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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway: Repurchase Limit to $170 Per B-Share

Some thoughts on Berkshire's first quarter results

Berkshire Hathaway (BRK.A)(BRK.B) reported first quarter results on Saturday morning. For the period, Berkshire reported a loss of $1.1 billion, compared to $4.1 billion of earnings in the year-ago period. As usual, the headline figures aren’t worth much; there’s a lot of noise in each quarter that requires some adjustment before we can say anything meaningful about the results.

Consider, for example, the new accounting rule that requires Berkshire to run unrealized gains and losses from the change in fair value (market price) of equities through the income statement. With $173 billion of equity investments (not including the $19 billion Kraft Heinz stake), this change is going to be material for Berkshire (which will make the headline numbers meaningless). Consider, for example, the $6.9 billion year-over-year change in investment and derivatives gains and losses (from a gain of $500 million to a loss of $6.4 billion). If we back out that line item from both periods, Berkshire’s operating earnings increased by 47% to $5.3 billion.

But even that number requires further examination. For example, some of the year-over-year improvement is attributable to underwriting results in the insurance business, which swung from a $267 million loss to a $407 million profit. More than anything else, the timing of gains and losses in Berkshire’s insurance businesses comes down to luck. It’s inevitable that large catastrophe losses will occur in the future – we just don’t know when. Berkshire will “under earn” in periods when the wind blows and the earth shakes, and “over earn” when the world is tranquil.

Finally, there’s the significant benefit that Berkshire (and other companies) will see in their 2018 results from the reduction in the U.S. statutory tax rate. The significant year-over-year increase in profitability from the lower effective tax rate will not repeat in 2019 (once the new base is set). As these examples show, it’s becoming increasingly difficult to say anything useful about Berkshire Hathaway without looking at the individual operating segments.

Digging into the insurance results, we can see that GEICO had another strong start to the year. Earned premiums increased by 16% to $7.9 billion. This growth reflects a mid-single digit increased in policies-in-force (PIFs), with the remainder attributable to higher rates to cover accelerating losses. These rate increases helped push the loss and LAE ratio down by five points in the quarter. In addition, the underwriting expense ratio fell again and was less than 15% of earned premiums in the quarter. By comparison, Allstate (ALL) spent roughly 25% of earned premiums on underwriting expenses in its auto business in the quarter. As a result of these factors, GEICO’s combined ratio fell by six points in the first quarter to 92%.

Earned premiums in the BH Reinsurance Group were down significantly as they lap the retroactive reinsurance agreement with AIG. That deal has a significant impact on profitability (as expected), with retroactive reinsurance reporting a loss of more than $300 million.

Earned premiums for BH Primary Group increased by 14% to $1.9 billion. Strong top-line results were offset by higher loss and LAE and underwriting expenses, with the underwriting gain falling to $100 million.

Net investment income from the insurance businesses was $1 billion, an increase of roughly 10% from the year-ago period (despite the redemption of the Restaurant Brands (RBI) preferred stock at the end of 2017). At quarter end, float was $116 billion – up 10% from a year ago.

At BNSF, revenues increased 9% in the quarter to $5.6 billion on a 5% increase in volumes. For comparison, revenues increased 7% at Union Pacific (UNP) in the first quarter on a 2% increase in volumes. Pre-tax earnings at BNSF increased by 13% due to a lower operating ratio, with after-tax earnings increasing by more than 35% on a lower effective tax rate (declined from 38% to 24%).

Revenues at BH Energy were $4.5 billion, an increase of 7% over the prior-year period. Pre-tax profits were lower due to a material decline at PacifiCorp, where refund accruals related to the 2017 tax reform ate into the results. Revenues and pre-tax earnings for the remaining businesses within BH Energy were generally higher than the year-ago period. With help from a negative effective tax rate (with continued help from the production tax credits), after-tax profits across BH Energy increased 22% to $585 million.

In Manufacturing, Service and Retailing (MSR), revenues increased 5% to $31.7 billion. Notably, revenues increased at PCC (+6%), Lubrizol (+6%), Marmon (+9%), Clayton Homes (+16%) and IMC (+27%). There was a significant increase in pre-tax earnings (+23%), but that reflects the impact of charges at Lubrizol in the year-ago period. Adjusted for that one-time event, pre-tax earnings in Manufacturing, Service and Retailing increased 14% in the quarter.

Conclusion

Book value now stands at $211,200 per A-share and roughly $141 per B-share. At 1.2x book, the board has authorization to repurchase A-shares of Berkshire Hathaway at a price up to $253,000 per share (or $169 per B-share), about 15% below where it currently trades.

All-in, things appear to be going pretty well at Berkshire. The cash continues to pile up, so hopefully Warren, Charlie, Todd, Ted and the dozens of leaders in Berkshire’s operating businesses can find a way to intelligently put many billions to work in the coming years.

Disclosure: Long BRK.B and KHC.

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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