berkshire, apple, and some fiction

Here's an interesting post that talks about Berkshire's acquisition of Apple. I know the work is of some fiction, but still, I don't know why Berkshire should buy 100% of Apple, and not the other way around. Well in fiction, anything is possible, I suppose. As per its latest proxy statement, Vanguard group and Black Rock owned more than 6% each of Apple. After Berkshire's latest quarter filing, it owns about 5% of Apple; and unless it bought more after June 2018, that makes it the third largest owner of Apple. Buffett seems very bullish on Apple, and everyone is going gung-ho after his statement. 

The man doesn't know what to do with his cash. He is adamant about not distributing through dividends or buybacks. What else he could do than stick to some maturing business giving him just about or slightly more than the market returns? 

The post that I referred to says that Berkshire's current cash flows are $45 b and that of Apple are $65 b, and continues to believe that these are going to be their future cash flows too. The author has promptly referenced the workings to Berkshire and Apple here. Well, one reason I don't rely on the third party's numbers are that they can be inaccurate. Even for some fiction action, we need the right numbers, which the post misses. Here's why.

Berkshire's net earnings were $45 b, $24 b, and $24 b respectively for 2017, 2016, and 2015. Earnings aren't free cash flows, remember. Berkshire made some adjustments to its net income, removed the effect of taxes and changes in working capital, and showed operating cash flows of $45 b, $32 b, and $31 b for the three years. Again, operating cash flows aren't free cash flows, remember. For any business, reinvestment is required for two reasons: One, to be where it is in terms of inflation, competition, profitability, and cash. Second, to feed its growth. This is more important. If not for growth prospects, the market will price the business as a no-growth business. If that were so, Berkshire would not be a $500 b business, it would be way less. That means, there has to be some meaningful reinvestment of cash back into the business, which Berkshire has been doing: $11b, $12 b, and $16 b. Then there are acquisitions which are a sort of reinvestment, but may not be required. Berkshire spent $2 b, $31 b, and $4 b in the past three years for acquisitions. It may not spend $30 b for precision castparts like acquisition, but there will be some. To say that Berkshire's free cash flows are $45 b is just hilarious. 

This is what I would do to arrive at Berkshire's free cash flows. The operating income: $25 b, $35 b, and $38 b for the past three years. If you want to include Kraft-Heinz as part of its operations, add another $3 b to its current operating profits. Berkshire had one-off gains in 2017 due to changes in the recent tax laws. Let's just forget it for the moment, and assume an effective tax liability of 25%. That brings down aftertax operating earnings to $20 b, $26 b, and $28 b. Depreciation ($9 b, $8 b, and $7 b) is a non-cash charge, and therefore gets added to the earnings. But then as we noted earlier, Berkshire's capital spending requirements are imperative to its future growth; so they get reduced from earnings. Now we have the adjusted numbers: $18 b, $22 b, and $20 b. We need to make two more adjustments before we arrive at the free cash flows of the operating business. Berkshire took $25 b as positive cash due to its losses and loss adjustment expenses for 2017. I see it as exceptional because they were not as high in the previous years. They were like $4 b, $2 b, $7 b, and $0.5 b for 2016, 2015, 2014, and 2013. In the absence of linearity, we are left to be judgmental. I would take $2 b positive adjustment change in non-cash working capital, which works out be average of the previous few years. I would also keep $2 b as average spending on acquisitions, for these may be required to feed some of the operating businesses. 

In summary, for Berkshire, we have operating earnings adjusted for taxes, depreciation, capital spending, acquisitions, and working capital before we arrive at the free cash flows for the business. And they work out to $18 b, $22 b, and $20 b for the years 2017, 2016, and 2015 respectively. More importantly, they are not $45 b as the aforementioned post likes to have.

For a normal business, to arrive at the free cash flows to equity, we should be adding income from cash and marketable securities, and deduct finance costs, and net cash from debt financing. But Berkshire isn't a normal business, and its income statement reporting is also somewhat not normal, may be because of its insurance business element. Because of this, I have already included income from investments in the earnings, but have not deducted finance costs. Berkshire's finance costs for 2017 were $5 b. There it goes from our free cash flows to firm of $18 b calculated earlier. Nevertheless, I would like to keep financing cash (interest, new debt, debt repayments) separately, and use fcff rather than fcfe. Ttherefore, my estimate of Berkshire's fcff is what I looked at before: $18 b, $22 b, and $20 b. Let's keep it that way.

I can also argue that Apple's free cash flows capacity is not $65 b, but $45 b. Now we need to have another look at Berkshire's fiction of Apple acquisition. Can a $20 b free cash generating firm, and having $200 b of cash, $123 b of investments, and $102 b of debt, be in a position to buy Apple? In fact, Berkshire also has some operating lease debt of $7 b not included in its books. 

Buffett may be exuberant, and he has reasons for that: He is looking for growth somewhere. Even a teeny bit more than that of market's is good for him. That does not mean he will be in a position to buy the whole of a business having $250 b cash, $130 debt (including leases and non-cancellable purchase obligations), and having an equity market value of $1 t. Buffett must have mentioned it on a lighter note, let's just take it that way. In fact, Apple could look to buy 100% of Berkshire if it wants some growth. Again I am talking fiction, am I not? Fun is good.