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The Science of Hitting
The Science of Hitting
Articles (429) 

Berkshire Hathaway: Repurchase Limit Crosses $135 Per Share

A review of company's 2016 results

In addition to the release of Warren Buffett (Trades, Portfolio)’s shareholder letter this past weekend, Berkshire Hathaway (BRK.A) (BRK.B) reported full-year fiscal 2016 financial results as well – so let’s dive in.

Berkshire reported $24 billion in net income in 2016, comparable to 2015. On 2.466 billion equivalent B shares, that’s equal to roughly $9.75 per share in 2016 reported earnings.

I personally make a few adjustments to try and normalize these results. First, I largely back out the roughly $6.7 billion in investment and derivatives gains included in net income (replaced by roughly $2.3 billion in income, which is equal to ~50% of the trailing five-year average). Second, I add back unreported earnings from the “Big Five” – The Coca-Cola Co. (KO), American Express (AXP), Wells Fargo (WFC), IBM (IBM) and Apple (AAPL); by my math, there was roughly $3.1 billion (aftertax) in unreported earnings from these five holdings (the Apple stake is adjusted to reflect the disclosures Buffett made Monday morning on CNBC). Finally, I make a few other adjustments that I believe are reasonable (most notably an estimate of earnings power on the excess cash Berkshire holds and higher depreciation expense at BNSF to account for the real maintenance cost attributable to the railroad). All in, my math estimates that Berkshire Hathaway’s normalized earnings power is approaching $10 per B share.

For the full year, Berkshire generated $32.5 billion in cash flow from operations (a decade ago that number was ~$10 billion). Roughly $13 billion was reinvested in the business as capital expenditures with $5.1 billion and $3.8 billion spent at Berkshire Hathaway Energy and Burlington Northern Santa Fe. Another $31.4 billion was spent on acquisitions (largely Precision Castparts [PCP] but also $1.4 billion for bolt-on acquisitions). The net shortfall from these three buckets (roughly $12 billion) was covered by incremental long-term debt issued at low single-digit interest rates.

Insurance businesses

Berkshire’s insurance businesses reported a pretax underwriting gain of ~$2.1 billion in 2016, an increase of 16% from 2015. The gain was attributable to Berkshire Hathaway Reinsurance Group, where underwriting income nearly doubled, to $822 million. Within BHRG, “Retroactive Reinsurance” losses declined from $469 million to $49 million. It’s difficult to say anything meaningful based on headline changes in the reported reinsurance results from year to year. As an example, the retroactive reinsurance agreement recently signed with American International Group (AIG) – for which Berkshire received a premium of $10 billion will generate $375 million in pretax deferred charge amortization losses for BHRG in 2017. Focusing only on the losses without considering the economics of the whole deal leads you to faulty conclusions.

GEICO had another solid year of growth in 2016, with earned premiums up 12%. For the year, GEICO added nearly 1 million net auto policies in force (PIFs), compared to a net 700,000 additions in 2015. While the loss ratio increased in 2016, pressuring profits, this is a reasonable trade-off in the short term (it’s worth noting that storm-related losses at GEICO increased by $260 million in 2016 as well). GEICO has a sustainable competitive advantage that becomes more powerful in an environment where consumers are increasingly cost conscious. Management has proven adept at managing the business for the long-term. GEICO will emerge from the industry’s current challenges in a stronger position than it started.

Berkshire Hathaway Primary Group continues to report solid numbers as well, with earned premiums increasing to $6.3 billion in 2016 (up more than 40% from 2014). The combined ratio was just shy of 90%, resulting in more than $650 million in pretax underwriting income.

At the end of 2016, the float attributable to Berkshire’s insurance businesses exceeded $91 billion (compared to $70 billion five years). Inclusive of the AIG deal discussed a moment ago, Berkshire’s float exceeds $100 billion. In his letter, Buffett restated his belief that a decline in float, should it occur, will be very gradual – “at the outside no more than 3% per year.”

Noninsurance businesses

2016 was a tough year for rails generally and BNSF specifically, with revenues falling 10% on comparable declines in volumes and average revenue per car. The coal business took a beating in 2016, with volumes and revenues down 21% and 27%, respectively; even after declining by more than one-quarter, the coal business still accounted for ~17% of BNSF’s revenues in 2016. The operating ratio increased in the face of sliding revenues (meaning lower operating margins), resulting in a 16% drop in earnings. 2016 was undoubtedly a struggle for BNSF; if guidance from Union Pacific (UNP) is any indication, 2017 should be a step in the right direction.

Berkshire Hathaway Energy reported $17.9 billion in 2016 revenues, a low single-digit decline from 2015. A small increase in pretax income ended up as a 7% increase in aftertax profits, partly attributable to a lower effective tax rate (down two points to 14%). There’s plenty of room to run here: my research suggests production tax credits from wind-powered electricity generation will be a material tailwind to BHE’s net income over the coming years (MidAmerican owns more wind-powered capacity than any other rate-regulated electric utility in the country).

Berkshire’s Manufacturing, Service and Retailing (MSR) businesses reported ~$5.6 billion in earnings in 2016, an increase of ~$1 billion versus the prior year (both measures exclude amortization of intangibles). The entirety of the gains came from the Manufacturing bucket due to the inclusion of Precision Castparts; pretax Manufacturing earnings declined in 2016 when Precision Castparts is backed out (largely due to a $365 million loss from the disposition of part of Lubrizol’s business in the fourth quarter). MSR was also impacted by other one-time costs, such as $110 million in acquisition/integration and transition costs from the Duracell deal.

Finally, Finance & Financial Products revenues increased 10% in 2016, with earnings up 4%. Clayton Homes’ reported a solid year, selling more than 42,000 units (an impressive 25% increase from 2015). Strength in manufactured homes from Clayton offset less impressive results in the remainder of the business (notably at Marmon).

Conclusion

Book value increased by ~11% in 2016 to $115 per B share (trailing three-year CAGR of 8%). The repurchase authorization (up to 120% of book value) enables Buffett to buy back stock at ~$138 per B share. As he noted in the shareholder letter, “purchases at that level clearly bring an instant and material benefit to continuing shareholders”. Starting at ~$170 per share, that would require a pullback of ~20%. Shares are reasonably valued at current levels.

Berkshire’s fortress balance sheet continues to offer significant optionality; at some unknown point in the future, it will be used to create meaningful per-share value for investors. My favorite quote from Bufett's shareholder letter addressed this in a roundabout way:

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

Disclosure: Long BRK.B, IBM and Union Pacific.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus.

As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.

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Comments

AlbertaSunwapta
AlbertaSunwapta - 3 weeks ago    Report SPAM

I'd love to see a summary of Buffett's actual comments on the buyback.

As I recall, when Buffett first announced his buyback ratio he didn't say too much about what actions he'd actually take if the price hit the ratio. (Everyone started saying that Buffett had put a "floor" under the price. My thinking was that he wasn't providing a floor price because he might just see it as an entry point, and so the price could fall substantailly below the ratio. If the market is entering a panic, why rush, just start slowly accummulating at 'possibly' cheaper and cheaper prices.)

In short order however, Buffett added some clarity saying that he'd be an 'agressive buyer' if the price fell below that ratio. Well, that seemed more like setting a floor price to me - within acceptable and legal exchange / trading limits.

Since then I haven't heard much.

Just recently though, in the current report the fact that Buffett is again discussing it makes me wonder if he's one, thinking beyond his own demise and/or two, that at current market levels a 'very dramatic' market repricing might be in order and it might just provide an opportunity within his term to commence a buyback. It also seems that he's sending a subtle but clear message to existing shareholders not to get caught up in a panic of a market crash where often buyers vanish. (I think he's acknowleging for the first time that the pricing could crash through the 120% ratio towards the downside.)

Here's Buffett's exact words:

"The authorization given me does not mean that we will “prop” our stock’s price at the 120% ratio. If that level is reached, we will instead attempt to blend a desire to make meaningful purchases at a value-creating price with a related goal of not over-influencing the market.

To date, repurchasing our shares has proved hard to do. That may well be because we have been clear in describing our repurchase policy and thereby have signaled our view that Berkshire’s intrinsic value is significantly higher than 120% of book value. If so, that’s fine. Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low. Furthermore, our buying out “partners” at a discount is not a particularly gratifying way of making money. Still, market circumstances could create a situation in which repurchases would benefit both continuing and exiting shareholders. If so, we will be ready to act." - Warren Buffett (Trades, Portfolio), 2016 shareholder letter

http://www.berkshirehathaway.com/letters/2016ltr.pdf

The Science of Hitting
The Science of Hitting - 3 weeks ago    Report SPAM

Alberta,

The one constant I've seen in the commentary is that Warren clearly believes 120% of book value is well below intrinsic value. For the outside investor, buying at a small premium (call it 125% - 130% of book value) seems like shooting fish in a barrel (as Warren noted in the 50th anniversary letter, "Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time"). I'm still kicking myself for not buying more BRK.B in early 2016...

Thanks for the comment!

Please leave your comment:


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