Wednesday, August 7, 2013

A Closer Look at Berkshire Hathaway's Second-Quarter Results

Warren Buffett could be considered the greatest investor of all time. Nobody could beat him when it comes to investing results. Under his leadership and his capital allocation talent, Berkshire Hathaway's (NYSE: BRK-A) operating performance has kept growing, leading to magnificent share price growth, from only $15 per share in 1965 to $176,500 per share at the time of writing, marking an incredible annualized gain of 21.5% in the past 48 years.
A close look at Berkshire Hathaway’s derivative positions
Recently, Berkshire Hathaway posted huge growth in its second-quarter earnings results. In the second quarter, Berkshire Hathaway increased its revenue from $38.55 billion to nearly $44.7 billion. The year-over-year revenue growth was due to a 13% growth in the insurance business, 7.2% growth in railroad, utilities and energy segment, and a significant improvement in derivative positions, from a loss of more than $1 billion last year to a profit of $461 million this year.
The huge gain in its derivative positions could be mainly attributed to the gain in the European equity index put options, written on four major equity indexes including S&P 500, FTSE 100, the Euro Stoxx 50, and the Nikkei 225, with the expiration dates in the range of June 2018 to January 2026. The remaining weighted average life of all contracts were estimated to be around 7.5 years as of June 2013.
Writing European style put options with long maturities let Warren Buffett have much more cash in premium to go investing and earn decent returns on it. He does not have to pay his counterparty until maturity, and the payment is made only if the reference index to which the put was tied goes lower than it was at the inception of the contract.
Dated back to 2009, Warren Buffett has explained the “equity put” portfolio in detail in his letter to shareholders, he mentioned that “only the price on the final day that counts.” In order for Berkshire Hathaway to lose nearly $31 billion in options, all of those four major indexes have to fall to zero on their various termination dates. Thus, the increase in value in many major indexes in the past year has been the main factor for the significant rise in the equity index putoptions value.
In the operating business, Berkshire Hathaway experienced the highest gain from the railroad BNSF business, from $1.28 billion to nearly $1.4 billion. Moreover, the growth also happens in the financial products, Marmon, McLane and MidAmerican businesses.
Berkshire Hathaway’s two biggest equity positions
For the long-term, Warren Buffett is still bullish on Wells Fargo (NYSE: WFC)and Coca-Cola (NYSE: KO). Those two companies are the two largest positions in the Berkshire Hathaway investment portfolio. With more than 458.17 million shares, Wells Fargo was the largest position, accounting for 19.9% of his total portfolio, while Coca-Cola, with 400 million shares, ranked second, accounting for 19% of his total portfolio as of March 2013.
Wells Fargo is known to have conservative lending practices, which might generate lower income than its peers in a boom phase, but it would let its shareholders sleep well in challenging times. The bank, with presence in nearly 9,100 stores, serving more than 70 million customers, is considered the market leader in consumer and small business lending, residential mortgage, and the commercial market. In the long run, the bank targets its efficiency ratio at 55%-59%, with the ROA in the range of 1.40%-1.60%, while the ROE could be in the range of 12%-15%.
Income investors might like Wells Fargo with its capital plan. For full year 2013, the bank estimates to spend more money than 2012 to buy back its shares. If Wells Fargo spent the equivalent amount of money like last year, of $4 billion, for share repurchases, the repurchase yield could be around 1.7% at its current price. It is trading at $44.50 per share, with the total market cap of $235.6 billion. The market values Wells Fargo at 1.57 times its book value. The dividend yield comes in at 2.80%.
Coca-Cola has also been a favorite long-term stock for investors with its marvelous concentrates. It has a long operating history dated back to 1886, having more than 500 beverage brands in more than 200 countries. Coke has become the global product for all walks of life, from the rich to the poor, from a billionaire to farmer. It has a global leading position with nearly 42% market share, while PepsiCo, its closet competitor, has only around 30% of the market. Other non-alcoholic ready-to-drinks (NARTD) products including Fanta, Sprite, and Del Valle are also the leaders in their markets.
In the second quarter, Coke reported sluggish results, due to the “challenging global macroeconomic environment and unusually poor weather conditions in the quarter.” Despite the recent not-so-good quarter, the company sticks to its 2020 Vision. Its Chairman and CEO, Muhtar Kent, remained bullish in the large NARTD market of 585 million, 37% under the age of 21 and more than 18 million in the emerging middle class.
By 2020, the company expects to double its system revenue with higher margins. The number of servings is estimated to double to more than 3 billion a day, equivalent to around 3%-4% annual volume growth. It is trading at around $40.20 per share, with a total market cap of $178.3 billion. The market values Coke at as much as 15 times its trailing EBITDA.
My Foolish take
Berkshire Hathaway, under Warren Buffett’s leadership, will still be a great long-term stock for patient investors. With more than 70 diversified great operating businesses, Berkshire Hathaway should deliver decent returns for its shareholders in the future. Long-term common stock investors could also invest in Coke and Wells Fargo, due to their global market leading positions, decent profitability, and potential growth.

Three Successful Social Networking Sites

Recently, Facebook (NASDAQ: FB) experienced a significant daily gain of 26% to more than $33.40 per share. After the rise, Facebook’s total market cap has approached around $80.80 billion. Facebook soared mainly due to an impressive second quarter earnings result. Let’s take a closer look at those results to see whether or not Facebook is a good buy now.
Impressive second quarter growth
In the second quarter, Facebook has managed to increase its revenue by as much as 53%, from $1.18 billion last year to $1.81 billion this year. The advertising revenue came in at $1.6 billion, accounting for around 88% of its total revenue. The net income was $333 million, or $0.13 per share, a big improvement compared to a loss of $(157) million, or a $(0.08) per share in the same quarter last year. Facebook has reached 1.15 billion monthly active users (MAUs) as of June 2013, a year-over-year growth of 21%. The mobile MAUs experienced a much higher year-over-year growth of 51% to 819 million.
LinkedIn is for professional networking
Facebook is considered the most popular global social networking site in the world. It owns a lot of private users’ data, including pictures, profiles, comments and updates. Another famous social networking site is LinkedIn (NYSE: LNKD). However, LinkedIn focuses on professional social networking, giving people the chance to network based on the career and professional basis. In the first quarter 2013, LinkedIn managed to grow its member base to 218 million. LinkedIn is trading at $204.50 per share, with a total market cap of around $22.5 billion.
LinkedIn members could feel comfortable to pay to be upgraded to the premium level for better professional networking and have more valuable contact access, while it will be much harder for Facebook to charge its members. Consequently, Facebook’s main revenue source is advertisements. Interestingly, LinkedIn’s main revenue stream was Talent Solutions, which generated around $184.3 million in the first quarter of 2013, whereas the Marketing Solutions and Premium Subscriptions segments contributed only $74.8 million and $65.6 million, respectively, in sales.
Yelp – connecting people to local businesses
In terms of valuation, LinkedIn has a much higher price-to-sales valuation at 19.7, while Facebook is valued at only nearly at 11.7 times its price-to-sales. Another much smaller social networking site, Yelp (NYSE: YELP), is also valued at a higher valuation that Facebook at 16.45. Yelp is trading at $41.50 per share, with total market cap of around $2.6 billion. The market values Yelp at 16.4 times its price-to-sales. Yelp concentrates its business on a different niche, connecting people with local businesses. When you go somewhere, you want to know about different types of restaurants, plumbers or salons to choose from, which is why people use Yelp. Yelp provides reviews that help users share different opinions and experiences about local businesses. The company reported that there were around 102 million unique investors visiting the websites, with around 39 cumulative reviews.
Facebook, LinkedIn and Yelp do not directly compete with each other. LinkedIn and Yelp have been quite successful with its social networking niche markets. I personally think that all of those three businesses will grow rapidly in the future. Importantly, with the rising trend of mobile usage, all three sites need to increase the number and the stickiness level of mobile users.
My Foolish take

Facebook, LinkedIn and Yelp could fit well in the technology portfolio of long-term investors. However, with the high valuation and the fast changing nature of the technology industry, all three stocks are expected to be extremely volatile. Thus, investors should diversify their technology portfolio with a lot of other large well-established tech companies.

This Cash-Cow Nitrogen Fertilizer Business is Cheap

Dan Loeb, the famous hedge fund manager, has successfully delivered sweet long-term returns for his investors by investing in attractive event-driven equity and credit opportunities around the world. Since its inception in December 1996, his fund, Third Point Offshore Fund, has generated a 17.8% annualized return, outperforming the S&P 500’s return of only 6.6%.
According to his second quarter letter to shareholders, he initiated a long position in CF Industries Holdings (NYSE: CF) in the second quarter. Right after the news, CF Industries experienced a significant daily rise at nearly 12%. Should we follow Dan Loeb into CF Industries? Let’s take a closer look.
Low cost producer with low dividend payout ratio
CF Industries is considered one of the biggest nitrogen and phosphate fertilizer products manufacturers and distributors, owning five nitrogen fertilizer-manufacturing facilities in the U.S., a 75.3% stake in Terra Nitrogen, a 66% economic interest in the biggest nitrogen fertilizer complex in Canada and other nitrogen and ammonia joint ventures around the world. The two biggest revenue contributors are UAN, with nearly $1.89 billion in revenue, and Ammonia, with $1.68 billion in 2012 sales.
What I like about CF Industries is its historical consistent positive cash flow generation. Its operating cash flow has increased from $344 million in 2004 to nearly $2.38 billion in 2012, while the free cash flow rose from $311 million to more than $1.85 billion during the same period. Since 2005, the company also offered growing dividends to shareholders, from $0.02 per share in 2005 to $1.60 per share in 2012.
However, the dividend yield is very small because of the very low payout ratio. CF Industriesis trading at $202.30 per share, with the total market cap of around $12 billion. The current dividend yield is only 0.90%, with the payout ratio of only 5%.
Sustainable cash flow and cheap
Dan Loeb liked CF Industries because it was one of the lowest-cost producers in the world. He thought that its structured cash flow generation strength was not recognized by investors and proposed that the company’s management should increase dividend payments to shareholders. CF has the advantage of having access to low-cost North American natural gas, the main input for nitrogen fertilizer manufacturing. Assuming the input cost was $5 Henry Hub/natural gas and $275 per ton nitrogen fertilizer price, Dan Loeb estimated that the annual free cash flow could be around $1.2 billion. Thus, CF Industries is trading at around 10% free cash flow yield.
Moreover, if the demand for nitrogen fertilizer is higher than the supply, CF will benefit further, generating higher cash flow than the above assumption. With the conservative cash flow multiple of 4, every $25 change in nitrogen price above the cost floor (the breakeven price for nitrogen manufacturers) will generate an additional $15 value per share. In addition to the increase in dividend payments, Dan Loeb also suggested the company to execute the remaining $2.25 billion share buyback, creating an additional yield of nearly 19%.
Agrium and Potash are more expensive, with higher dividend yields
Its peers, Agrium (NYSE: AGU) and Potash of Saskatchewan (NYSE: POT), offer investors much higher dividend yields and have a much higher valuation than CF Industries. Agrium is trading at $91.50 per share, with the total market cap of around $13.70 billion. Agrium has a much higher valuation than CF Industries, at 6.4 times its trailing EBITDA. At the current trading price, Agrium’s dividend yield is 2.30%, with the payout ratio of around 16%.
Agrium was also the activism target of JANA Partners. JANA Partners thought that Agrium’s full value potential was not realized because of its conglomerate structure with two different businesses: a volatile fertilizer business and a stable farm product distribution business. Thus, JANA proposed that it should separate the retail business via a tax-free spin-off transaction and reduce excessive unallocated corporate expenses. Afterwards, it should release excess working capital and increase cash return to shareholders via dividends and share buybacks. JANA estimated that the business restructure could unlock as much as $50 value per share for Agrium shareholders.
Potash has the highest valuation among the three. It is trading at $37.90 per share with a total market cap of $32.90 billion on the market. It is valued at as much as 10.1 times its trailing EBITDA. Potash offers the highest dividend yield at 3.80% with the highest payout ratio at 33%. Potash is the global leading company in crop nutrients. The company ranks number one, accounting for 20% of the global potash capacity, while it is the third largest player in the world in nitrogen and phosphate.
Looking forward, Potash is well-positioned for the global growth in fertilizer consumption. Inthe period of 2012-2016, the annual growth in potash, nitrogen and phosphate came in at 3.5%, 1.3% and 2.7%, respectively. Potash estimated that it could account for 42% of the new global operational capacity in 2012-2016, and 23% of the global operational capability in 2016. In the next three years, the company expects to generate stronger cash flow but reduce capital spending so that it could have more financial flexibility.
My foolish take
CF Industries seems to be a good nitrogen long-term stock for patient investors due to its low payout ratio, strong cash flow, low-cost operational structure, and low valuation. Furthermore, under the pressure from activist investor Dan Loeb, investors might expect that CF Industries could take action in the near future to unlock shareholders’ potential value. 
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