Berkshire Hathaway (BRK.A)(BRK.B) reported third-quarter results on Saturday morning.
Net earnings were $12 billion, up nearly three times from the year-ago period. As always, we need to make adjustments to try to normalize these results. The most prominent example comes from recent changes in GAAP accounting rules that require Berkshire to include unrealized gains or losses from changes in fair value on their equity investments in the income statement. In Q2, that resulted in an additional $4.5 billion in profits for Berkshire. As noted in the press release, the amount of investment gains or losses in any given period is usually meaningless.
Operating earnings (which exclude investment and derivative gains or losses) increased 67% in the quarter to $6.9 billion. If we back out insurance underwriting (which is lumpy in the short term), earnings increased 44%. Much of this improvement was attributable to a lower effective tax rate, which declined from 28% in the first half of 2017 to 19% in the first half of 2018.
The five largest equity positions at quarter-end – Apple (AAPL), Wells Fargo (WFC), Bank of America (BAC), The Coca-Cola Company (KO), and American Express (AXP) – accounted for 70% of Berkshire’s $180 billion in equities. Apple alone accounts for more than one quarter of Berkshire’s equity portfolio. I still find it amazing that they only started buying Apple in May 2016 – and it wasn’t even Buffett at the time (as he later explained on CNBC, Todd or Ted bought the first $1 billion). Fast forward two years, and the position is worth ~$50 billion (if you asked Buffett how likely this was 10 years ago, I wonder what he would’ve said).
Through the first six months of the year, Berkshire generated $16 billion in cash flow from operations. Over the same period, capital expenditures and M&A have used $6.3 billion and $400 million, respectively (Capex spending at BNSF and BHE is expected to be weighted towards the back half of the year). That leaves a lot of dry powder, with cash and short-term investments sitting at well over $100 billion. I’ll repeat something I’ve said in the past: I don’t have the slightest clue on the timing, but you shouldn’t be surprised if you wake up one morning to find that Berkshire has announced a deal with a price tag in the tens of billions of dollars.
Insurance
Berkshire’s insurance businesses reported a $940 million underwriting gain in the quarter, compared to a small loss in the year ago period.
GEICO continues to report solid results, with earned premiums +14% in Q2 and +15% year to date. Growth was split between customer growth (+5%) and higher rates (+9%). GEICO has added 370,000 voluntary auto policies in force (PIF’s) in 2018. For the first half of the year, loss & LAE was 78% of earned premiums, an improvement of five points against a tough first half of 2017. Underwriting expenses continued to impress at just 14% of earned premiums. As a result, the combined ratio was 92%.
Earned premiums at Berkshire Hathaway Reinsurance Group (BHRG) were down significantly from the first half of 2017 as the business laps the large retroactive reinsurance agreement with American International Group (AIG). The P/C reinsurance businesses (National Indemnity and GenRe) both reported solid results, with help from no significant cat losses to date in 2018.
Earned premiums at Berkshire Hathaway Primary Group increased 11% in the quarter and 13% in the first six months of the year. The combined ratio was less than 90% in the second quarter.
At the end of June, the float attributable to Berkshire’s insurance businesses was $115 billion (+2% since the start of 2018). Through the first six months of the year, net investment income increased 15% to $2.2 billion. We’re seeing some impact from higher short-term interest rates on the P&L.
Non-Insurance
Revenues increased 12% at BNSF in the quarter (+10% year to date), due to a combination of unit volume growth and higher average revenue per car. The operating ratio was slightly higher through the first six months of the year, with a lower tax rate driving 37% earnings growth.
Revenues at Berkshire Hathaway Energy (BHE) increased 10% in the quarter and 8% year to date, largely attributable to growth in the non-energy business (Real Estate Brokerage). Gains in this business have been supported by recent business acquisitions. BHE earnings increased at a faster rate than revenues (+18% year to date), reflecting the benefit of production tax credits and the U.S. tax bill on BHE’s tax rate. It’s worth noting that, as called out in the quarterly filing, the impact of the lower effective tax rate will be substantially offset over time in the regulated businesses by lower customer rates (and as a result, lower revenues and pre-tax earnings).
Manufacturing, Service and Retailing (MSR) reported a 5% increase in revenues in the quarter and year to date, reflecting solid growth in Manufacturing. Adjusted for disposition related losses at Lubrizol in the first half of 2017, pre-tax earnings in Manufacturing increased 10% year to date. Service and Retailing revenues increased low-single digits, with revenue growth at some of the smaller businesses (like TTI and FlightSafety) offset by declines at McLane. It’s worth remembering that while McLane accounts for a large percentage of segment revenues, it’s relatively immaterial to profitability due to low-single digit operating margins.
Conclusion
Book value has increased 3% in 2018 to $145 per “B” share (and +19% over the past year). From my perspective, this was a good quarter and a strong start to 2018. As it relates to the recently announced changes in Berkshire’s repurchase policy, here’s what was in the 10-Q:
“For several years, Berkshire had a common stock repurchase program, which permitted Berkshire to repurchase its Class A and Class B shares at prices no higher than a 20% premium over the book value of the shares. On July 17, 2018, Berkshire’s Board of Directors authorized an amendment to the program, permitting Berkshire to repurchase shares any time that Warren Buffett (Trades, Portfolio), Berkshire’s Chairman of the Board and Chief Executive Officer, and Charlie Munger (Trades, Portfolio), a Vice-Chairman of the Board, believe that the repurchase price is below Berkshire’s intrinsic value, conservatively determined.”
It will be interesting to see what “intrinsic value, conservatively determined” will mean in practice. My sense is they would hope to take meaningful action as opposed to nibbling at the first opportunity. If the stock makes its way back towards where it was trading earlier this year, I wouldn’t be surprised if Warren and Charlie decided to repurchase a large number of shares.
Disclosure: Long BRK.B and WFC.
