On Saturday, Aug. 8, Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) released its earnings report for the second quarter of 2020, which ended on June 20.
Noteworthy developments included a 10% drop in operating earnings year over year, as well as a record $5.1 billion worth of share repurchases in May and June. Investors also get a glimpse of what the conglomerate's overall investing strategy has been like throughout the first half of the year, with Berkshire reporting net sales of equity securities and more funds allocated to U.S. Treasury Bills and fixed maturity securities.
Following the news, Berkshire saw a 1% increase in the price of both B shares and A shares.
Repurchasing shares
When Berkshire changed its share buyback policy in July 2018 to no longer rely on book value, some investors were expecting the conglomerate to step up its share buybacks immediately, but that was not the case. Instead, it was more of an update that the economic environment required, as Buffett and Charlie Munger (Trades, Portfolio) no longer considered book value a good indicator of Berkshire`s value. Specifically, the company wrote:
"Berkshire's common stock repurchase program permits Berkshire to repurchase its Class A and Class B shares any time that Warren Buffett (Trades, Portfolio) (Trades, Portfolio) (Trades, Portfolio), Berkshire's Chairman of the Board and Chief Executive Officer, and Charlie Munger (Trades, Portfolio) (Trades, Portfolio) (Trades, Portfolio), Vice Chairman of the Board, believe that the repurchase price is below Berkshire's intrinsic value, conservatively determined. The program continues to allow share repurchases in the open market or through privately negotiated transactions and does not specify a maximum number of shares to be repurchased. However, repurchases will not be made if they would reduce the total value of Berkshire's consolidated cash, cash equivalents and U.S. Treasury Bills holdings below $20 billion. The repurchase program does not obligate Berkshire to repurchase any specific dollar amount or number of Class A or Class B shares and there is no expiration date to the program."
Given the ongoing pandemic crisis and relative overvaluation in the markets, it seems likely Buffett may have revised his estimate of the minimum amount Berkshire needs to hold in cash and equivalents. However, with few better places to deploy cash during the second quarter, Berkshire stepped up its share buybacks, spending $5.1 billion compared to $2.2 billion in the final quarter of 2019. Berkshire's share prices are down approximately 6% year to date, increasing the value of these repurchases for shareholders.
Buffett has long held that companies should only repurchase shares when they are undervalued and when there is no better way to return capital to shareholders. The increase in share repurchases indicates that the Oracle of Omaha may believe both of these conditions have been met.
Earnings results
Like many companies, Berkshire saw an overall negative impact from the ongoing pandemic and economic downturn, with a decline of approximately 10% year over year for both operating revenue and operating earnings.
The results were driven by a 19% decline in the service and retailing segment, a 20% decline in manufacturing and a 26% fall in BNSF. Berkshire Hathaway Energy's earnings decreased only 5%. The insurance segment, which accounts for about 40% of the company's operating earnings, reported a 4% year-over-year increase.
When looking at the earnings of a company that manages a significant equity portfolio, including Berkshire, Buffett recommends looking beyond net income to operating earnings. The unrealized gains and losses from equity holdings are considered part of a company's earnings, meaning that earnings can fluctuate wildly depending on the movements of the stock market. In his 2019 annual letter to shareholders, Buffett wrote the following:
"Charlie and I urge you to focus on operating earnings, which were little changed in 2019, and to ignore both quarterly and annual gains or losses from investments, whether these are realized or unrealized."
While it is essential to consider operating results to be the truest reflection of what business operations are producing, it is equally important to consider everything else that goes into net earnings.
For example, thanks to the stock market rallies in the U.S., Berkshire received a $31.6 billion tailwind from investment and derivative gains during the quarter, resulting in "net income" of $26.2 billion. Thus, the $10.9 billion goodwill and indefinite-lived asset impairment charges of $10.9 billion did not manage to cause a net loss on paper.
Taking a closer look at the impairment charges reveals that $10 billion was related to Precision Castparts, a manufacturer of components for the aerospace industry. Also included was an equity method share of impairment charges recorded by Kraft Heinz (KHC, Financial). As stated in the earnings report:
"The amounts of the impairment charges were determined based on discounted cash flow methods and reflect our current assessments of the risks and uncertainties associated with the aerospace industry-
The COVID-19 pandemic events will continue to evolve and the effects on our businesses may differ from what we currently estimate. If the effects prove to be worse than is reflected in our current estimates, additional goodwill or indefinite-lived intangible asset impairment charges could be required."
If we were to take investment and derivative gains out of the picture, the conglomerate would have recorded a net loss of $5.35 billion (including the impairment charges) compared to net income of $7.91 in the second quarter of 2019.
An overview of investment activities
While we will have to wait for Berkshire`s 13F filing to know exactly which stocks the company bought and sold during the quarter, there is some important information we can gain from the earnings report.
On the cash flow statement for investing activities, we learn that Berkshire spent $113.16 billion on U.S. Treasury Bills and fixed maturity securities in the first six months of 2020 compared to $66.75 billion in the first six months of 2019.
We also see that Berkshire spent $4.80 billion on the purchase of equity securities for the first half of the year versus $2.83 billion for the first half of 2019. In comparison, the company sold $15.74 billion worth of equity securities in the first half of 2020 and $4.46 billion worth in the same period of last year.
Thus, it would appear that during the first six months of this year, Berkshire has been a net seller of equity securities, instead increasing its allotments to lower-risk assets such as U.S. Treasury bills.
Berkshire's cash, cash equivalents and restricted cash totaled $36.58 billion at the end of the second quarter compared to $45.10 billion a year ago.
According to the statement of quarter-end assets, the company holds $207 billion worth of equity securities, $110 billion in short-term U.S. Treasury Bills and $35 billion in cash and equivalents.
In terms of acquisitions, Berkshire "reached a definitive agreement with Dominion Energy Inc. (D, Financial) to acquire substantially all of Dominion's natural gas transmission and storage business, which includes more than 7,700 miles of natural gas transmission pipelines, about 900 billion cubic feet of operated natural gas storage capacity and partial ownership of a liquefied natural gas export, import and storage facility. The acquisition price will be approximately $4 billion. BHE will also assume approximately $5.7 billion of existing asset-related long-term debt. The acquisition is subject to customary closing conditions and is expected to close during the fourth quarter of 2020.
Conclusion
As many investors anticipated, Berkshire Hathaway has been taking a cautious approach during the first half of the year, seeking more returns through lower-risk assets compared to the same period of the previous year. It also returned a record amount of cash to shareholders through share buybacks, following Buffett's principle of only buying back shares when they are undervalued.
The company continued to be a net seller of equity securities, selling approximately three times as much as it bought and continuing its stance of caution as operating earnings dropped by 10%. As for when Buffett`s next "big deal" will be, it seems the Oracle of Omaha is still waiting for more favorable prices like the Dominion deal.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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