Has Warren Buffett run out of long-run?
The stars aligned and Warren Buffett issued an annual shareholder letter that was forced to include an embarrassing charge for significant losses on Berkshire Hathaway’s investment in Kraft Heinz.
Buffett’s letter was a rant against GAAP, and a 180 degree turn from his typical long-term focus.
I was in New York Feb. 21-22 to give a workshop for my colleagues there about the accounting and audit issues to keep an eye on when reporting on earnings releases and S-1 IPO filings. Friday the 22 was supposed to be focused on doing an update on Valeant, now called Bausch Health.
But then news broke about a $15 billion impairment non-cash charge at Kraft Heinz. My editor told me, “Find your angle in, Francine.”
So I wrote, “Why the $15.4 billion Kraft Heinz brand write-down was unusual”, based primarily on an excellent report from Audit Analytics on the history of Kraft Heinz accounting missteps since Heinz acquired Kraft in 2015 and the SEC’s scrutiny of its financial reporting. Kraft Heinz also surprised the markets, and not in a good way, with an unexpected announcement of an SEC investigation.
The $15.4 billion impairment by Kraft Heinz wasn’t just one of the largest in corporate history. It also was unusual in how the write-down of its Kraft natural cheese business, Oscar Mayer cold cuts business and Canada retail business was carried out.
The company also rocked investors with unexpected news of a probe by the Securities and Exchange Commission that prompted an internal investigation which resulted in a $25 million inventory accounting correction.
Audit Analytics had concluded that, “Quite unusually, the impairment was triggered by short term developments in the second part of 2018, as opposed to a routine impairment evaluation.”
(Update from Audit Analytics on March 1)
On February 28, 2019 Kraft Heinz Co [KHC] disclosed that they will be unable to file their 2018 annual report by the SEC deadline. The Company cites an ongoing internal investigation into procurement, resulting from the SEC subpoena received in October 2018. Kraft Heinz does not expect to file their annual report until the investigation has concluded.
In a current report filed on February 28, 2019, Kraft Heinz provided additional details of their impairments determined during their interim impairment test. The update was provided using 8-K Item 2.06 filing, which emphasized the significance and unusual nature of the impairment. Item 2.06 impairments are not very common and only a handful of goodwill and other intangible impairments is disclosed using an 8-K Item 2.06. (Contact Audit Analytics for the list).
Kraft Heinz had already performed its annual impairment testing in the second quarter and had already taken some charges much lower in the third quarter as a result. The write downs in the third quarter, after the annual assessment, were a warning, Audit Analytics wrote, since any softness in the underlying business could, and did, force the company to now take this even larger hit.
Berkshire Hathaway first invested significantly in H.J. Heinz Holding Corporation in 2013 and now owns 26.7 % of Kraft Heinz accounted for using the “equity” method because it’s part of the control group with the Brazilian investment firm 3G.
Berkshire, and Buffett, were poised to issue Buffett’s annual shareholder letter on Saturday morning, Feb 23, so there was enormous curiosity about how much of a charge Berkshire would take for Kraft Heinz announcement and what Buffett would say about it.
The letter not only included lengthy discussion of the Kraft Heinz situation but led off, unusually with a lengthy criticism of GAAP and the accounting rules that prevent Buffett, in his mind, from accurately reflecting his performance in either his equity investment portfolio or his operating companies. It’s so bad, he’s finally completely given up on “book value per share” as the metric he believes investors should track and capitulated to the short-termist share price focus.
In its fourth quarter earnings release, Berkshire took a $3 billion hit for its share of the Kraft Heinz $15 billion write-down of goodwill and intangible assets that reflects the company’s deteriorating brand value. Kraft Heinz also adjusted out its $15 billion loss in its earnings release. Berkshire Hathaway suggest investors should also adjust GAAP net income for the nearly $27.6 billion net loss on its investment portfolio for the fourth quarter.
“I was wrong in a couple of ways about Kraft Heinz,” Buffett told CNBC’s Becky Quick on Squawk Box on Monday. “We overpaid for Kraft,” he said.
On Monday Feb 26 I wrote, “Buffett criticizes others for using non-standard accounting — but he does too,” highlighting the hypocrisy of his chronic criticism of others who create non-GAAP metrics such as “adjusted EBITDA” while Berkshire Hathaway does the same thing, but choses different charges it doesn’t like to create their own narrative.
Buffett doesn’t explicitly call the number he’d rather investors focus on an “adjusted EBITDA.”
However, Berkshire Hathaway does use certain non-GAAP financial measures regularly, adjusting every period for losses and gains on its investment portfolio, a routine GAAP expense made more significant for Berkshire Hathaway now that companies must also record the impact of unrealized gains and losses in their bottom-line number.
In his most recent letter to shareholders, Buffett claims his brand of earnings adjustment is a “far cry” from the presentations made by others. Too often, he writes, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of what Buffett says are “all-too-real” costs. In particular, Buffett rails against claims that stock-based compensation should not be counted as an expense. He also says expenses for restructurings are common in business—Berkshire’s shareholders see the impact of those activities.
Back in May of last year, I wrote about how he had set up a contra-narrative to distract from what he knew would be the ongoing volatility of his equity investment portfolio.
Buffett knew he’d have to book big investment losses, something he hates with passion only exceeded by his love for Coca Cola and Dilly Bars, so he started setting up the contra-narrative back in March. https://t.co/rwxYISd77U
— Francine McKenna (@retheauditors) May 5, 2018
Buffett has also chronically touted a type of non-GAAP metric he calls “intrinsic value.”He defines it as the “discounted value of the cash that can be taken out of a business during its remaining life.”
Buffett and his partner Charlie Munger never disclose their estimates of Berkshire Hathaway’s intrinsic value, because, they say, it’s an estimate and very subjective.“What our annual reports do supply, though,” Buffett wrote for the 2017 annual report, “are the facts that we ourselves use to calculate this value.”
That’s a lot like several of the companies we reported on at MarketWatch that started slipping numbers to journalists or providing the components of SEC prohibited non-GAAP metrics and pointing analysts and journalists to assemble them on their own, after the SEC cracked down on abuses beginning in May 2016.
However Buffett and Munger do use the intrinsic value figure to determine whether the company will buy back shares. In 2018, Berkshire repurchased $1.3 billion worth of class A and B common stock. Berkshire’s common stock repurchase program was amended on July 17, 2018 to permit Buffett to repurchase its shares at prices that are below Berkshire’s intrinsic value, a value “conservatively” determined by Buffett and Munger, the annual report says.
The SEC has sent comment letters to Berkshire Hathaway about its non-GAAP reporting. In 2017 the SEC asked Berkshire Hathaway…
…why it had not disclosed expenses related to the amortization of certain intangible assets. Buffett rationalized the move in his letter to shareholders last year: “We present the data in this manner because Charlie and I believe the adjusted numbers more accurately reflect the true economic expenses and profits of the businesses aggregated in the table than do GAAP figures,” he said, referring to Charlie Munger, the vice chairman of the board.
Buffett is suggesting again this year that investors ignore the volatility of the value of the equity investment portfolio, but he had to admit its influence is expected to grow rather than diminish. Despite “hoping to move much of our excess liquidity into businesses that Berkshire Hathaway will permanently own” the immediate prospects for that, he writes in this year’s letter, are “not good.
“Prices are sky-high for businesses possessing decent long-term prospects,” he says.
There was also some interesting info about a previous acquisition, Marmon Group, which I discussed when I presented at the Grant’s Interest Rate Observer Annual Conference last October. That investment doesn’t seem to be going as well as previously hoped, either.
In 2007, for example, Berkshire Hathaway bought a 60% stake in Marmon Holdings, the industrial holding firm owned by Chicago’s Pritzker family, for $4.5 billion. Buffett now owns 99.75% of the company, all but a sliver held by a family holdout, after a series of transactions where he also criticized the impact of GAAP accounting.
“Our transaction was done just the way Jay would have liked it to be done – no consultants or studies,” Buffett said in a statement in 2007, referring to Jay Pritzker, the founder of the family’s Hyatt hotel empire and uncle of J.B. Pritzker, the current governor of Illinois and his sister Penny Pritzker, a former commerce secretary under President Barack Obama.
By 2012 Buffett was already complaining about the growing challenge of using book value and intrinsic value to measure his company’s performance when he talked about the accounting for the deal.
The Marmon deal was one of the largest acquisitions Buffett has made in recent years. Marmon had more than 125 businesses in a wide range of industries and revenues of about $7 billion at the time. It now consists of 13 diverse business sectors and more than 100 autonomous manufacturing and service businesses, according to Berkshire’s latest annual report.
“Marmon provides an example of a clear and substantial gap existing between book value and intrinsic value. Last year I told you that we had purchased additional shares in Marmon, raising our ownership to 80% (up from the 64% we acquired in 2008). I also told you that GAAP accounting required us to immediately record the 2011 purchase on our books at far less than what we paid. I’ve now had a year to think about this weird accounting rule, but I’ve yet to find an explanation that makes any sense – nor can Charlie or Marc Hamburg, our CFO, come up with one,” Buffett wrote in 2012.
But Marmon has been struggling in the last few years. Berkshire does not disclose its individual profits anymore, but does say in its latest annual report that Marmon’s pre-tax earnings decreased 5.6% in 2018 from 2017 despite a 5.5% increase in revenues to $8.2 billion. Marmon’s earnings also declined in 2017 by 3.5% from 2016, despite a revenue increase of $305 million, or 4.1% this years annual report disclosed.
That’s not what Berkshire reported in its 2017 annual report, when it said Marmon’s revenues increased by $349 million, or 7%, in 2017 versus 2016 and combined pre-tax earnings for Marmon, and International Metalworking Companies increased in 2017 compared to 2016, “due to a combination of increased sales, increased manufacturing efficiencies, the effects of business acquisitions and ongoing expense control efforts.”
/s/ Deloitte & Touche LLP
February 23, 2019
We have served as the Company’s auditor since 1985.
I’ve written a lot more about Berkshire Hathaway over the years at Forbes and other publications. There’s even an e-book about the Sokol scandal!
April 4, 2011 – Warren Buffett’s Berkshire Hathaway is rarely subjected to the scrutiny almost every other public company endures. The media, with a straight face and very little of their storied balanced reporting, refers to Buffett routinely as a “sage” and an “oracle.”
May 3, 2011 – There are many ways journalists, investors, and Warren Buffett himself refer to the Berkshire Hathaway Annual Meeting, held in Omaha, Nebraska. These short-cuts and sobriquets add a larger-than-life aspect to what is typically, for almost any other public company, a rather perfunctory affair. Barring any significant controversy, expected or unexpected, no one that doesn’t absolutely have to show up at an annual meeting usually makes the trip.
Sep 2, 2011 – His latest stunt, ostensibly meant to save Bank of America while closing a savvy deal for Berkshire Hathaway, garnered laudatory headlines.
James McRitchie wrote about the above article:
Francine McKenna isn’t afraid to take on the big four auditing firms or the rich and powerful. Look for her column, Accounting Watchdog at Forbes.com. The following is an extended excerpt from a recent post, The Berkshire Hathaway Corporate Governance Performance. “Buffett judges the investments he makes ruthlessly, but allows his operating companies to run on autopilot.” That decentralized structure allows plausible deniability when anything goes wrong.
I encourage reading the entire article and getting familiar with McKenna’s work. It is good to see such an expert willing to speak truth to power. As a Berkshire Hathaway shareowner, her analysis certainly makes me nervous and it is hard to imagine shareowners taking on such an iconic figure through governance initiatives successfully.