Tuesday, February 28, 2012

Whoops: Buffett Says Energy Future Holdings Bet at Risk of Being Wiped Out (BRK.B)

For our younger readers, in 1983 and '84 Mr. Buffett famously bought the bonds of Washington Public Power Supply Service (WPPSS pronounced Whoops).*
From Bloomberg:
Warren Buffett, who bought about $2 billion in bonds of power company Energy Future Holdings Corp., said the investment is at risk of losing all its value after natural gas prices fell.

Buffett’s Berkshire Hathaway Inc. (BRK/A) wrote down the debt by $390 million last year, following a $1 billion impairment in 2010, the billionaire said in his annual letter to shareholders posted Feb. 25 on the company’s website. The market value of the investment was $878 million at the end of December, he said.

“If gas prices remain at present levels, we will likely face a further loss, perhaps in an amount that will virtually wipe out our current carrying value,” wrote Buffett, Berkshire’s chairman and chief executive officer.

“Conversely, a substantial increase in gas prices might allow us to recoup some, or even all, of our writedown.”

Buffett, 81, invested in the bonds in 2007 after Energy Future, then called TXU Corp., was bought by KKR & Co. (KKR) and TPG Capital in the largest leveraged buyout. The private-equity firms wagered that gas prices would rise, pushing up wholesale electricity rates. Instead, prices fell amid an expansion of drilling, forcing down what Energy Future charges in unregulated markets for power produced from sources including coal....MORE 
*The 1984 Letter to Shareholders has a short treatise on  bond valuation:

Washington Public Power Supply System

     From October, 1983 through June, 1984 Berkshire’s insurance 
subsidiaries continuously purchased large quantities of bonds of 
Projects 1, 2, and 3 of Washington Public Power Supply System 
(“WPPSS”).  This is the same entity that, on July 1, 1983, 
defaulted on $2.2 billion of bonds issued to finance partial 
construction of the now-abandoned Projects 4 and 5. While there 
are material differences in the obligors, promises, and 
properties underlying the two categories of bonds, the problems 
of Projects 4 and 5 have cast a major cloud over Projects 1, 2, 
and 3, and might possibly cause serious problems for the latter 
issues.  In addition, there have been a multitude of problems 
related directly to Projects 1, 2, and 3 that could weaken or 
destroy an otherwise strong credit position arising from 
guarantees by Bonneville Power Administration.

     Despite these important negatives, Charlie and I judged the 
risks at the time we purchased the bonds and at the prices 
Berkshire paid (much lower than present prices) to be 
considerably more than compensated for by prospects of profit.

     As you know, we buy marketable stocks for our insurance 
companies based upon the criteria we would apply in the purchase 
of an entire business.  This business-valuation approach is not 
widespread among professional money managers and is scorned by 
many academics.  Nevertheless, it has served its followers well 
(to which the academics seem to say, “Well, it may be all right 
in practice, but it will never work in theory.”) Simply put, we 
feel that if we can buy small pieces of businesses with 
satisfactory underlying economics at a fraction of the per-share 
value of the entire business, something good is likely to happen 
to us - particularly if we own a group of such securities.

     We extend this business-valuation approach even to bond 
purchases such as WPPSS.  We compare the $139 million cost of our 
yearend investment in WPPSS to a similar $139 million investment 
in an operating business.  In the case of WPPSS, the “business” 
contractually earns $22.7 million after tax (via the interest 
paid on the bonds), and those earnings are available to us 
currently in cash.  We are unable to buy operating businesses 
with economics close to these.  Only a relatively few businesses 
earn the 16.3% after tax on unleveraged capital that our WPPSS 
investment does and those businesses, when available for 
purchase, sell at large premiums to that capital.  In the average 
negotiated business transaction, unleveraged corporate earnings 
of $22.7 million after-tax (equivalent to about $45 million pre-
tax) might command a price of $250 - $300 million (or sometimes 
far more).  For a business we understand well and strongly like, 
we will gladly pay that much.  But it is double the price we paid 
to realize the same earnings from WPPSS bonds.

     However, in the case of WPPSS, there is what we view to be a 
very slight risk that the “business” could be worth nothing 
within a year or two.  There also is the risk that interest 
payments might be interrupted for a considerable period of time.  
Furthermore, the most that the “business” could be worth is about 
the $205 million face value of the bonds that we own, an amount 
only 48% higher than the price we paid.

     This ceiling on upside potential is an important minus.  It 
should be realized, however, that the great majority of operating 
businesses have a limited upside potential also unless more 
capital is continuously invested in them.  That is so because 
most businesses are unable to significantly improve their average 
returns on equity - even under inflationary conditions, though 
these were once thought to automatically raise returns.

     (Let’s push our bond-as-a-business example one notch 
further: if you elect to “retain” the annual earnings of a 12% 
bond by using the proceeds from coupons to buy more bonds, 
earnings of that bond “business” will grow at a rate comparable 
to that of most operating businesses that similarly reinvest all 
earnings.  In the first instance, a 30-year, zero-coupon, 12% 
bond purchased today for $10 million will be worth $300 million 
in 2015.  In the second, a $10 million business that regularly 
earns 12% on equity and retains all earnings to grow, will also 
end up with $300 million of capital in 2015.  Both the business 
and the bond will earn over $32 million in the final year.)

     Our approach to bond investment - treating it as an unusual 
sort of “business” with special advantages and disadvantages - 
may strike you as a bit quirky.  However, we believe that many 
staggering errors by investors could have been avoided if they 
had viewed bond investment with a businessman’s perspective.  For 
example, in 1946, 20-year AAA tax-exempt bonds traded at slightly 
below a 1% yield.  In effect, the buyer of those bonds at that 
time bought a “business” that earned about 1% on “book value” 
(and that, moreover, could never earn a dime more than 1% on 
book), and paid 100 cents on the dollar for that abominable 

     If an investor had been business-minded enough to think in 
those terms - and that was the precise reality of the bargain 
struck - he would have laughed at the proposition and walked 
away.  For, at the same time, businesses with excellent future 
prospects could have been bought at, or close to, book value 
while earning 10%, 12%, or 15% after tax on book.  Probably no 
business in America changed hands in 1946 at book value that the 
buyer believed lacked the ability to earn more than 1% on book.  
But investors with bond-buying habits eagerly made economic 
commitments throughout the year on just that basis.  Similar, 
although less extreme, conditions prevailed for the next two 
decades as bond investors happily signed up for twenty or thirty 
years on terms outrageously inadequate by business standards. 
(In what I think is by far the best book on investing ever 
written - “The Intelligent Investor”, by Ben Graham - the last 
section of the last chapter begins with, “Investment is most 
intelligent when it is most businesslike.” This section is called 
“A Final Word”, and it is appropriately titled.)

     We will emphasize again that there is unquestionably some 
risk in the WPPSS commitment.  It is also the sort of risk that 
is difficult to evaluate.  Were Charlie and I to deal with 50 
similar evaluations over a lifetime, we would expect our judgment 
to prove reasonably satisfactory.  But we do not get the chance 
to make 50 or even 5 such decisions in a single year.  Even 
though our long-term results may turn out fine, in any given year 
we run a risk that we will look extraordinarily foolish. (That’s 
why all of these sentences say “Charlie and I”, or “we”.)

     Most managers have very little incentive to make the 
decision.  Their personal gain/loss ratio is all too obvious: if 
an unconventional decision works out well, they get a pat on the 
back and, if it works out poorly, they get a pink slip. (Failing 
conventionally is the route to go; as a group, lemmings may have 
a rotten image, but no individual lemming has ever received bad