Citi Keeps it Retail Partner Card Division
Oct/110
This post about Citi’s Retail Partner Card Division originally ran on MarketWatch.com on October 28, 2011.
In Citigroup’s recent earnings release, Citi’s CEO Vikram Pandit announced that the company would move its Retail Partner Cards division from Citi Holdings to Citicorp. This effectively means the company has decided to keep the division as a core business and is no longer trying to exit through a sale.
This is good news for Citigroup shareholders because it is a good strategic and capital allocation decision by management.
Citi’s Retail Partner Cards division’s business has improved, so it makes sense to keep the business. When management placed the division into Citi Holdings in 2009, it was not profitable and credit quality was weak with credit losses over 13%. However, there has been a turnaround in the past two years. According Citi’s third-quarter financial supplement , the division made $476 million pre-tax in the quarter. The division is earning a return on assets (ROA) of 2.7% (assuming 38% tax rate and $41 billion in assets.) If Citi employs 10x leverage, this is a 27% ROE business. Both of the ROA and ROE estimates are significantly higher than the current corporate average.
There was no obvious buyer for the business. Citi is one of the largest players in retail partner credit cards, so it would take another player with a large balance sheet to buy the business. The largest competitors in retail credit cards are GE Capital, JP Morgan and Capital One. Capital One is in the process of buying HSHB’s credit card division, so it couldn’t bid on Citi’s unit. GE has been on record of wanting to reduce the size of GE Capital, so it would be unlikely to pay a premium for the business. JP Morgan was probably unlikely to acquire Citi’s business for a premium. Without an obviously buyer, Citi would probably have had to cut its price to complete a sale.
By keeping the Retail Partner Cards division, Citi will not leak value from a forced sale. By not forcing the sale, Citi will not take a write-down to enable the sale. The exact opposite happened in September 2010 when Citi took a $500 million charge to earnings to complete the sale of Student Loan Corp to Discover and Sallie Mae. I wascritical of the Student Loan sale because I believed Citi could have realized the full value of the student loan business by holding onto that asset. By keeping Retail Partner Cards, Citi is not taking a write-down in order to sell the asset.
Citi will be able to use some of its excess capital by keeping the business. Citi is generating excess capital by winding down Citi Holdings. As assets from Citi Holdings are sold or pay off, the capital used to hold these assets becomes excess capital. Also, Citi is generating excess capital as it realizes portions of its deferred tax asset each quarter as it generates income. I am anticipating that Citi will start to deploy this excess capital by announcing a large stock buyback in March 2012 when the Fed completes updated stress tests for each of the systemically important banks. It is unlikely that the Fed would allow Citi to use all of its excess capital in a stock buyback. By keeping the Retail Partner Cards division, Citi deploys some additional excess capital that would have otherwise been trapped by regulators.
The decision to keep the Retail Partner Cards division signals that regulators are letting management make good strategic decisions. For me, one of the most important aspects of the decision to keep the Retail Partner Cards division is it appears that regulators are taking a balanced approach to Citi’s strategic decisions. They are not ruling with an iron fist and forcing Citi to divest this division because two years ago management earmarked it for sale. New facts have appeared in the form of the business turning around, so management changed their minds about how the business fit with its core operations, and the regulators allowed them to implement the new strategy.
Overall, Citi’s management made the right decision to keep the Retail Partners Cards division. It is good to see Citi make good strategic decisions. This is also a better capital allocation decision. Moving the division back into Citicorp from Citi Holdings also shows good character on the part of management. They were flexible in their thinking when new facts appeared.
This commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
AUTHOR DISCLOSURE: Long C, JPM, COF
3rd Quarter Letter from Gator Released
Oct/110
The 3rd Quarter letter for Gator Financial Partners was released yesterday to investors. If you would like a copy, please complete the following form:
Are Private Equity Firms as Volatile as Their Stock Prices?
Oct/113
This post about private equity business franchises originally ran on MarketWatch.com on October 11, 2011.
Publicly traded private equity firms KKR & Co, The Blackstone Group and Apollo Global Management declined more than the overall financial sector during the 3rd quarter. It appears that investors had concerns that these firms would suffer from liquidity drying up in the financial markets and hurt values realized on their existing investments.
I believe private equity firms’ business franchises don’t change in value as much as the volatility of their stock prices would predict. When these firms’ stocks sell-off on fears that their existing portfolios are declining in value, I believe there is an opportunity in their stocks.
The Blackstone Group BX has proven to be a volatile stock. BX opened for trading at $36.60 on June 22, 2007. Less than 2 years later, it had fallen 90% when it hit $3.55 intra-day on February 27, 2009. BX then climbed 450% to a recent high of $19.49 in April 2011. Since April, it has declined another 43% on the broader market sell-off.
During this time, I would argue that the value of Blackstone’s business franchise has not been nearly as volatile as the stock price. Here’s a chart showing Blackstone’s fee-paying assets under management since coming public. As you can see, Blackstone’s assets under management have increased 76% since coming public in 2007 with little volatility.
Chart: Gator Capital; Data: Blackstone SEC Filings
I would argue that investors place too high a value on the immediate prospects for exiting the firms’ current investments. While exiting investments and recording incentive fees on these investments is an important part of the income stream, there are times when these stocks sell off to such low levels that they are good values, even ignoring any future incentive fees. Currently, Blackstone trades at 15x the 2012 estimates made by Oppenheimer analyst Chris Kotowski for Blackstone’s earnings only from its management fees. At its February 2009 lows, Blackstone traded at just 9x its 2009 management fee-only earnings. (Source: Oppenheimer note 9/6/11 “Resetting for the New World Order”)
In thinking about a private equity firm’s business franchise, I believe the value of the firm lies in its ability to continue to raise additional funds from investors. This fund raising ability is affected by past absolute and relative performance of its investments, its reputation, and its personal relationships with its clients. When the stock market declines, only the absolute performance of a private equity firm’s investments declines, but it does not quickly affect the other factors that predict a private equity firm’s fund raising ability. Blackstone has demonstrated a strong ability to raise assets since coming public. I would argue that its ability to raise assets demonstrates its business franchise has increased in value.
The other part of investing in private equity firms that is often missed in stock market declines is the increased investment opportunities these firms have. Unlike their investment banking peers, when liquidity gets tight, private equity firms have dry powder to make new investments. Plus, they do not become forced sellers like Bank of America BAC +0.94% was in selling its private equity stake in HCA a few weeks ago. Of course, private equity firms may not be able to use as much leverage as they could in a more liquid capital markets environment, however the declines in investment prices may offset the lack of leverage in these new investments.
The current sell-off in the stock market is presenting a second opportunity to buy the publicly traded private equity firms. I believe the stocks of these firms are more volatile than the underlying business franchises. The volatility comes from investors focusing on realizing value from the firms’ existing portfolios. Instead, I’ll focus on the private equity firms’ ongoing franchise values as measured by their ability to raise money for new funds they offer.
Disclosure: Long KKR, APO, BX
The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
Citigroup: Collateral Damage from Bank of America
Sep/111
This is the second of a three part posting on Citigroup. The first part explored how I own Citigroup and other large banks despite the risk of a systemic collapse if there was a hard Greek default. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Bank of America has been in the headlines about its mortgage exposure and capital situation. Its stock is down 42% this quarter through September 23rd, but Citigroup, which I do not believe has similar problems, is also down 40%. In fact, the two stocks seem to be perfectly correlated. It appears that investors are making macro trades against the banking sector without doing fundamental research on the individual companies within the sector. I do not know whether investors are just scrambling to hedge exposures using any bank stock they can find or whether they are expressing their views mainly through sector ETFs. However, good stock pickers appear to have an opportunity within the banking sector since the stocks have moved in such close correlation during the quarter.
I have been adding to my Citigroup position at recent levels. It has a tangible book value of $48.75 as of June 30th, but is trading around $25, or at about 50% of tangible book value. It trades at this discount to book value in spite of reporting profits the last six quarters, having improving credit metrics, building capital, an improving its business mix, and potentially beginning a stock repurchase program next spring.
Bank of America trades at a similar 50% of June 30th tangible book value despite what I perceive as having much higher uncertainty about legacy mortgage costs and having recently diluted common shareholders through the preferred stock and warrant sale to Berkshire Hathaway announced in late August.
It seems to me that Citigroup is being unfairly tarnished by Bank of America’s problems and is a better stock to own at the same valuation. An investor could own Citigroup and short Bank of America as a hedged pair trade. I own both stocks, but my position in Citigroup is much larger than my position in Bank of America.
A Classic Turnaround
I believe Citigroup has all the ingredients of a classic turnaround situation. A large conglomerate with an iconic brand performs poorly because it has become too unwieldy to manage. A new CEO comes in and implements a new strategy to exit non-core assets and businesses. The capital generated from the asset sales has been earmarked for share repurchases. The remaining core businesses operate more profitably and grow faster than before because management can now focus resources on these businesses.
Citigroup’s CEO Vikrum Pandit is executing this turnaround. It has been more difficult than normal because of the difficult economic environment, the need for government assistance at the height of the credit crisis, and the massive size of the organization. That being said, it appears from the outside that things are on track. Management has split the company into two segments: one segment (named Citicorp) holds the company’s three core businesses and the other segment (named CitiHoldings) holds various businesses and assets that Citigroup management has decided they no longer want to own. The assets in CitiHoldings have been declining steadily (see slide 13 on Citigroup’s 2nd Quarter Earnings Presentation.) Although I have thought that Citigroup has given up too much value during some of the asset sales, the management has made steady progress with the asset sales.
I project that Citigroup will generate about $15 billion of excess capital over the next two years. I expect the main source of the excess capital will be from the proceeds of asset sales from the wind down of CitiHoldings. Plus, I estimate that Citigroup will generate more capital than required for growth of its core business. The final piece of the turnaround may come by April 2012 when I expect Citigroup will get approval for a stock buyback program with the excess capital it has generated in 2011. Of course, this approval will be dependent on the operating environment and Citigroup’s results and regulators assessment of Citigroup’s capital and risk positions.
After exiting most of the assets in CitiHoldings and hopefully shrinking the outstanding share count substantially, I believe that investors will be attracted to the remaining Citigroup businesses which are currently in the Citicorp segment. These three businesses are the global retail bank, the corporate bank and institutional securities unit, and the transaction processing business. I believe these remaining three businesses are all good franchises and have the ability to produce attractive growth and returns for shareholders. The corporate structure should be much simpler to understand and analyze.
Global Retail Bank
Of the three core businesses within Citigroup, I believe the global consumer banking franchise is the most attractive business and a unique world-class asset. In my opinion, Citigroup has the only global consumer banking brand with possibly only HSBC as a distant #2. This positions Citigroup for better long-term growth prospects than its U.S.-centric peers (BAC, WFC and JPM.)
The global nature of the Citigroup’s consumer banking franchise positions it for better loan growth than a typical domestic bank. The retail bank benefits from the fast growing economies of the emerging markets. Plus, Citigroup has the option to redirect resources to or from any particular market based on whether that market’s prospects are attractive. With stronger economies outside the U.S., I believe Citigroup’s consumer banking franchise will generate attractive profits and growth and investors will one day give it a premium valuation compared to its domestic peers like Bank of America.
Comparison to Bank of America
I believe Citigroup should trade at a premium to Bank of America because it doesn’t have the same legacy mortgage and capital issues that I believe have been pressuring Bank of America’s stock in Q3. Here’s a look at some statistics that directly compare the two companies:
| Citigroup | Bank of America | |
| YTD Repurchase Provisions | $352 million | $15 billion |
| Mortgage Servicing Portfolio | $571 billion | $2,003 billion |
| Delinquency Rate in Loan Servicing | 8.1% | 13.7% |
| P/E 2012 | 5.0x | 5.2X |
| P/TB | 50% | 51% |
| Market Cap | $75 billion | $64 billion |
| P/E 2012 | 5.0x | 5.2X |
Source: SEC filings, Yahoo! Finance
I believe that Bank of America’s mortgage issues are an order of magnitude worse than Citigroup’s. Bank of America, including its acquisitions of Countrywide and Merrill Lynch, originated a higher amount of the mortgage loans in the worse vintage years of 2006-2008. Bank of America has realized more mortgage losses so far in 2011 than Citigroup, and it has a mortgage servicing portfolio almost three times the size of Citigroup’s.
Do You Believe the Bond Market or the Stock Market?
The bond market is telling us that Citigroup’s stock is undervalued. Ed Najarian, Head of Bank Research at the ISI Group, wrote an interesting note earlier last week showing the strong relationship between the major banks’ Price-to-Tangible Book ratio compared to where their CDS spreads are trading. Wells Fargo and JP Morgan trade with the tightest spreads and the highest P/TB ratios. At the other end spectrum, Bank of America and Morgan Stanley trade with the widest spreads and the lowest P/TB ratios. In the middle, Goldman Sachs and Citigroup trade with CDS spreads about equivalent to each other. Goldman’s P/TB ratio is perfectly between JPM and WFC on one end and BAC and MS on the other. The interesting part is Citigroup doesn’t have a P/TB close to Goldman’s; rather, it has the same P/TB as Bank of America and Morgan Stanley, which both have wider spread levels.
As of 9/20/11:
| P/TB | CDS Spread | |
| WFC | 1.40x | 126 bps |
| JPM | 1.03x | 127 bps |
| GS | 0.84x | 233 bps |
| C | 0.55x | 231 bps |
| MS | 0.57x | 320 bps |
| BAC | 0.55x | 339 bps |
Source: Bloomberg, SEC filings
As a believer that the bond market is collectively smarter than the stock market, I believe the bond market’s assessment of Citigroup’s risk is more accurate, and Citigroup is undervalued by the stock market.
Citigroup is a classic turnaround. They are selling non-core assets and I expect the management to use the proceeds to repurchase stock at attractive valuations. I believe the core businesses within Citigroup, especially the global consumer bank, appear attractive and could generate high levels of profitability and growth than their U.S.-centric peers. I believe investors are unfairly penalizing Citigroup for Bank of America’s woes.
Disclosure: Long C, BAC, MS, WFC
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Citigroup: A Bet Against the End of the World
Sep/112
This is the first of a three part posting on Citigroup. The second part compared the opportunity in Citigroup to Bank of America. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Betting on the End of the World by shorting the major U.S. banks is not a winning strategy. This is not to say investors should blindly depend on policy makers to bailout the financial system every time there is an issue. We have clear, recent evidence from September 2008 that bailouts do not always come for investors. Also, I fear we will have a repeat of September 2008 in the future as anti-bailout proponents continue to gain power in Washington. However, the current financial policy makers (Geithner and Bernanke) will not repeat the mistakes of September 2008, so shorting the major U.S. banks now is a losing strategy.
The sellers of bank stocks at these levels fear the financial system will collapse if there is a hard default by Greece. Their thesis is if Greece defaults, major European banks will take losses directly and suffer additional counterparty losses from the failure of smaller banks. As the European banks take losses, risk aversion will rise and liquidity will drain from the system. Lower levels of liquidity will drive asset prices lower causing losses in both U.S. and European banks. These additional losses may cause a major a European bank to fail, and U.S. banks will suffer additional losses as a result. If the losses for the U.S. banks rise to a high enough level, we may see a major U.S. bank have to fire-sale assets and/or raise capital at dilutive stock prices.
I disagree with several parts of this thesis. Most important, I believe the current policy makers learned an important lesson from September 2008 and will not compound a crisis by letting their financial institutions fail due to a lack of liquidity. Plus, the major U.S. banks have liquidity and capital levels that will allow them to survive a severe downturn in the financial markets. I have been expressing my view by adding to my position in Citigroup.
My preferred way to implement my view that the financial system will not collapse is to own shares of Citigroup. I believe all of the large banks are attractive, including JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo. I own most of them, but my largest position is in Citigroup. My preference for Citigroup is due to its low valuation and its ongoing corporate restructuring which is generating excess capital.
I do not think the financial system is going to collapse due to the current European crisis. Political leaders have learned important lessons from the Lehman Brothers bankruptcy that orderly wind-down of major financial institutions is needed. I believe the distress in the financial system in September 2008 is etched on the minds of Geithner and Bernanke. They will not allow a major financial institution to fail due to a shock from Europe.
Treasury Secretary Tim Geithner consistently shows in his speeches and interviews that the lessons learned from September 2008 are well in grained. On September 19th, Geithner said in a Bloomberg interview, “I think you’re going to see them draw on the lessons of our crisis, draw on the lessons of things that worked here in the United States. I think you’ll see that reflected in some of the choices they make.”
In the end, I believe the European leaders have learned these same lessons. They will protect their own country’s banks from losses. It may be bumpy trip, but we see evidence that European political leaders are starting to get it. Merkel and Sarkozy released a joint statement saying that they “are convinced that Greece’s future is in the eurozone.” At the recent G7 meeting, the finance ministers stated their support for the banks, “We will take all necessary actions to ensure the resilience of banking systems and financial markets,”
In addition to the support from political leaders, I believe Citigroup is approaching a potential Greek default with much more solid liquidity and capital positions than. Here’s a look at the high level numbers:
| Dec 2007 | June 2011 | |
| Cash as % of Assets | 10.2% | 16.7% |
| Reserves/Loans | 1.9% | 5.3% |
| Deposits/(Loans+Securities) | 79% | 89% |
| Tangible Common Equity/Tangible Assets | 1.6% | 7.3% |
These are clearly stronger numbers and position Citigroup to handle a stressful environment better than 2008. In addition, Citigroup has spent the past 3 years reducing risk within its loan book. With the credit quality metrics declining, I get the sense that management has a much better sense of its balance sheet and the risks than it did 3 years ago.
I believe Citigroup is well positioned here to survive a stressful period in the markets due to a Greek default. With the stock at 60% of tangible book value, I believe it is an attractive stock. The reason it is at these low valuation level is the potential for potential problems in the financial system due to a Greek default. I do not believe
Disclosure: Long C, BAC, WFC & MS
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Freddie Mac 2011 Q2 Earnings Review
Aug/1110
Last night Freddie Mac, which is in conservatorship, released its second quarter earnings. The headline numbers were a net loss of $2.1 billion and a requested draw from the Treasury of $1.5 billion. Although these results are worse than the first quarter report, there is an accounting entry which obfuscates the underlying progress Freddie is making in its return to profitability.
Freddie’s income statement shows more volatility than the underlying business because FASB requires the company to mark-to-market its derivative portfolio. When Freddie needs to issue long-term debt to fund its mortgage portfolio, it looks for the cheapest execution. It can either issue a cash bond with a fixed rate or it can replicate issuing a fixed-rate cash bond by entering into a pay-fixed swap and issuing short-term debt. In a pay-fixed swap, Freddie will pay the counterparty a fixed-rate and the counterparty will pay Freddie a short-term rate, which will be used to pay the rate on the short-term debt. Freddie will rollover the short-term debt until the pay-fixed swap matures. [I don't like this practice of substituting pay-fixed swaps for issuing long-term cash bonds because it exposes the company to financing risk. The company is constantly rolling over its massive portfolio of short term debt. It puts the company at risk when the capital markets close like in September 2008. However, it is what it is.] So over time, Freddie has entered into hundreds of billions of dollars of pay-fixed swaps. Every quarter, Freddie must mark-to-market this portfolio of pay-fixed swaps. When interest rates decline in a quarter like Q2, Freddie must report a loss, which it did to the tune of $3.4 billion.
If we are looking at Freddie’s income statement to get an idea of the company’s long-term performance and profitability, we need to ignore the derivatives mark-to-market line item. If rates rise the next quarter and this line item moves to a gain, then we’ll ignore it again. Eventually, this line item will be reflected in the income statement through net interest income. By ignoring the noise from the derivatives mark-to-market, we get a better sense of Freddie’s recurring earnings performance.
| 2011 Q2 | 2011 Q1 | |
| Net interest income | $4,561 | $4,540 |
| Loan Loss Provision | (2,529) | (1,989) |
| NII after Provision | 2,032 | 2,551 |
| Securities Impairment | (352) | (1,183) |
| Other non-interest income | 302 | 368 |
| Non-Interest Income | (50) | (950) |
| Non-Interest Expense | (546) | (697) |
| Income Before Taxes | 1,436 | 904 |
| Tax Benefit | 232 | 74 |
| Net Income ex-Derivatives | 1,668 | 978 |
| Other comprehensive income | 1,039 | 2,064 |
| Total comprehensive income | 2,707 | 3,042 |
So, from the table, we can see absent the derivative mark, the headlines should have read “Freddie makes $1.7 billion in the quarter and does require a draw from the Treasury.” I believe ignoring the quarterly mark on the derivatives portfolio gives a more realistic view of Freddie’s recurring earnings.
Here are some other observations from the Freddie’s 2nd Quarter earnings report:
1. Credit losses remained stable in Q2 at $3.1 billion compared to $3.2 billion and $3.1 billion in Q1 and Q4, respectively.
2. The loan loss reserve continues to look too high given the level of charge-offs. Freddie has more than 12 quarters worth of credit losses in its loan loss reserve. For comparison, Wells Fargo has 7 quarters of credit losses in its loan loss reserve.
3. I am not seeing evidence that Freddie has raised guaranty fee rates as the Treasury proposed in January this year. This may be because the rate is contracted with customers on an annual basis.
4. As of Q2, 46% of the portfolio was written after 2008. The legacy book is steadily declining and losses from the legacy book are declining.
5. Deliquencies for 30 days ticked higher in Q2, which reverses a multi-quarter decline in delinquencies.
6. Based on the interest rate moves in Q3, I would expect another sizable negative mark-to-market for the derivatives portfolio in Q3. It will probably cause Freddie to report another loss and draw again from the Treasury.
7. Q3 may be the last time Freddie has to make a draw from the Treasury if credit losses continue to stabilize or improve and the steep yield curve continues.
I continue to hold my positions in a few of the classes of Freddie Mac preferred stock. I think there is a chance that starting Q4, Freddie Mac will report profitable quarters and will be in a position to begin paying down the Treasury’s stake in the company.
Disclosure: Long FMCKJ, FMCKI & FMCCT
Disclaimer: There is no guarantee that Freddie Mac’s stock price will rise. There is significant risk that shareholders could be wiped out and you would lose all of your money. There are other reasons the stock may not perform. Please do your own analysis.
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Signals from Berkshire Hathaway’s Buyback Announcement
Sep/113
Yesterday, Berkshire Hathaway announced a share repurchase program. This is an important milestone announcement in the history of the company because it signals many things to current and prospective shareholders. It signals that the Oracle of Omaha thinks his stock is undervalued. It signals that the stock may perform well over the short-to-medium term. The most important signal is Buffett has setup a framework for buybacks that his successors could use in the future.
Buffett Thinks His Stock is Undervalued
To me, the buyback announcement clearly shows that Buffett thinks Berkshire’s stock is undervalued. On a price-to-book ratio, the stock is the cheapest it has been in the past twenty years. Buffett would not repurchase shares unless
he was getting more value than he was paying. I think this is an uncontroversial point and has been made by other commentators such as Morgan Housel’s Buffett Gets Bullish at the Motely Fool and Jason Sweig and Jonathan Cheng’s Buffett Spots Fresh Bargain: Shares in His Own Company at the Wall Street Journal.
Potential stock outperformance
The last time I can remember Buffett offering to repurchase Berkshire shares was in the 1999 Annual Report which was issued on March 11, 2000. In the 1999 Chairman’s letter, Buffett included a section (starting on page 16) with his views about share repurchases. The letter is famous among value investors because not only did it mark the bottom in Berkshire’s stock, but it also marked the all-time closing high in NASDAQ Composite Index at 5048.62.
The March 2000 mention of share repurchases by Buffett was a great signal to buy Berkshire’s stock. Here’s a table comparing Berkshire’s stock to the S&P 500 over the next few time periods
In 2000, the stock had strong performance over the next year on both a relative and absolute basis. Even though the stock was up 8.6% yesterday, which is weirdly similar to its 1-Day performance after the 2000 repurchase offer, the stock could go on to additional gains in the coming time periods. I believe this is due to the market anomaly that stocks under react to good news because investors have a tendency to sell shares to lock-in gains in spite of good news.
Allocate Capital from the Grave
The most important signal from Buffett’s announcement of a stock repurchase plan is it sets up a major part of Berkshire’s capital allocation framework for the post-Buffett time period. In Buffett’s announcement of the share repurchase, he added three unique guidelines that:
The combination of these three guidelines will allow the Board and his successors to execute the share repurchase program after Buffett has passed without argument or second-guessing.
The worse scenario post-Buffett for Berkshire shareholders would be for the stock to trade at a discount to intrinsic value and have a Board argue that the company shouldn’t implement a stock repurchase program because Buffett had never had one. The cash would continue to pour into the company’s coffers and be trapped. The stock would trade at a higher and higher discount as cash was trapped. Even worse, his successors could try to use the capital to make acquisitions when repurchasing the stock would be a better capital allocation decision. The only way out of such a situation would be the break-up of Berkshire Hathaway.
This announcement takes away this downside risk of Berkshire’s Buffett premium turning into a post-Buffett discount. Buffett’s successors will have a clear framework as to how to evaluate stock repurchases. It could put a floor on the company’s valuation. I believe it could put the company’s capital allocation decisions on auto pilot for decades. If the stock trades close to book value, Buffett’s successor will probably use excess cash to buyback more and more shares and not make additional acquisitions.
Changes My Opinion of Berkshire’s Stock
The Berkshire share repurchase announcement changed my opionion of the stock. Prior to yesterday’s announcement, I had thought Berkshire’s stock was uninvestable due to Buffett’s inevitable death. With the framework that Buffett setup for share repurchases, the downside scenario of Berkshire trading at a steep discount to intrinsic value post-Buffett is nearly eliminated.
Based on how the stock performed in 2000 after Buffett’s last repurchase offer, I would guess there is still more upside to the stock.
If you have a different opinion or perspective please comment.
Disclosure: Long BRK-B
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Berkshire. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.