Berkshire Hathaway held its annual meeting recently and released its first quarter report this past Friday, so there is no better time to examine the factors that have contributed to the uncommon success of Warren Buffett’s conglomerate.
Buffett watchers will often point to Berkshire’s unique culture, the competitive advantages of its operating businesses, and Buffett’s investing and deal-making acumen. These are indeed critical factors, but Berkshire Hathaway has some structural advantages that are less well understood. One of them is the size of its deferred tax liabilities — a whopping $63.2 billion, based on the most recent data (hat-tip to the Financial Times’ Alphaville blog for drawing my attention to this).
Better than debt or equity: Zero-cost financing
Warren Buffett, who has an aversion to issuing debt or equity, has been able to gain advantage from two sources of free financing, as he explains in the Berkshire Hathaway Owner’s Manual:
But if they are akin to debt, then the creditor isn’t just anybody. As Buffett later pointed out, “In economic terms, the [deferred tax] liability resembles an interest-free loan from the U.S. Treasury.”
What is a deferred tax liability?
A deferred tax liability arises from temporary differences between a company’s financial accounts and its tax accounts. In the quote above, Buffett was referring to a deferred tax liability stemming from the unrealized gains on Berkshire’s stocks holdings, including American Express Company and Coca-Cola Co.
Because it is assumed that companies will eventually realize the investment gains achieved through the sale of their winning stocks thereby incurring capital gains tax, that future liability is reflected on the balance sheet as a deferred tax liability.
Are Berkshire Hathaway’s deferred tax liabilities really that large?
A $63.2 billion net deferred tax liability seems like a big number, but Berkshire is, after all, a big company. How does it compare with other companies, once we adjust for size?
Among the companies in the S&P 500, Berkshire is ranked 20th on the basis of deferred tax liability as a percentage of its balance sheet and 19th on the basis of deferred tax liability as a multiple of pre-tax income, putting it in the top 4% of companies on both measures.
Among companies with a market value in excess of $100 billion, only Pfizer and AT&T rank above Berkshire Hathaway:
(Interestingly, Kraft Heinz Co, in which Berkshire and 3G Capital have a controlling interest, ranks in the top 10 on both metrics.)
How has Berkshire’s deferred tax liability changed over time?
In 1994, the earliest year for which Berkshire’s financial accounts are available, the unrealized appreciation of investments accounted for all of Berkshire’s net deferred tax liability (more than the totality, in fact — there was a small offsetting deferred tax asset).
That’s no longer the case as Berkshire’s stock holdings have become less important relative to the operating businesses, and to capital-intensive businesses, in particular. As of the end of 2015, property, plant equipment (PP&E) represented more than half (51%) of Berkshire’s gross deferred tax liability, while investments contributed roughly a third (35%).
When it comes to PP&E, the deferred tax liability stems from a difference in depreciation schedules for financial reporting and tax purposes (the use of accelerated depreciation creates a tax incentive). If you’re feeling particularly curious/wonkish, you’ll find a worked example of this here.
What impact does the change in the make-up of the deferred tax liabilities have?
At the 2015 Annual Meeting, research analyst Jonathan Brandt put the following question to Buffett:
In other words, as the depreciation-linked component of deferred tax has increased, the quality of this form of capital has degraded.
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Does Warren Buffett maneuver to capture the tax advantage of a deferred liability?
No. Warren Buffett’s stock investments and his affinity for long holding periods are not dictated by tax considerations. Neither was BNSF Railway’s decision to make $5.8 billion in capital expenditures in 2015, for example. The deferred tax liabilities arise under the ordinary course of Berkshire’s business. Nevertheless, it’s a happy by-product which gooses Berkshire’s ability to compound shareholders’ capital — and no one understands that better than Buffett himself.
Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway and Coca-Cola. The Motley Fool recommends American Express. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.