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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway Buyback Limit Crosses $140 Per Share

Following the shareholder meeting, a closer look at Berkshire's 1st-quarter results

Berkshire Hathaway (BRK.A) (BRK.B) reported first-quarter results after Friday’s close. While Warren Buffett (Trades, Portfolio) covered the headline figures for a few minutes at the annual meeting, it’s always important (and interesting) to take a deep dive into the quarterly filing.

With that, let’s begin.

Berkshire ended the quarter with more than $90 billion in cash and equivalents, a meaningful increase from three months earlier. The largest driver of this increase was a large cash payment that Berkshire received from AIG (AIG) in early February.

Compared to $18.3 billion in cash flow from operations, Berkshire spent $7.1 billion (net) on equity purchases, $2.4 billion on capital expenditures and $1.6 billion on acquisitions.

The value of fixed income securities held on the balance sheet declined marginally to $23 billion. As we’ve seen quarter after quarter, Berkshire’s continues to hang out at the short end of the curve: ~85% of the portfolio has a maturity of five years or less.

There was a lot of action among the “top five” equity positions, which collectively account for ~65% of Berkshire’s common stock investments. The company’s Apple (AAPL) stake was worth more than $19 billion at the end of the quarter, compared to just $7 billion three months earlier. IBM (IBM) went the other direction, with the position worth $11.2 billion at the end of the first quarter, compared to $13.5 billion at year-end 2016; based on recent commentary from Buffett (and weak performance by the stock), this value is likely to be even lower at the end of the second quarter.

As I’ve noted previously, Berkshire’s investment in Kraft Heinz (KHC) isn’t included in this bucket. The position, which is held on the books at $15.4 billion, was worth nearly $30 billion at the end of the quarter. The same is true for “Other” investments, most notably the 700 million Bank of America (BAC) warrants that Berkshire holds; currently, the fair value of Berkshire’s “Other” investments exceeds its carrying value on the balance sheet by more than $10 billion.

Business summary

Berkshire reported $5.7 billion in pretax income in the quarter, down 12% from a year ago. The biggest shortfall relative to the prior-year period was in insurance, where the underwriting results swung by ~$700 million. As always, there are other one-time items to adjust for, most notably the investment and derivative gains and losses. If we simply back out that line item, net earnings declined 5% from the prior-year period. As we’ll see when we discuss the segment results, there are other factors that investors should consider. If you accept the adjustments I use, “normalized” earnings increased mid- to high single digits in the first quarter.

Segment results

The insurance businesses reported a pretax underwriting loss of ~$380 million in the quarter, compared to a gain of ~$340 million in the year-ago period. The primary driver was Berkshire Hathaway Reinsurance Group, where the incremental underwriting loss exceeded half a billion dollars. Roughly $270 million of losses related to prior years’ events (“unanticipated reported claims from hurricane and earthquake events in 2016”).

Another $260 million of pretax losses came from the “Retroactive Reinsurance” business, which deserves more discussion. In the first quarter, National Indemnity agreed to indemnify AIG on a book of business for 80% of up to $25 billion in losses (excess of $25 billion retained by AIG). In exchange, AIG made a cash payment to National Indemnity of $10.2 billion.

In the accounting for this deal, Berkshire must record a deferred charge amortization expense to account for the losses it ultimately expects to be responsible for. For the entirety of fiscal 2017, it is estimated this expense will be just shy of $1 billion. While the deal has a negative impact on reported profits, particularly in the short term, it’s likely Berkshire has entered into a deal with favorable long-term economics (I’m basing that on its experience with these types of transactions as well as the limited competition it faced in completing the deal). If you’re trying to think intelligently about the underlying economics of Berkshire’s insurance businesses, relying solely on GAAP accounting doesn’t get the job done.

We see another example when we look at GEICO. Earned premiums increased 13% in the quarter, with auto policies-in-force (PIF) climbing 9% year over year. As Buffett noted at the annual meeting, GEICO added roughly 700,000 net PIFs in the first four months of 2017 – the largest gain he can ever remember for that period of time. With higher rates working through the auto insurance industry (to account for higher loss trends), consumers are incentivized to shop around when they’re hit with “sticker shock” on rate renewals. This is the ideal environment for a low-cost provider like GEICO to win new business. Buffett discussed this at the annual meeting:

“This is a wonderful period for us at GEICO. Some of our major competitors have decided to intentionally cut back on new business because new business carries with it a significant loss in the first year so when you write a lot of new business you’re going to lose money on that portion of the business that year. We wrote a lot of new business, and at least two of our competitors announced they are lightening up for a while on new business because they did not want to pay the penalty of the first-year loss. That’s made to order for us so we just put our foot to the floor and try to write as much good business as we can.”

The trade-off is a reduction in near-term profits in exchange for new business that clearly creates incremental value for BRK shareholders. In the first quarter, this meant that GEICO’s underwriting gain fell more than one-third, to $175 million. To borrow a phrase from Tom Russo (Trades, Portfolio), GEICO has the “capacity to suffer” in the short term. Shareholders should hope that the current environment holds, giving GEICO additional opportunities to win new customers.

Looking beyond insurance, Burlington Northern had a good quarter, with revenues up 9% on an increase in volumes (6.4%) and average revenue per car (2.7%). Operating expenses increased at a similar pace, largely due to higher fuel costs. Based on Union Pacific’s (UNP) first-quarter results, there were likely some expenses associated with difficult weather as well (this was not specifically mentioned in Berkshire’s 10-Q). Pretax earnings increased 7% to $1.35 billion.

The businesses within Berkshire Hathaway Energy (BH Energy) reported $4.3 billion in revenues in the first quarter, up 3.5% from the year-ago period (helped by 19% top-line growth in the “Real Estate Brokerage” business). Despite the small increase in revenues, net earnings climbed double digits, reflecting the continued impact of production tax credits (primarily wind-production from MidAmerican). In the first quarter, the effective tax rate was less than 10%.

The Manufacturing, Service and Retailing segment reported more than $30 billion in revenues, an increase of 7% from the prior-year period. This growth still reflects the timing benefit from the inclusion of PCC and Duracell. Pretax earnings were up marginally, inclusive of a loss of $184 million from the disposition of an underperforming business Lubrizol acquired in 2014.

Finally, Finance & Financial Products profits declined by low single digits in the quarter. Continued growth at Clayton Homes, where units and revenues increased 20% and 31%, was offset by weakness in Transportation Equipment Leasing (railcars, trailers, cranes and other products). As a reminder, this segment accounts for less than 10% of Berkshire’s earnings.

Conclusion

In the first three months of 2017, book value per “B” share increased 3.5% to ~$119 per share. With the buyback limit currently at 120% of book value, the board has authorized repurchases up to ~$142 per “B” share. As of Monday’s close ($165 per share), Berkshire Hathaway is trading at roughly 1.4x book. The stock needs to fall less than 15% to breach the repurchase ceiling.

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

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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