Recapitalizing Berkshire Hathaway

So I had a conversation recently and I mentioned LEAPS and leveraged recapitalizations (or synthetic recapitalizations) as one idea mentioned in Greenblatt's You Can Be a Stock Market Genius  (see the book here). 

Actually, Greenblatt calls this "creating your own stub stock".  A stub stock is the post recapitalized shares of a company that borrowed a bunch of money and paid it out to shareholders (or swapped debt for equity in some combination;  see chapter six, page 201, "'Baby Needs New Shoes' Meets 'Other People's Money': Recapitalizations and Stub Stocks, LEAPS, Warrants and Options")

I thought I wrote this up before but can't seem to find it.  I probably mentioned it within some post somewhere, but I'll take a look at this idea again, maybe in more detail than when I wrote it up last time.  I also know that buying LEAPS on BRK is not a new idea; people have been doing this and talking about it for years.

But anyway, when you listen to Berkshire Hathaway (BRK) shareholders, the two biggest complaints I tend to hear are:

1. BRK should pay dividends!
2. BRK is underleveraged; all that cash and bonds are holding down returns; why doesn't BRK buy back a ton of stock?!

Dividends
This gets debated to death on the internet and I don't want to get into that.  Buffett has said quite simply that he won't pay dividends as long as he thinks he can outdo the S&P 500 index with the retained earnings.   

For people who want dividends, the answer is easy.  They can just sell 2% or 4% of their BRK holding every year as a 'synthetic', self-created dividend.  With intrinsic value growing 10%/year over time, the value of their holdings should increase over time too.

I guess the problem with that is people hate the idea of selling BRK stock below what they consider intrinsic value.  But then again, if BRK pays out a dividend, that reduces book value on a dollar for dollar basis and at the same price-to-book ratio, the value of BRK goes down a like amount.

At least BRK is trading at above book value, so selling shares may be better than getting a payout at book value (which is what happens when you get a dividend; $1.00 valued at 1.2x by the market ($1.20) held at BRK becomes $1.00 (at 1.0x) in your pocket).

For now, dividends have a low tax rate but in normal times selling stock over time can be better too.  Most of the time (at least in my time), capital gains tax rates were lower than ordinary income rates (which is what dividends are usually taxed at until the Bush tax cuts).

Plus, you have to pay the entire amount of tax on dividends received but only on the 'gain' in the case of capital gains realized when you create your own dividend.

Anyway, that's just my thought; I am no tax expert so I may have missed something.  In any case, this is not really the topic of this post.

Recapitalization
For those who haven't read Greenblatt's book, I would encourage you to go and read it.  Readers here know by now that I am a big fan of his work.  I do really put You Can Be a Stock Market Genius as probably the worst titled book ever, but one of the best investment books ever written.

It goes right up there with Securities Analysis and Intelligent Investor (and Seth Klarman's Margin of Safety).  But it's more like Intelligent Investor in the readability than Securities Analysis, which tends to intimidate people; it's a big, heavy book. 

Most people would be able to read the Genius book over a single weekend (and it's funny).

Anyway, in that book Greenblatt talks about a special situation that was popular in the 1980s.  It was the recapitalization trade.  Sometimes it's called leveraged recapitalization.  The idea is that if a company borrows a ton of money and pays it out to shareholders (or repurchases stock), the value of the left over (called the stub) increases in value.  This is due to the tax effect; interest payments on the debt reduce pretax income but also reduces the tax burden so at the same multiple, the post recap firm would have a higher value (excluding the paid out cash).

Even if the post recap P/E ratio is somewhat lower (due to higher leverage), the value of the stub (and of course the value of the combined cash + stub) is higher than before the recap.

Greenblatt pointed out that recaps were no long popular (he wrote this in 1997) due to the bankruptcies of many highly leveraged companies in the late 1980s and early 1990s.

But he said, not to worry!  There are hundreds of LEAPS listed on the exchanges so we can create our own stub stocks.

So, this is what we're going to do.  I will take a quick look at creating our own BRK stub stock.

Stubbing BRK
OK, so here's the deal.  BRK, as of June-end 2012 had $182 billion in shareholders equity.  Of that, $36.8 billion was in cash and $30.5 billion was in fixed income investments.   That's a total of $67.3 billion in low return assets.   So 37% of BRK's net worth is invested at very low rates.  No wonder why the P/B ratio has come down so much (compared to when BRK was highly levered to the stock market long ago.  I took a look at that a while ago; you can just look for posts labeled BRK for that).

Wouldn't it be great if we can just have BRK pay that 37% out?  Yes, of course it would.  But we know that they can't do that.  BRK is an insurance company with a lot of obligations.  One of BRK's strengths is their rock solid balance sheet and high credit rating.  So much of the fixed income and cash is not really pay outable.  Buffett has said he wants $20 billion cash, minimum, so there is maybe a bit more than $16 billion usable, though.

And the fixed income portfolio is also pretty much mandated by insurance regulation to support the 'float'.

So it's clear that the insurance companies will have to hold a lot of these cash and bonds, so let's just fantasize for a second and ignore credit ratings and reality.

Let's Dream For a Moment
Since the insurance companies can't pay out the cash and bonds, let's look at the holding company.  Let's say BRK can just borrow, say, $70 billion at the holding company level and then pay that out to shareholders.  Wow, that would be huge.  And yes, I know, impossible.  A $70 billion debt offering is insane too.

But we are just trying to get our arms around what leverage can do.

BRK borrows $70 billion and pays that out to shareholders.  What will that do?  Of course, it will reduce shareholders equity by $70 billion (and leaves $70 billion new debt on the balance sheet). 

So BRK's net worth goes down to $112 billion.   BRK's structure, earnings and balance sheet is complicated, but to keep it simple, let's just say that BRK earns around 10% on book every year (including all the businesses and increases in value of stock holdings etc.).

BRK was able to earn 10% before the recap, so that's a $18.2 billion run rate.  With $70 billion in new debt on the balance sheet, BRK will incur interest expense.

A quick search tells me that BRK's credit spreads versus governments and funding costs were:

              BRK credit spread                Treasury yld                  BRK cost of funds
5 year        T+49 bps                             0.6%                           1.1%
10 year      T+105 bps                           1.6%                           2.7%
30 year      T+131 bps                           2.8%                           4.1%

So let's use the really long term rate since this is a complete recapitalization.  We don't want to have to worry about refinancing and stuff like that.

At 4.1%, that's an after tax interest cost of 2.5%.   On $70 billion of debt, that's an annual interest expense of $1.75 billion.

We said that BRK earns, at 10% return on book, around $18.2 billion/year on the $182 billion in book value.  After the recap, BRK would earn $16.5 billion (accounting for the $1.75 billion after tax interest expense).

But the new book value is $112 billion so the post recap return at BRK is 14.7%, almost 1.5x what it would do before the recap.  The stub would be worth 1.5x what is was before the recap (excluding the cash paid out) if we assume a 10% discount rate for fair value.  Actually, you would have to value it a little lower as the market would demand a discount due to the leverage.

Still, that's not bad at all.

But of course, if BRK really had $70 billion of debt on the balance sheet, the credit rating would not be the same, and it probably wouldn't be the preferred provider of reinsurance etc.  This would be a very different animal.

Creating Your Own Stub
Of course, this will never happen but let's see what happens if we create our own stub.  We do this by buying LEAPS.  What are LEAPS?  A LEAPS is an acronym (presumably trademarked) for Long Term Equity AnticiPation Securities.  They are just long term options on stocks.  Maturities tend to go out two years.

The bottom line is that if the company isn't going to go out and borrow money to lever up (and enhance the value of the firm), the stockholder can add leverage at the stockholders' level to create leverage.  Leverage is leverage, right?

So if we bought stock on margin, for example, we are creating our own leverage.  The final economics of the position can be similar (although there will be plenty of differences too).   But margin can be tricky as you can get margin calls, be sold out (what if we have another flash crash or worse?) and who knows what margin rates will be over time.

With LEAPS, once you buy an option, you don't have to worry about anything else; you can only lose your initial investment.

Let's look at the above recap and see what it looks like when we do it ourselves. 

In the above example, BRK borrowed 40% of it's net worth to pay it out.  BRK is now trading at close to $90/share, so if we wanted to create our own stub (post-recap stock), we would go out and buy the $36 ($90 x 40%) strike price LEAPS as far out as is available, which happens to be January 14, 2014.   Since there is no $36 strike, we will just use the $40 strike price.  Close enough.

So what happens when we buy a $40 strike call?

Here are the facts:

$40 strike call price:    $49.38  (mid-point of truck-wide spread)
BRK/B share price:      $88.70

Intrinsic value of call:  $48.70  (current stock price minus strike price)
Premium:                      $ 0.68

Intrinsic value of the call option is simply the amount the option is in-the-money.  If a stock price is $50 and the strike price is $40, then the intrinsic value is $10 (the value realized if option is exercised right now).

So what happens when you buy a LEAPS now at $49.38 is:

1. You are borrowing $40/share worth from the market as you only have to pay that when you exercise the option and
2. You are buying downside protection on BRK because if BRK goes to below $40/share, the option is worth zero and you can't lose more whereas the stockholder will continue to lose money beyond a decline below $40/share.

So compared to just buying BRK/B today at $88.70/share, when you own the above LEAPS, you essentially have a loan and a put option (exercisable at $40/share).

Let's break that down:

BRK/B share value:       $88.70

BRK/B LEAPS value:   $49.38
Implied Loan:                $40.00  (strike price)
Premium:                       $0.68   (includes interest on loan and put option value)

So the 'loan' on your balance sheet is 40% of the full value of BRK/B shares, similar to the above dream recap when BRK borrowed $70 billion.

Pricing the LEAPS
So the intrinsic value of the January 2014 $40 strike call is $48.70, but it is trading now at $49.38, a little higher.  This premium includes: the financing cost of the $40 strike price (which is the amount you are borrowing until expiration:  a call buyer puts up $40 less than the buyer of the stock) and the put option value of a $40 strike put.

Since the put option is so out of the money, let's just ignore that and see what the implied financing cost is on our $40 loan (or we can see it as a loan that includes this insurance).

The difference between the current LEAPS price and intrinsic value is $0.68.  If that is the interest cost on the $40 loan, that comes to 1.7%.  But wait, that's not annualized.

Since the option expires 473 days away, that's 1.3 years away.  So the 1.7% interest expense is actually just 1.3%/year.

So by buying the LEAP, you are essentially buying a $88.70 stock by putting up only $49.38 and borrowing $40 at an interest rate of 1.3%/year with insurance (you can walk away from the loan if the stock is under $40 at expiration).

That's not a bad deal at all.

If we do the above return analysis, you can see that the stockholder can expect to earn $8.9/share (10% increase in value per year; we assume 10% growth in book value per share and constant P/B ratio.  I initially used the increase in book value per share for these calculations, but realized that that would understate the return to shareholders if they assume a constant P/B ratio since BRK is trading at around 1.2x book).  You can do the same using 10% increase in book value per share as a proxy for EPS instead of 10% increase in share price and the results would be a little lower). 

What will the LEAPS holder earn on an equivalent basis?  Since he only put up $49.38/share, he will get a levered return.  But he is also paying interest on the loan (premium on the LEAPS).  The loan costs 1.3%/year on the $40 loan, so that comes to $0.52/share.  If the BRK stockholder can earn $8.9/share, then the LEAPS holder is earning $8.4/share.  $8.4/share on $49.38/share investment is a return of 17%.

So by levering up with LEAPS, the BRK holder has created his own stub stock and bumped up his return from 10%/year to 17%/year.

Of course, these returns assume that the P/B ratio of BRK remains the same and BRK increases book value at 10%/year.

Some upside can be had if the P/B ratio expands too for some upside kicker (and of course, it would be lower if P/B contracts, but most Berkshire holders aren't expecting that).

And what's really great about this self-stubbing or synthetic leveraged recapping or whatever you want to call it is that it does nothing to BRK's credit rating!  And BRK doesn't scare the credit markets (and compete with the Feds) with a $70 billion bond offering.

Of course, there is a big downside too.  Options have maturities, so if the stock does nothing until January, you lose 1.0%/year right off the bat (that doesn't sound too bad, actually.  You are essentially betting 1.0% to earn 7% extra, not a bad risk/return?   But not really; you do have leverage to the downside, so the 1% is the cost of the leverage (and you get it both ways).   The 1% comes from the premium (implied interest expense) of $0.52/year against the $49.38/share price of the LEAPS, which is around 1%).

If the stock goes to below $40/share by expiration, the LEAPS will expire worthless but BRK owners will still own the stock so if it comes back up, they can still be OK.

I looked at this from the point of view of a fundamental analyst looking at earnings;  pre and post recap earnings and returns.

But let's just look at it from the point of view of an investor/trader. What is the difference in returns between owning the stock and the LEAPS?

Returns Comparison for $40 Strike LEAPS

This table is pretty self explanatory.  The left column is the stock price at expiration of the LEAPS and the following column is the intrinsic value of the LEAPS (or value of LEAPS at expiration given stock price levels).  The two columns that follow just look at what the returns would be assuming various levels for the LEAPS and BRK stock.  The last column is just the leverage you get on the LEAPS compared to just buying the stock.

Of course, this ratio is similar to the above "return on book" calculation above, which is similar to the "dream recap" scenario above that.  

Let's Look at Another Strike
OK, so that one is really deep in the money.   What about getting even more leverage?  We all really like BRK and think it's really undervalued and it's a coiled spring ready to jump up 30-40% to intrinsic value very soon.  (OK, maybe that's a bit much.  But it does look OK around here, doesn't it?)

So let's look at a more realistic, higher strike price for a LEAPS, which actually makes it more leveraged.  I say 'realistic' because it's a litte more liquid at the higher strikes.

Let's look at the $60 strike, January 18, 2014 calls.  This should give us almost triple leverage since we are borrowing $60 against a $89 stock price.

Here is the relevant information:

Stock price:       $88.52  (yes, it has moved while I'm writing this)
LEAPS price:    $30.50
Intrinsic value:  $28.52
Premium:            $1.98  (LEAPS price minus intrinsic value (of LEAPS))

So again, ignoring the put option value, the implied financing cost on our $60 loan would be ($1.98 / 1.3 (annualize it) / $60) 2.5%.

At 10% return on unleveraged BRK, the BRK shareholder earns $8.9/share.  The annualized cost of the loan (including put option value) is $1.52, so the LEAPS holder would earn $7.38/share ($8.90 - $1.52).  Against the purchase price of the LEAPS of $30.50, the return for the LEAPS holder is 24%.

So with this self-stubbing of BRK, we created a security with an implied rate of return of 24% from a stock with an expected return of around 10%.

Again, let's look at a table of this for those who only care about what the LEAPS will do according to various stock price scenarios:

Returns Comparison For $60 Strike LEAPS

The above table shows that we get substantial upside leverage by creating our own stub stock.  We turn a $90 stock into a $30 leveraged stub stock and the returns shows how the earnings can be geared up.

Of course, leverage is a double-edge sword so you lose a lot more on the downside too.  If the stock goes down 10%, the LEAPS value goes down more than 30%.   If the stock goes down to $70, the stockholder loses only 21% but a LEAPS holder loses 67%.

But this would be true if BRK did a real leveraged recap too. The net worth of the company would go down much faster post-recap than as it is currently as a conservative-balance-sheet high grade credit (but this would be driven by company fundamentals, not the stock price).

Rolling LEAPS over time can be quite expensive if the stock stays flat over long time periods.  I know that BRK LEAPS have been popular in the past few years.  One value investor owned LEAPS and long term OTC call options, and I wonder how that worked out as the stock price of BRK has been flat over the years.

The cost, though, is easily calculable.  Your carry cost is basically the premium you pay above and beyond the intrinsic value of the option.  The more deep-in-the-money the option is, the less premium you pay and the less cost of carry (due to lower interest cost on smaller implied loan and lower value of the put option).  This is offset, of course, by the lower leverage you get.   You can think of an option with a zero strike price as being similar to a stock (even though you wouldn't have stockholders' rights and other things).

Also, there may be tax implications even if the stock does well; if you roll LEAPS, you will have to realize gains and pay taxes on each roll etc.  

Conclusion
So with this simple idea, we can take a stock with expected returns of 10% and turn it into one that earns 17% or 24% (depending on which strike price).  And the cost seems very reasonable. The interest expense (which includes the put option value) was 1.3% and 2.4% for the 40 strike and 60 strike call options.  Who would lend you money at those rates?  (I have seen margin loans advertised at very low rates but margin rates seem to be pretty high).

If you buy LEAPS, you do borrow and lock in those rates for the term of the option; margin loan rates can change at any time.

So, the benefits are:

• Even if Buffett doesn't want to lever up BRK, we can do it ourselves at very attractive rates.
• We can turn a 10% returning stock into a 17% or 24% returning leveraged stub.  The risk is the initial investment so there is no margin call worries.
• Buy doing the recap at the investor level, it doesn't impact BRK's credit rating and won't impact the credit markets.

Of course, there are cons:

• If the stock goes down, you get leveraged downside too.  If it stays flat over the years, this may be costly, even though it seems at current levels the 'cost' seems cheap (and therefore attractive?)
• Even if BRK does well, the stock market can be irrational.  This can obviously be bad for the  LEAPS holder (but this could be bad for BRK holders too if it did a real recapitalization).
• LEAPS do expire, so that's an issue.  A real recapitalized firm has to deal with rolling debt, but not expiration every two or three years.
• There is some risk in owning LEAPS; if BRK starts to pay a regular dividend the strike price isn't adjusted so LEAPS holders would lose out on unexpected dividends.  Special cash dividends and other corporate actions are adjusted, though.
• There are tax issues; you may have to realize gains every time you roll your LEAPS whereas long time BRK shareholders can compound continuosly without paying taxes (until they sell).

These are just some of the things that immediately come to mind.  I'm sure there are other things.   But this is just a quick sketch of this concept.  It can work with any other company, of course.  You can take a stock you like, lever it up and create your very own, personal stub stock.   You can also do all of the above with other strike prices too.

I should say that leverage is dangerous.  Buffett always says don't risk something you need for something you don't need.  Why lever up if you don't have to?   So it feels funny to make a post about levering up by using options on BRK.  But hey, this is an idea out of Greenblatt's book.  Don't blame me!  (Greenblatt didn't mention BRK, though).

They say most options expire worthless (well, that's not true for deep in-the-money options, of course); you can really piss away a lot of capital being long options so I would caution people to be very careful with these things. 

As usual, do your own work and only do something if you really understand it!