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Tweet from CNNMoney stock market editor. One of a few tweets likening Google's move to Berkshire Hathaway

AUGUST 13, 2015

Soon after Google (GOOGL) announced plans to form an overarching parent company named Alphabet, several journalists drew comparisons to Berkshire Hathaway (BRK-A, BRK-B). Since 2010 Google and Berkshire Hathaway's stocks have traded at similar market caps and increased at a similar pace, with rankings of the top most valuable companies listing Berkshire third and Google fourth in the first quarter of 2015.

Google sprinted ahead of Berkshire Hathaway recently, taking an approximate $100B lead. In their announcement Alphabet leadership pointed to diverse operations (see the line placed in bold below) as one reason for change:

"What is Alphabet? Alphabet is mostly a collection of companies. The largest of which, of course, is Google. This newer Google is a bit slimmed down, with the companies that are pretty far afield of our main internet products contained in Alphabet instead. What do we mean by far afield? Good examples are our health efforts: Life Sciences (that works on the glucose-sensing contact lens), and Calico (focused on longevity). " source: abc.xyz

There are some differences between Alphabet and Berkshire Hathaway at this point. However, there are also similiarities. For instance in an average day people encounter products and services from both these companies. Berkshire Hathaway, for such a large company, is surprisingly simple thanks to strong principle and business model that is focused on a sense for profitability.

Berkshire Hathaway and Google are strong forces in their respective industries. Berkshire Hathaway draws from a more established world of business: Insurance, finance, grocery supply, popular candy, fast-food, underwear, jewlery, vehicle services and so on. What remains to be seen is whether Alphabet will acheive the same success.

This article will focus on Berkshire Hathaway and particularly the acquisition of Precision Castparts. Please note, this article will refer to Precision Castparts as "Precision" at times, because it's not like there's another metal company out there named Precision. Even if there were, it's not like they're owned by the same company, and on the off chance it turns out there are, this article will use "Precision" to refer to the one worth about $37B.

Berkshire's Acquisitions

Take a look at a few of the investments leading up to the acquisition of Berkshire Hathaway. Remember part of Berkshire's model is to simultaneously invest in and own companies in what could be considered key areas. Here are a few highlights of Berkshire's portfolio:

• Many of Warren Buffett's early business accomplishments are detailed in his biography: The Snowball
• In the early 1950's Buffett bought GEICO stock. He sold GEICO and invested in Kansas based Western Insurance and National Fire Insurance Company (67% of which was acquired by Continental Casulty Co. in 1956 to form Continental-National Group, now CNA Financial) (Sources: ValueWalk, Buffett's Early Investments. gurufocus, How Warren Buffett Made His First $100,000. Reference For Business, CNA Financial)
• In 1961 Buffett Limited Partnership bought the majority of Dempster Mill Mfg. Co. (Wind Mills). Here is an excerpt from an article from 1963 recapping Buffett's Dempster deal, when the partnership decided to divest from Dempster:

• Between 1962 - 1964 Buffett Limited Partnership bought Berkshire Hathaway shares (a textile business formed from mergers of Valley Falls Company with Berkshire Cotton Mfg. Co., which became Berkshire Fine Spinning. Berkshire merged with Hathaway Mfg. Co. in 1955.) (source: Wikipedia, Berkshire Hathaway, History)
• In 1967 Berkshire Hathaway acquired National Indemnity Co (Berkshire still owns National Indemnity)
• In 1968 Berkshire bought Omaha Sun Newspapers
• In 1969 Berkshire bought the majority of Rockford, Illinois based Illinois National Bank & Trust
• In 1970 Buffett Limited Partnership dissolved
• In 1970 Berkshire invested in Blue Chip Stamps, which bought See's Candy and also invested in Wesco Financial in 1972 (Wesco acquired Chicago, Illinois & Charlotte, North Carolina based Precision Steel Warehouse in 1979, similarly named yet unrelated to Portland, Oregon based Precision Castparts)
• Berkshire began investing in The Washington Post Co. in 1973
• In 1974 Berkshire acquired Diversified Retailing (which owned department stores, reinsurance and 16% of Blue Chip Stamps)
• In 1975 Berkshire bought Waumbec Mills (described as a "mistake" in the 1979 Annual Letter)
• Berkshire bought Nebraska Furniture in '83 (& fully acquired Blue Chip Stamps) source: encyclopedia.com Berkshire and Berkshire Hathaway 1983 Annual Shareholder Letter
• In 1985 Berkshire supported Capital Cities Communications acquisition of the larger American Broadcasting Co. now owned by Disney (DIS)
• Also in 1985 Berkshire Hathaway's textile business closed
• In 1986 Berkshire acquired Scott Fetzer Co. (Scott Fetzer currently lists 21 subsidiaries)
• In early 1989 Berkshire acquired Borsheim's Fine Jewelery. The 1989 Annual Letter included a gem:

  "In the past, we have labeled our major manufacturing,
  publishing and retail operations "The Sainted Seven." With our
  acquisition of Borsheim's early in 1989, the challenge was to
  find a new title both alliterative and appropriate. We failed:
  Let's call the group "The Sainted Seven Plus One."

  This divine assemblage - Borsheim's, The Buffalo News,
  Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer
  Manufacturing Group, See's Candies, World Book - is a collection
  of businesses with economic characteristics that range from good
  to superb. Its managers range from superb to superb."

• In 1991 Berkshire bought H.H. Brown shoes. H.H. Brown soon after bought Lowell Shoe Co.
• In 1992 Berkshire bought 82% of Central States Indemnity Of Omaha
• In 1995 Berkshire acquired Helzberg's Diamond & R.C. Willey Home Furnishings source: Berkshire's 1995 Letter
• In 1996 Berkshire acquired GEICO
• Berkshire Hathaway acquired General Re in 1998
• Berkshire aquired Justin Boots in 2000
• Berkshire bought Fruit of the Loom in 2002 for $835M
• Berkshire bought foodservice supply McLane Company from Wal-Mart (WMT) in 2003
• Berkshire also bought Tennessee based Clayton Homes for $1.7B in 2003

  

  Clayton Homes: Pictured Schult Collection 2 bedroom, 2,040 sq. ft. & exanple models with price ranges

• In 2006 Berkshire bought 80% of metal cutting tools company: Iscar
• In 2007 Berkshire initiated a multi-year acquisition of Marmon Group (Berkshire's recent acquisition of Duracell from Procter & Gamble (PG) is reportedly going to Marmon, additionally Marmon made a $1B acquisition from UK based IMI (Imperial Metal Industries) for a business that produces soda machine equipment. Marmon already owns a few foodservice businesses, including Prince Castle LLC.



Marmon acquired Union Tank Car in 1981, as part of TransUnion Credit Union (originally formed to hold Union Tank) Marmon spun TransUnion off in '05

• In 2009 Berkshire acquired BNSF Railway
• In 2011 Berkshire bought Lubrizol a chemical manufacturer. Here are some innovations Lubrizol highlights on their website:

• This year Berkshire announced their largest acquisition, Precision Castparts for approximately $37B

Berkshire's Investments

• Berkshire top holdings include Wells Fargo (WFC), Coca-Cola (KO) and IBM (IBM).
• Berkshire Hathaway invests in brands like Procter & Gamble (PG)
• Berkshire's portfolio includes 12.9M shares of VeriSign's (VRSN) approximate 113.49M shares outstanding.
• As well as 1.5M shares Verisk Analytics' (VRSK) approximate 169.07M shares outstanding. Verisk specializes in analytics for the insurance industry.
• Berkshire Hathaway also invests in several media companies, including newspapers, cable television networks & production.
• Berkshire also holds 38.5M shares of DaVita Healthcare's (DVA) approximate 214.9M shares outstanding
• Illustrative of Berkshire's extensive and diverse investments, the company holds 3.9M shares of Sanofi's (SNY) approximate 2.6B shares outstanding.
• Berkshire also has 6.3M shares of life/health insurance provider Torchmark's (TMK) approximate 126.1M shares outstanding.
• Note, Berkshire maintains some investments long-term and also buys and sells stock.

So, a pattern that emerges is investment in historic, proven businesses. Additionally the networking of a few investors' preferences, working in conjunction with the guidance of Berkshire's leadership.

DaVita Healthcare being a primary instance. Another pattern is the intersection of ideals with profitability, with the supposed potential for Berkshire to increase efficiency through years of experience. Berkshire obviously does not have a so-called Midas Touch, the textile business did not exactly blossom into fruition. However, what Berkshire did right was diversify, it appears.

Acquisitions Ensuring Diversification

Before news broke of the Precision Castparts acquisition, the focus of Berkshire's Q2 earnings release was a drop in profits. Berkshire Hathaway profits were dragged down, by larger insurance losses and greater cost of sales & services, as presented in this extract:

In this sense Berkshire Hathaway's business is tied to natural phenomenon. For example heavy flooding across the United States during the summer could have impacted some of Berkshire's insurance businesses.

In addition to these expenses, Berkshire reported $2.3B investment gain in Q2 2014 and $136M in Q2 2015. The insurance business' sales and service revenue went up $2.9B, still not enough to balance the cumulative effect of greater costs, expenses and much lower investment gains.

While Berkshire's finance & financial products segment reported a $226M investment gain in Q2 2015, compared to no investment gain in Q2 2014, there was also a ($174M) derivatives loss compared to a $155M derivatives gain in Q2 2014. The first 6 months of 2015 still boasts a much larger $1.1B derivatives gain compared to $391M derivatives gain for the first 6 months of 2014.

Berkshire Hathaway finalized a moderate sized automotive dealership acquisition: Van Tuyl Group (announced in October 2014.) Between Van Tuyl and regulated electric transmission company AltaLink, Berkshire reported acquisition expenses of $6.8B.

Source: berkshirehathawayautomotive.com (formerly VanTuylGroup.com)

Van Tuyl established 81 dealerships and appears to have saturated many of their markets. There are several locations in Florida, Western Missouri, Eastern Nebraska, Texas, Arizona, San Francisco and Los Angeles. With single locations in southwestern Indiana, central Illinois and New Mexico.

The Business Of Owning Businesses

Take a look at Precision Castparts most recent annual report, for an idea of what may have appealed to Berkshire:

Berkshire did not walk into the deal from the cold, they built up a position to begin with, though it was recent. Precision's market cap went from approximately $1B in the late 1990s to $3.4B in 2004, then brokeout between 2010-2015, stabilizing around $15.6B in 2010. Precision Castparts experienced hypergrowth in the past 10 years, and all the while implemented an acquisition strategy.

Here is Precision Castparts map of business locations:

Soure: Precision Castparts Locations

Precision appears to have a strong global presence and caters to larger businesses like General Electric (GE). While Precision mentions potential competition in their annual report, from the likes of Alcoa (AA), currently Precision states they have taken the lead, as the snapshot above states:

"Precision Castparts is the world leader in structural investment castings, forged components and airfoil castings for aircraft engines."

Precision Castparts appears to further Berkshire's interest in businesses that serve business. Lubrizol and BNSF Railway share similar traits. Whereas Berkshire partnered with other companies on deals like Wrigley, Heinz, and Kraft. Those companies focus more on brands recognizable to average consumers, than companies like: BNSF, Lubrizol and Precision Castparts' brands familiar to business leaders.

Berkshire picked Precision up on a dip and the remaining question is whether the former upward trend will return?

Source: Precision Castparts Investor Relations, 2015 Annual Report

Of course Berkshire is in a unique position to afford integrating Precision over the long-term. Between Van Tuyl Automotive (now Berkshire Hathaway Automotive) and Precision, Berkshire's annual revenue could increase approximately $19B. With Precision reporting $10B for the previous year and Van Tuyl's current annual revenue estimated around $9B. Precision reported $2.6B EBITDA compared to Van Tuyl's estimated $350M earnings before taxes.

Precision Castparts is labor intensive, and relies on global metal prices and international production. Also of note, miners have struggled in recent years. For instance, on August 11, 2015 Rio de Janeiro based Vale SA (VALE) dropped 5.67%, Melbourne based BHP Billiton (BHP) dropped 4.78% and London based Rio Tinto plc (RIO) dropped 3.68%. While companies like Pittsburgh based U.S. Steel (X) dropped 8.93% on August 11th, and New York City based Alcoa dropped 5.95%; Luxembourg based Arcelor Mittal (MT), the top producer of steel, dropped 4.64%.

With Alcoa, BHP, Vale and Rio Tinto staging slight recoveries on August 12th. While United Steel and Arcelor Mittal added to their stock losses.

The Business Of Making Materials More Valuable

The difference between the miners and Precision Castparts is: Precision uses materials to produce parts necessary for products with more value. Comparatively several of Berkshire's successful companies work on similar advancements of basic materials; making chocolate, for instance more valuable. Keep in mind Precision Castparts' annual net income was an average of $1.57B for the past 3 years.

Soure: Precision Castparts

Notice the materials: "Nickel-based superalloy, titanium, stainless steel and aluminum." Given the fact the U.S. dollar has performed well recently, compared to several top metal producing nations' currencies, there could be an added advantage.

Take a look at one of Precision's segments focusing on titanium. In 2012 Precision paid approximately $2.9B for TIMET:

Soure: Precision Castparts

TIMET is now a part of PCC Forged Products. The company has a long history, a major presence in its field and is a global business.

Precision Castparts also made a $721M acquisition of Wyman Gordon in 1999 and acquired Fatigue Technologies in 2008. Additionally Precision Castparts bought Permaswage from Bridgepoint Capital in 2013 for $600M.

Here is Permaswage's business summary, on their website:

Permaswage, Wyman Gordon and Fatigue Technologies have all won contracts for major aerospace products like the F-35. Potential for similar large contracts, in the future, are added reasons Precision may have been attractive to Berkshire. As they perhaps attempted to further diversify operations.

As the name of the company implies "precision" and quality are fundamentally important in this area of business. Take for instance the fact the F-35 production was suspended for a short time recently, due to what was believed to be faulty titanium products.

Here is an extract from an opinion from Flight Global:

"...faulty titanium products have triggered a 15-year-long string of aircraft groundings and lawsuits...

In response, the Department of Defense convened a task force in 2009 dedicated to examining the problem of suspect titanium in the US military aircraft supply base. Based on their findings, last April NASA published a handbook for government acquisition managers to identify defective shipments of finished titanium.

The published reports make it clear that the fault does not lie with the producers of raw titanium bar and plate, such as TIMET, ATI and RTI.

The culprits are the distributors that take the raw material and do the finishing work. The NASA handbook identifies two kinds of titanium cheaters. Some take raw titanium plate and forge the finished component even though the specification calls for using a more complex rolling process. Others cheat by simply cutting down a raw titanium billet into the final shape, rather than using a forging or rolling process as required in the contract." Soure: Flight Global Opinion: Why aerospace firms must tackle titanium cheats

This illustrates some of the complexities Precision must balance.

Berkshire's 13-F filing from March 2015 showed 47 stock holdings, including Precision. Precision was the 16th top holding according to dollar value, at $882M. There was also a 47% increase in the position.

According to Berkshire's holdings, Deere & Company (DE) ranked 13th in their portfolio. Here is an article republished by Yahoo! Finance detailing Berkshire's recent investment in Deere. Deere has a market cap of approximately $32B and annual revenue around $36B. Deere averaged $3.25B net income for the past 3 years.

Deere's Q2 2015 earnings stated:

"Net sales of the worldwide equipment operations declined 20 percent for the quarter and six months compared with the same periods a year ago...

Company equipment sales are projected to decrease about 19 percent for fiscal 2015 and to be about 17 percent lower for the third quarter compared with year-ago periods."

Deere's revenue is 3 times Precision's and annual net income is double. Their respective market caps are also in a similar range. Deere reported stronger performance in '13 than in '12, however weakened somewhat in '14, like Precision. Since February 2009 Deere and Precision both recovered nicely, additionally Deere pays a reasonable 2.5% dividend compared to Precision's 0.10%.

Precision did lift off compared to Deere's flatter performance since May 2011. However, Deere quite simply made far more profit. Also consider the fact Precision's annual 0.12 cent dividend paid $504k a year on 4.2M shares ($882M total position before the acquisition.) Compared to Berkshire's larger position in Deere: 17.3M shares collects approximately $41.5M in dividends (on Berkshire's $1.5B Deere investment.)

Will S&P Downgrade Berkshire's Credit Rating?

Clearly Precision Castparts realized an impressive growth trend in the past few years. An important characteristic to consider is Precision accomplished this on their own. So, expectations are they have the potential to continue the trend.

Few companies are in a position to accomplish the deal Berkshire has engaged in with Precision. Even fewer could, as part of an even larger acquisition strategy. Though S&P is currently reviewing Berkshire's rating and some reports indicate they are considering a downgrade, due to the Precision acquisition. S&P rated Precision Castparts' corporate debt A- before the Berkshire deal and rates Berkshire corporate debt AA.

Precision reported $678M in pension and other post-retirement expenses in their 2015 annual report. Additionally the report stated:

"As of March 29, 2015, we had accrued environmental liabilities of $448 million for future costs arising from environmental issues relating to our properties and operations."

Precision reported $4.77B in long-term debt, that Berkshire plans to take on. In addition to Berkshire's present debt of approximately $84.59B (including $20.9B from BNSF due between 2015-2097) compared to Berkshire's cash & equivalents at the end of the second quarter of $66.5B, up from $55.4B at the end of Q2 2014. So, minus $37B the cash position potentially could go to $29.5B and the debt could go to approximately $90B.

One clue to Berkshire's philosophy can be found in their 2014 report, where leadership wrote:

"Late in 2009, amidst the gloom of the Great Recession, we agreed to buy BNSF, the largest purchase in Berkshire’s history. At the time, I called the transaction an “all-in wager on the economic future of the United States.”

That kind of commitment was nothing new for us. We’ve been making similar wagers ever since Buffett Partnership Ltd. acquired control of Berkshire in 1965. For good reason, too: Charlie and I have always considered a “bet” on ever-rising U.S. prosperity to be very close to a sure thing.

Indeed, who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see."

To a degree the acquisition strategy hinges on whether Precision can not just sustain; build momentum. Whereas BNSF was more specific to the U.S., Precision goes global.

The Bottom Line

Critically, the two arguments that could be made are Berkshire paid too much and would have potentially seen more near-term profit if they bought Deere. Though, clearly, Berkshire makes moves based on the perception of value. Whereas a concept many years ago was agriculture based economy for instance, Berkshire draws business from business and is distinctly focused on insurance, finance, consumer goods and transportation.

If the argument against Berkshire's extension of business is that insurance underperformed during a season with heavy flooding, then the counter argument is: Deals like Van Tuyl and Precision diversify Berkshire's foundation, as BNSF did. The purpose of this article is not to agree with or disagree with Berkshire's acquisition. Only to state what seems important in the aftermath: Precision Castparts' performance and capacity to offer diversification.

Berkshire's business model succeeds because of a strong principle and sense for profitability. Additionally acquisition strategy, though Berkshire Hathaway leaders have lamented the original purchase of the textile company in the mid 1960s, they did trace their origins to the American Industrial Revolution. At the time Buffett Limited Partners purchased Berkshire Hathaway, some strategists recommended selling:

The opinion from 1963 may have accounted for several important factors, and even under the leadership of Buffett Limited Partners, Berkshire Hathaway encountered difficulties. Simply because of competition and quality of materials that were unforeseen. Though, as it turns out 100 shares of Berkshire Hathaway for $11.75 a share was probably a good deal.

Both Berkshire and Alphabet are powerhouses and are dependent on leadership that does not deter from business principle and sense for profitability. It is worth repeating, Berkshire's portfolio of investments is focused; holding 47 stocks. Rather than walking into Precision cold, Berkshire allowed some time to see how Precision works and to judge performance, relative to a few large core investments.

Google made approximately 182 acquisitions before introducing Alphabet. DoubleClick, Motorola Mobility and Nest Labs (home automation) were some of the larger purchases. Google paid $12.5B for Motorola Mobility in 2012, kept approximately 2,000 patents and sold the remaining Motorola Mobility assets for $2.9B to Lenova in 2014. (source: Wikipedia, Motorola Mobility)

Whereas DoubleClick was a keeper, Google was able to extract the parts it wanted from Motorola Mobility. So, it is important to emphasize, the world of mergers and acquisitions is complex and often some areas of the businesses succeed while others do not. This makes acquisitions made by an experienced force like Berkshire all the more important, given they can afford to be precise.

Berkshire's 1990 annual letter points to their 1984 letter:

"In the past we have bought a few below-investment-grade bonds with success, though these were all old-fashioned "fallen angels" - bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. In the 1984 annual report we described our rationale for buying one fallen angel, the Washington Public Power Supply System."

Though, relative to acquisitions this excerpt from Berkshire's 1984 annual letter stands out:

"When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended."

Clearly success, simply depends on decision making that places the best interest of the business at the forefront. If that is what Berkshire intended with Precision, then there appears to be more of a chance of success. If that is what Alphabet intends with their new design, perhaps their chance of success increases, relative to their business. Since there is always risk. Berkshire's 1990 letter addresses this with a reference to one of Benjamin Graham's mottos:

"'Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.'"

Berkshire has experience with smaller metal companies like Precision Steel Warehouse (the smaller, unrelated business acquired by Marmon in 1979) and Iscar. The Precision deal certainly appears to have the potential to make Berkshire more powerful. In reference to the 1992 acquisition of Central States Indemnity, Berkshire's annual letter offered some wisdom that seems relevant to the Precision acquisition:

"...useful advice I once got from a golf pro... Said the pro: "Practice doesn't make perfect;
practice makes permanent." And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices."

This quote seems related since the Precision deal appears designed to forge more permanence. Precision expands Berkshire's product and service offerings. Though modern tech companies are simply not in the same business as Berkshire, one important consideration is: Berkshire's business model alone does not automatically produce success. In addition to business principle and sense for profitability, it is the balance of diversification that allowed a historic textile business to actually close; yet continue to grow into one of the most valuable companies in the world.

*Note: This article is corrected to reflect Precision Castparts' $0.12 annual dividend, instead of $0.10 cent dividend.

Disclaimer: This article is not a recommendation to buy or sell. Mark Quarter Investment News authors hold Berkshire Hathaway stock and / or have exposure to Berkshire Hathaway & Precision Castparts and Google stock & bonds through funds. Please consult a qualified financial adviser to determine proper allocations, if any to investments.