Berkshire Hathaway (BRK.B) reported second-quarter results after the close last Friday, capping off an eventful first half of the year. For the quarter, pretax earnings declined by 35% to $5.85 billion. As always, there are one-time items that we need to account for – in this case, more than $2.5 billion in investment and derivative gains in the prior year period, primarily reflecting the gains related to the Phillips 66 (PSX) and Graham Holdings (GHC) deals from a year ago.
If we move up to the segment results to account for these “lumps,” Berkshire reported pretax earnings of $6.06 billion – down 7.5% from the year ago quarter (year to date, cumulative segment pretax earnings are 4% higher than a year ago). The change versus the prior year reflects weaker results in the insurance businesses – most notably at GEICO.
Operating segments: Insurance
GEICO reported an increase in earned premiums of ~10% in the second quarter, right in line with the first quarter numbers. GEICO continues to take market share from competitors, adding more than half a million (net) auto PIF’s in the first six months of 2015 – roughly ten times greater than the number of PIF’s Allstate’s (ALL) Esurance brand added over the same period.
Strong premium growth was offset by a significant increase in the combined ratio, from ~92% in the year ago period to ~99% in the current period; as a result, GEICO’s pretax underwriting gain plummeted from $393 million to $53 million. The culprit was a substantial increase in the loss and loss adjustment expense (LAE) ratio, which jumped more than seven points to 83.6% of premiums earned. The ratio was pushed higher by increases in frequencies and severities in several of GEICO’s major coverages. The company will push for rate increases to account for these changes, a move that may limit PIF growth in the near term (it’s worth noting other insurers, like Allstate, will also be looking to push rates on rising loss & LAE).
As I recently noted in two articles discussing Warren Buffett (Trades, Portfolio)’s GEICO investment in 1976 and 1980, he was attracted to the company by its staggering cost advantage relative to others in the industry. In the second quarter, GEICO’s expense ratio as a percentage of premiums earned was 15.4% – a half a percentage point improvement versus the prior year. By comparison, Progressive (PGR) reported an expense ratio of 19.4% across their personal lines in the second quarter; Allstate’s expense ratio for its auto businesses (even adjusted for outsized advertising spending at Esurance) was in the mid-20’s. The current issue with loss & LAE expenses is essentially one of timing; the expense line captures GEICO’s competitive advantage in auto – an advantage that will lead to continued share gains over time.
Across the company’s reinsurance businesses, volumes continue to be constrained due to generally inadequate rates. Berkshire Hathaway Reinsurance Group reported a large underwriting loss compared to the prior year, attributable to a $115 million storm loss in Australia and foreign currency transaction losses of nearly $170 million (offsetting gains in the first quarter). BHRG will see a decent bump in premiums in the third quarter, as the company’s quota-share contract with Insurance Australia Group becomes effective.
Berkshire Hathaway Primary Group reported another large increase in earned premiums (+25% from the prior year), driven by across the board volume increases. The pre-tax underwriting gain outpaced premium, as in the first quarter, with the underwriting gain for the first half of 2015 ($378 million) up 60% from 2014. Of the four insurance groups, BH Primary was the only one to report a higher underwriting profit in the quarter or year to date period.
Cumulatively, the insurance businesses reported an underwriting loss of $38 million in the quarter – a swing of $450 million from a year ago (year to date, they’ve reported a pretax underwriting gain of $700 million). This is the first time Berkshire’s insurance operations have reported an underwriting loss (in aggregate) in as long as I can remember. That’s pretty astounding, and says a lot about the collection of insurance businesses Berkshire owns.
Net investment income from the insurance operations fell 13% in the quarter, to $977 million; this was attributable to declines in dividends earned from stocks and from interest on fixed maturity investments (while the total amount of equities didn’t change materially in the quarter, a few billion dollars moved from “Insurance and Other” to “Finance and Finance Products” – I’m not entirely sure why that happened). As it relates to fixed income securities, duration continues to be restrained (~75% of fair value is held in securities that mature within five years); Berkshire has maintained a focus on safety over yield, and is positioned accordingly.
Operating segments: Other
As expected, BNSF had a tough quarter, with revenues falling 6.5% to $5.37 billion (by comparison, Union Pacific (UNP) reported a 10% decline in freight revenues this quarter). The revenue declines were offset by an improvement in expense controls, with the operating ratio improving 360 basis points year over year (to 67.1%). As a result, BNSF was able to report a 4.4% increase in pretax profits. Year to date, pretax earnings at BNSF have increased more than 20%, to $3.2 billion; compared to 2013 (to account for service issues in 2014 that makes the results a misleading comparison), pretax earnings have increased roughly 10% a year.
BH Energy had another solid quarter, with most businesses reporting revenues and profitability that were largely in-line with the prior year. The two standouts were “Other,” where earnings jumped ~50% due to the inclusion of AltaLink (down slightly otherwise), and “Real Estate Brokerage,” where revenues have jumped more than 20% in the quarter and year to date on a higher number of closed transactions and higher average selling prices (as well as prior year acquisitions). Overall, BH Energy reported a ~12% increase in pretax earnings in the quarter.
Manufacturing, Service and Retailing reported a 5% increase in pretax earnings in the second quarter, reflecting broad improvement in the business lines. It’s still early, but Van Tuyl is starting to make an impact on the financial statements: it is largely responsible for the 75% increase in Service & Retailing revenues (to $6.3 billion) in the second quarter. While earnings growth was constrained by issues elsewhere in the segment (most notably at NetJets), it’s a safe bet that pretax earnings will ultimately move higher as well as Van Tuyl grows over time.
Conclusion
Berkshire ended the quarter with $66.5 billion in cash and equivalents. Against ~$14 billion in cash flow from operations (up 18% year to date), Berkshire has spent ~$700 million on fixed income investments (net), ~$2.5 billion on equity investment (net), ~$6.8 billion on capital expenditures (up 12% year over year), and ~$4.5 billion on M&A – most notably Van Tuyl. In total, these uses exceeded cash generated from operations in the first half by ~$500 million.
Another $5.26 billion was spent on the first day of the third quarter (July 1) to acquire newly issued shares of Kraft Heinz (KHC) – with Berkshire owning 26.9% of the combined entity.
The Precision Castparts (PCP) deal will pull another ~$23 billion from Berkshire’s coffers (Warren suggested they’ll borrow to fund the remainder), and add another ~$2.5 billion in pretax profits to the income statement. Between large acquisitions and investments in Berkshire’s current stable of businesses (capital expenditures and bolt-on M&A), meaningful amounts of capital are being put to use – and adding substantially to Berkshire’s earnings power.
At quarter end, book value on “B” shares was just shy of $100 per share. The stock trades ~20% higher than where shares could be repurchased under the current authorization. If Mr. Market was feeling generous, I would happily buy more BRK.B near those levels; Berkshire continues to be my largest position – and that won’t be changing any time soon.
