Berkshire letter, part 4 -- Leasing operations, secular vs. cyclical, and goodwill

Here's an interesting sentence from the shareholder letter about "How hard our furniture (CORT) and trailer (XTRA) leasing operations have been hit by the recession. Though their competitive positions remain as strong as ever, we have yet to see the bounce in these businesses."

                        2009         2008       2007       2006        2005

Leasing              $14           $87        $111         $182         $173

We don’t know a whole lot about what is happening at XTRA, one of Berkshire’s many miscellaneous economically-sensitive businesses. Berkshire’s annual report refers to lower rental income driven by relatively low utilization rates for over-the-road trailer and storage units. To understand these numbers we should think about what is happening at CORT. Using material in Wesco’s financial statements about CORT, we can back out Berkshire’s share of CORT’s pretax earnings to infer the pretax earnings of XTRA.

                     2008            2007            2006            2005            2004

XTRA               64                 77               139               143               85

CORT               23                34                 43                 30                8

BRK                  87               111              182               173              93

*CORT’s 2008 earnings included an inventory writedown.

When it was purchased in 2000, CORT was enjoying what turned out to be bubble-era sales. Wesco recorded only 10 months of results that year. So CORT’s peak sales and earnings, as reported by Wesco, therefore, were in 2001. (Sales: $395  Pretax earnings $54.5)  

Since 2001, pretax earnings of CORT have averaged $16.8 million (ranging from a high of $43.3 million in 2006 to a loss of $11.1 after minority interest in 2003). These numbers are through 2008; we don’t know CORT’s 2009 earnings or sales yet. Based on Berkshire’s combined $14M of earnings for CORT and XTRA, though, they’re probably a loss, and it would not surprise me to see more inventory writedowns.

By 2008, CORT had made several “tuck-in” acquisitions and diversified its business – and hewed to its core competency. Thus as you would expect, its move into the relocation business continued CORT’s ties to the real estate and housing markets. Including these acquisitions, by 2008, CORT’s revenues were essentially the same as in 2001 (an increase of 4%).

Charlie Munger makes a point of stressing in Wesco’s annual report that readers should pay attention to the various bits and pieces of information about CORT that are disclosed elsewhere in the financials. He writes about his businesses in the manner that makes analysts salivate. Charlie's discussions are very thorough, but he does not change a word in the report from year to year unless there is some reason to change it.  This is the kind of management discussion and shareholder letter that analysts dream about. It conveys only meaningful information in a form that is consistent from year to year.

About CORT’s prospects in 2008, Charlie said this: (emphasis added) The furniture rental business is dependent on economic growth, and the recent economic contraction has contributed to a weakening of the furniture rental business. However, CORT has continued to make several selective acquisitions since it was purchased by Wesco, and it is believed that CORT is now better positioned to benefit from job growth and any corresponding economic expansion.

Compare this to what he said in 2007: CORT’s operations are subject to economic cycles. We are pleased with CORT’s progress in the past few years; however, we believe that it will likely suffer its share of the downturn as we enter a period of economic contraction. CORT is now a stronger company than it was when acquired by Wesco, helped by several “tuck-in” acquisitions, and poised towards long-term growth despite periodic bumps to be encountered along the way. Because CORT has made several selective acquisitions since it was purchased by Wesco, it is believed that CORT is now well positioned to benefit from domestic job growth and any corresponding economic expansion.

And in 2006: We are pleased with the progress CORT made in the past two years. We are cautiously optimistic that, in future years, we will be able to look back to the recent past and consider it merely a cyclical aberration in CORT's growth. We note, however, that the number of furniture leases outstanding has been slightly declining in each of the past two years.

What’s the difference? Charlie a) stressed the business’s cyclicality in 2006 and 2007 and omits this in 2008; and b) seemed more optimistic about its prospects in 2006 and 2007 than now (“well” positioned rather than 2008’s “better positioned” after acquisitions) and c) adds reference to dependence on economic growth in 2008.

Interpretation? Charlie is telling you, in a straightforward way, that CORT’s problems now look secular, not cyclical. That also is the logical conclusion from its flat sales, despite acquisitions, and its long-term decline in earnings during a protracted “bubble” economy. You have to consider these facts in light of the recent op-ed by Charlie, “Basically, It’s Over,” which describes his pessimism about the economy in his own words.

I draw a couple of conclusions from this. First, Charlie is saying that CORT earnings may not return to peak levels, or at least not anytime soon. Second, he may be considering the need for a goodwill writedown. Last year CORT was carrying $277.7 million of goodwill, most of which was acquired in the original acquisition. In each annual report, Charlie has discussed at least briefly the goodwill impairment test for CORT, and has sometimes described its goodwill layers in detail. Berkshire’s report this year does not mention a goodwill writedown at CORT, so we may infer that it did not happen yet (?). But you may want to pay attention to what Charlie says about CORT’s goodwill this year.

Meanwhile, we can draw some inferences about XTRA from what Charlie is saying about CORT. As you can see from the numbers, XTRA's fortunes tend to mirror CORT's. In fact, the question of goodwill writedowns might apply to other businesses whose downturns could be viewed as secular, not cyclical. CORT is probably one of the more extreme examples. I don’t expect Berkshire to be writing off big chunks of goodwill. I do think corporate America will be facing this issue in spades, and Berkshire may eventually have to deal with it on some level in some of its businesses.