Berkshire Hathaway's (BRK.B) long-time vice chairman, Charlie Munger (Trades, Portfolio), has no qualms bashing the "unethical" practices of Valeant Pharmaceuticals (VRX). He recently made several public comments about the harm the company is doing to society. Like Munger, many investors find some of the company's practices to be highly questionable. Berkshire, however, has engaged in some of the same tactics for years. Munger's condemnation of Valeant may have some valid points, but should the vice chairman of the world's largest glass house really be throwing these stones?
Investors critical of Valeant may want to apply the same view to Berkshire. Valeant has been criticized for slashing costs at acquired firms, then subsequently increasing drug prices. Berkshire, similarly, is guilty of the same practices. This could damage the company's seemingly impeccable public image and cost its investors.
Berkshire Hathaway is regarded by many investors as one of the world's best-run companies. This is largely the result of the methodical management style of the company's chairman and CEO, Warren Buffett. While shareholder returns speak to his wisdom, investors may want to dive deeper into how the company has extracted impressive margins and record revenue. It is largely through a deliberate business model of exploiting U.S. laws to squeeze every penny from America's most vulnerable populations, an accusation similar to the one facing Valeant.
Earlier this year, the Seattle Times ran an in-depth investigation looking into one Berkshire-held subsidiary, Clayton Homes. The company is the largest provider of mobile homes and mobile home financing in the U.S. Ninety-nine percent of Clayton financed homes came with fees that the government deems onerous enough that additional disclosures must be provided to borrowers. This is in contrast to the rest of the mobile home industry, where less than half of all loans are characterized as onerous in fees. When asked about the questionable terms of these loans, Buffett said, "I make no apologies whatsoever for Clayton's lending terms."
There is something to be said about the near genius of the business model Berkshire has employed through Clayton Homes. The company is the largest manufacturer of mobile homes. Other Berkshire brands provide the raw materials for construction. Through a series of 18 brands, the mobile homes are advertised and sold with the appearance of offering choice, though they are all being sold by the same company. Clayton is also the largest financier of mobile home loans, claiming a 39% market share. The next largest competitor, Wells Fargo (WFC), claims just 6% share in the market. Berkshire also happens to be the largest shareholder in Wells Fargo.
With such little competition, Clayton has the highest financing terms in the industry. Limited government oversight in many southern states has allowed Clayton to dominate the industry with nearly 40% market share in mobile home sales and loans. Build it, sell it, finance it, charge extra, then repo it and start all over. Unethical, probably. Genius, definitely.
Munger derided Valeant as "deeply immoral" for acquiring drug rights, then subsequently increasing the price of the newly acquired drugs. But this strategy is not unique to Valeant, in fact, it was pioneered by Berkshire Hathaway itself.
"The single most important decision in evaluating a business is pricing power," according to Buffett. This was the exact strategy employed when Berkshire acquired Clayton Homes in 2003. Immediately after the buyout, Berkshire began purchasing competitors and growing its control over the manufactured home market. It should not come as a surprise that financing cost began increasing shortly thereafter. Regions where competition is limited, like Texas for example, have the highest financing costs for mobile homes. Clayton controls 70% of the market in that state. To some of those who lost their mobile homes through Clayton's often predatory fees, that could be considered "deeply immoral."
In response to allegations presented by short sellers, Valeant conducted an investor presentation. One key area of concern was the questionable dealings with Philidor. According to Valeant's CEO, specialty pharmacies accounts for just 10% of total revenues. The reaction to alleged illegality has caused Valeant's stock to decline by 60%. Clayton Homes represents just 1.8% of total revenues and 2% of profits at Berkshire, but any civil investigation of short seller report could disproportionately impact the stock, as was the case with Valeant.
Valeant has also been criticized for the practice of acquiring other pharmaceutical brands, then cutting R&D and other expenses. While Berkshire is not the one making the cuts on its acquisitions, it has relied on 3G Capital to do just that. When Berkshire facilitated the merger of Heinz and Kraft this year, they collaborated with 3G in cutting operational costs. This is absolutely no different than what Valeant does.
After the announcement that 3G and Berkshire would team up to combine Heinz and Kraft and own a 51% stake, 3G promised to cut $1.5 billion of expenses from the combined company by 2018. That would mostly come in the form of layoffs. When 3G and Berkshire have gotten involved in companies, they have decimated the cost structure in order to increase margins. When 3G first became involved with Heinz, they laid off 7,000 workers (20% of the entire workforce). Doing so increased adjusted earnings by 38%.
Munger has suggested Valeant's business model is unsustainable and will ultimately fail. He may have a point, but the same argument can be made for some Berkshire companies.
A recent analysis conducted by McKinsey & Co. looked into 3G Capital's operations. They came to the same conclusion about 3G as Munger did with Valeant: The models are unsustainable. 3G and Berkshire have relied on slashing expenses and cutting every element of the businesses they purchase. A look a the most recent operations of 3G with their involvement in Burger King, Anheuser-Busch, and Heinz reveals a strategy that mirrors Valeant. Costs are cut drastically as a means to improve margins and earnings. This often comes at the expense of revenue growth. Investors should expect the strategy to result in declining revenues at Kraft Heinz in coming years. Entire departments, some of which are critical to sales growth, are being slashed. A business that solely focuses on bottom line growth over top line growth is ultimately going to fail, McKinsey said.
Criticism of Valeant has been two-fold. First, the company has come under fire for its aggressive cost-cutting moves. The company often eliminates many jobs and slashes R&D in the acquired brands. The second criticism has been the negative press associated with increasing prices on drugs, an act seen as exploitive to those who rely on those medications.
That criticism, while certainly valid, should apply to Berkshire as well. Berkshire is aggressively cutting jobs and expenses at Kraft Heinz solely to boost profits, even at the expenses of sales growth. Through Clayton Homes, the company is increasing fees and interest rates on low-income populations. While the negative PR associated with increasing vital drug prices is bad, so is the negative PR associated with charging absorbent fees on low-income Americans, then throwing them on the street when those buyers cannot pay. It seems those critical of Valeant, but supportive of Berkshire, should compare the similarities in both businesses and consider whether the risks facing Valeant could eventually face Berkshire.
It is entirely fair to criticize Valeant for its ruthless, and at times, questionable practices. However, for Munger to call these actions "deeply immoral" represents the height of hypocrisy when he and Buffett have pioneered this exact strategy in their businesses.
