Thursday, April 10, 2014

JPM Annual Report 2013

So the JPMorgan Chase (JPM) annual report is out.  After the Berkshire Hathaway report, this is my favorite read of the year.  I say "annual report", but I actually just mean "letter to shareholders".

Anyway, here are some comments as usual.  This is not meant to be a comprehensive summary or anything close to that; I will just comment on what comes to mind.  So I would highly recommend reading the whole letter; reading this post is no substitute!  It is definitely worth your time even if you don't have any interest in investing in JPM.  Read it here.

More on earnings later, but Dimon points out that excluding the legal expense and some gains on asset sales and some benefits from reserve releases (which he has never considered "real" earnings), JPM earned $23 billion in 2013 versus the reported $17.9 billion.   Deducting preferred dividends and other stuff that go between net income and net to common, that leaves $22.5 billion net to common for an adjusted EPS of $5.94/share. With the stock at $57.40, JPM is currently trading at 9.7x p/e.   That is cheap for such a high quality company.  I understand that people think JPM has a lot of risk (derivatives, is a money center bank subject to many new regulations that will hold them back etc.), but still.  That's cheap.

Dimon makes some comments about growth initiatives and normalization of interest rates, so we'll look at earnings again a little later.  But just hold these figures in your head for a moment.

Performance Over Time
So here's the usual stuff.  Tangible book value per share has grown +12%/year between 2005-2013.  As I always say, that's pretty amazing when you think about what has happened over the past eight years; Great Recession, Whale trade etc.  If you said back in 2005 that JPM will grow tangible BPS +12%/year over the next eight years, people would have laughed at you.  They would have told you that with that huge derivatives book (and credit cards, mortgages exposure), one speed-bump in the economy and *poof*, JPM will be gone. If you said that tangible BPS would grow +10.9%/year over the next six years in 2007 or +12.6%/year over the next five years in 2008, they would have laughed even harder.

Here is a look at the stock price and book value performance since Dimon took over Bank One (and since the merger):

The stock has outperformed both the financials index and the S&P 500 index since March 2000.  Since the merger, the stock has outperformed the financials index by a wide margin but slightly lagged the S&P 500 index.

But on a tangible book value basis JPM has outperformed the S&P 500 index in both periods:

And all of this has been achieved with higher capital ratios:

And the high returns on equity are across the various business lines:

So let's take a look at this.  ROE is pretty stable at 15% or so (on a tangible equity basis) while capital ratios are going up.

Check this out for a second:

               Basel 1
               Tier 1                     ROTCE
2007        7.0%                     21%
2008        7.0%                       4%
2009        8.8%                     10%
2010        9.8%                     15%
2011      10.1%                     15%
2012      11.0%                     15%
2013      11.8%                     15%*

For 2013, I used the figure excluding the legal charge, one time gains etc.  For all other years, it is as reported in the annual reports.  So even as capital ratios creep higher, ROTCE remains constant.  The peak was in 2007, the height of the bubble.  2006 ROTCE was 20%.

So one can argue that the capital ratio went from 7.0% to 11.8% and ROTCE went from 21% down to 15%.  All else equal, a 21% ROTCE should have gone down to 12% (still not a bad business), but has been pretty consistent at 15%.

But wait a minute!  2006/2007 was the height of the bubble so may be on the high side of normal.  Plus, we know that the abnormally low interest rates now are holding down earnings at the banks.  More on this later, but Dimon did say that normalizing of interest rates can improve after-tax profits by $6 billion.  Of course, this will not happen in a straight line or overnight.  It may take three to five years. But just for the sake of comparing ROTCE under the higher capital standards, let's say that interest rates were 'normal' last year.

Tangible common equity averaged $149 billion last year, and $6 billion is 4% of that.  So if yield curves were normal, they would have earned 19% ROTCE last year.   Another way to look at it is to say that the drop in ROTCE from 21% to 15% was more driven by abnormally low interest rates than higher capital ratios.   Of course, higher capital ratios dampen ROTCE, but that can be and has been managed around.

And think about it, this is 19% ROTCE with the current subdued environment; this only accounts for a normalized interest rate environment and adjusts for the legal cost (and one-time gains) of 2013.  Imagine the potential if housing really picks up, capital investment picks up etc.

Also, this is just a simple, static look at this; if the yield curve was different last year, other things would have been different too so this is way too simple, but it is interesting nonetheless.   Actually, if higher rates are driven by a stronger economy, then this analysis might be good and even conservative (as loans and business volume would increase).

Lower Returns Due to Higher Capital Standards?
OK, so we sort of looked at this above, but Dimon addresses this issue going forward in the letter:

Lower Return Guidance?
And to summarize all of this, Dimon said he has usually guided a 16% through-the-cycle ROTCE but lowered that to a figure somewhere between 15-16%:
In the past, we told you we would expect our average return on tangible equity through the cycle (by this, we mean in average times with normalized credit losses) to be 16%.  With higher levels of capital, significant regulatory changes and some remaining uncertainties, we moved the number to be somewhere between 15% and 16%. 
This is not a huge adjustment given the complexity of issues involved.

Also, here is the table of businesses that they are eliminating and the financial impact:

Earnings Over Time
Other than this 15-16% ROTCE range, he said that current investment initiatives ongoing will add $3.5 billion or so in net earnings to the 2017 run-rate, and normalized interest rates may add $6 billion after-tax by increasing net interest margins by 2.2-2.7%.  He sees short rates at 3-4% and 10 year treasury rate of 5% as normal.  This may happen over three to five years and not in a straight line.  Also, the $6 billion figure, he cautions, is an "all else equal" number but we all know that all is never equal.

But just for fun, let's tack this on to the 2013 adjusted earnings of $23 billion.  So adding the $3.5 billion and $6 billion from the above, that's $32.5 billion.   And deducting $525 million of stuff that goes to other than common shareholders (preferred dividends etc), that leaves around $32 billion.   With 3.8 billion shares outstanding, that's $8.42/share in EPS.   As Dimon said on investor day, the $3.5 billion from ongoing investments doesn't incorporate business growth over time; that's just the earnings that will come directly from the growth initiatives/investments.

So just on the above two, JPM stock can be worth $84 at 10x this figure, or $126 at 15x.   A 12x multiple will get you to $100.  JPM closed at $57.40/share today.

Anyway, this is just playing around with some numbers, not projections or forecasts; just some numbers to think about.

Other things Dimon talks about are:

Scale and breadth create large cross-sell opportunities and strong competitive advantage
Presumably addressing regulators and potential activist investors, Dimon makes the case for why JPM works with the various business units together.  Don't break us up! He says there is $15 billion in additional revenues due to the businesses being together.

New Global Financial Architecture
Dimon goes into detail about what JPM is doing to prepare for the new world.   This includes CCAR, capital/liquidity issues, Dodd-Frank, Volcker rule etc...

Long term Outlook is Bright
  • The world is getting better, not worse:  He mentions the book, The Better Angels of Our Nature by Steven Pinker.  Pinker talks about how mankind has improved society throughout the centuries. 
  • Abiding faith in the U.S.  (the usual, best universities, strongest army, (among the) most entrepreneurial people, best financial markets etc...)
Some of the interesting economic things are:
  • World GDP to grow 7%/year to 2023
  • World's exports grew 11%/year from 2002-2012; many expect trade to grow faster than GDP over time
  • $57 trillion in infrastructure spending needed to support this GDP growth between now and 2030; this is 60% more than in the past 18 years.  40-50% of this will be in emerging markets
  • 7000 new large companies (sales greater than $1 billion) will develop between 2010 and 2025; 70% of them in emerging regions.
  • By 2025, 230 of the Fortune Global 500 will be from emerging markets versus 85 in 2010.  120 will be from China. 
  • Total global financial assets grew to $248 trillion at the end of 2013; expected to grow +6.6%/year to $453 trillion in 2023. 
He talks about some of the positives and negatives in the current environment, and he mentions the things that might be holding things back: 
  • concern about excessive regulation and red tape
  • uncertainty related to Obamacare
  • inability to face fiscal reality; Simpson-Bowles would have been good
  • entitlement spending
  • uncertainty related to Fed's QE
  • political gridlock/government shutdown/debt ceiling crisis
  • inefficient corporate tax policy
  • immigration policy; good immigration policy can add 0.2% to economic growth. 2% over ten years / 3 million jobs

Also, Dimon says uncertainty and hypersensitivity to risk is holding us back.  He says,
It seems that just about everyone has become a risk expert and sees risk behind every rock.  They don't want to miss it - like they did in 2008.  They want to be able to say, "I told you so."  And, therefore, they identify everything as risky. 
  • Corporations seem unduly conservative
  • U.S. gross capital formation to GDP lower in last five years than any time in last 40 years.
  • Big corporations may be more conservative as ratings agencies are tougher:  In 1993, there were 413 AAA and AA issuers.  Now there's 147.  Financial metrics (debt to equity etc) are the same but defaults are lower.  Ratings agencies may have overreacted to the financial crisis. 
  • Other than in Silicon Valley, failure is severely punished. 

Taper Fears
The Fed balance sheet went from $1 trillion to $4.5 trillion.  It has been buying $85 billion a month in treasuries and recently scaled that back to $55 billion.  This is expected to go to zero by the end of the year.  

Dimon points out that the value of all financial assets in the U.S. is $90 trillion, and when the Fed stops buying treasuries, the balance sheet will run off to $2 trillion by 2020 just from paydowns of principal.   The Fed won't have to take the balance sheet down to $1 trillion.    He says that even if the Fed needed to sell some securities, the economy should be able to handle it easily, especially in a stronger economy. 

He has no doubt QE worked because it lowered long-term interest rates, but he also points out that a lot of QE remains "unused".  QE essentially replaced $3 trillion in treasuries held by the public with cash reserves created by the Fed.  If this cash is deposited in a bank and the bank deposits this cash at the Fed, there would be no economic effect. 
At the end of 2007, before QE started, banks had $6.7 trillion in deposits, $6.8 trillion in loans and only $20.8 billion in deposits at the Fed.  Today, banks have $10 trillion in deposits, $7.6 trillion in loans and $2.6 trillion in deposits at the Fed.  You can see that loans increased very little, while deposits and reserves at the Fed increased dramatically.
The fear is that this unused money will suddenly flow into the economy causing inflation, but Dimon points out that the Fed can reverse this if needed, and that banks are more constrained in lending now due to liquidity and capital requirements.

So anyway, as usual, it's a really good letter.  There is a lot of stuff other than what I mention in there, so you should definitely go read it.

Wednesday, April 2, 2014

$24 Billion Wealth Transfer?!

So David Winters is upset about the "biggest transfer of wealth from shareholders to management" in history.  According to Winters Coke's (KO) new 2014 Equity Plan may cause 14.2% dilution to shareholders over the next four years.

His calculation is that there are 4.4 billion shares outstanding so 14.2% of that is 625 million shares, and at $38/share, that's $24 billion of wealth that will be transferred directly from shareholders to management.

Of course this is ludicrous.  How can this much wealth transfer occur in a company like Coke?

This is where the 14.2% comes from (2014 KO proxy):

Expected Value Transfer and Dilution
The Compensation Committee and the Board also considered the expected shareowner value transfer and potential dilution that would result by adopting the 2014 Plan, including the policies of certain institutional investors and major proxy advisory firms. Potential dilution is calculated as shown below:

[shares underlying equity awards that may be made under the 2014 Plan] + [shares to be issued on exercise or settlement of
Potential Dilution=outstanding equity awards under the Prior Plans] + [Holdback Shares] (collectively, “Total Award Shares”)
[total number of issued and outstanding shares of Common Stock (excluding treasury shares)] + [Total Award

Actual dilution will depend on several factors, the most important of which is the type of awards made under the 2014 Plan. This is because the 2014 Plan uses a fungible share pool, under which each share issued pursuant to an option or SAR will reduce the number of shares available under the 2014 Plan by one share, and each share issued pursuant to awards other than options and SARs will reduce the number of shares available by five shares.

The Company expects to continue to grant a mix of stock options and full value awards, primarily in the form of PSUs, under the 2014 Plan. To illustrate the range of potential dilution, the table below shows potential dilution pursuant to the above formula based on 4,405,893,150 shares of Common Stock issued and outstanding as of February 24, 2014 and assuming that all authorized shares under the 2014 Plan are granted (i) 100% as stock options, (ii) at the current mix of approximately 60% stock options and 40% full value awards and (iii) 100% as full value awards.

Current 60%/40%
Mix of stockmix of stock
options/full value100% stockoptions and full100% full value
awardsoptionsvalue awardsawards
Potential Dilution16.8%14.2%10.0%

The problem with this comment is that much of this dilution is going to occur via stock options (in terms of number of shares), and a grant of stock options is not a direct transfer of wealth of the entire underlying amount to the employee who receives it.  For example, if the stock is trading at $38 and an option is offered at a $38 exercise price, the cost to KO (which is expensed) would be around $3.8/share granted, not the entire $38/share.

Here are the inputs to value the stock options from the 2013 10-K:

The fair value of our stock option grants is amortized over the vesting period, generally four years. The fair value of each option award is estimated on the grant date using a Black-Scholes-Merton option-pricing model. The weighted-average fair value of options granted during the past three years and the weighted-average assumptions used in the Black-Scholes-Merton option-pricing model for such grants were as follows:



Fair value of options at grant date



Dividend yield1
Expected volatility2
Risk-free interest rate3
Expected term of the option4
5 years

5 years

5 years

The dividend yield is the calculated yield on the Company's stock at the time of the grant.
Expected volatility is based on implied volatilities from traded options on the Company's stock, historical volatility of the Company's stock and other factors.
The risk-free interest rate for the period matching the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
The expected term of the option represents the period of time that options granted are expected to be outstanding and is derived by analyzing historical exercise behavior.
If you plug the 2013 inputs into an option model, you will get a fair value of less than 10% (of the stock price).

But if the KO stock price goes up over the next five years and the option is exercised, KO will "sell" stock cheap and then buy it back (repurchase) high.  Assuming the stock price goes up 8%/year, which is the EPS growth target (so is a reasonable estimate of stock price appreciation over the long term), then it may actually end up costing KO $18/share.  Some will say the true cost of the option, then, is the difference between the exercise price and the market price at the time of exercise.  Never mind if that's right or not for now.

The 2014 Equity Plan is based on historic trends in equity grants.  They are just reloading the gun, so the 500 million shares doesn't really mean anything in terms of year-to-year grants.

For real dilution or wealth transfer effects, maybe it's better to just look at the historic burn rate for KO which is disclosed here in the proxy:

Historical Equity Award Granting Practices
In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.

The Compensation Committee and the Board also considered the Company’s three-year average burn rate (2011-2013) of approximately 1.3%, which is lower than the industry thresholds established by certain major proxy advisory firms.

Based on historical granting practices and the recent trading price of the Common Stock, the 2014 Plan is expected to cover awards for approximately four years.

The burn rate is 1.3% for the three-years 2011-2013.  That is very far from a 14.2% dilution over four years that Winters talks about.  The 14.2% includes options already granted and are outstanding from previous years.

By the way, check this out from Goldman Sachs' equity compensation presentation of 2013:

Of course, it's not a good idea to bring in GS and other banks to defend KO; I can imagine the outcry of some folks (who think bankers are even more overpaid).  But Buffett is a large shareholder of GS and is well aware of this.  I also don't mind this stuff too much at financial firms as I tend to look at BPS growth over time, and all of this is reflected in shareholders' equity.   For example, if JPM has a high looking burn rate of 2.1% but has grown BPS in double digits, that's fine with me.

OK, back to KO.  KO's burn rate is 1.3%.  I don't know that there is anything in the proxy that indicates that the burn rate will be any higher going forward.  

Well, using this comment:
In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.
We may conclude that the burn rate might rise to 1.5%/year.  But I don't know if that conclusion is correct. Setting up the plan and granting things from year to year are not the same thing; maybe they want to have enough shares to grant just in case.  I just took the 60 million, 63 million and 73 million and averaged them and then divided by 4.4 billion shares (actually, shares outstanding was 4.6 billion in 2012).

So using a 1.5% burn rate (and for simplicity let's just assume it is mostly options granted) and 8%/year increase in stock price over five years, that's 0.75% actual 'cost':  8%/year would make the stock price go up around 50% in five years, so at-the-money options granted will eventually be worth 50% of the stock price.  1.5% of outstanding shares in options are granted every year so that's 0.75% in total cost.  But since KO gets to deduct the difference between the exercise price and market price (at time of option exercise) for tax purposes, the after tax cost would be around 0.5%/year.

With the current stock price at $38/share, that's $0.19/share in total cost or actual 'dilution'.

2013 EPS was $1.90, so it comes to 10% of 2013 earnings.

Accounting treatment now is that the cost of stock options is expensed using an option model but the difference between exercise price and market value at the time of option exercise, although tax deductible, does not show up on the income statement as an expense but does show up in a reduction in shareholders' equity (so is a "wealth transfer" from shareholders to employees).

Anyway, the above is theoretical, using assumptions (1.5% burn rate, all options, 8%/year stock price appreciation etc.)

We can see what the actual cost was in the recent three years by looking at the 2013 10-K:

Stock option activity for all stock option plans for the year ended December 31, 2013, was as follows:
(In millions)

Exercise Price

Contractual Life
Intrinsic Value
(In millions)

Outstanding on January 1, 2013






Outstanding on December 31, 20131


5.82 years

Expected to vest at December 31, 2013


5.78 years

Exercisable on December 31, 2013


4.25 years

Includes 3 million stock option replacement awards in connection with our acquisition of CCE's former North America business in 2010. These options had a weighted-average exercise price of $18.02, and generally vest over 3 years and expire 10 years from the original date of grant.
The total intrinsic value of the options exercised was $815 million, $780 million and $631 million in 2013, 2012 and 2011, respectively. The total shares exercised were 53 million, 61 million and 65 million in 2013, 2012 and 2011, respectively.
The above table shows the intrinsic value of the options exercised in the past three years.  Intrinsic value, of course, is the difference between the exercise price of the option and the market price of the stock at time of exercise.  This is the tax deductible 'expense' (that is not expensed) that occurs when KO has to sell the shares to the option holder for a low price versus a higher market price.

The figure in 2013 was $815 million, which comes to $0.19/share using 4.4 billion shares outstanding, but after tax would come to $0.12/share.  So that's the wealth transfer that has occurred at KO in 2013 (sold shares cheap, bought back high).  That also comes to 0.5% of the market cap.

And by the way, $815 million compares to $46.9 billion of sales (1.7% of sales) and  $10.2 billion of operating income (8% of operating income).

There are 302 million options outstanding already.  Someone might see this as an $11 billion transfer of wealth, but you can see that the instrinsic value of the options is $3.6 billion (as of the end of 2013).  If all options outstanding were exercised at once and KO repurchased shares in the market to offset it (at the year-end price), it would cost KO $3.6 billion, and after tax $2.3 billion.  That's against a current market cap of $167 billion, or 1.4%.  That's a 1.4% transfer of wealth from KO shareholders to employees.

The above excludes full value awards, but since those are expensed one-for-one and the number of shares are a lot lower than those represented by options, I tend not to think that it's that much of an issue.

I understand the frustration with excessive executive compensation, but I really don't think this sort of hyperbole is productive.  To call this equity plan a $24 billion transfer of wealth is very misleading.   Speaking of hyperbole, the recent "market is rigged" comment seems like that too, which may be another post.

I know there have been issues in the past about the treatment of stock options.  I don't have a strong view on that (other than that is should be expensed) and that's really not the point of this post.

David Winters is a BRK-holding value investor and I have a high degree of respect for him but I sort of wish he didn't resort to this kind of soundbite-ism.  I know that's the way of the world now; people won't pay attention unless you can get the message out in 140 character or less or in four words ("the market is rigged"), and that's very unfortunate.  

Friday, March 28, 2014

10x Pretax Earnings! Case Studies: KO, BNI etc.

So, one of the great things about writing a blog is that I get feedback from some pretty intelligent people.  Most of us don't have a Munger to call, but a blog works well too.  If I say something wrong, I'm sure someone would jump in to point it out.

10% Pretax for Stocks Too?
Anyway, I have mentioned 10x pretax earnings or 10% pretax yield as Buffett's valuation measure numerous times here and more than once I've gotten a response saying that this hurdle is for private deals and not for pricing listed companies.  The argument, of course, is that if you buy a stock at 10% pretax earnings, you won't actually earn 10% pretax (due to the additional tax at the investee corporate level whereas in a wholly owned business, a 10% pretax return is actually a 10% pretax return).

It is true that when Buffett speaks of returns in the stock market, he uses GDP growth and dividend yields; earnings can't grow more than GDP and stock returns will reflect earnings growth over time plus whatever dividends you get.

Translating that into individual stocks, you will get earnings growth plus dividend yield equals expected return on the stock.

The only problem with this is that it doesn't tell you what the business is worth.  Would you pay 50x p/e for it?  20x?  The above calculation only works if valuation stays the same.

Anyway, my usual response to this is that many value investors (including Buffett) likes to analyze businesses based on what a rational businessperson would pay for the business in a private transaction.

So, if Buffett is willing to pay 10x pretax earnings for Wells Fargo in a private transaction to buy the whole thing, that is a valuation benchmark for me.  I know that this is not actually possible.  There are size and regulatory issues that will make this unlikely.  But in terms of valuing businesses, I think it is still a useful benchmark.

Is this how Buffett thinks about it? If he pays 10x pretax earnings for WFC stock, he will not necessarily earn a 10% pretax yield.  I don't know the answer to that question. Maybe that's a good annual meeting question.

But as long as I know that Buffett  would be totally happy to pay 10x pretax for the whole business, that's good enough for me regardless of whether that will actually happen.

Yes, you can argue that these "private business transaction" valuations are only valid when there is some chance of a private deal occurring.  But I only think of that when the private valuations don't make too much economic sense to me; valuations per eyeball or per POP valuations in the past, for example, or 40x EV/EBITDA for some media assets, or per acre land valuations etc.; just because some people are paying high prices doesn't mean anything unless there is a real prospect that what you are looking at will also be taken out at some point at the same high level.

Is 10x Pretax Reasonable? 
But 10x pretax earnings, even for listed companies, is not unreasonable at all.  You can translate that 10x pretax into a 15x after tax p/e ratio, and that wouldn't be far off from the 100 year or so long term average of U.S. listed businesses.   Since Buffett buys quality, above average businesses, paying 10x pretax is like paying an average price for an above average business.

So even if my view is wrong, it passes the rationality test; why not pay average prices for above average businesses?  And this is not dependent on market p/e or interest rates because you are using a long term average.  We are not increasing valuations due to decreased interest rates.

Case Studies
So, this discussion piqued my interest again so I decided to go back and look at some more of Buffett's big deals.  I use the term "case study", but it's far from it, really.  I'm only looking at one measure; pretax earnings yield or price to pretax profits.  So I apologize for the exaggerated terminology and to folks who come here looking for a 300 page paper on why Buffett bought something; you'll only see one line.  We all know how great the businesses he owns are, so there really is no need to look at that.

So, I looked at the 2005 purchase of Wells Fargo, Walmart and the recent IBM purchases, but what about some of the other older ones?

Again, since the Warren Buffet Library of Corporate Annual Reports doesn't exist yet, I can only look at some of them.

I got lucky and found a 1988 annual report of Coke, so that's good. Let's start there.

Below, let's take a quick look at Coke (KO), American Express (AXP) and Burlington Northern (BNI) (which a prominent value investing academic said was a crazy/insane deal or some such.  We'll see if it really was a bad price) and some others.

Coca Cola  (KO)
From the 1988 KO annual report:

Pretax earnings:   $1,582 million
Net earnings:        $1,045 million
EPS:   $2.85
Shares outstanding: 365 million
Year-end stock price:  $44.63

From the Berkshire Hathaway annual reports, the cost of KO was:

                     #shares owned           cost ('000)       cost/share (my calculation)
1988 AR       14,172,500                  $592,540       $41.81
1989 AR       23,350,000               $1,023,920       $43.85

So with $1,582 million in pretax profits and 365 million shares outstanding, that's $4.33/share in pretax earnings per share.

So it turns out he paid 9.7x pretax earnings as of 1988 and 10.1x pretax earnings as of the end of 1989.  

That's a pretty stunning discovery, even for me.  I think a lot of value investors were puzzled at what looked like a growth stock purchase by Buffett at the time, but it fits right in with the 10x pretax benchmark perfectly.  He didn't pay up because KO was a really high quality business; he paid what he normally pays.

American Express  (AXP)
So this one doesn't quite fit the mold, but let's take a quick look at it (it doesn't fit only because he didn't pay almost exactly 10x pretax earnings, but far less).

The 1994 annual report is the first time AXP showed up in the BRK letter so let's look at that and what he paid for it:

                        # of shares owned          cost  ('000)          cost/share (my calculation)
1994 AR         27,759,941                     $729,919             $26.29

By the way, I know that this is only an estimated cost per share of the stocks.  There may be some adjustments somewhere that might throw this off, but I don't think it would change things materially.

Thankfully, the SEC database goes back to 1994, so let's pull the relevant AXP figures from 1994:

Pretax earnings:  $1,891 million
EPS: $2.75
Shares outstanding:  496 million

So we don't even have to go very far with this one.  It looks like Buffett paid 9.6x net earnings for AXP.

Pretax earnings per share comes to $3.81/share, so he paid a 6.9x pretax earnings.

It looks like he got AXP really cheaply.   It got pretty cheap in 2009 too.

Moving on.

U.S. Bancorp (USB)
It looks like he started buying USB in 2006, but maybe earlier.  It shows up first in 2006 on the annual report.  He bought more in 2007.  This is from the annual reports:

                     #shares owned           cost ($mn)       cost/share (my calculation)
2006 AR       31,033,800                  $969                 $31.22
2007 AR       75,176,026                $2,417                $32.45

And here are the figures for USB in 2006 and 2007:

              Pretax          diluted (mn)                  Pretax
              earnings       shares outstanding        EPS
2006       $6,912         1,804                            $3.83
2007       $6,282         1,758                            $3.57

2013       $7,990         1,849                            $4.32

So in 2006, BRK was paying 8.2x pretax earings, and the total cost through 2007 comes to 9.1x pretax earnings of 2007.

And interestingly, BRK increased shares held in USB from 78 million in 2012 to 96 million at the end of 2013.  The pretax EPS of USB was $4.32 in 2013 and the stock traded in the range of 7.4 - 9.5x that figure throughout the year.

Burlington Northern (BNI)
So this is one of his other major purchases that made everyone scratch their heads.  There are two things to look at here; one purchase when he just bought the shares and then a second time when he bought out the whole company.  Let's take a look.

The first time BNI appeared in the annual report was 2007.  In 2006, he said there were two positions worth $1.6 billion that was not listed, so BNI was probably purchased in 2006 and other times too (could be some before and some after).

Here is what the 2007 BRK annual report showed:

                       # of shares owned          cost  ($mn)          cost/share (my calculation)
2007 AR         60,828,818                     $4,731                  $77.78

And these are the figures for BNI for 2006 and 2007:

                                                   2006               2007
EPS:                                           $5.11              $5.10
Pretax earnings:                         $2.96 bn         $3.0 bn
diluted shares outstanding:           370 mn        359 mn
Pretax EPS:                                $8.11             $8.25

So from this, it looks like Buffett was paying 9.4x - 9.6x pretax earnings per share.  Voila!

And then of course, BRK bought the whole thing in late 2009 (on an announcement basis).  The offer price was $100, so let's see what the BNI figures were for 2009.  Even though the figures haven't come out yet when the announcement was made, most of the year was over, so they would have known pretty much what the earnings were going to be.

Here it is:

BNI 2009
EPS:   $6.08
Pretax earnings:  $3,368 mn
Diluted shares outstanding:  348 million
Pretax EPS:   $9.68

So at $100/share, Buffett paid 10.3x pretax EPS of BNI.

A lot of people thought Buffett overpaid, but it turns out he just paid what he always seems to pay.  I know, I know.  What about capex, maintanence capex / depreciation and all that?   Yes, that was the argument back then.  I don't know.  I'm just looking at this and noticing a pattern.  I don't have all the answers!

BNI Tangent
What's a blog post here without a tangent?  As I was doing this stuff, I just took a quick look at the famous 'projections' of BNI that was included in the merger proxy.  Buffett has said that he ignores these management projections, but these are often done by management / investment bankers in mergers so they can do their cash flow discount model analysis and whatnot.

So here are the various projections for BNI from the proxy dated December 2009:

2010 Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,994  $16,601  $17,611  $18,667  $19,418  6.7
Freight revenue w/o fuel
  12,372  12,830  14,063  15,014  15,834  16,558  6.0
Operating income
  3,204  3,421  4,336  4,921  5,360  5,745  12.4
  4,737  5,052  6,056  6,746  7,313  7,825  10.6
Net income
  1,631  1,717  2,224  2,476  2,663  2,831  11.7
Earnings per share
  4.77  5.04  6.88  8.41  9.71  10.96  18.1
2011 Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,254  $15,436  $16,629  $17,839  $18,877  6.1
Freight revenue w/o fuel
  12,372  12,424  13,345  14,291  15,244  16,044  5.3
Operating income
  3,204  3,092  3,638  4,241  4,775  5,209  10.2
  4,737  4,723  5,357  6,063  6,724  7,283  9.0
Net income
  1,631  1,515  1,842  2,149  2,386  2,572  9.5
Earnings per share
  4.77  4.41  5.43  6.74  8.10  9.35  14.4
No Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,012  $14,410  $14,622  $14,844  $15,069  1.5
Freight revenue w/o fuel
  12,372  12,377  12,736  12,953  13,176  13,401  1.6
Operating income
  3,204  3,010  3,224  3,324  3,314  3,310  0.7
  4,737  4,639  4,939  5,138  5,249  5,363  2.5
Net income
  1,631  1,465  1,607  1,660  1,631  1,610  (0.3%) 
Earnings per share
  4.77  4.27  4.65  4.87  4.94  5.07  1.2
Deeper Recession Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $13,544  $13,618  $14,000  $14,283  $14,756  1.0
Freight revenue w/o fuel
  12,372  12,107  12,147  12,351  12,632  12,929  0.9
Operating income
  3,204  2,759  2,728  2,778  2,841  2,898  (2.0%) 
  4,737  4,387  4,440  4,588  4,770  4,943  0.9
Net income
  1,631  1,310  1,295  1,326  1,369  1,399  (3.0%) 
Earnings per share
  4.77  3.82  3.74  3.80  3.89  4.05  (3.2%) 

And check this out.  These are the figures for 2013 that BNI actually booked (from the BNI 10-K):

BNI 2013 Results
Revenues:             $22,014 million
Operating income:  $6,667 million
Pretax income:        $5,928 million
Net income:             $3,793 million

The most bullish projection in 2009 was for operating income of $5,360 million and net income of $2,663 million.  Operating income came in 24% higher and net came in 42% higher!

OK, so here's one more acquisition.  This name might not give BRK holders a warm and fuzzy feeling (due to the Sokol incident), but it is a major acquisition so it is a relevant data point.

BRK bought Lubrizol in 2011 for $135/share.

For the 2010 year, here are some figures for Lubrizol:

EPS:  $10.64
Pretax earnings:  $1.00 billion
Diluted shares outstanding:  68.8 million
Pretax EPS:  $14.53

So a $135/share purchase is 9.3x pretax EPS.

So let's just recap all of this stuff I said in the last post (part 5) and this one.

These are the multiples to pretax earnings Buffett paid in these big deals:

KO in 1988/89:    10.1x
AXP in 1994:         6.9x
WMT in 2005:      10.3 - 12.9x (range of stock price in2005)
WFC in 2005:         9x
USB in 2006/2007:  9.1x
USB in 2013:  7.4 - 9.5x (range of stock price in 2013)
BNI stock purchase: 9.5x
BNI acquisition:  10.3x
Lubrizol:   9.3x
IBM:  9.7x

I exclude Heinz here as it is a different situation and I think he said he wouldn't have done the deal without 3G.  I may be missing some here as I didn't intend this to be comprehensive by any means, but just looked quickly at some of the large purchases he has made over the years and it is very interesting.

It's amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that.

Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying.

And yes, right now I'm the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it's really interesting.

Of course, this actually makes no sense as every company has different capital needs (free cash flow / owner earnings etc.)  Of course, what Buffett calls "owner earnings" are more important than pretax profits.  This was one of the arguments about the BNI deal.

And it is silly to think you can price anything and everything at 10x pretax profits.  Buffett obviously looks at everything else and has a deep understanding of the various businesses and is only willing to pay this amount for the very best businesses out there.

Why he says he will pay 9-10x pretax earnings (OK, for private deals) and yet seems to go out and pay 9-10x pretax earnings on stocks is a good and valid question.

It's amazing, though, isn't it?  Even if it is an odd coincidence.

But I don't think 10x pretax earnings for a stock is a bad price if it's a high quality business that can grow over time etc...  (But you still have to answer the question how much growth there will be and how much a shareholder can expect to get back.)