Berkshire Hathaway AGM this weekend. What are "owner earnings" anyway?

Provided to subscribers May 4, 2023.

Here is the latest from Canadian Value Investors!

• Berkshire Hathaway AGM this weekend!

• What are Owner Earnings? The way Buffett might think about Canadian National Railway

But first…

Fun chart of the day - U.S. energy companies continue to not over-invest. And real capex spending is really down much further from 2017-2019 given inflation.

 Berkshire Hathaway AGM this weekend

Some of us are attending the Berkshire Hathaway AGM this year again after a COVID hiatus. For those that haven’t seen the annual report cover yet, here it is. The retro 70’s style makes us think inflation is top of mind for Warren and Charlie.

The guide is here - https://www.berkshirehathaway.com/meet01/visguide2023.pdf

And for those that won’t be attending in person, you can watch the whole thing here - https://www.cnbc.com/brklive/

Old Old Pitches

Rick Guerin was a good friend and partner of Charlie Munger who was also great investor (33% for 19 years). Here’s his stock pitch of a leasing company back in 1962.

https://twitter.com/72types/status/1640699466494668801

Will North America have its own wave of Japanese-style zombie firms? We think yes

We continue to hunt for companies and have definitely come across a few that we view as being complete zombies, with higher interest rates creating more and likely finally tipping a few. But, how many of these companies are out there? Potentially a lot.

Bloomberg - Beware of the undead (company, that is). Tighter money policy is threatening to create new zombie firms — companies that struggle to service their debt, or banks that are technically insolvent — and kill off others that had been barely holding on. Zombies don’t just undermine investment, they can also cause job losses, reduced consumption and tighter lending.

Banks in North America, more so the U.S. than Canada, are more aggressive than Japanese banks in shutting down marginal business that can barely service their debt. However, this falls apart when a fat PE firm is involved, and will definitely fall apart if that PE firm has a huge portfolio of similar businesses, and the bank has an even bigger portfolio of similar PE-backed businesses in the same boat.

How to take a public company private – Denton’s

https://insights.dentons.com/464/27513/uploads/dentons---going-private-in-canada-brochure---english.pdf

What are Owner Earnings? The way Buffett might think about Canadian National Railway

To celebrate the Berkshire Hathaway AGM, we thought we would do a post about one of our favorite value investing concepts – Owner Earnings.

Warren Buffett coined the term "owner earnings" to describe a company's true earnings power. Owner earnings, as defined by Buffett, are the cash flows generated by a business that are available to its owners after accounting for all capital expenditures necessary to maintain the company's existing operations. In other words, owner earnings are the amount of cash that a business can actually generate that actually belongs to its owners, including both the cash that can be distributed to shareholders as dividends and the cash that can be retained for reinvestment in the business.

Let's say you are considering investing in a company that generates $10 million in net income for the year. However, the company needs to invest $2 million in new equipment and capital expenditures above depreciation reported in net income to maintain its existing operations. Therefore, the owner earnings would be $8 million ($10 million - $2 million). This is the amount of cash that the company can generate that actually belongs to its owners; if it is not reinvested the business will deteriorate (or just grow more slowly depending on what your scenario is).

The crazy thing we find is that this is often ignored by investors and even big firm analysts.

Canadian National Railway

Before we start, we want to recommend the book – “The Pig that Flew: The Battle to Privatize Canadian National" by Mark McLaughlin. It walks through the privatization of -Canadian National Railway and the challenges faced by the government and the opposition from labor unions, political opponents, and the public. Or, how to get a square peg through a round hole. If you are just being introduced to CNR, start with this.

Anyway, a real-world example of owner earnings that we think would be close to Buffett’s heart is Canadian National Railway. Obviously, he owns BNSF, but is familiar with CNR (and his close friend Bill Gates happens to own ~8% of the company).

Is CNR a good business? Yes. Can this misunderstanding of owner earnings still lead to a material difference in your expected return as a shareholder? Yes… Is this because of accounting shenanigans? No. It’s just the way accounting works and you need to be aware of this.

Here are the numbers. Since 2009, Canadian National’s actual cash capex has been ~104% higher than depreciation, and, because of this, adjusted “owner earnings” is ~36% lower than stated net income. 

Is this a problem? No, so long as you account for it. In CNR’s case, owner earnings have grown by 230% since 2009, or about 8.3% per year. It helps that gross profit margin and operating profit margin grew from 48% and 33% to 56% and 46% over this period.

What is driving this? Deregulation, consolidation, and discipline, with higher trucking costs sprinkled in – A Class I railroad is a term used by the Association of American Railroads (AAR) to describe the largest freight railroads in the United States. The Class I designation was initially applied to railroads with annual operating revenues of $1 million or more, but this threshold has since been adjusted for inflation. Obviously.

In 1940 there were 33 class 1 railways, and by 2021 there were seven. More interestingly, total track peaked in 1916 at ~254 thousand miles, decreasing to ~140 thousand today, while employment has decreased from over 2 million people in the 1920s to about 200,000 today.

For CNR, things have been pretty good.

What is Free Cash Flow Anyway? The fallacy of net income: A case study of Canadian National Railway (TSX:CNR)

Here at Canadian Value Investors, we focus on the actual earnings that shareholders would be able to receive after all actual cash expenses are paid and investments are made. This is not the earnings per share number flashed in the news at earnings time. For some companies, it might be a good proxy, but for others it can vary widely, and cause real earnings – what matters - to be significantly higher or lower depending on what is driving the line items. And with inflation all the rage these days, both literally and figuratively, it can exacerbate these differences, and yet people still quote earnings per share (EPS) like it’s no big deal. Canadian National Railway (TSX:CNR) is a great example of this.

We want to say up front that we like CN’s financial statement presentation and disclosures. They give you the information you need to do your own analysis and make your own adjustments. The issue is with how standard accounting principles work and making sure we understand the pitfalls and potholes.

CN is a relatively simple business. They move freight around North American on their rail line. They have ongoing operating costs like fuel and people to operate the railway. They also have major capital investments - like rail, engines, and IT systems - that are needed to keep the trains running on time and on the tracks. Certain costs like fuel are expensed every year as they are used, but other items like track have very long lives and so are capitalized and depreciated over time.

Assets with very long lives that need to be replace periodically – like CN’s mainline tracks - can lead to huge differences in depreciation versus actual cash capital expenditures that must occur every year. Rail today costs more than it did the last time they replaced it. However, if you compare CN’s depreciation rate to their actual capex, it is significantly lower. In fact, actual capex is, on average, exactly 100% more than depreciation if you look back to 2001. Now some of this spending can be considered expansion capex, like a new rail siding or terminal, but a significant proportion of this is related to just maintaining its existing business.

If you then adjust earnings available to owners, it cuts earnings up to half.

Why does this difference occur? Reasonable accounting estimates

CN provides disclosure on depreciation, which we have taken from their 2020 annual report and heavily condensed to simplify this discussion.

Properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company has a process in place to determine whether or not costs qualify for capitalization, which requires judgment. The cost of properties, including those under finance leases, net of asset impairment write-downs, is depreciated on a straight-line basis over their estimated service lives, measured in years, except for rail and ballast whose services lives are measured in millions of gross tons. The Company follows the group method of depreciation whereby a single composite depreciation rate is applied to the gross investment in a class of similar assets, despite small differences in the service life or salvage value of individual property units within the same asset class. The Company uses approximately 40 different depreciable asset classes…

See their annual report for the full note, which takes up a whole page (2020 – pg 41) - https://www.cn.ca/en/investors/reports-and-archives

They also provide a table breaking down how they group into the overall categories.

Going back to our track example, track and roadway is depreciated at 2% a year. That means that a piece of track has an implied lifespan of 50 years (1/2% year). Let’s say there is a section of track that was last replaced in 1971 for $1 million and it needs to be replaced in 2021 (of course this is greatly simplified, there’s ballasting, tie replacements, repairs, and other things happening over the years). Will it cost the same? No, because the suppliers have suffered from 50 years of cost inflation. CN has to continually replace track, engines, and everything else it needs to maintain its existing business, and this means that if there is any cost inflation since the last purchase, the actual cash capex costs will always outstrip historical depreciation, meaning that actual real cash available to owners will always be less than stated earnings (when only adjusting for this one item). This is not accounting shenanigans, it’s just the way accounting does and should work. But is also means it is prudent to keep this issue top of mind. Assuming 2% inflation and all else being kept equal, that piece of rail will cost 2.7x as much to replace as compared to the original cost. And if we get higher inflation, this issue gets exacerbated. One could also argue that the actual depreciation rate could be adjusted higher. We, as analysts, can adjust for ourselves.

It should be noted though that CN is just maintaining their existing business, replacing only a small percentage of their overall infrastructure every year, and so cost inflation affects CN slowly over time. However, if we were back in the late 1800s/early 1900s where railroads were building new lines across Canada from scratch, a short period of very high cost inflation would be devastating. Interestingly, CN is a collection of previously bankrupt railroads - https://en.wikipedia.org/wiki/Canadian_National_Railway#Creation_of_the_company,_1918%E2%80%931923

Beware of EPS headlines; do your own work

Doing your own work will help you make sure you don’t end up overestimating or even underestimating how much you are truly earning from your investments. Trying to collect a phantom dollar that doesn’t exist that instead has to go back into the business to keep it rolling is no fun.

As we said earlier, we like CN’s disclosures. They even provide a free cash flow calculation table to help analysts along in understanding the business. We do our own math, but this is a good starting point.

And for those interested, this is where a few billion of capex every year is going.