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Morningstar | Berkshire Hathaway Alters Share-Repurchase Plan as Cash Balances Remain Elevated; No Change to FVE

We were surprised more by the timing than the move by wide-moat-rated Berkshire Hathaway to alter its share-buyback program to allow the firm to repurchase shares when CEO Warren Buffett and vice chairman Charlie Munger believe "the repurchase price is below Berkshire's intrinsic value, conservatively determined." This basically scraps the firm's previous buyback threshold, which required prices to be below 1.2 times book value per share, but still requires Berkshire to keep at least $20 billion in cash on its books at all times. As this decision does not alter our long-term view of the firm (which we see evolving into a vehicle for returning capital to shareholders), we are leaving our $330,000 ($220) per Class A (B) share fair value estimate in place.

For much of the past year, we've believed that Buffett boxed himself into a corner at Berkshire's 2017 annual meeting by noting that he could not envision having $150 billion or more in cash on the company's books in 2020 and be able to defend it to shareholders. With Berkshire on pace to generate $5 billion-$10 billion in quarterly free cash flow going forward and little to no deal activity (or share repurchases) expected to materialize until market valuations come down, we saw nothing preventing Berkshire's cash balances from rapidly ascending to this benchmark, with cash and equivalents sitting at $108.6 billion at the end of the first quarter.

While Buffett has been clear about share repurchases being his preferred option (after acquisitions and/or investments) for Berkshire's excess cash, we couldn't see, given the dearth of share-repurchase activity the past seven years, how he expected to buy back any stock at all unless Berkshire was willing to alter its share-repurchase program. With that now done, the key will be for Berkshire to buy back enough stock and put enough capital to work in acquisitions and/or investments to keep cash balances from getting much larger than they already are.

As we noted in our May 15 Select presentation, "Berkshire: Large Acquisitions, Share Repurchases, or Dividends?" Berkshire has always been a bit of an outlier when it comes to assessing the job a management team is doing with regards to returning capital to shareholders. Any assessment we make of a firm's stewardship of shareholder capital rests on whether management's ongoing investments support the company's core business or, at the very least, leverage the strengths of these businesses and further enhance their moats. Most mature companies struggle to find value-enhancing opportunities for investment, so they dedicate a fair amount of their excess capital to dividends and share repurchases. That has not been the case historically with Berkshire. With Buffett and Munger having demonstrated an ability to increase not only book value per share but also the share price throughout the company's history, shareholders have afforded them a lot of leeway, including building up large amounts of cash on the balance sheet in anticipation of the next attractive deal, as opposed to returning it to shareholders.

That said, over the past few years we have started to hear some unusual comments from management about the firm's growing cash hoard, with Berkshire likely to need to start returning capital to shareholders in the near to medium term. At last year's annual meeting, Buffett noted that it would be incredibly difficult for him to come back to shareholders "three years from now and tell (them) that we hold $150 billion or so in cash or more, and we think we're doing something brilliant by doing it." With the firm expected to generate $5 billion-$10 billion quarterly in free cash flows the next several years, valuations likely to still be high for publicly traded and privately held firms (which makes acquisitions and share repurchases all that much harder), and the company's two largest and most reliable capital expenditure outlets (BNSF and BHE) expected to spend less on capital improvements as we move past 2019-20, Berkshire will likely be at the $150 billion threshold at some point midway through our five-year forecast period.

Buffett also noted at last year's annual meeting that the time could come (and reasonably soon) where Berkshire would likely need to reconsider its repurchase threshold and/or consider paying a dividend. This fits with our longstanding belief that Berkshire will have to eventually evolve from its history as a reinvestment machine into one that is far more focused on returning capital to shareholders--which is exactly what we'd expect from a company of its size with dwindling investment opportunities. Buffett has also noted that the inferences that investors are likely to draw from a dividend policy (with the main one being that once a quarterly/annual dividend has been put in place, it won't be cut) are different from a change in Berkshire's repurchase policy, and that those issues would need to be taken into consideration when assessing any future capital returns to shareholders.

Our own take has been that absent a return to more normalized valuations (which would allow Buffett to feel like he is paying a fair price for assets in the marketplace), Berkshire would likely need to return at least $25 billion to shareholders in 2020, and a similar (if not greater) level every several years, to work cash balances down to a more manageable level (which we assume to be around $120 billion with $20 billion being set aside as a backstop for the insurance business). The problem for Berkshire is that the company was already generating around $5 billion a quarter in free cash flow before the recent change in U.S. corporate tax rates. It now faces an environment where interest rates are rising (which should improve the yield on its fixed-income portfolio over time), and the firm overall is expected to spend less longer term on capital improvements. As such, we believe it will be harder and harder for Berkshire to keep its cash balances from growing unless Buffett is willing to return some of it to shareholders via share repurchases or a dividend.

For share repurchases, the question has always been whether the value of Berkshire's shares would fall enough, or the firm would alter its repurchase threshold of only buying back stock if prices dropped below 1.2 times book value per share enough, to allow Buffett to buy back a large chunk of stock. One of the biggest issue for us historically with Berkshire's share-repurchase program (which was initially started in September 2011 with a threshold of 1.1 times book value per Class A equivalent share) is that it has led to very little share repurchase activity. The last (and only) major buyback of shares occurred in December 2012, when the firm raised the threshold for share repurchases to 1.2 times book value per share to facilitate the sale of 9,200 Class A shares belonging to the estate of a longtime shareholder for $1.2 billion. Since that time, Berkshire has not repurchased any shares.

The main problem for Berkshire with its repurchase efforts is that the company's shares rarely trade below 1.3 times book value per share (with the last time being January/February 2016), let alone below the 1.2 times threshold required for the company to be able to start buying back stock. While it might not have been Buffett's stated intent when Berkshire introduced its share-repurchase program, the company's price/book value per share threshold for buybacks has effectively put a floor on the company's shares. As we move forward, we think that that floor will likely still hold in a 1.2-1.3 times book value per share range (given the historical precedent that has been established), but it will be interesting to see how far Buffett is willing to go up the price/book value per share spectrum to buy back shares.