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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway: Buyback Limit to $150 Per 'B' Share

A look at the conglomerate's third-quarter results

Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) reported third-quarter results last Friday. Net earnings were $4.1 billion, a significant decline from a year ago (-43%). As always, we need to make some adjustments to try and normalize the results. For example, in the insurance businesses, Berkshire incurred after-tax underwriting losses of nearly $2 billion (cumulative) from three hurricanes (Harvey, Irma and Maria) and an earthquake in Mexico. In addition, investment and derivatives gains (which can be lumpy from quarter to quarter) was a $1.7 billion headwind compared to Q3 2016. If we look at the results excluding insurance underwriting and investment and derivatives gains, operating earnings increased by roughly 7% in the third quarter.

The five largest positions at quarter-end – Wells Fargo (NYSE:WFC), Apple (NASDAQ:AAPL), The Coca-Cola Co. (NYSE:KO), Bank of America (NYSE:BAC) and American Express (NYSE:AXP) – accounted for more than 60% of Berkshire’s $158 billion in equities. It is pretty amazing that Apple was only added to Berkshire in May 2016 – and it was not even Warren Buffett (Trades, Portfolio) buying at the time (as he later explained on CNBC, Todd Combs or Ted Weschler bought the first $1 billion). Fast-forward 18 months: the value of the Apple position is approaching $25 billion.

Through the first nine months of the year, Berkshire generated more than $37 billion in cash flow from operations. Over the same period, capital expenditures and M&A (mergers and acquisitions) have used $8.4 billion and $2.6 billion respectively. That leaves a lot of dry powder, with Berkshire’s cash ($42.6 billion) and short-term investments ($66.5 billion) balance crossing $109 billion (just to be clear, that's not excess cash; that includes what is needed to run the businesses on a day to day basis). I do not have a clue on the timing, but you should not be surprised if you wake up one morning to find Berkshire has announced an acquisition with a price tag in the tens of billions of dollars.

Insurance businesses

Berkshire’s insurance businesses reported a significant underwriting loss in the quarter due to the significant cat losses discussed above. The primary driver was Berkshire Hathaway Reinsurance Group, which reported a $1.3 billion underwriting loss in the quarter (roughly 75% from the hurricanes and earthquake and roughly 25% from the retroactive reinsurance agreement with American International Group (NYSE:AIG) that became effective earlier this year).

GEICO continues to impress, with earned premiums up mid-teens in the quarter and year to date. The insurance giant has added more than 1.1 million voluntary auto policies in force (PIFs) over the first nine months of 2017. While GEICO’s underwriting gain declined (largely due to the impact of Hurricanes Harvey and Irma), we saw another notable improvement in the expense ratio (190 basis point improvement over the year-ago period to 13.6% of earned premiums). Despite a huge advertising budget, GEICO is still able to undercut its competitors due to significantly lower operating costs; hopefully these results continue for a long, long time.

Earned premiums at Berkshire Hathaway Primary Group increased 12% through the first nine months of year. Despite incurring $225 million of losses related to the hurricanes, the combined ratio has only increased by 170 basis points through the first nine months of the year (to 91%).

At the end of the quarter, the float attributable to Berkshire’s insurance businesses was $113 billion (increase of 24% since the start of the year). Notably, within investment income for the insurance businesses, interest increase increased more than 50% in the quarter to $344 million; we are seeing some impact from higher interest rates on short-term investments in profits and losses.

Non-insurance businesses

Revenues increased 8.5% at BNSF through the first nine months of the year, largely due to an increase in volumes (as well as a low single-digit increase in average revenue per car). The operating ratio improved slightly over the same period, driving low double-digit earnings growth.

Revenues at Berkshire Hathaway Energy (BHE) increased 4.5% through the first nine months of the year, largely attributable to an increase in the non-energy business (Real Estate Brokerage). Net earnings increased at a faster rate over the same period (up 7%), reflecting the benefit of production tax credits on BHE’s effective tax rate (down three points to 13%).

Manufacturing, Service and Retailing (MSR) reported a 5% increase in revenues in the quarter and year to date, reflecting gains across the segment. The same was largely true for segment profitability as well. A notable exception was McLane, where “significant pricing pressure” led to a 49 basis point decline in EBIT margins – and a 65% decline in grocery earnings. This result seems odd in the face of a small revenue increase (said differently, it does not sound like the loss of a large customer or unexpected downturn). I have not had any luck yet, but I will keep trying to find a more detailed explanation of what exactly happened at McLane (if you have any industry knowledge and are willing to share your thoughts, that would be greatly appreciated as well).

Conclusion

Through the first nine months of the year, book value increased 9% to $125 per B share. The authorization (up to 120% of book value) allows for repurchases at prices up to $150 per B share.

It has been quiet at Berkshire since the Precision Castparts acquisition in January 2016. Unless we see some dislocation in the market or economy, that might not change anytime soon.

I continue to believe Berkshire’s fortress balance sheet offers significant optionality. At some point in the future, I think it will be used to create meaningful per-share value for investors.

Disclosure: Long BRK.B and WFC.

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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