Berkshire Hathaway’s Warren Buffett adjusts his bottom line with non-GAAP metrics, just like the Wall Street bankers and corporate CEOs he frequently criticizes for adjusting standard earnings to tell a better story.
The difference is that Buffett doesn’t explicitly call the number he’d rather investors focus on an “adjusted EBITDA.”
In his most recent letter to shareholders, Buffett claims his brand of earnings adjustment is a “far cry” from the presentations made by others. Too often, he writes, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of what Buffett says are “all-too-real” costs. In particular, Buffett rails against claims that stock-based compensation should not be counted as an expense. He also says expenses for restructurings are common in business—Berkshire’s shareholders see the impact of those activities.
However, Berkshire Hathaway BRK.A, -0.28% BRK.B, -0.25% does use certain non-GAAP financial measures regularly. Every period it adjusts for losses and gains on its investment portfolio, a routine GAAP expense made more significant for Berkshire Hathaway now that companies must also record the impact of unrealized gains and losses in their bottom-line number.
For more info: Why Buffett will keep Berkshire Hathaway reporting earnings during the weekend
In its fourth quarter earnings release, Berkshire adjusts GAAP net income for the nearly $27.6 billion net loss on its investment portfolio for just one quarter, as well as a $3 billion hit for its share of the Kraft Heinz $15 billion write-down of goodwill and intangible assets that reflects deteriorating brand value.
Kraft Heinz adjusted out its $15 billion loss in its earnings release.
Read: Why the $15.4 billion Kraft Heinz brand write-down was unusual
Generally Accepted Accounting Principles, or GAAP, are the standard accounting rules all U.S. listed companies must use to present their financial results. The SEC says “earnings” means net income as presented in the statement of operations under GAAP in its May 2016 updated guidance on the use of non-standard accounting metrics. Measures that are calculated differently than those described as EBIT and EBITDA are supposed to be distinguished with a title such as “adjusted EBITDA.”
The SEC asked Berkshire Hathaway in 2017 why it had not disclosed expenses related to the amortization of certain intangible assets. Buffett rationalized the move in his letter to shareholders last year: “We present the data in this manner because Charlie and I believe the adjusted numbers more accurately reflect the true economic expenses and profits of the businesses aggregated in the table than do GAAP figures,” he said, referring to Charlie Munger, the vice chairman of the board.
Berkshire to move away from one metric
For nearly three decades, Buffett opened his letters with a discussion of another metric he loved to tout: Berkshire’s per-share book value. Book value represents a company’s assets minus its liabilities and is otherwise known as shareholders’ equity, or simply equity.
Buffett also touts a type of non-GAAP metric he calls “intrinsic value”, which is defined as the “discounted value of the cash that can be taken out of a business during its remaining life.”
In the 2017 letter, Buffet said: “We give you Berkshire’s book-value figures, because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.”
However, Buffett and his partner Charlie Munger never disclose their estimates of Berkshire Hathaway’s intrinsic value, because, they say, it’s an estimate and very subjective.
“What our annual reports do supply, though,” Buffett wrote for the 2017 annual report, “are the facts that we ourselves use to calculate this value.”
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Berkshire Hathaway may hold back on disclosing intrinsic value estimates because the SEC has said that “free cash flow” metrics, which are non-GAAP figures, are liquidity measures. The SEC prohibits companies from disclosing per-share amounts for liquidity measures.
“Perhaps intrinsic value was never criticized as a non-GAAP metric because it was not an input to a company valuation model but an output,” Ed Ketz, a professor of accounting at Penn State University, told MarketWatch.
Berkshire Hathaway’s CFO Marc Hamburg did not respond to a request for comment on the company’s use of non-GAAP metrics or its acquisition record.
For more, see: SEC tells companies to be careful how they talk about free cash flow
To read: Take-Two Interactive is using a revenue metric the SEC does not allow to calculate bonuses
“It’s now time to abandon that practice,” Buffett wrote in this year’s letter, referring to his discussion of the book value per-share metric—because he believes it’s no longer relevant.
“Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses,” said the letter.
Buffett’s prior focus on book value per share and intrinsic value is based on his belief that it was more useful for investors to focus on what he thought acquisitions were worth. But that’s after paying a premium that was recorded to goodwill, rather than the value that accounting rules said he had to assign to them.
Buffett laments that “while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years.”
But the other half of his business is marked to market, and he doesn’t like that either. That’s because given the size of the portfolio—nearly $173 billion at the end of 2018 – and its concentration of financial services and technology companies, it “will often experience one-day price fluctuations of $2 billion or more.” In the fourth quarter, Berkshire Hathaway experienced several days with a “profit” or “loss” of more than $4 billion, he writes.
That volatility is now immediately apparent in his bottom line.
Bringing back the buybacks
Buffett writes in this year’s letter that Berkshire will be a significant repurchaser of its own shares going forward. Those transactions will occur at prices above book value but below his estimate of intrinsic value.
“Over time, however, Berkshire’s stock price will provide the best measure of business performance,” not book value per share or the mysterious intrinsic value, he concludes.
Paul Zarowin, a professor of accounting at the Stern School of Business at New York University, told MarketWatch, “If Berkshire Hathaway is holding a lot of assets that are marked-to-market now, it makes sense that he would shift his focus to share price. A new emphasis on share repurchases is aligned with that.”
Berkshire’s common stock repurchase program was amended on July 17, 2018, and permits Buffett to repurchase its shares at prices that are below Berkshire’s intrinsic value, a value “conservatively” determined by Buffett and Munger, the annual report says. In 2018, Berkshire repurchased $1.3 billion worth of class A and B common stock.
However, just last June Buffett, and JPMorgan CEO Jamie Dimon, wrote a Wall Street Journal OpEd criticizing the “unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability” that is promoted by companies that provide quarterly earnings-per-share guidance.
Despite his concerns that financial markets have become too focused on the short term, Buffett says Berkshire Hathaway plans to highlight its share price, not its book value per share, in future financial results.
Professor Zarowin says he tends to give Buffett the benefit of the doubt and does not see these changes as self-serving given his status as an investing icon, and someone at the forefront of many great initiatives like advocating for higher taxes on the wealthy and making the Gates Foundation philanthropic Giving Pledge.
“Even someone with Buffett’s record, however, ‘can’t fight City Hall.’ Everyone is focused on share price and Berkshire Hathaway will lag the market if he doesn’t move with the trends,” Zarowin told MarketWatch.
Read now: The Sanders-Schumer buyback test would block almost all company stock repurchases
Deals and more deals
Buffett may prefer that investors ignore the volatility of the value of the equity investment portfolio, but he admits its influence is expected to grow rather than diminish.
Berkshire’s reputed prowess in making brilliant acquisitions that might deflect attention from the buildup of equity investments is now history.
Despite “hoping to move much of our excess liquidity into businesses that Berkshire Hathaway will permanently own” the immediate prospects for that, he writes in this year’s letter, are “not good.
“Prices are sky-high for businesses possessing decent long-term prospects,” he says.
The sudden announcement of bad news at Kraft Heinz also calls into question previous disclosures and the outlook for earlier acquisitions.
In 2007, for example, Berkshire Hathaway bought a 60% stake in Marmon Holdings, the industrial holding firm owned by Chicago’s Pritzker family, for $4.5 billion. Buffett now owns 99.75% of the company, all but a sliver held by a family holdout, after a series of transactions where he also criticized the impact of GAAP accounting.
“Our transaction was done just the way Jay would have liked it to be done – no consultants or studies,” Buffett said in a statement in 2007, referring to Jay Pritzker, the founder of the family’s Hyatt hotel empire and uncle of J.B. Pritzker, the current governor of Illinois and his sister Penny Pritzker, a former commerce secretary under President Barack Obama.
By 2012 Buffett was already complaining about the growing challenge of using book value and intrinsic value to measure his company’s performance when he talked about the accounting for the deal.
The Marmon deal was one of the largest acquisitions Buffett has made in recent years. Marmon had more than 125 businesses in a wide range of industries and revenues of about $7 billion at the time. It now consists of 13 diverse business sectors and more than 100 autonomous manufacturing and service businesses, according to Berkshire’s latest annual report.
“Marmon provides an example of a clear and substantial gap existing between book value and intrinsic value. Last year I told you that we had purchased additional shares in Marmon, raising our ownership to 80% (up from the 64% we acquired in 2008). I also told you that GAAP accounting required us to immediately record the 2011 purchase on our books at far less than what we paid. I’ve now had a year to think about this weird accounting rule, but I’ve yet to find an explanation that makes any sense – nor can Charlie or Marc Hamburg, our CFO, come up with one,” Buffett wrote in 2012.
But Marmon has been struggling in the last few years. Berkshire does not disclose its individual profits anymore, but does say in its latest annual report that Marmon’s pre-tax earnings decreased 5.6% in 2018 from 2017 despite a 5.5% increase in revenues to $8.2 billion. Marmon’s earnings also declined in 2017 by 3.5% from 2016, despite a revenue increase of $305 million, or 4.1% this years annual report disclosed.
That’s not what Berkshire reported in its 2017 annual report, when it said Marmon’s revenues increased by $349 million, or 7%, in 2017 versus 2016 and combined pre-tax earnings for Marmon, and International Metalworking Companies increased in 2017 compared to 2016, “due to a combination of increased sales, increased manufacturing efficiencies, the effects of business acquisitions and ongoing expense control efforts.”
Berkshire first invested significantly in H.J. Heinz Holding Corporation in 2013. Berkshire Hathaway owns 26.7 % of Kraft Heinz accounted for using the “equity” method because it’s part of the control group.
“I was wrong in a couple of ways about Kraft Heinz,” Buffett told CNBC’s Becky Quick on Squawk Box on Monday. “We overpaid for Kraft,” he said.
“The Kraft Heinz goodwill impairment tends to prove that goodwill is not an asset but merely a comment about how much the acquirer tended to overpay for the acquired company,” said Ketz from Penn State. “If there were any true synergies, these impairments would not occur.”
Another big deal
Buffett refuses to throw in the towel on acquisitions, however.
In this year’s letter to shareholders, he writes that he and Munger “continue, nevertheless, to hope for an elephant-sized acquisition. Even at our ages of 88 and 95—I’m the young one—that prospect is what causes my heart and Charlie’s to beat faster.”
At 88 and 95 it may be a better idea to play more bridge instead.
