Buffett’s Berkshire Letter for 1991

1991 saw Scuds and Patriots battle over desert skies. Cracks became fissures, and the brittle Union of Soviet Socialist Republics finally dissolved. In the stock market, the S&P 500 launched from the gate—rising from 325 to 380 in the first quarter—only to chortle along for the remainder, and close with a two week sprint to 417. Including dividends, the 500 gained 30.5% for the year.

Over at Berkshire, net worth rose to $2.1 billion, or 39.6% YOY. In its most recent 27 years (i.e., since present management took over), per-share book value has grown from $19 to $6,437, or at a rate of 23.7% compounded annually. “Look-through earnings” declined from $602 million in 1990 to $516 million.

For Buffett, the goal of each investor should be to create a portfolio that will deliver the highest possible look-through earnings a decade from now. Successful investing requires the investor to think about long-term business prospects rather than short-term stock market prospects. It is crucial then that an investor competently distinguish companies with long-term “economic franchises” from mere businesses, those companies with wide moats from those with none.

An economic franchise “arises from a product or service that: 1) is needed or desired; 2) is thought by its customers to have no close substitute and; 3) is not subject to price regulation.” These conditions enable a company to “regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

A mere “business” earns exceptional profits “only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

In Berkshire’s stock portfolio in 1991, Coca Cola, Gillette, and Guinness PLC meet Buffett’s definition of an economic franchise. Only a few years prior, The Washington Post Company and Capital Cities/ABC would have also sat in this class. However, in recent years, “the economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.” By 1991, newspaper, television, and magazine properties now resemble businesses more than franchises in their economic behavior. GEICO and Wells Fargo represent mere businesses, albeit ones which are some of lowest cost providers in their industry. Each has superior management—as Buffett often notes—but were mismanagement to arrive, costs could quickly escalate, and their moats erode.

Given Buffett’s lecture, one may be surprised to find that Berkshire acquired another “business” in 1991—H.H. Brown Company, a shoe manufacturer. Candor reigns, for “shoes are a tough business… and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank Rooney and the group developed by Mr. Heffernan can prosper.”

What distinguishes H.H. Brown’s management? For one, their compensation system is one of the most unusual Buffett has encountered: “key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.” Unlike most compensation schemes which are “long on carrots but short on sticks,” the system at Brown has served both the company and managers exceptionally well, for “managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Ultimately, the best investments are those with favorable long-term economic characteristics, honest and able management, and a fair price. With H.H. Brown, Buffett shows that two out of three is sufficient to pass his tests.

In light of our contemporary economic environment—with new government equity stakes in highly competitive industries with questionable economics—Buffett offers a final and interesting coda. Recall that a few years back, Berkshire bought convertible preferred stock in a notoriously bad “business”—US Air. On Berkshire’s balance sheets, Buffett and Munger valued this stock at a significant discount to its par value, to reflect the risk that “the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible.”

1991 was a “decimating period” for airlines, as Midway, Pan Am and America West all entered bankruptcy. Continental and TWA followed some months later. And the risk to the entire industry was further heightened by the fact that “the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry’s costs because the bankrupts don’t incur the capital costs faced by their solvent brethren and because they can fund their losses—and thereby stave off shutdown—by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.”

[If history serves as precedent, keep an eye out for GM and Chrysler promotions in the months and years ahead. And you really thought Ford could survive?]

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

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Valuing the Washington Post, Revisited

Yesterday, we drew up a laundry list of the Washington Post Company’s assets and discerned the free cash flow (FCF) of Kaplan, its wholly held education subsidiary. Relative to the average FCF multiple of its peers (19.75x), one could make the case that Kaplan itself is worth more than the current market cap of WPO (which stood at 3.38 billion today, 2/27/09).

Yet, that 19.75x FCF valuation may look like a steep price, too high to provide the investor with a sufficient margin of safety. Even if the conservative investor grants that the education business is counter-cyclical and has good growth prospects, he may require future earnings to be more visible than Kaplan’s in order to justify that multiple.

Another way to value Kaplan’s intrinsic value is via a discounted cash flow analysis. Looking through the 10-Ks, we see that Kaplan had FCF of 189.8 million in 2008, 127.7 million in 2007, and 112.7 million in 2006. The older 10-Ks do not break out the depreciation and amortization expense for Kaplan alone, so it is difficult to discern Kaplan’s FCF growth rate. If we posit a modest 10% growth rate in FCF for Kaplan’s next decade, and a lower 5% for the next, and then discount those cash flows at 15% and demand a 25% margin of safety, the investor should feel comfortable buying the whole business for 12 times Kaplan’s 2008 FCF plus its equity. What’s Kaplan’s equity value? Given Kaplan’s acquisition streak, the 10-K shows over 2 billion in goodwill for Kaplan alone. The financial statements do not break out shareholder equity for Kaplan, so we’ll estimate it at half of their stated goodwill, or 1 billion. Thus, an investor seeking a 15% return and satisfied with a 25% margin of safety should be willing to pay 3.28 billion for Kaplan (2.28 billion for the cash flows and 1 billion for the equity).

Of course, while Kaplan is arguably WPO’s crown jewel, its other assets have significant value as well. Cable ONE had FCF of nearly 170 million in 2008. The television stations had over 90 million in FCF. The newspaper and print businesses were breakeven on free cash flow or slightly negative. Even after the market sell-off, its pension was overfunded by 320 million (as of Dec. 31) and its future return expectations reasonable (or, in my lights, low).

If we value Kaplan lower than its competitors, at 3.28 billion, put a cheap 8x FCF multiple on the growing cable business, and a 6x FCF multiple on the television stations, we get a value of 5.18 billion. Add in the 333 million in marketable securities and 320 million in the over-funded pension plans, and the value stands at 5.83 billion. And that’s assuming that we get all of their print and online publications for free.

In sum, we expect that an investor seeking a 15% return and 25% margin of safety would pay at least 5.83 billion for the Washington Post Company, or $622 per share. Though it may not be a dollar priced at 20 cents (like when Buffett first bought WPO), it looks to us like a dollar selling for less than 50 cents.

Disclosure: No position in the aforementioned companies at the time of this post.

Valuing the Washington Post

Newspapers these days are a tough business. The publically traded ones have significantly cut their dividends, with Gannett being only the most recent. The less fortunate (read—those highly levered) have entered bankruptcy, to be chopped into pieces sized for the auction block. Nor has the Washington Post Company been immune to the challenges of this recession, having seen a significant decline in advertising revenue in recent quarters (with print ad revenue down 21% at the Post and 22% at Newsweek ).

As most are aware, the print newspaper business is in serial decline. As Warren Buffett has noted, “when they take people to the cemetery, they’re taking newspaper readers, but when people graduate from high school, we’re not gaining newspaper readers.”

The Washington Post Company however is much more than a newspaper business. In fact, in our lights, less than a quarter of its intrinsic value lies in its newspapers and magazines. Contrary to appearances, the Washington Post Company is an education business. And the numbers bear this out. In 2008, 52% of its consolidated revenues derived from its wholly-owned subsidiary Kaplan, which operates in three business segments: for-profit higher education, test preparation services, and corporate training. In addition to Kaplan, WPO’s assets include: Cable ONE, a cable service with nearly 700,000 subscribers across 19 states; its namesake newspaper and affiliated publications, which include their website and related investments (e.g., Slate.com, The Root, The Big Money); a 16.5% stake in online classified ad provider Classified Ventures LLC; Newsweek and its thirty affiliated publications; The Daily Herald, which publishes The Herald in Everett, WA as well as other affiliated publications; six VHF television stations located in Houston, Detroit, Miami, Orlando, San Antonio, and Jacksonville; a 49% stake in Bowater Mersey Paper Company; and $333.3 million in marketable equity securities (as of 12/31/08), which includes $218.8 million of shares in Berkshire Hathaway. Whew.

To give a detailed intrinsic value that accounts for all these parts would require more work than we’re prepared to offer today. But let’s just focus on Kaplan. Kaplan generated 206.3 million in operating income in 2008, with 67.3 million in depreciation, and 15.5 million in amortization. After subtracting 99.3 million for capital expenditures, Kaplan had free cash flow of 189.8 million. In 2007, Kaplan posted free cash flow of 127.7 million; in 2006, 112.7 million. For now, let’s ignore Kaplan’s growth rate and the counter-cyclical character of the education business (McKinsey’s research shows a 90% increase in education spending during the past two recessions).

Looking at Morningstar’s numbers, we see that competitor DeVry currently trades at 18x FCF. Capella Education at 21x FCF. Career Education at 12x. Corinthian Colleges at 48x. ITT at 6x. Strayer at 28x. If we throw out the high and the low, we get a sector average of 19.75x FCF. Applied to Kaplan’s 189.8 million FCF, we get a value of 3.75 billion. As of 2/26/09’s close, the whole Washington Post Company traded for less than 3.5 billion.

Now, we recognize that to some, a 19.75 multiple on FCF may seem high. So tomorrow, we’ll take a closer look at the rest of the Post’s assets and give a more comprehensive estimate of its fair value.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.