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The Science of Hitting
The Science of Hitting
Articles (454) 

Berkshire Hathaway: Buyback Limit to $146 per B Share

A look at the conglomerate's second-quarter results

Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) reported second-quarter results last Friday. Net income was $4.3 billion in the quarter, a decline of 15% from the year-ago period. As always, we need to make some adjustments to try and normalize the results. For example, if we exclude investment and derivatives gains and losses, as well as the change in corporate interest expense from the year-ago period (which primarily reflects the impact from movements in foreign currency exchange rates on euro denominated debt), earnings increased marginally. Those changes are timing issues. For an apples-to-apples comparison, we should also account for the impact of business decisions that diminish reported profitability but make sense in the long term (for example, retroactive reinsurance agreements, which I will discuss in a moment). Looking at the headline numbers on their own will not get the job done if you truly want to understand the underlying trends in Berkshire's businesses.

The five largest positions at quarter-end – Wells Fargo (NYSE:WFC), Apple (NASDAQ:AAPL), The Coca-Cola Company (NYSE:KO), American Express (NYSE:AXP) and IBM (NYSE:IBM) – accounted for more than 60% of Berkshire’s $137 billion in equities. For now, that list does not include Bank of America (NYSE:BAC). That should change in the coming months: Berkshire announced at the end of June that it intends to exercise the Bank of America warrants, at which point it will own 700 million shares of common stock – worth $17.7 billion at today’s stock price.

In the first six months of 2017, Berkshire generated $26.6 billion in cash flow from operations. Capital expenditures were $5.1 billion during the first half of 2017, with $1.8 billion invested in BH Energy (-14%) and $1.5 billion invested in BNSF (-25%). There hasn’t been much M&A activity, with less than $2 billion spent on bolt-on acquisitions. The net result was a significant increase in dry powder, with Berkshire ending the quarter with nearly $100 billion in cash and short-term bonds. It's worth remembering Warren Buffett (Trades, Portfolio) said at this year’s annual meeting that $20 billion is an “absolute minimum,” and that they're unlikely to go below $25 billion. Without incurring additional debt, that still leaves $70 billion to $75 billion for Buffett and Charlie Munger (Trades, Portfolio) to invest (if the Oncor deal gets completed, that will take care of $10 billion).

Insurance businesses

Berkshire’s insurance businesses reported a small underwriting loss in the second quarter, compared to a $500 million pre-tax gain in the year-ago period. The primary driver was Berkshire Hathaway Reinsurance Group, which reported a $330 million underwriting loss from retroactive reinsurance. For the full year, Berkshire expects BHRG to report a pre-tax underwriting loss of nearly $1 billion from deferred charge amortization, primarily due to the reinsurance agreement with American International Group (NYSE:AIG) announced in January. The economics of this transaction is a good example of why you cannot take Berkshire’s reported results at face value.

Geico continues to put up solid results, with earned premiums up 15% in the quarter. The insurance giant added nearly 900,000 voluntary auto policies in force (PIF’s) over the first six months of 2017, driving a 10% increase in PIFs. While Geico’s underwriting gain declined, this reflects the first-year impact of new customers (gaining market share) on the profit and loss statement. We cannot say for sure either way, but I would bet the results for Geico’s seasoned business improved during the quarter.

Earned premiums at Berkshire Hathaway Primary Group saw a mid-teens increase in the second quarter and year to date. The combined ratio improved by roughly two points in the first half of the year, resulting in a 42% increase in pre-tax underwriting income (to $420 million).

At the end of the June, the float attributable to Berkshire’s insurance businesses was $107 billion – an increase of 17% since the start of the year. Buffett has warned investors numerous times a decline in float may be on the horizon; fortunately, 2017 will not be the year it begins.

Non-insurance businesses

Revenues increased 15% at BNSF, driven by a rebound in coal (revenues up 39% year over year). As I have noted in previous articles, the railroad is lapping a soft comparison after a difficult 2016. Through the first six months, volumes at BNSF have climbed 8%, with average revenue per car increasing 4% (due to fuel surcharges and positive mix). During the quarter, the operating ratio improved to 65.8%, driving a more than 20% increase in operating income (to $1.8 billion).

Berkshire Hathaway Energy (BHE) reported $4.6 billion in revenues for the second quarter, an increase of 8%. Through the first six months of the year, net earnings have increased 10% on a small single-digit increase in operating income, reflecting the benefit of production tax credits on its tax rate (for the first six months of the year, BHE’s tax rate fell five points to 11%).

Manufacturing, Service and Retailing (MSR) reported an 11% increase in earnings in the quarter, reflecting broad-based improvements in the businesses (notable exceptions were CTB, Lubrizol and McLane). It is worth pointing out they were lapping one-time charges in the Building Products business, which made the results (31% earnings growth) appear stronger than they were.

Lubrizol took a pre-tax charge of $190 million in the quarter related to the disposition of an underperforming business (bolt-on deal from 2014); that is on top of the $365 million charge taken in 2016 for the disposition of another underperforming business (which Buffett called a “big mistake”). It sounds like the struggles for Lubrizol, acquired for $9.7 billion in 2011, continue.

Conclusion

Book value increased 6% in the first half of the year to $122 per B share. The repurchase authorization (up to 120% of book value) now allows for repurchases at $146 per B share.

Holding $100 billion in cash and short-term bonds is unenjoyable; interest rates have remained low and stock prices have continued their incessant climb higher. With that said, I continue to believe Berkshire’s fortress balance sheet offers significant optionality. At some unknown point in the future, I think it will be used to create meaningful per-share value for investors; I am willing to wait.

Disclosure: Long BRK.B, WFC and IBM

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 a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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