2006: How should investors value NetJets and BerkshireRe?

AUDIENCE MEMBER: I’m Marc Rabinov from Melbourne, Australia. I had a two-part question on the 2005 annual report.

Firstly, NetJets is a substantial part of our operations. Unfortunately, its value is obscured by losses in recent years, and I can’t estimate its value from the report. I was hoping you might be able to help me on that.

The second thing, how do I value the Berkshire Hathaway reinsurance group in light of the deferred charges on retroactive policies? Thank you.

WARREN BUFFETT: The second question, that — about the — we have an item that’s about $2 billion on the asset side.

I think I’m addressing the question of deferred charges on retroactive policies. That reflects the fact that those retroactive policies, where we insure — we reinsure, in effect — the losses that somebody has already incurred, although they may not know how much they’ve incurred, and we have limits on these.

But we set up a factor that, essentially, recognizes the fact that we will have that money for a considerable period of time. We set up an asset, and that gets amortized over the length of time we have that asset.

That number, which I think has gotten as high as 3 billion over the years, since we haven’t done any of those — any big contracts recently, is down around 2 billion.

There’s nothing magic about that. It means that we’re going to amortize that 2 billion over the lifetime of the use of the funds, and we think we’ll make money, net, during that time.

But we misguessed on one a couple years ago and took a $100 million charge, for example, in the first quarter of — I think it was the year before last.

The other question was about NetJets, wasn’t it, Charlie?

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: And I didn’t get it all. I love the Australian accent of our gecko, but I didn’t pick up the exact nuances of what you asked.

But my guess is you asked about the earnings and operation of NetJets.

And NetJets has grown rapidly, and so far, our expenses have grown faster than our revenue.

We’ve got the top service in the world. We’ve got, really, the only worldwide service. We have a very strong position, particularly in larger airplanes.

But I’d have to tell you that I did not anticipate — I thought we would have economies of scale, to some degree, and so far you can almost argue that we’ve had diseconomies of scale.

And our expenses, particularly last year, you know, basically got out of hand. And there are various reasons I could give you for that. All I can tell you is, it’s being addressed.

Rich Santulli, who runs that operation, you could not have a better operator. He loves NetJets. He works at it 16 hours a day. He’s — there’s nobody in the world I would have run that except for Rich.

I think it’s an important service. It’s tough to make money with airplanes. They’re capital-intensive. We’ve had fuel do what it has, although that’s a pass-through to people, but it still affects the business.

And I would — I had expected we would be profitable last year, and as I put in the annual report, I was dead wrong.

I think we will be profitable before long, but you should take my prediction there with — probably with — a certain amount of skepticism until it actually happens because I, like I say, I’ve been wrong.

We’ve got a good business in that almost anybody looking for a large plane on a fractional jet program comes to us. We are able to get full price for our service. But there were a variety of inefficiencies last year which added up to a lot of dollars.

And you know, you’re entitled to hold me accountable for the fact that we paid a lot of money for the business many years ago, and we haven’t earned any money since.

And we’ve got a much bigger business now, probably five times or so the size of the business we bought. That may be some solace to — I looked at Raytheon’s figures the other day. They lost a lot of money, and they have the second largest operation.

They sell their — they sell airplanes too, so they may not feel it the way I do.

But if I had to bet one way or the other, I would bet we will be making money before long, but I’ve lost that bet in the past.

Charlie?

CHARLIE MUNGER: Yeah. The product integrity is so extreme between flight safety and NetJets. The pilots are subjected to real oxygen withdrawal in the course of the safety training so they will recognize the subtle sensation that you get, and not everybody does that. It’s an expensive, difficult thing to do.

In place after place after place, that system is very obsessive about product integrity, and it’s my guess that that obsession, in due course, will be rewarded.