Intrinsic Value

Viad (VVI)

INTRODUCTION

Since work on the 13F Screener has kept me busy, I haven't had time to do a formal writeup of my most-recent investment—Viad Corp (VVI). While only a 1.5% position, it's a good company trading at a very reasonable price, and I may buy more. But rather than do a full writeup, this time I'm posting a:

  1. VVI "Living Document" (running overview of operations, financials, management, valuation, etc.)
  2. VVI Valuation Model (pro forma financials, DCF, margin analysis, etc.)

Whenever I research a new company, I'll start by creating these two documents, which I then edit and add to as events and circumstances change. For the Living Document, I'll add links to other analyst write-ups, interesting reports or articles about the company/industry, interviews with management, and investor presentations. I'll also include a running list of highlights/lowlights from conference calls,10-Ks, and 10-Qs to see if management actually does what they say they're going to do. 

For the Valuation Model , I create historical and pro forma financial statements, making conservative adjustments and estimates. Then I'll run a few models (e.g., DCF, Residual Earnings, EV/EBITDA) at various margin and growth rate assumptions. The goal here isn't to come up with an exact share price or multiple, but rather to see what range of values are likely, and if the current price affords a healthy margin of safety. 

For Viad, I've published both documents below; alternatively, the Google Docs versions can be accessed via the links above. 

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Berkshire Hathaway (BRKB)

INTRODUCTION

Berkshire Hathaway is a conservatively-run, well-capitalized business, managed by one of the greatest CEOs of all time. It uses minimal leverage, operates across many recession-resilient industries, and has grown earnings 20% per year since 1999. Businesses like this rarely trade for less than 20x earnings. Berkshire Hathaway trades for 7x.

While the company is best known for being a collection of “Warren Buffett’s stock picks”, it now derives a significant—and growing—portion of its value from another source: earnings from the company’s wholly-owned subsidiaries. We argue that this latter group—whose earnings exceed those of Amazon, Google, Netflix, Tesla, Twitter, and Uber; combined—is being under-appreciated by the market.

BUSINESS HISTORY

In 1964, Warren Buffett took control of a struggling New England textile manufacturer, named Berkshire Hathaway. Its net worth was $22m at the time. Fifty years and $411b later, Berkshire Hathaway is now the fourth largest company in the US, with a reach so wide it makes money nearly every time:

  • a plane is flown
  • a car is sold
  • a house is built 
  • goods are transported to/from the West Coast
  • an iPhone is purchased
  • a lightbulb goes on in Nevada
  • someone drinks a Coke
  • a french fry is dipped in ketchup
  • and the guy at DQ does this

So how did Buffett grow a modest textile company into a sprawling conglomerate—one that now owns dozens of operating companies and a stock portfolio worth $150b?  

In the decades after taking control of Berkshire, Buffett steered the company through three major—and lucrative—shifts. He began in the late 1960s by acquiring insurance companies. Then he started using the insurance premiums generated by their operations to buy shares of publicly traded companies. Finally, in the 1990s, he began buying large businesses outright. 

Phase I: Buying Insurance Companies to Generate Float

The first step took place in 1967, when Berkshire purchased a small Nebraskan insurance company called National Indemnity for $8.6m. Buffett was drawn to characteristics unique to the insurance business: cash—in the form of premiums—is collected years before claims are paid out. In the meantime, the insurance company is free to invest it. This money is commonly referred to as “float”. Buffett explains further: 

“Float is money we hold but don't 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.”

In other words: for most insurers, the combined cost of running their business and paying out claims usually exceeds the money they receive from premiums. Most insurers make up for these underwriting losses by profitably investing their float. If they just so happen to earn an underwriting profit—that is, if premiums ultimately exceed the cost of running the business plus the cost of claims—it’s simply a bonus. 

Unlike most insurers, Berkshire consistently earns an underwriting profit. So not only does Berkshire get to invest the float, but it’s effectively paid to do so! Buffett says, “That’s like your taking out a loan and having the bank pay you interest.” 

An insurer that consistently generates float and earns an underwriting profit is a great business. Still, Buffett saw more potential. Instead of investing the float in conservative and low-yielding bonds like a traditional insurance company does, Buffett took a new approach: he used the float to buy stock in other companies selling for reasonable prices.

Phase II: Using Float to Buy Partial Ownership of Other Companies (i.e., Stocks)

Throughout much of the 1970s and 1980s, Buffett used the proceeds from Berkshire’s insurance businesses to buy shares of a number of fantastic companies—such as Coca Cola, American Express, and The Washington Post—which were at the time selling for far less than their intrinsic values. By investing the borrowed money (i.e., float) that Berkshire was in effect being paid to hold, Buffett was able to lever his returns—earning Berkshire and its shareholders 20%+ per year. Even better, this leverage came from owned insurance operations rather than debt—which meant Berkshire reaped all the benefits of leverage without shouldering its traditional downside (such as interest expenses and an increase in risk).

Until the early 1990s, Berkshire Hathaway was in essence a lightly-leveraged, publicly-traded stock portfolio, managed by an unusually prudent investor. But as Berkshire grew in size, it became increasingly difficult to find opportunities in publicly traded companies that were large enough to move the needle. So Buffett changed track for the third time: he began acquiring operating businesses outright.

Phase III: Buying Full Ownership of Operating Businesses

Though Buffett did buy a few operating businesses in the 1970s and 1980s, it wasn't until the 1990s that he started doing so in earnest. Present-day Berkshire fully owns dozens of businesses, including: GEICO, Burlington Northern Santa Fe Railroad, Dairy Queen, Benjamin Moore Paints, Clayton Homes, and ACME Brick. At first, the collective net worth of these businesses was dwarfed by Berkshire’s investment portfolio. And to this day it is the investment portfolio which remains the focus for most investors. But as Buffett continued to acquire simple, stable businesses that possessed what he deemed favorable long-term competitive advantages, their total value swelled. Today, they make up half of Berkshire’s intrinsic value.

PRESENT-DAY BUSINESS OVERVIEW

I. What is the Value of Berkshire’s Investment Portfolio (and Cash & Bonds)?

Included in this half of Berkshire’s value are its cash, bonds, and 5%-15% partial ownership stakes in companies such as American Express, Kraft Heinz, Apple, Coca Cola, IBM, Bank of America, and many others. Valuing Berkshire’s investment portfolio is simple. Since “cash is cash”, and the market prices the stocks and bonds every day, one needs only to look up the price and the number of shares owned by Berkshire to get an approximation of their worth:

An investor can then apply a premium or a discount, based on whether current market prices are under or overvalued.  An argument could be made that Berkshire’s stock portfolio warrants a slight premium in light of Buffett’s investing prowess, but for simplicity’s sake we are assigning no premium, and assume the market is pricing each company correctly. 

After summing up available cash, stocks, bonds, and preferred shares—and subtracting out deferred taxes Berkshire may eventually have to pay—we get $262b worth of investments.

On a per share basis, this totals $105, or 64% of Berkshire's current $163/share price. 

II. What is the Value of Berkshire’s Operating Businesses?

The rest of Berkshire’s value comes from its operating businesses. After backing out the $105/share of investments from Berkshire’s current share price ($163), the remainder—or $58/share—is what the market believes the operating businesses are worth. 

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Since the true value of its investment portfolio is more or less determined by the market, the question of whether or not Berkshire is properly valued at $163/share comes down to this: is $58/share a fair price to pay for Berkshire’s operating businesses? Considering these companies earned $8.56/share (pre-tax) in 2016, we feel that paying $58/share for this group—or 7x earnings—is a bargain.

Let’s break this down. Berkshire’s group of wholly-owned operating businesses has grown20%/yr for nearly two decades, earning $21b ($8.56/share) in 2016. Broadly speaking, its businesses fall into one of five segments: insurance; Berkshire Hathaway Energy (BHE); Burlington Northern Santa Fe Railroad (BNSF); Manufacturing, Services, & Retailing (MSR); and Finance & Financial Products. 

1. Insurance

  • 2016 earnings: $2.1b (10 % of total)
  • Companies: GEICO, General Re, National Indemnity, etc. 

Since the purchase of National Indemnity in 1967, Berkshire’s insurance operations have become the largest and most profitable in the world. They have delivered 14 consecutive years of underwriting profits—a feat unheard of in the industry. 

Aside from unusually consistent earnings, the insurance group provides Berkshire with an even greater benefit discussed earlier: float. At year end 2016, the company’s float—money that Berkshire holds but does not own—stood at over $100b. This free financing is available to Berkshire to acquire more businesses across a range of industries.

2. Finance and Financial Products

  • 2016 earnings: $2.1b (10% of total)
  • Companies: Clayton Homes, XTRA, Marmon, CORT

This is Berkshire’s smallest group, made up of companies that specialize in mobile home manufacturing/financing, furniture rentals, and equipment leasing. 

3. Berkshire Hathaway Energy (BHE)

  • 2016 earnings: $2.7b (13% of total)
  • Companies: NV Energy, MidAmerican Energy, PacifiCorp, etc. 

Berkshire Hathaway Energy is a group of regulated utilities, renewable power sources, and gas pipelines operating in Nevada, Utah, Iowa, Oregon, Canada, and the United Kingdom. Regulators allow these monopolies to exist, in exchange for a limit on how much they can earn. Even with these limits in place, this group of companies provides predictable and recession-proof earnings, with the important added benefit of allowing Berkshire to defer billions of dollars in taxes because of their large capital expenditure needs. 

Said more simply: owning utilities is not a way to get rich; it’s a way to stay rich. And Berkshire intends on staying rich.

4. Burlington Northern Sante Fe Railroad (BNSF)

  • 2016 earnings: $5.7b (27% of total)
  • Companies: Burlington Northern Santa Fe Railroad

Railroads play a vital role within the US economy; they ship goods from point A to point B more efficiently and cheaply than all other forms of transport. And because railroads require massive amounts of capital, land, equipment, and government cooperation, these companies are virtually impossible to duplicate—making disruption by a new competitor extremely unlikely. 

The railroad industry is made up of regional duopolies, with BNSF and Union Pacific controlling the western US. While their earnings are cyclical and highly dependent on the health of the national economy, their long-term returns will almost assuredly be above average. Since acquiring BNSF in 2010 for $30b, the company has already earned a total of $24b, and is now the second largest contributor to Berkshire’s operating profit. Like the BHE group, BNSF requires large amounts of capital investment every year to maintain the infrastructure. And just like BHE, these capital outlays can be used to defer taxes at the parent-level for decades to come. Being able to “pay today’s taxes tomorrow” is another nice little form of float; one that lets Berkshire profitably—and tax-efficiently—reinvest billions of dollars back into both segments. 

5. Manufacturing, Services, and Retailing

  • 2016 earnings: $8.5b (40% of total)
  • Companies: See’s Candy, Lubrizol, Dairy Queen, Marmon, The Pampered Chef, etc. 

This segment drives the lion’s share of Berkshire’s operating earnings. It is an eclectic collection of businesses, selling everything from Dilly Bars to partial ownership of private jets. As a whole, the group earns very respectable returns on capital—with almost no use of financial leverage. Furniture, ice cream, airplane parts, and underwear may not be the most trendy businesses in the world, but they’re safe, stable, and profitable, with many earning 15%-20%/year. 

Together, these five groups earned $21b last year for Berkshire, or $8.56/share.

Are Berkshire’s Operating Businesses Being Fairly Valued by the Market? 

Back to the question: Is $58/share a fair price to pay for Berkshire’s operating businesses? 

For $58/share, investors are getting $8.56 of earnings generated by a group of stable companies that: earn solid returns on capital; have been vetted by an investor widely recognized as the greatest of all time; have grown earnings at 20%/yr since 1999; are unlikely to be disrupted by technological advances; and have long-term competitive advantages. 

A standalone company with similar characteristics would probably trade above $170/share. Yet Berkshire’s operating business group trades for only $58. Perhaps if Berkshire renamed this part of their business Berkshire Hathaway AI Biotech Cloud Data Inc., it would it start trading at a more appropriate level. To put this in perspective, let’s imagine that certain popular tech companies started trading at a similar multiple to Berkshire’s operating businesses. Google’s share price would be $245 (versus actual $823); Netflix’s would be $4.50 (versus actual $142); and Amazon’s would be $64 (versus actual $884).

So how many times earnings should an investor be willing to pay for Berkshire’s operating businesses? Each of the five groups has different economic characteristics, so one could apply specific multiples to each (for example, 10x for insurance, 12x for BHE, 15x for BNSF, 15x for MSR, and 10x for Financial Products are probably appropriate). Doing so may yield a more precise (and probably higher) assessment of Berkshire's worth. But with either approach, the message is clear: the market is undervaluing Berkshire.  

We apply a simple—and rather conservative—10x multiple to Berkshire’s group of operating businesses, which yields $85/share in value. When combined with its $105/share of stocks, bonds, and cash, this puts Berkshire’s intrinsic value at somewhere around $190/share—a 15% premium to today’s price.

Conclusion

50 years ago, Berkshire Hathaway was a struggling New England textile manufacturer. The business—which required a lot of capital, was barely profitable, and had no long-term competitive advantages—was not a good one. But Warren Buffett decided to buy it anyway, thinking the company’s assets (e.g., machines, factories, accounts receivable, etc.) were worth more than the price he could could pay for the entire business. After assuming control, business steadily deteriorated, and it became apparent the market had been right—Berkshire was a dud. 

Half a century later, Berkshire Hathaway is far from a dud. In fact, it’s probably one of the best companies in the world. While the textile business is long gone, what remains is an investment portfolio worth $105/share, and a collection steadily growing, well managed, and very profitable businesses, that together earned $8.56/share in 2016. A company like that should trade for 20x earnings. Berkshire is available for 1/3rd that.

Seritage Growth Properties (SRG)

INTRODUCTION

In 2015, Sears Holdings faced the real threat of bankruptcy. In a move to raise much-needed cash, the struggling retailer spun off 266 store locations into a real estate investment trust (REIT), giving birth to a new, separate entity: Seritage Growth Properties (SRG). As part of the spin-off, Sears and SRG entered into a Master Lease Agreement (MLA) which required SRG to lease the stores back to Sears at rates far below market. 

Currently, SRG is unprofitable. But the MLA they entered with Sears contains hidden value for the REIT—and its shareholders—in the form of “recapture rights". These rights allow SRG to reclaim up to 50% of the gross leasable space currently occupied by Sears Holdings, and then re-lease it to new tenants at much higher rates. By reclaiming existing space—along with the adjacent land—from Sears, and then re-leasing it to new tenants, SRG stands to increase their average rent anywhere from 2x to 5x. 

In addition to the rent/sqft charged to new tenants, SRG’s value will also be determined by how quickly stores can be redeveloped, and the success of opportunities outside the core portfolio (i.e., the “adjacent lands”). Because each element can play out a number of ways, any valuation that relies too heavily on specific predictions is unlikely to be accurate. Instead, investors are best off looking a range of possible outcomes—from “worst case” to “best case”—and how they compare to today’s price. 

Even with pessimistic estimates, SRG is undervalued.

BUSINESS OVERVIEW

SRG’s portfolio consists of 266 properties. Of those, 31 are "Class A” (or "prime”) mall properties. The remaining properties are a combination of "Class B” mall anchors, 89 free-standing Sears Auto Centers, and the surrounding parking lots and land. Sears currently occupies 90% of SRG’s leasable space, at an average rent of $4.30/sqft. 

At a cursory glance, SRG might seem an unwise place to invest money: it offers below-market rents across its portfolio; mall attendance is declining; and its primary tenant, Sears, is on the verge of bankruptcy. 

And yet, four famed Buffett disciples—Eddie Lampert, Bruce Berkowitz, Mohnish Pabrai, and Guy Spier—have substantial positions in SRG. Even Buffett himself recently revealed an 8% ownership stake in the company. So what is it they see that the market does not? 

OPPORTUNITY

Today, only 10% of SRG’s space is occupied by non-Sears tenants, but because those tenants pay rents more in line with market averages, these leases bring in $56m (or 27% of SRG’s total revenue). As SRG recaptures additional space from Sears (which, as a reminder, they’re entitled to 50% of, per the MLA), their overall average rent will only increase—and revenue and profit along with it.

SRG’s portfolio is made up of three main property types—Class A mall stores, Class B mall stores, and Sears Auto Centers—all with differing redevelopment costs, prospective tenants, and expected rents. But even when using conservative estimates, the yield on investment across all of SRG’s core portfolio should approximate a very respectable 12%. 

The MLA also gives SRG the right to recapture 100% of the space at 21 high-value properties, which should command rents around $25/sqft (versus the $4.30/sqft that Sears pays). If exercised, average rents will net even higher.

Further, in many cases SRG also owns the adjacent land, which provides other development opportunities such as: adding space to auto centers to attract additional tenants (e.g., restaurants, banks); constructing new buildings on top of parking lots, and/or creating new mixed-use developments such as hotels, office complexes, apartment rentals, and open air “villages”. 

But even if investors were to ignore these other opportunities and solely consider SRG re-leasing 50% of the properties in their core portfolio, the stock still looks undervalued. 

VALUATION

Real Estate Investment Trusts are commonly valued using one of four methods: Net Operating Income (NOI), Funds From Operations (FFO), Adjusted Funds From Operations (AFFO), or Net Asset Value (NAV). While each method differs in how they handle certain accounting conventions, NOI, FFO, and AFFO are essentially just tweaked iterations of profitability; and NAV is a rough estimate of the value of the real estate less any outstanding debt. Importantly, by any of these measures, SRG appears undervalued.

At $44/share, SRG’s current price assumes slower-than-expected redevelopment, lower-than-expected rent, and zero opportunity outside the core portfolio. But the chance of SRG failing on all three counts is low. What’s more likely is that by 2025, SRG will have recaptured 50%+ of the space from Sears, and raised their average rent to somewhere in the $14/sqft range. In that scenario, investors would earn ~12% per year at today’s price. Even if they’re wrong—and SRG can only raise rents to, say, $8/sqft—they’ll still earn a solid (albeit not spectacular) ~6%. This implies a healthy margin of safety built into SRG’s stock price. 

Those estimates could also be over-conservative. If SRG can successfully recapture 100% of the space from Sears, increase rents to $16/share, and maybe have some success outside the existing core portfolio, investors could even stand to gain a remarkable 20%+ annually.

But the most likely outcome is probably somewhere between $8 - $16/sqft rents, 50% - 100% recapture rates, and maybe a few successful projects outside the core property portfolio. Therefore, it doesn’t seem unreasonable to expect a still wonderful ~15% annual return. 

CONCLUSION

It’s hard to pinpoint what SRG's proper valuation is with a high degree of certainty. However—and most importantly—we can be reasonably confident that it’s worth more than what the market thinks. If Sears can stay solvent for another 6-8 quarters and SRG delivers even the low-end estimates of recapture rates and rents, investors will do okay. If SRG delivers any upside, investors will do quite well.

Associated Capital (AC)

"I don't throw darts at a board. I bet on sure things." - Gordon Gekko

In November 2015, GAMCO—an investment management and advisory company owned and managed by famed value investor Mario Gabelli—moved a substantial portion of its cash, investments, and 4.4m of their own shares into a newly created company named Associated Capital. As of this writing, Associated Capital currently has a market value of $770m, which seemingly indicates that the company’s stash of cash and investments is being fairly valued by Wall Street. 

Yet in addition to the spin off of cash and investments, GAMCO also created a five year $250m promissory note (i.e., loan), payable to Associated Capital at 4% interest.

Despite the note representing a very real economic benefit to Associated Capital, its true worth is obfuscated by the GAAP accounting because it’s a “related party loan”—i.e., a loan between two companies controlled by the same person—thus excluding it from the asset side of the balance sheet. But as the note matures, Associated Capital will receive payment from GAMCO, thereby increasing the company’s cash balance by an additional $9.83 on a per share basis.

Additionally, Associated Capital’s downside risk is relatively low because its other assets are highly liquid and thus easy to value: cash can be taken at face value, and many of AC’s investments have market quoted prices. And Mario Gabelli—who owns 75% of both companies—has a proven track record of creating long-term value. Recognizing that Associated Capital is trading at a discount, the Board of Directors has authorized a buyback of 500k shares, which will help to close the gap between value and price. 

With 25% of its value not yet realized by the market, a value-centric owner in Mario Gabelli, and a highly liquid asset base, Associated Capital makes for an attractive opportunity with very limited downside. An investment in the company would be like buying a house worth $500k for $500k, and then a month later discovering that there’s shoebox buried in the yard stuffed with $125k. The GAMCO note—much like the shoebox—represents hidden value not yet appreciated by Wall Street. 

It’s very likely this accounting quirk has created an opportunity for prudent investors to almost literally buy $1 of assets for $.75, which, according to both common sense and Warren Buffett “is a very good thing to do.”