Man Without Qualities

Wednesday, March 12, 2003

Mr. Market: Moats And Castles

Writing to the Berkshire-Hathaway shareholders, Warren Buffet asserts:

Both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: "Competition may prove hazardous to human wealth."

Actually, competition is essential to the maintenance of human wealth - but it does erode the profit margins of individual, un-moated economic competitors.

That's quite an emphasis on moats or what an anti-trust economist, lawyer or regulator would call barriers to entry. As noted previously, Berkshire-Hathaway is generally said to deploy its resources into insurance and "brands." Having raised the issue of the need to avoid the principle that "competition may prove hazardous to human wealth," surely Mr. Buffett is at least as concerned to maintain "moats" to protect both of Berkshire-Hathaway's insurance and non-insurance castles.

So what's the "moat" that protects Berkshire-Hathaway's insurance business from competition eroding its profit margins? One searches the cumulative Buffett/shareholder correspondence in vain for the moats. One finds many paeans to Berkshire-Hathaway's great "float," its sound financial condition, its marvelous management, its cagey evaluations of risks. But no moats.

Is there a clue to Berkshire-Hathaway's insurance business moats in this year's letter from Mr. Buffett to the Berkshire-Hathaway shareholders? In that letter we find that Berkshire-Hathaway's largest non-insurance source of revenue is a commodity company. A natural gas pipeline company, to be exact - and one which for which Berkshire-Hathaway has little voting control:

Berkshire also made some important acquisitions last year through MidAmerican Energy Holdings (MEHC), a company in which our equity interest is 80.2%. Because the Public Utility Holding Company Act (PUHCA) limits us to 9.9% voting control, however, we are unable to fully consolidate MEHC’s financial statements. Despite the voting-control limitation – and the somewhat strange capital structure at MEHC it has engendered – the company is a key part of Berkshire. Already it has $18 billion of assets and delivers our largest stream of non-insurance earnings. It could well grow to be huge. Last year MEHC acquired two important gas pipelines. The first, Kern River, extends from Southwest Wyoming to Southern California. This line moves about 900 million cubic feet of gas a day and is undergoing a $1.2 billion expansion that will double throughput by this fall. At that point, the line will carry enough gas to generate electricity for ten million homes. The second acquisition, Northern Natural Gas, is a 16,600 mile line extending from the Southwest to a wide range of Midwestern locations. This purchase completes a corporate odyssey of particular interest to Omahans. From its beginnings in the 1930s, Northern Natural was one of Omaha’s premier businesses, run by CEOs who regularly distinguished themselves as community leaders. Then, in July, 1985, the company – which in 1980 had been renamed InterNorth – merged with Houston Natural Gas, a business less than half its size. The companies announced that the enlarged operation would be headquartered in Omaha, with InterNorth’s CEO continuing in that job. Within a year, those promises were broken. By then, the former CEO of Houston Natural had taken over the top job at InterNorth, the company had been renamed, and the headquarters had been moved to Houston. These switches were orchestrated by the new CEO – Ken Lay – and the name he chose was Enron. Fast forward 15 years to late 2001. Enron ran into the troubles we’ve heard so much about and borrowed money from Dynegy, putting up the Northern Natural pipeline operation as collateral. The two companies quickly had a falling out, and the pipeline’s ownership moved to Dynegy. That company, in turn, soon encountered severe financial problems of its own. MEHC received a call on Friday, July 26, from Dynegy, which was looking for a quick and certain cash sale of the pipeline. Dynegy phoned the right party: On July 29, we signed a contract, and shortly thereafter Northern Natural returned home.

When 2001 began, Charlie and I had no idea that Berkshire would be moving into the pipeline business. But upon completion of the Kern River expansion, MEHC will transport about 8% of all gas used in the U.S.

Again missing from this benevolent discussion of MEHC's prospects is any discussion of how a company largely in the business of transporting a commodity plans to maintain the kind of profit margin that Mr. Buffet and his shareholders expects (MEHC also owns a significant residential real estate business, whose description I have not included). But there is one thing insurance and natural gas pipeline companies have in common: they are subject to many layers of regulation and service markets in which competition is low because of political considerations. And there is little dispute among economists that a major source of barriers to entry is regulation.

Could it be that Mr. Buffet's insurance and gas pipeline revenues depend on Berkshire Hathaway being able to continue to overcharge customers relative to an efficient, competitive market, and therefore on Mr. Buffett's and Berkshire Hathaway’s political influence? Of course, insurance and gas pipeline markets can be made efficient, or close to it. But would one expect Mr. Buffett and Berkshire-Hathaway will favor or disfavor regulatory reforms that would tend to make markets efficient? How about in California, for example, a major area served by Mr. Buffett's new pipeline?

What would a dependency on supra-competitive profits do to one's understanding of what one commentator has called "Warren Buffett's growing network, a formidable collection of corporate heads, financiers, money managers and celebrities, ... profitable connections that have been one key to Mr. Buffett's success." The comments continue:

The innermost circle ... now numbers almost 60, [and] gets together once every two years for a retreat led by Mr. Buffett. .... The conclaves ... fall somewhere between group therapy and a huge board meeting of "Buffett Inc." .... With corporate competitors and independent investors getting together, the sessions could raise antitrust or other tricky issues. But "no one wants to talk about things that could be a possible problem," says Mr. Tisch. "They won't do that. These people are too smart."

Still, Mr. [Bill] Gates, a first-time retreat guest this year, tells of a cruise around Victoria's inner harbor where he says Mr. Tisch, Mr. Buffett and Mr. Murphy talked at length about "issues of price and valuation in media." Among other things, Mr. Gates says, "they were talking about where ad rates are going, and where they should be."

Legal experts consider such conversations "a gray area of antitrust," says Garth Saloner, an antitrust specialist at Stanford University's Graduate School of Business. "To prosecute that kind of thing, you need to show they agreed, whether explicitly or implicitly, to some course of action. That's hard to prove."

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