Berkshire Hathaway (BRK.A, BRK.B) reported first-quarter results after the close on Friday. While Warren Buffett covered the headline figures for a few minutes at the annual meeting, it’s always important (and interesting) to take a deeper dive into the 10-Q (filing). With that, let’s get started.
Overview
Berkshire ended the first quarter with $58 billion in cash, compared to $72 billion three months earlier. The most noteworthy item in the quarter was the acquisition of Precision Castparts (PCP, Financial), which drew ~$32 billion from Berkshire’s coffers on Jan. 29 (a slightly lower figure is shown in the cash flow statement to account for the net cash acquired in the Duracell deal). The reported change in cash on the balance sheet ($14 billion) is less due to incremental long-term borrowings (which were ultimately used to repay the credit agreement associated with the PCC deal) and more than $7 billion in cash from operations generated in the quarter.
The value of fixed income securities on the books declined marginally to $24.5 billion. As we’ve seen quarter after quarter, the vast majority of the fixed income portfolio continues to weigh toward the short end: More than 75% of the portfolio has a maturity of five years or less.
There wasn’t much action in the equity portfolio in the quarter, with net purchases of less than $1 billion ($3 billion in purchases less $2.2 billion in sales). The four largest positions – Wells Fargo (WFC), Coca-Cola (KO), IBM (IBM) and American Express (AXP) – accounted for 60% of the equity portfolio at quarter end (the total fair value of the equity portfolio was $106 billion). The change in fair value for each of those four positions, as compared to their year-end values and their stock price movements in the first quarter, suggests limited purchases in the first quarter.
It’s worth noting that Berkshire’s investment in Kraft Heinz (KHC) common isn’t in this bucket. The 26.8% of Kraft Heinz owned by Berkshire is held on the books at $15.8 billion – or $10 billion less than the market value of the position at quarter end. Over time, Berkshire’s Kraft Heinz investment will become another driver of the widening gap between book value and intrinsic value (Kraft Heinz preferred stock, on the books for $7.7 billion, will likely be redeemed in June for $8.3 billion).
Business summary
Berkshire reported $6.5 billion in pretax income in the quarter, down 15% from a year ago. The biggest shortfalls relative to the prior-year period were in reinsurance and at BNSF.
As always, the results include some one-time items. For example, Berkshire booked a $1.9 billion after-tax gain in the first quarter related to the Duracell transaction with Procter & Gamble (PG). This was offset by an $800 million loss from the derivatives book, reflecting a change in fair value for Berkshire’s equity index put option contracts (European-style options with an average remaining life of nearly five years). If we adjust for items like these in both periods, pretax earnings declined roughly 10% in the first quarter versus the year-ago period.
Segment results
The insurance businesses reported $350 million in pretax income in the first quarter, down more than 50% from the year-ago period. The primary driver was a ~$540 million swing at Berkshire Hathaway Reinsurance Group (from a $460 million profit to an $80 million loss). At both GenRe and BHRG, new business is being written by competitors at prices that management views as inadequate. As long as that's the case, premium volumes will continue to decline.
While we’ve seen some variability in the past few quarters, GEICO continues to be a real gem for Berkshire. Earned premiums increased 12% in the quarter to $6 billion; the year-over-year increase reflects 4% growth in auto policies-in-force (PIF), with the remainder due to higher rates (to account for both higher frequency and severity). Loss and LAE remained around 80% of earned premiums; after accounting for underwriting expenses (16% of earned premiums), GEICO reported an underwriting margin of roughly four points (96% combined ratio).
The insurance businesses reported $919 million in net investment income, an increase of 5%. As was highlighted above, Berkshire continues to focus on safety over current yield, holding billions in excess cash and short duration, highly rated fixed income securities. As you think about this, remember that an incremental percentage point on $10 billion is worth $100 million a year. At some point, the tens of billions in cash on Berkshire’s books will be put to better use.
Revenues at Burlington Northern declined 15% in the quarter, with volumes and average revenue per car falling 5% and 10%. Operating expenses didn’t keep pace, which pushed the operating ratio up to 68.5% (up 220 basis points from a year ago). Pretax earnings fell by 25% to $1.26 billion. Just like at Union Pacific (UNP), coal volumes fell by more than 30% in the quarter. Low natural gas prices and outsized utility coal inventories will make the remainder of 2016 tough for the rails (coal isn’t the only business line facing pressure either).
The businesses within Berkshire Hathaway Energy (BH Energy) reported $4.1 billion in revenues in the first quarter, down 5% from the year-ago period. The small increase in net earnings for the segment (+5% to $441 million) reflects a falling tax rate, partially attributable to production tax credits from wind-powered electricity generation within Berkshire Hathaway Energy (primarily MidAmerican). The company has made sizeable commitments to new renewable projects that should result in years of additional production tax credits for BH Energy (applicable for the first 10 years from when the facility is placed into service).
The Manufacturing, Service and Retailing segment reported sizeable increases in both revenues and earnings in the first quarter (both up low teens). This growth primarily reflects the inclusion of Precision Castparts in the segment for the last 60 days of the quarter. Adjusted for both PCC and Duracell, revenues and earnings would have been roughly flat year over year.
Finally, Finance & Financial Products profits increased 8% in the quarter to $311 million. A 22% increase in home sales at Clayton Homes drove double-digit revenue and earnings growth, partially offset by smaller items in Finance & Financial Products. Despite some well publicized negative press in 2015, Clayton has continued to post solid business results.
Conclusion
At quarter end, shareholder’s equity was $258.7 billion – up 1.2% from year end. On a per share basis, that’s ~$157,400 per “A” share and ~$105 per “B” share. With the buyback limit currently at 120% of book value, the board has authorized repurchases up to ~$126 per “B” share. In the early weeks of February, the stock traded right around these levels. With the stock now trading in the low $140s per “B” share, Berkshire Hathaway trades at ~1.35x book.
This was a relatively weak start to 2016. In addition, it seems likely that the reinsurance businesses and BNSF will both continue to struggle for the remainder of the year (if not longer). Personally, I can live with that. In the long run, a well-run operation in either of these businesses will do just fine, despite the ups and downs that will come along from time to time. Berkshire shares offer attractive risk-adjusted returns to the long-term investor.
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