At
Berkshire's annual gathering on May 6, 2023, I presented the first quarter's
results which had been released early that morning. I followed with a short
summary of the outlook for the full year: (1) most of our non-insurance businesses faced lower earnings in
2023; (2) that decline would be cushioned by decent results at our two largest
non-insurance businesses, BNSF and Berkshire Hathaway Energy ("BHE")
which, combined, had accounted for more than 30% of operating earnings in 2022;
(3) our investment income was certain to
materially grow because the huge U.S. Treasury bill position held by Berkshire
had finally begun to pay us far more than the pittance we had been receiving
and (4) insurance would likely do well, both because its underwriting earnings
are not correlated to earnings elsewhere in the economy and, beyond that,
property-casualty insurance prices had strengthened.
Insurance
came through as expected. I erred, however, in my expectations for both BNSF
and BHE. Let's take a look at each.
Rail is
essential to America's economic future. It is clearly the most efficient way -
measured by cost, fuel usage and carbon intensity - of moving heavy materials
to distant destinations. Trucking wins for short hauls, but many goods that
Americans need must travel to customers
many hundreds or even several thousands of miles away. The country can't run
without rail, and the industry's capital needs will always be huge. Indeed,
compared to most American businesses, railroads eat capital.
BNSF is the
largest of six major rail systems that blanket North America. Our railroad
carries its 23,759 miles of main track, 99 tunnels, 13,495 bridges, 7,521
locomotives and assorted other fixed assets at $70 billion on its balance
sheet. But my guess is that it would cost at least $500 billion to replicate
those assets and decades to complete the
job.
BNSF must
annually spend more than its depreciation charge to simply maintain its present level of business. This
reality is bad for owners, whatever the industry in which they have invested,
but it is particularly disadvantageous in capital-intensive industries.
At BNSF,
the outlays in excess of GAAP depreciation
charges since our purchase 14 years ago have totaled a staggering $22 billion
or more than $1 1/2 billion annually. Ouch! That sort of gap means BNSF
dividends paid to Berkshire, its owner, will regularly fall considerably short of BNSF's reported earnings
unless we regularly increase the railroad's debt. And that we do not intend to
do.
Consequently,
Berkshire is receiving an acceptable return on its purchase price, though less
than it might appear, and also a pittance on the replacement value of the
property. That's no surprise to me or Berkshire's board of directors. It
explains why we could buy BNSF in 2010 at a small fraction of its replacement
value.
North
America's rail system moves huge quantities of coal, grain, autos, imported and
exported goods, etc. one-way for
long distances and those trips often create a revenue problem for back-hauls.
Weather conditions are extreme and frequently hamper or even stymie the
utilization of track, bridges and equipment. Flooding can be a nightmare. None
of this is a surprise. While I sit in an always-comfortable office, railroading
is an outdoor activity with many employees working under trying and sometimes
dangerous conditions.
An evolving
problem is that a growing percentage of Americans are not looking for the
difficult, and often lonely, employment conditions inherent in some rail
operations. Engineers must deal with the fact that among an American population
of 335 million, some forlorn or mentally-disturbed Americans are going to elect
suicide by lying in front of a 100-car, extraordinarily heavy train that can't
be stopped in less than a mile or more. Would you like to
be the helpless engineer? This trauma happens about once a day in North
America; it is far more common in Europe and will always be with us.
Wage
negotiations in the rail industry can end up in the hands of the President and
Congress. Additionally, American railroads are required to
carry many dangerous products every day that the industry would much rather
avoid. The words "common carrier" define railroad responsibilities.
Last year
BNSF's earnings declined more than I expected, as revenues fell. Though fuel
costs also fell, wage increases, promulgated in Washington, were far beyond the
country's inflation goals. This differential may recur in future negotiations.
Though BNSF
carries more freight and spends more on capital expenditures than any of the
five other major North American railroads, its profit margins have slipped
relative to all five since our purchase. I believe that our vast service
territory is second to none and that therefore our margin comparisons can and
should improve.
I am
particularly proud of both BNSF's contribution to the country and the people
who work in sub-zero outdoor jobs in North Dakota and Montana winters to keep
America's commercial arteries open. Railroads don't get much attention when
they are working but, were they unavailable, the void would be noticed
immediately throughout America.
A century
from now, BNSF will continue to be a major asset of the country and of
Berkshire. You can count on that.
Our second
and even more severe earnings disappointment last year occurred at BHE. Most of its large electric-utility businesses, as
well as its extensive gas pipelines, performed about as expected. But the
regulatory climate in a few states has raised the specter of zero profitability
or even bankruptcy (an actual outcome at California's largest utility and a
current threat in Hawaii). In such jurisdictions, it is difficult to project
both earnings and asset values in what was once regarded as among the most
stable industries in America.
For more
than a century, electric utilities raised huge sums to finance their growth
through a state-by-state promise of a fixed return on equity (sometimes with a
small bonus for superior performance). With this approach, massive investments
were made for capacity that would likely be required a few years down the road.
That forward-looking regulation reflected the reality that utilities build
generating and transmission assets that often take many years to construct.
BHE's extensive multi-state transmission project in the West was initiated in
2006 and remains some years from completion. Eventually, it will serve 10
states comprising 30% of the acreage in the continental United States.
With this
model employed by both private and public-power systems, the lights stayed on,
even if population growth or industrial demand exceeded expectations. The
"margin of safety" approach seemed sensible to regulators, investors
and the public. Now, the fixed-but-satisfactory- return pact has been broken in
a few states, and investors are becoming apprehensive that such ruptures may
spread. Climate change adds to their worries. Underground transmission may be
required but who, a few decades ago, wanted to pay the staggering costs for
such construction?
At
Berkshire, we have made a best estimate for the amount of losses that have
occurred. These costs arose from forest fires, whose frequency and intensity
have increased - and will likely continue to increase - if convective storms
become more frequent.
It will be
many years until we know the final tally from BHE's forest-fire losses and can
intelligently make decisions about the desirability of future investments in
vulnerable western states. It remains to be seen whether the regulatory
environment will change elsewhere.
Other
electric utilities may face survival problems resembling those of Pacific Gas
and Electric (PCG) and Hawaiian
Electric (HE). A
confiscatory resolution of our present problems would obviously be a negative
for BHE, but both that company and Berkshire itself are structured to survive
negative surprises. We regularly get these in our insurance business, where our
basic product is risk assumption, and they will occur elsewhere. Berkshire can
sustain financial surprises but we will not knowingly throw
good money after bad.
Whatever
the case at Berkshire, the final result for the utility industry may be
ominous: Certain utilities might no longer attract the savings of American
citizens and will be forced to adopt the public-power model. Nebraska made this
choice in the 1930s and there are many public-power operations throughout the
country. Eventually, voters, taxpayers and users will decide which model they
prefer.
When the
dust settles, America's power needs and the consequent capital expenditure will
be staggering. I did not anticipate or even consider the adverse developments
in regulatory returns and, along with Berkshire's two partners at BHE, I made a
costly mistake in not doing so.
Enough
about problems: Our insurance business performed exceptionally well last year,
setting records in sales, float and underwriting profits. Property-casualty
insurance ("P/C") provides the core of Berkshire's well-being and
growth. We have been in the business for 57 years and despite our nearly 5,000-fold increase in volume - from $17 million
to $83 billion- we have much room to grow.
Beyond
that, we have learned - too often, painfully - a good deal about what types of
insurance business and what sort of people to avoid. The most
important lesson is that our underwriters can be thin, fat, male, female,
young, old, foreign or domestic. But they can't be
optimists at the office, however desirable that quality may generally be in
life.
Surprises in the P/C business -
which can occur decades after six-month or one-year policies have expired - are
almost always negative. The industry's accounting is designed to recognize this
reality, but estimation mistakes can be huge. And when charlatans are involved,
detection is often both slow and costly. Berkshire will always attempt to be
accurate in its estimates of future loss payments but inflation - both monetary
and the "legal" variety - is a wild card.
I've told
the story of our insurance operations so many times that I will simply direct
newcomers to page 18. Here, I will only repeat that our position would not be
what it is if Ajit Jain had not joined Berkshire in 1986. Before that lucky day
- aside from an almost unbelievably wonderful experience with GEICO that began
early in 1951 and will never end - I was largely wandering in the wilderness,
as I struggled to build our insurance operation.
Ajit's
achievements since joining Berkshire have been supported by a large cast of
hugely-talented insurance executives in our various P/C operations. Their names
and faces are unknown to most of the press and the public. Berkshire's lineup
of managers, however, is to P/C insurance what Cooperstown's honorees are to
baseball.
Bertie, you
can feel good about the fact that you own a piece of an incredible P/C
operation that now operates worldwide with unmatched financial resources,
reputation and talent. It carried the day in 2023.
