S&P downgrade the firm just in time for Berkshire's attempt to place a whopping $8 billion in a four-part deal underwritten by JP Morgan (What, no Goldman)?
- Berkshire Hathaway plans to purchase Burlington Northern Santa Fe for approximately $26 billion in cash and stock for the shares it does not already own. The transaction is pending shareholder approval.
- We believe that the railroad acquisition will reduce what historically has been extremely strong capital adequacy and liquidity, and that investment risk with sizable concentrations remains very high.
- The group's risk tolerances are, in our opinion, not clearly defined at the enterprise level and are a concern as the group's profile becomes more complex.
- We are lowering our ratings on Berkshire and various affiliates.
- We are removing the ratings from CreditWatch, where they were placed with negative implications on Nov. 4, 2009. The outlook is stable.
On Feb. 4, 2010, Standard & Poor's Ratings Services lowered its long-term counterparty credit rating on Berkshire Hathaway Inc. (BRK) to 'AA+' from 'AAA'. We also lowered our financial strength ratings on BRK's core insurance operations to 'AA+' from 'AAA'. At the same time, we removed the ratings from CreditWatch, where they were placed with negative implications on Nov. 4,
2009. The outlook is stable.
We are taking these actions in anticipation of BRK's acquisition of Burlington Northern Santa Fe Corp. (BNSF), which we expect to close no later than Feb. 15. The transaction is BRK's largest acquisition to date. BRK already owned more than 22% of the stock of BNSF. BRK will finance the acquisition of the remaining shares for about $26 billion with a combination of 60% cash and 40% through the issuance of new BRK shares. The cash portion of about $16 billion will come from cash on hand and new debt issuance of approximately $8 billion. Standard & Poor's expects that a significant part of the internal cash will come from BRK's core insurance operations, as has been the case in other transactions.
The rating actions are based on our view that Berkshire's overall capital adequacy, as well as that of its insurance operations, has weakened to levels no longer consistent with a 'AAA' rating and is not expected to return to extremely strong levels in the near term. Furthermore, we expect that the consolidated liquidity position of BRK will be reduced from extremely strong historical levels as a result of the acquisition. As capital adequacy and liquidity levels have declined, investment risk remains very high in our view,
compounding the need for extremely strong capital and liquidity given potential investment volatility. A key concern is that BRK's risk tolerances appear to have increased, yet we believe they remain ill defined while the organization increases in complexity. Generally, we believe Berkshire has a high risk tolerance for capital volatility and investment risk. We do not believe that the company's overall risk management framework has evolved at the same pace as the organization's complexity and that enterprise risk management practices remain in silos within each investment.
Earnings remain very strong, and we expect them to increase following the acquisition of BNSF. It is our expectation that Berkshire likely will use these incremental earnings and cash flows to pay down the debt resulting from the acquisition rather than rebuild insurance company capitalization. We view BRK as having an extremely strong and well-diversified competitive position
across its business. Albeit weakened, we view the company's liquidity position and balance sheet as still very strong. However, we see meaningful exposure to adverse development of reserves held for long-term insurance liabilities, and uncertainty remains regarding management succession. The rating on the holding company is the same as the ratings on the
operating insurance companies and
reflects our opinion of the substantial diversity of assets, the large cash balance at the holding company, and the dividend capacity of the numerous noninsurance operations the holding company owns. BRK also has the ability to sell noncore operations in the event of an unforeseen liquidity need, though we would expect this to occur only under extreme circumstances.
BRK is a unique holding company that owns a large number of insurance and noninsurance subsidiaries. The core business of BRK is its extensive insurance operations, which include Berkshire Hathaway Insurance Group (BHIG), Berkshire Hathaway Reinsurance Group (BHRG), GEICO Insurance Group (GEICO), and General Re Group. Unlike many of its competitors, BRK's insurance and reinsurance operations have been able to maintain pricing power, manage through cycles, and create distribution and underwriting competitive advantages in a predominantly commodity business. These advantages are reflected in the group's exceptional underwriting results to date. The noninsurance subsidiaries are in a variety of sectors including utilities and energy, finance, manufacturing, retailing, and business services. The more prominent noninsurance affiliates (based on earnings contribution) are MidAmerican Energy Holdings Co. (BBB+/Stable/--; regulated utility subsidiaries are rated 'A-'), Clayton Homes Inc. (BBB/Stable/--), and Marmon Holdings Inc. Following the acquisition, BNSF will represent the second-largest noninsurance segment within Berkshire, after MidAmerican.
Even following the BNSF acquisition and related debt issuance, BRK's financial flexibility is extremely strong, in our opinion. Excluding the debt obligations of MidAmerican, which is rated on a stand-alone basis, and debt associated with the mortgage finance operations of Clayton Homes that is viewed as operating leverage, BRK's financial leverage as of Sept. 30, 2009,
was conservative at 5.3%. This increases to about 10% pro forma for the debt issued for the BNSF acquisition. Fixed-charge coverage declines to 21x on a pro forma basis from 34x in the first nine months of 2009.
Uncertainty surrounding management succession and management structure, corporate culture, and business strategy following an eventual transition of the company's leadership from current CEO Warren Buffett is an ongoing concern. This, in our view, is only partially mitigated by a board-approved succession plan and the experienced management teams in place at the operating companies, given Mr. Buffett's strong and positive influence on all aspects of operations at Berkshire.
The outlook on the ratings is stable. We expect BRK's consolidated operating earnings to improve in 2010, in line with an overall gradual economic recovery in the U.S. BNSF also likely will contribute to earnings for Berkshire in 2010 and prospectively. Despite this increase in earnings, sizable declines in capital adequacy and liquidity are expected to result in a multiyear rebuilding period for the company to restore to historical levels. Furthermore, earnings remain potentially volatile because of the insurance operations' exposure to any sizable natural peril or man-made catastrophe. Our expectation is that any such event would result in lower earnings in a given year but not an overall loss that would reduce capital in 2010. We expect financial leverage and coverage metrics to improve from their current levels over the next three years as BRK repays the debt related to the BNSF acquisition. The ratings could come under more pressure if BRK further increases its investment risk tolerance or if its overall level of capital adequacy relative to its risks deteriorates further. We currently do not expect that we would raise the ratings in the intermediate term.