However, as the insurance business is maturing, the growth of future insurance float is likely to reach pedestrian levels over the long-term, constraining Berkshire’s capacity to grow intrinsic value.
Luckily, the genius that Buffett is, has found a remedy in a secondary form of float which will soon be larger than its insurance float in the coming few years – deferred tax float.
Deferred tax float
Deferred tax float has grown from $11bn in 2004 to $57bn in 2013 and compares to the size of the insurance float at $77bn. Put another way, the deferred tax float is about 75% of the size insurance float – yet it doesn’t receive its fair share of analysis from investors.
Deferred tax liabilities are simply the deferral of payment of taxes. While it is a form of float, its potentially finite duration does not appear to be as good as insurance float at face value – but Buffett has found a way around this issue – I’ll get to this later.
But first, there are two main types of deferred taxes that need to be considered. BRK’s $57bn of deferred taxes comprise the following, of which I will primarily focus on #2 going forward.
- $26bn of deferred capital gains – This largely stems from its stock holdings. BRK’s holding period is ‘forever’ resulting in deferred capital gains tax as its investments perform – a form of float (free loan from the government).
- $32bn of PP&E deferred tax liability – This comes from the mismatch between the accelerated depreciation for tax accounting versus the slower depreciation for the books.
Let me explain #2 – accelerated depreciation for tax results in lower assessable income and therefore lower tax payable. The books use lower depreciation rates resulting in higher profits and income tax expense. Since the expense is bigger than tax payable this gives rise to a deferred tax liability – money which BRK gets to keep until it falls due and is therefore a form of float. Over the lifespan of an asset the differences unwind – it’s all square between the IRS and the books.
The key businesses giving rise to PP&E deferred tax liabilities are capital intensive, namely BNSF (railroads) and MidAmerican (utilities and energy). Previously I noted that deferred tax liabilities are temporary float, however these asset have very long useful lives. Railroads up to 100 years and the utility assets up to 80 years. Buffett has found assets that make PP&E related deferred tax liabilities enduring – an excellent source of float.
The next challenge for Buffett is to grow this type of float to drive instrinsic value growth. He does this by throwing large amounts of capex at these assets for long periods of time. Note that capex for BNSF/MidAmerican has risen from $6bn in 2011 to $11bn in 2014 and I would expect it will continue to rise with vigor. This achieves a number of things for deferred tax liability float:
- The level of fixed assets in capital intensive float-generating businesses will rise as capex tracks more than 2x above depreciation
- New capital will tax depreciate quicker than the existing book resulting in faster tax depreciation of the overall book and hence greater amounts of deferred tax liability per dollar of assets
- Rising amounts of capex will cause points #1 and #2 to occur with increasing intensity
- The end result is that the deferred tax liability float will grow at a rapid pace
Buffett is a float genius – the capital intensive businesses will generate decades of float well after his succession.
Lastly, how should we think about valuing the float? If we can assume that its characteristics are similar to insurance float (long-lasting, free and potential to grow) then its intrinsic worth is at least its face value and should not be deducted from the balance sheet. Additionally, we need to consider the cost of acquiring the float – the goodwill of the BNSF/Utility businesses.
The balance sheet intrinsic value approach would then go something like this:
- Reported book value
- Plus insurance float
- Less insurance goodwill
- Plus deferred tax liabilities
- Less goodwill related to capital intensive businesses
Using the 2Q14 reported figures I arrive at a float-adjusted book value of $192,962 for BRK.A implying a 1.35x book multiple. Over time this multiple has proven to be quite steady.
Disclosure: I do not hold BRK.A or BRK.B at the time of writing.
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