shareholders at least $1 of market value for each $1 retained. To date, this test has
been met. We will continue to apply it on a five-year rolling basis. As our net worth
grows, it is more difficult to use retained earnings wisely.

Why should $1 of retained earnings should at least have a gain of $1 in market value?
There are two ways for shareholders to make money (1) Dividends and (2) Price
appreciation. Berkshire does not pay any dividends and it retains all the earnings. If for
every $1 retained earnings results in a $1 gain in market value, we can get the retained
earnings by selling the stock. Prof. Sanjay Bakshi explained about it here. Let us do the
same for Berkshire.

Retained Earnings (In

Year
Billions)
2002 4.286
2003 8.151
2004 7.308
2005 8.528
2006 11.015
2007 13.213
2008 4.994
2009 8.055
2010 12.967
2011 10.254
2012 14.824
103.595

Berkshire retained $103.59 billion. Now let us look at the market capitalization. I
used wolfram-alpha for getting the market cap of Berkshire hence not very sure of its
accuracy.

Market Cap (In

Date
Billions)
2-Jan-02 115.5
30-Dec-
291.24
13
175.74

During the same period the market cap grew by $175.74 billion. For every $1 of
retained earnings the market price went up by $1.69. Hence there is a definite value that
is getting created for every $1 retained.

Total earnings retained = $103.59 billion

Delta market cap = $175.74 billion

Market price increase for $1 retained = Delta market cap / Total

earnings retained
Market price increase for $1 retained = $175.74 / $103.59
Market price increase for $1 retained = $1.69

If I do the same on a 5-year rolling basis how does the data look? For 3 out of 7 rolling
periods the market value was higher than retained earnings. During the period from
2008 to 2011 the market was undergoing enormous turbulence. Hence we cannot get
any useful information for the period ending from 2008 to 2011.
 Beg Market End Market Delta Market
5 Year Rolling Retained Earnings (In Market Value for $1
Cap(In Cap(In Cap(In
Period Billions) retained
Billions) Billions) Billions)
2002 2006 39.288 115.5 169.7 54.2 1.38
2003 2007 48.215 111.6 219.1 107.5 2.23
2004 2008 45.058 129.4 149.7 20.3 0.45
2005 2009 45.805 135.2 153.4 18.2 0.40
2006 2010 50.244 136.5 197.7 61.2 1.22
2007 2011 49.483 169.7 188.6 18.9 0.38
2008 2012 51.094 219.1 219.3 0.2 0.00

Valuation
Buffett treats book value as intrinsic value to measure Berkshires performance against
S & P 500. He knows that book value is much lower than Berkshires intrinsic value.
Why? Here are the reasons

1. Insurance float is treated as a liability and hence it reduces the book value. This
is a revolving fund and as long as the cost of this is close to zero it is a huge
asset for Berkshire. On 30th Sep 2013 it was recorded at $76.48 billion.
2. The deferred tax liability is booked as a liability and hence it reduces the book
value. Taxes are due only when the investments are sold. On 30th 2013 it was
recorded at $50.85 billion.
3. On 30th 2013 the market value of top four equity investments comes to $58.71
billion. These terrific companies retain their earnings and they are not reflected
in the book value.

Now how do we measure the value of Berkshire? We can get the answer from Buffett
himself. In 2012 letter he wrote

The third use of funds repurchases is sensible for a company when its shares sell at
a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined
repurchases are the surest way to use funds intelligently: Its hard to go wrong when
youre buying dollar bills for 80 or less. We explained our criteria for repurchases in
last years report and, if the opportunity presents itself, we will buy large quantities of
our stock. We originally said we would not pay more than 110% of book value, but that
proved unrealistic. Therefore, we increased the limit to 120% in December when a
large block became available at about 116% of book value.

Buffett will buy back stock if it is selling for less than 120% of the book value. On
Sep 30th 2013 the book value of Berkshire is $208.38 billion. Multiplying it with 1.2 we
get $250.05. The current market cap is $291.24 billion and this is 16% more than his
buy back limit.

Let us look at it another way. Investments of $163.34 billion plus insurance float of
around $76.48 billion comes to $239.82 billion. If you subtract $239.82 billion from the
the current market cap of $291.24 billion we get $51.42 billion. For $51.42 billion we
can buy [BNSF, MidAmerican, 75+ terrific businesses, Buffett, Munger, Ajit, Tony,
Todd, Ted, ]. What do you think?
Munger applied some of the same principles at a smaller venture
(Daily Journal)
Al contabilizar el impuesto correspondiente a un determinado ejercicio cuyo tipo de gravamen
es del 32,5%, surgen dos diferencias temporarias:

Una deducible por importe de 4.000 y

Otra imponible por importe de 6.000,

cuya reversin se producir en los ejercicios siguientes para los que el tipo de gravamen, ya
aprobado, ser del 30%.

El impuesto corriente del ejercicio asciende a 3.000, y las retenciones y pagos a cuenta a 1.400.

Concepto Debe Haber

Impuesto corriente (6300) 3.000,00
H. P., retenciones y pagos a cuenta (473) 1.400,00
H. P., acreedora por impuesto sobre sociedades (4752) 1.600,00

Concepto Debe Haber

Activos por diferencias temporarias deducibles (4740) (30% x
1.200,00
4.000)
Impuesto diferido (6301) 1.200,00

Concepto Debe Haber

Impuesto diferido (6301) 1.800,00
Pasivos por diferencias temporarias imponibles (479) (30% x
1.800,00
6.000)

Concepto Debe Haber

Resultado del ejercicio (129) 3.600,00
Impuesto corriente (6300) 3.000,00
Impuesto diferido (6301) 600,00
How Buffett Is Changing The Future Of
Berkshire's Float - From Insurance To
Uncle Sam
Aug. 15, 2014 4:32 PM ET by: Shreyas Patel

Disclosure: The author has no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. (More...)

Summary
Warren Buffett is generating new sources of float in capital intensive businesses
using depreciation.
Thanks to 'Uncle Sam', deferred taxes will soon surpass insurance as the primary
float generator.
Understanding how deferred taxes work for fixed assets will be crucial to
valuation going forward.
Why Buffett is spending large amounts of capex on BNSF and MidAmerican to
grow tax float.
What is the intrinsic value of deferred tax float, and valuation implications for
Berkshire Hathaway.

Insurance float is a concept that Warren Buffett has clearly explained as a source of
enduring value for Berkshire Hathaway Inc (BRK.A, BRK.B). However, there are other
sources of float that are becoming more important to Berkshire over time, but are not
well understood by investors.

This article was sent to 8,489 people who get email alerts on BRK.A.

Get email alerts on BRK.A

Deferred tax liabilities (DTLs) are one area worthy of focus, and while I know that tax
is boring, you will realize Buffett is truly a genius when it comes to float, so bear with
me as I try my best to explain how it works, as it is complex.

The first idea that might spring to mind for many people on deferred taxes is unrealised
capital gains - to be clear, the focus of this article extends deeper than just this. Read
on...

Uncle Sam (deferred taxes) are a large source of float

for Berkshire
So why are we focusing on deferred taxes? Because the Owners' Manual says so...

"Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to
safely own far more assets than our equity capital alone would permit: deferred taxes
and "float," the funds of others that our insurance business holds because it receives
premiums before needing to pay out losses. Both of these funding sources have grown
rapidly and now total about $135 billion." Warren Buffet (BRK Owners' Manual)

While insurance float has typically taken the limelight, the more 'boring' deferred tax
liabilities have taken a back-seat but are becoming increasingly more relevant, growing
rapidly from $11bn to $57bn during 2004-2013 and now comprise 43% of the total
$135bn of float.

The $77bn of insurance float is now looking mature with Buffett flagging a softer
inflationary-like (perhaps declining) outlook. DTL's look to be the next wave of new
float, and it appears likely to overtake insurance float in the near future as its rapid
growth continues.

The chart shows the two sources of float over time for Berkshire - insurance (in blue)
and deferred taxes (in orange).

So where exactly do deferred taxes come from and how is Buffett engineering
Berkshire's future around this?

Deferred tax - incur today, pay later

Deferred tax liabilities arise on the balance sheet from temporary differences between
taxes that will come due in the future and taxes paid today. Accounting rules require
this difference to be recognized as a liability and therefore a deduction in calculating net
worth. However, the deferral of this tax payment acts as a source of float, and the cash
can be invested elsewhere until it is due to be paid.

The key types of deferred tax liabilities for Berkshire

Specifically for Berkshire, there are two key sources of deferred tax liabilities which
are:

Unrealized investment gains - this source will be familiar to most readers and is
effectively deferred capital gains tax on investments. As Berkshire tends to have
long holding periods on stocks these deferred tax liabilities can be large. They
act as a free loan from the government which doesn't have to be repaid until the
investment is sold/realized (which could be never).

Fixed assets (PP&E) - this is a more interesting source of DTL for Berkshire and
effectively arises from differences between book accounting and tax accounting
of capital assets. For example, accelerated depreciation rates for tax accounting
give rise to lower assessable income resulting in low tax payments. However,
book accounting with less aggressive depreciation rates gives rise to higher
profits and higher tax expense. This mis-match results in a deferred tax liability.
Over the life of any fixed asset the tax paid on the IRS basis and the accounting
basis should be the same, and only the timing differs. The chart below illustrates
by example the higher depreciation for tax purposes versus book resulting in a
DTL.

Berkshire's Deferred Tax Liability mostly relates to

fixed assets
The chart below highlights these two key sources of DTL float with unrealized
investment gains (in blue) and fixed assets (orange). There is a third bucket (grey)
containing other items net of deferred tax assets which is not material in size.

The key observation from the chart is that the primary source of DTL is fixed assets,
with unrealised investment gains playing second fiddle. Fixed asset DTL's at $32bn are
greater than the $26bn of unrealized investment gains, and are also growing more
quickly.
You will also note the large step change in fixed asset DTL's in 2010 which occurred as
a result of the BNSF (railroad) acquisition, and has been growing strongly ever since.
This gives us a few clues as to what Buffett was thinking about float when purchasing
BNSF and may hint to the nature of future acquisitions for Berkshire.

As deferred capital gains taxes are largely self-explanatory I will not discuss them any
further, let's hone our focus onto the fixed asset DTL's.

Astute readers will realize that fixed asset DTL's should ordinarily reverse over time as
the mismatch between the accounting and tax basis converge for a single asset as it is
depleted over its life. Therefore, it might seem that float is temporary in nature and not
really enduring like insurance float which is revolving and permanent.

However, I think Buffett appears to have found a holy grail of DTL's - instead of being
temporary float, the characteristics of Berkshire's DTL float appear long enduring and
will grow strongly over time. There are two reasons why this is the case:

Una de las razones que esgrimi Buffett para la compra de Burlington fue su gran ventaja
competitiva en costes: el coste de transportar mercanca en tren era 1/3 del coste de hacerlo
por carretera !!! Y en vista de la escalada del precio del petrleo puede que hoy en da la
ventaja se haya acrecentado.
Otro aspecto es que Burlington va a desempear un papel importante entre el transporte de
mercanca entre Mxico y USA, especialmente a medida que Mxico vaya ganando
importancia y China (cada vez menos competitiva) la vaya perdiendo.
El propio Buffett cuando hizo la compra dijo que esperaba un "good but not great return". Hace
poco dijo que la evolucin del negocio (y la rentabilidad esperada de le inversin) haba
mejorado por encima de sus expectativas iniciales.
Por cierto, Burlington YA supone un 30% en las ganancias de Berkshire, con lo que la
evolucin de Burlington va a condicionar en gran medida la evolucin futura de Berkshire. Las
perspectivas no pueden ser mejores.
Buffett wins again on BNSF purchase (2014)

"You don't get bargains on things like that," said Warren Buffett five years ago after paying
what seemed like a steep price of $26.5B in the BNSF buyout. Five years on, the statement
seems like false modestly, as - with the onshore oil boom helping it along - BNSF has sent more
than $15B in dividends to Berkshire Hathaway (BRK.A, BRK.B), according to Berkshire''s latest
quarterly earnings.

Even better, the railroad is on pace to return all of the cash spent by Buffett before year's end.
Annual revenue at BNSF has risen 57% and earnings more than doubled to $3.8B since
Berkshire's purchase.

"He stole it," says Jeff Matthews. "He's got to feel really good that he bought it when he did,
because it's a wonderful asset, and it's done nothing but get more valuable in the time that he's
owned it."

Comps? Union Pacific (NYSE:UNP) trades for about 12.6x pretax, pre-interest income. Were
BNSF to sell for that kind of multiple today, Buffett's stake would be worth about $66.5B, more
than double what he paid

1. Buffett's long-life slowly depreciating fixed assets

increase the tenure of DTL float
A typical fixed asset with short to medium term lifespan will have any deferred tax
liabilities unwind over time. However, the large part of Berkshire's railroad assets
(BNSF's tracks and roadways) have useful lives of up to 100 years. The Utilities and
Energy assets (MidAmerican's generation, distribution, transmission and pipeline
assets) have useful lives up to 80 years.

(click to enlarge)

(image source: BRK 2013 Annual Report)

For financial accounting purposes, the depreciation rates for these particular assets are
provided independently and approved by the regulators. Book depreciation for
BNSF/MidAmerican is tracking around 3% of the gross assets - implying an overall
average useful life for the book of 33 years.

The IRS tax basis would depreciate these assets at a much more accelerated pace (useful
lives for a single asset much less than 80-100 years) resulting in higher depreciation and
lower tax payable.

High income taxes in the financial accounts would give rise to long enduring deferred
tax liabilities. These railroad and utility acquisitions which Buffett wants Berkshire to
own for "the next 100 years" were intended to provide sustainable deferred tax float for
Berkshire for decades to come.

2. Buffett is accelerating capital expenditures to fixed

assets resulting in rapid growth in DTL float
Having identified a source of float in the capital intensive assets, Buffett's next trick is
to make it grow thereby increasing its value. It is therefore no surprise that large
components of Berkshires capital expenditures are being directed towards BNSF and
MidAmerican - the two assets we identified above as being long-term DTL float
generators.

Capex in BNSF/MidAmerican has a number of impacts:

It increases the level of fixed assets in long-term DTL float generators

Capex above depreciation will cause the DTL float to grow
As new capital depreciates quicker than existing capital given accelerated tax
depreciation it creates more per dollar DTL float than the existing book.
Given the above, ever rising amounts of new capital expenditures will make the
DTL float start to balloon (or should i say float?) upward

This is already happening, in 2011 BNSF/MidAmerican capex was $6bn, and Buffett is
saying this will be $11.1bn this year in 2014, almost doubled in a few years.

(click to enlarge)
(image source: BRK 2013 Annual Report)

When buying BNSF, Buffett was likely thinking about very long-term DTL 'float' and
deploying very large (read 'huge') amounts of capital over time to grow that deferred tax
float. He is hungry to deploy rising amounts of capex to these railroad and utility
businesses:

"America's rail system has never been in better shape, a consequence of huge
investments by the industry. We are not, however, resting: BNSF spent $4 billion on the
railroad in 2013, double its depreciation charge and a single-year record for any
railroad. And, we will spend considerably more in 2014. Like Noah, who foresaw early
on the need for dependable transportation, we know it's our job to plan ahead." Warren
Buffett (2013 Annual Report)

"Our railroad, utilities and energy businesses (conducted by BNSF and MidAmerican)
maintain very large investments in capital assets (property, plant and equipment) and
will regularly make capital expenditures in the normal course of business. In 2013,
aggregate capital expenditures of these businesses were $8.2 billion, including $4.3
billion by MidAmerican and $3.9 billion by BNSF. BNSF and MidAmerican have
forecasted aggregate capital expenditures in 2014 of approximately $11.1 billion.
Future capital expenditures are expected to be funded by cash flows from operations
and debt issuances." Warren Buffett (2013 Annual Report)

So watch this space The pace of capex in the capital intensive businesses should see
the DTL surpass the insurance float over the coming years.

So what could Deferred Tax Liability float be

intrinsically worth?
As a relative starting point, we know Buffett values $1 of insurance float as having at
least $1 of intrinsic value given its characteristics of being (1) enduring, (2) costless,
and (3) growing.

It appears unrealised gains should largely fit this criteria over time if long-term
investments are not sold and continue to perform. However, shorter term investments
would not satisfy this criteria. I would expect that $1 of unrealised investment gains
might be worth <$1 of intrinsic value, but probably not by alot given the majority of the
DTL would reflect 'legacy' investments.

Fixed asset DTL's appear more akin to having all three characteristics similar to
insurance float. The nature of the assets appear very long-term, costless and should
grow. Again I would expect that $1 of fixed asset DTL's may be worth close to $1. You
would need to build a 80-100 year DCF with the relevant tax and accounting
depreciation rates for the Railroad/Energy assets to accurately assess this.
As a final data-point worth mentioning, Charlie Munger has previously commented on
the value of Wesco's DTL's in his annual letters (numbers below are per share values).

1997 - $102 of DTL was estimated to be intrinsically worth $25 = 25c in the $
1998 - $127 of DTL was estimated to be intrinsically worth $30 = 24c in the $
1999 - $99 of DTL was estimated to be intrinsically worth $20 or 20c in the $
2000-2007 DTL's intrinsically worth "much less" or "much lower" than its face
value

(image source: iinvestor)

While Munger's estimates for Wesco suggest 20-25c of intrinsic value per dollar of
DTL, he also makes this comment below (repeatedly each year) which suggest his
estimates may be too low in the context of Berkshire's DTL:

"Each dollar of book value at Wesco continues plainly to provide much less intrinsic
value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality
disparity in book value's intrinsic merits has, in recent years, continued to widen in
favor of Berkshire Hathaway". Charlie Munger (2009 Wesco Annual Report).

So on balance, I think we can discount Charlie's Wesco example when looking at

Berkshire given the quality differences, and my feeling is that the intrinsic value of a
dollar of Berkshire's deferred tax liability could potentially be worth near a dollar.

Float-adjusted valuation for Berkshire

If we assume that DTL's can be added back to book value at par, the only missing piece
is goodwill. Much like thinking about insurance float, there is a cost to acquiring it (ie
the goodwill). Therefore, if we are adding back DTL to book value, we should also be
subtracting any cost with acquiring that float (mostly related to the capital intensive
businesses). So in my calculation I net off the goodwill for the Railroad/Energy
division.

The results are indeed very surprising:

1. Adjusting book value for both insurance and capital intensive float suggests a
multiple of 1.35x book is warranted.
2. This multiple has been amazingly very steady over the last decade - Buffett is
carefully managing float over time
3. Float-adjusted book value stands at $192K and has growth at 10%pa over the
last decade
4. Insurance float net of goodwill has compounded 6% over the last decade
5. Deferred tax liability (float) net of capital intensive business goodwill has
compounded 14% over the last decade

(click to enlarge)

(image source: iinvestor)

(image source: iinvestor)

(image source: iinvestor)

Concluding summary
1. Buffett has found a very unique way to generate float, which is not widely
understood among investors.
2. Insurance float's time in the sun has passed, the next wave will be about deferred
tax liability float.
3. Buffett uses long-life capital intensive businesses and depreciation to do this
4. Future acquisitions are likely to be focused on acquiring and generating deferred
tax liability float.
5. Buffett is setting up Berkshire to utilize bigger amounts of float for decades to
come - he is a genius.
6. Investors should consider the value of deferred tax liabilities in determining
intrinsic value for BRK.
7. Float is the key value driver of Berkshire and Buffett just wants sustainable
growth in its float for long into the future, well after his succession.
8. I don't think anyone else can identify and manage float as well as he can. Most
of his acquisitions are really about acquiring cheap float. My bet is that if BNSF
didn't generate float, he wouldn't have bought it - it was therefore a key driver of
the decision.
9. If he can secure the float growth issue, BRK will be thriving for many years.
Todd/Tedd will use the float to do the stock picking just fine - whether it be low
capex growth stocks or the like...
10. He's just too big in insurance to grow that float aggressively in the next 100
years.
11. So these infrastructure assets basically provide a way to grow float at large scale
and long-tenure. Any assets with 100 year life is a potential acquisition target. If
he can secure a few more of these its happy days for the outlook for float growth
and hence intrinsic value growth
Each year for nearly half a century, Berkshire Hathaway (NYSE:BRK.B) has provided an
annual letter to shareholders that discusses the gains it has produced for holders of its
common stock. In 2012, according to its letter, that gain was $24.1 billion. Some $1.3
billion of that gain was used to repurchase Berkshire shares, leaving a $22.8 billion
increase in net worth that the company retained. Over nearly 50 years, the company's
shareholders equity, or book value, has grown almost 20% annually. Below, we discuss
how analyzing shareholders' or owners equity is among the most important exercises for
investors and shareholders.

What Do the Major Owners Equity Sections Tell an Investor?

Berkshire Hathaways book value growth over time has been relatively easy to measure.
This figure is relatively clean, because Chief Executive Warren Buffett rarely buys back
stock or issues additional shares, and he has never paid a dividend. For this reason, its
growth in book value is a relatively good gauge for the returns shareholders have earned
over the companys history. At the end of 2012, the company's total shareholders equity
grew to $191.6 billion and consisted primarily of retained earnings, which grew to $124.3
billion and is simply the earnings that have been reinvested back into the business over the
years.

Berkshire Hathaways Shareholders Equity Section - 2012:

Looking at the equity section table above, analysts need to become familiar with some line
items:

Common stock has been steady at $8 million and represents the likely amount
originally issued when the current incarnation of Berkshire Hathaway was formed
in 1977. This par value amount of $8 million is primarily for legal and issuance
purposes and is set at a very low initial value that is initially recorded on the books.
The capital in excess of par value is also known as paid-in capital, which represents
the premium over stated par value (the $8 million) at which the original shares were
issued. In the literal sense, it truly represents the capital paid in by early-round
investors, or capital contributed by owners. This comes primarily in the form of
common stock but can also include other related securities such as preference shares
or preferred stock. It also changes over time as new shares are issued, such as for
acquiring interests in other businesses.
Accumulated other comprehensive income (AOCI) is worthy of its own analysis
and is a very insightful line item that is best seen as a more expansive view of
reported net income on the profit and loss statement. It represents net income plus
other comprehensive income, which covers items that dont flow directly through
 the income statement. For instance, for financial firms such as Berkshire that own
large insurance operations, AOCI gives details on unrealized gains and losses in the
investment portfolio. The impact of corporate retirement plans is also covered in
this section, as well as foreign currency fluctuations. For Berkshire, AOCI was
$27.5 billion in 2012, or more than 14% of shareholders equity.
Treasury stock reflects the shares of a company that it has bought back or
repurchased from secondary markets. For this reason, it is also known as a contra
account because it reduces reported owners equity. As we mentioned, Berkshire
doesnt buy back its own stock often, but it has to the tune of $1.4 billion over its
history.
The final category in its owners' equity statement is noncontrolling interests, which
represents Berkshires ownership in other companies where it doesnt have a
controlling interest. However, they have value and are a key component of book
value.

Statement of Changes in Owners' Equity

Another insightful financial statement that is not relied on enough is that of changes in
owners' equity. As the name implies, it lets shareholders look at how owners equity has
changed over time. For Berkshire, its 2012 statement goes back three years. It says
Berkshire issued common shares that increased paid-in capital, that AOCI grew by more
than $10 billion because of investment appreciation, and retained earnings increased as
profits were retained. Treasury stock was purchased over the past two years, as were non-
controlling interests in other businesses.

Less Common Owners Equity Line Items

Less common items are reflected in book value. For example, the drawing account is used
for businesses that arent incorporated or publicly traded. The drawing account tracks any
money that a business owner takes out of the business. If the business has several partners,
each partner gets his or her own drawing account. Private firms can also have employee
stock ownership plans (ESOP) that issue shares to employees. Loans to ESOPs, such as to
fund them initially, represent a contra account and reduce the value of shareholders equity.

Important Items to Look Out for When Analyzing the Shareholders Equity Sector

Analyzing and tracking a firms growth in book value over time is a valuable exercise,
especially for stable firms such as Berkshire Hathaway. Basically, this investigates how
well (or badly) a firm is managing the capital that shareholders have invested in the
company. However, it is important to note that this looks at accounting and historical cost,
not market value. Market value is reflected in how well a companys share price performs
over time. Over the long haul, it should resemble book value growth as it has done for
Berkshire. Warren Buffett has detailed that book value growth has been a conservative
measure as Berkshire's profits are taxed over time, where shareholders can and have owned
the stock for many years, avoiding taxes as unrealized long-term gains build. But there can
be significant differences over the short term.

Analyzing tangible common equity also has great value. This strips out the value of
goodwill and other intangible assets on the balance sheet. Tangible book is meant to more
closely analyze the value for a firm if it was liquidated and the proceeds were paid out to
shareholders.
Return on equity (ROE) is another important determinant of whether a company is doing its
job for shareholders. An ROE in double digits basically indicates a firm is managing
shareholder capital well. The higher the better. Below is an overview of Berkshire's ROE to
demonstrate that it stacks up well against its insurance industry, but not as well compared to
the financial sector:

Berkshire Industry Sector

Return on Equity (TTM) 9.44 8.76 23.52
Return on Equity - 5 Yr.
7.13 2.87 22.43
Avg.

The Bottom Line

Analyzing owners equity is an important analytics tool, but it should be done in the context
of other tools such as analyzing the assets and liabilities on the balance sheet, the difference
of which represents book value. There is also a need to look at the income and cash flow
statements for a comprehensive fundamental analysis on a firm.

The Future Of Berkshire's

Float, Part II: 'Naked Credits'
From Precision Castparts
Feb. 28, 2017 1:22 PM ET
|

Shreyas Patel
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Deep value, special situations, growth at reasonable price, contrarian
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Summary
Buffett generates balance sheet leverage through insurance float and deferred tax
liabilities.
The latest annual report reveals a new source of quasi-permanent deferred tax float.
Asset write-ups of Indefinite-lived intangibles result in long-term deferment of tax liabilities
known as "naked credits.".
These were created via acquisition fair-value adjustments in the Precision Castparts and
Duracell acquisitions.
The release of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B)
2016 Annual Report has revealed some new insights - in particular
new sources of leverage. While Buffett is a great investor, much of
the value created within Berkshire to date is attributed to his capital
structure - which takes advantage of low-cost leverage through the
use of insurance "float." More recently, we have seen the rapid rise of
a secondary source of "float" in deferred tax liabilities (DTLs).

I previously wrote on this topic, drawing attention to how Buffett uses

the capital-intensive businesses to drive long-term DTLs
accompanying fixed assets. I recommend reading the initial article
first as background, as this followup aims to extend some of the ideas
presented in the initial article.

Deferred taxes Are a Source of Float That Are Growing Rapidly

Why are we focusing on deferred taxes? This excerpt from the

Owners' Manual (emphasis mine) highlights why:

Berkshire has access to two low-cost, non-perilous sources of

leverage that allow us to safely own far more assets than our
equity capital alone would permit: deferred taxes and 'float,' ...
Both of these funding sources have grown rapidly and now total
about $168 billion.

Better yet, this funding to date has often been cost-free.

Deferred tax liabilities bear no interest Neither item, of course,
is equity; these are real liabilities. But they are liabilities without
covenants or due dates attached to them. In effect, they give us
the benefit of debt - an ability to have more assets working for
us - but saddle us with none of its drawbacks. - Warren Buffett

As at 2016, Berkshire had a total of $168bn of "float" consisting of

$91bn from insurance and $77bn from DTLs. The share of DTLs has
risen from 20% in 2004 to 46% in 2016 (note that insurance float is
higher post balance date given an additional $9.8bn via the AIG deal,
taking insurance float >$100bn). As the level of insurance float
matures over time, it likely that DTLs will overtake insurance float in
the long term.
(Source: authors analysis, company reports)

Deferred Tax Liabilities

Deferred taxes liabilities arise on the balance sheet from temporary

differences between taxes that will come due in the future and taxes
paid today. Accounting rules require this difference to be recognized
as a liability and therefore a deduction in calculating net worth. The
deferral of this tax payment acts as a source of quasi-float,
generating a return without cost, until it is due to be paid.

DTLs are not as intuitive to understand as insurance float which are

readily thought of as "temporary inflows" versus DTLs which are
essentially "deferred outflows." In each instance both insurance float
and DTLs have an NPV which deems it more like an asset than the
stated balance sheet liability values. Insurance float has greater
flexibility in terms of investment options versus DTLs which are tied
to specific assets.

The key types of deferred tax liability for Berkshire are:

Unrealized investment gains: This is a familiar source of DTL,

essentially deferring capital gains tax on listed investments given
Buffett's reluctance to sell certain equity holdings. They act as a
free loan from the government which doesn't have to be repaid
until the investment is sold/realized.
 Fixed assets (PP&E): In my previous article, I discussed how the
mismatch in depreciation schedules between book accounting and
tax accounting of capital assets can give rise to DTLs. Capital
intensive businesses such as the railroad and energy business
have long-life slowly depreciating assets which give rise to these
long-term DTLs. For more background on this, please read my
previous article (linked to above).
Intangible assets: This is a new source of DTL for Berkshire which
is the main thrust of this analysis. And it was driven primarily by
the $32.7bn Precision Castparts acquisition, and to a lesser
extent Duracell.

The chart below shows the composition of the above deferred tax
liabilities - with around $11.3bn related to these new "intangible
assets," which was a sizable $8.5bn step-up from 2015. Deferred
taxes have been becoming of increasing importance over the last 7
years, and the composition is changing.

(Source: authors analysis, company accounts)

Precision Castparts Intangibles Are Revalued Significantly on

Acquisition

Buffett does not directly explain how and why these new Intangible
related DTLs work. However, a good place to start looking is usually
acquisitions made during the year:
 On Jan. 29, 2016, Berkshire acquired Precision Castparts Corp.
(NYSE:PCP) for $32.7bn. PCP is a diversified manufacturer of
complex metal components and products. It serves the
aerospace, power and general industrial markets.
On Feb. 29, 2016, Berkshire acquired the Duracell business from
Procter & Gamble (NYSE:PG) in exchange for PG shares worth
$4.2bn. Duracell is a leading manufacturer of high-performance
alkaline batteries and is an innovator in wireless charging
technologies.

Related to these acquisitions were a number of balance sheet

adjustments:

During the fourth quarter of 2016, Berkshire revised the

previously reported acquisition date fair values of certain
identified assets and liabilities of PCP and Duracell, which
primarily resulted in decreases in the amounts of identified
intangible assets and deferred income tax liabilities, offset by
increases in the amounts of goodwill. These revisions were
immaterial to our Consolidated Financial Statements. Goodwill
from these acquisitions is not amortizable for income tax
purposes. The fair values of identified assets acquired and
liabilities assumed and residual goodwill of PCP and Duracell at
their respective acquisition dates are summarized as follows (in
millions).

(Source: annual report)

For the subsequent analysis I will mostly focus on Precision Castparts
(and largely ignore Duracell) to make things a little simpler to follow,
and because it is the larger PCP acquisition which is driving most of
the change, and Duracell to a smaller extent.

We can see below the fair-value adjusted balance sheet for Precision
Castparts, noting that of the $32.7bn acquisition price, there was
$16bn of goodwill, $23.5bn of intangibles and $7.5bn of DTL. If we
then compare the adjusted balance sheet to what Precision Castparts
reported in their last 10-Q prior to being acquired we can see some
very large upward adjustments that have been made. Of the ~$21bn
premium paid to book value, there was asset revisions of +$9bn
allocated to goodwill and +$20bn to intangibles, and a +$6.6bn
increase to the deferred tax liability. So the question is what is going
on here, and what do these purchase allocations mean?

(Source: authors analysis, company accounts)

Goodwill adjustments are ordinarily expected when making

acquisitions. The acquirer pays a premium to book-value and the
premium gets booked as goodwill. Right? Not quite, and the sheer
size of intangible fair-value adjustments and DTLs does raise some
curiosity.
So to see what's happened we can take a look at the composition of
Precision Castparts Intangibles prior to being acquired by Berkshire,
which we can find in their 10-Q. This highlights Precision Castparts
view of their own acquired intangibles. There is roughly $4bn worth:

Amortizable intangibles: $0.5bn primarily related to long-term

customer relationships.
Unamortizable intangibles: $0.7bn related to tradenames and
$2.7bn related to long-term customer relationships

There is not really much to speak of here at first glance. Other than
identifying some various types of intangible assets, the values in the
books are not overly significant, and perhaps easily glossed over to
an unsuspecting analyst. What is important here is the categories
(amortizable/un-amortizable, trade names/customer relationships,
etc.) and how they appear unimportant given their relatively small
carrying amounts on PCP's books.

(Source: annual report)

If we now have a look at Berkshire's Note 11 in the Annual Report we

see quite significant changes year-on-year for various other
intangibles primarily as a result of the inclusion of these acquisitions
and the fair-value adjustments of PCP + Duracell. There was around
a $2.3bn increase in trademarks and trade names and $22bn
increase in customer relationships - similar categories to the ones we
glossed over for PCP prior to being acquired.

(Source: annual report)

The note to the table provides the necessary color (emphasis mine):

Intangible assets with indefinite lives as of December 31, 2016

and 2015 were $18.7bn and $3.0bn million, respectively [a
$15.7bn increase]. Other intangible assets at December 31,
2016 included assets of PCC and Duracell of approximately
$24.8 billion, which included approximately $13.6 billion in
customer relationships and $2.3 billion in trade names that were
determined to have indefinite lives.

So we can clearly see the purchase accounting adjustments coming

through in Berkshires book via the intangibles disclosures. Although
slightly messy to interpolate, the key points here are that 1) PCP's
intangibles were significantly undervalued in its own books, and 2)
Buffett subsequently revalued them on acquisition allocating
oversized amounts of his purchase cost to customer relationships
which have indefinite life. These provide important clues into PCP's
moat and what Todd Combs probably saw in the business (who
brought the deal the Buffett).

Why Are Indefinite-Lived Intangibles Important?

Typically intangibles attract an amortization charge until they are fully

written off. Buffett alludes to the fact amortization can result in fully
written off intangibles that still provide economic benefit in the annual
letter:

Eventually amortization charges fully write off the related asset.

When that happens - most often at the 15-year mark - the
GAAP earnings we report will increase without any true
improvement in the underlying economics of Berkshire's
business. (My gift to my successor.)

However, this is a little misdirected as Buffett seems to be alluding to

intangible assets with finite life, those with indefinite life are different.
Indefinite-lived assets do not typically attract an amortization charge.
Instead, they are periodically tested for impairment. It is therefore
interesting that Buffett revalued a large part of Precision Castparts
intangibles as having indefinite life and as such is unlikely to attract
any ongoing amortization charge.

How Do Intangible Asset Writeups Create DTLs?

Acquisition accounting adjustments resulting in DTLs is nothing new.

The purchase price needs to be allocated somewhere and the
revaluation of assets is usually accompanied by a DTL, reflecting
expected future tax payments.

In allocating the purchase price: DTL = tax rate * (fair value - tax
basis)

This is easily reconciled for PCP. The assets (excluding goodwill) were
revalued upwards a net $18.6bn and at a 35% tax rate equates to an
expected increase of $6.5bn in DTLs (vs. recorded $6.6bn - close
enough).

This sort of DTL would arise from any upward revaluation of the
purchased assets, not just intangible assets. So what's so great about
the Precision Castparts DTLs?

Naked Credits

It is the nature of these DTLs that makes it novel. While the

Intangibles are largely indefinite-lived, they will likely never be
amortized or written off, so this brings into question will the
accompanying deferred tax liability ever be paid? Probably not
Therefore, the DTLs related to indefinite-lived intangible assets could
well be a permanent fixture of the balance sheet - and hence good
quality float.
DTLs for indefinite-lived intangible assets are known as "naked
credits." In addition to the other types of DTLs we have identified,
perhaps we will see greater use of these naked credits in future
acquisitions. It is a very clever strategy identifying Precision
Castparts' value (customer relationship moats) and coupling this with
smart accounting and structuring (reclassifying them as indefinite-
lived) resulting in the benefits of float through quasi-permanent
deferral of taxes. Had the purchase cost been allocated differently (to
upward revision of finite-life assets) this would also have resulted in a
DTL, but would wind down over time as taxes are paid - a subtle but
financially important difference.

So the fact is using indefinite-lived assets makes the NPV of the

accompanying DTL greater than it would otherwise be. Is Buffett just
being a little too cheeky with his fair-value purchase adjustments
here?

In any case, the last few years we have seen an evolution in the use
of float from insurance and unrealized capital gains to fixed asset
DTLs and now DTLs related to indefinite-lived intangibles. It would
appear identifying new and novel sources of float is part and parcel of
Berkshires DNA and the impact of this on Berkshires leveraged capital
structure should allow it to benefit from this for many years.

Disclosure: I/we have no positions in any stocks mentioned, and no

plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am

not receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is
mentioned in this article.