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Berkshire Hathaway
Berkshire's Growth Opportunities

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By Tode
March 21, 2006

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With today's Barron's article anointing Sokol as the next CEO of Berkshire, and the recent posts on this board discussing where the cash hoard might be put to work, it seemed an opportune time for a quick Google search on "utility consolidation."

The electric utility industry is massive and highly fragmented. A recent article noted that PUHCA resulted in more than 3,000 electric utilities in the United States. Of these, over 240 are publicly listed companies which generate 75% of the sector's power. With the repeal of PUHCA, the article predicts that a new wave of consolidation is just beginning, and that Buffett will be one of the buyers.

There are about 160 natural gas pipeline companies in the United States, which operate over 285,000 miles of pipe. Midamerican has already made some very astute buys in this arena at bargain prices. There is plenty of potential for more consolidation in this industry.

While Midamerican has not yet entered the water utility industry, this is another arena that is being reshaped by consolidation.

Moody's says there are 180,000 water systems in the U.S. alone, mostly municipal and small private companies, many of which are hard pressed to meet the new federal water standards, while funding new treatment plants and repairing their aging infrastructures.

Moody's predicts that that within the next decade the water utility industry will likely be transformed into a few large water companies or systems on the national level.

These three utility sectors alone represent huge opportunities for the deployment of capital over the next decade. To be sure, there are other large pools of capital that will be competing with Berkshire/MidAmerican
to pursue these opportunities. But the recent Pacificorp deal gives us some reason to believe that Berkshire's reputation for being a patient, long-term owner may help it in securing approvals from state regulatory boards. Sokol did an astute job selling the deal to the regulators. The wheeler-dealer, fast money crowd may find it harder to persuade skeptical regulatory boards that they will be around for the long haul and will be willing to invest billions in infrastructure improvements.

WEB stressed again this year that he is looking to make "some very large purchases" in the utility sector. "Note the plural--we'll be looking for more."

He also devoted a section of the report to explaining how MidAmerican will use debt to finance these acquisitions. The debt will not be guaranteed by Berkshire, but will be "unquestionably secure because it is serviced by MidAmerican's diversified stream of highly stable utility earnings." He adds that "even a worrier like Charlie can't think of an event that would systematically decrease utility earnings in any major way."

Now flash back to Charlie's comments several years ago about Berkshire morphing into a spread business that gathers float costing 3% and deploys it at yields around 13%. I think it is increasingly clear that Berkshire is going to get much, much bigger in the utility sector, using the type of spread model that Charlie envisioned (but using free float instead of float costing 3%). Even if utility regulators cannot be counted on to always allow 13% returns on invested capital, the use of leverage at the MidAmerican level will help magnify the spreads earned at the Berkshire level.

Best of all, this has lots of potential for scale. I don't think it is crazy to envision a Berkshire that controls utility assets exceeding its insurance float. We already have $20 billion of utility assets (not counting Pacificorp) compared to $46 billion float. With prudent leverage, and "some very large purchases" as WEB hopes for, I think the utility assets could FAR exceed Berkshire's float ten years from now.

While all this is going on in the utility segment of Berkshire under Sokol's supervision, I can also envision the finance sector of Berkshire expanding dramatically. Again, as WEB lays out in his letter, we are willing to "borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand." More leverage, but only of the prudent variety.

I see Berkshire gradually coming to more closely resemble GE in its balance sheet structure. We will get more leveraged, and will own a wide variety of businesses that earn good to excellent returns on invested capital. The business model appears to be sound, scalable and sustainable. Meanwhile, the market is declaring that Berkshire is worth 1.5x book value, close to a ten-year low as the Barron's article notes.

It is curious that GE sells for 3.3x book, at a market cap of $360 billion, over double Berkshire's book multiple. As Berkshire morphs into a GE-type balance sheet over time (but without the GE earnings smoothing games), it will be interesting to see if the market reappraises Berkshires and concludes that it deserves a GE multiple.


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