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Berkshire Coverage

Diversification Helped Berkshire Out in First Quarter

Weaker results from BNSF were largely offset by better results from insurance and financial products, as well as the addition of Precision Castparts.

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Wide-moat rated  Berkshire Hathaway (BRK.B) released results for the first quarter of 2016 that were basically in line with our expectations, with weaker results from BNSF being largely offset by better results from insurance and finance and financial products, as well as the addition of Precision Castparts to overall results. We do not expect to change our fair value estimate.

First-quarter revenue increased 7.7% year over year to $52.4 billion, with the biggest contributions coming from Berkshire's insurance operations (where earned premiums rose 16.6% year over year), followed by its manufacturing, sales and retail operations (which benefited from the closure of the Precision Castparts acquisition) and finance and financial products (which posted 11.1% revenue growth year over year). Excluding the benefits from the Precision Castparts acquisition, first-quarter revenue increased 2.8%.

On the profitability front, pretax operating earnings declined 15.6% year over year to $6.5, and would have been much lower had the Precision Castparts acquisition been excluded from quarterly results. That said, the firm did see about half as much of a contribution from investments and derivatives during the first quarter, which when eliminated from consideration, left pretax operating earnings down just 8.4% year over year.

Book value per Class A equivalent share was $157,369 at the end of the first quarter--up 7.1% year over year and 1.2% when compared with the fourth quarter of 2015. This was slightly lower than our forecast, which had book value per share increasing to $157,834. The company closed out the first quarter of 2016 with $58.3 billion in cash on its books, down from $71.7 billion at the end of last year, with much of the difference due to cash that was laid out for the Precision Castparts deal (which closed at the end of January). Berkshire did not buy back any shares during the first quarter of 2016.

Looking more closely at Berkshire's insurance operations, three of the firm's four insurance segments--Geico, Berkshire Hathaway Reinsurance Group (BHRG) and Berkshire Hathaway Primary Group (BHPG)--posted earned premium growth during the first quarter. And from an underwriting perspective, everyone but BHRG posted positive results during the period, with combined ratios ranging from a high of 91.6% at BHPG to a low of 103.5% at BHRG. On a combined basis, Berkshire's insurance operations generated and operating profit, although its firmwide combined ratio of 96.9% during the first quarter was a bit if a let down from the 95.4% level that was posted during the fourth quarter of 2015 and the 92.2% ratio put up during the period year's period.

  Geico's first-quarter earned premium growth of 12.3% was stronger than last year's 10.3% and the fourth-quarter's 11.2%, reflective of voluntary auto policy-in-force growth of 4.3% and increased premiums per auto policy of 7.2% during the past twelve months. The lumpy recovery in Geico's combined ratio continued during the first quarter, with the 95.6% level reported during the period a marked improvement over the 100.2% level seen during the fourth quarter of 2015, and a better showing than the 97.0% result put up during the prior year's period. As we noted last time around, it has paid to be a bit cautious on Geico's recovery, as a slowly improving U.S. economy, fueled by lower gas prices, has left more drivers on the road and increased the potential for accidents. On top of that, the problem of distracted drivers using smartphones to talk, text or even watch videos while driving is not going away any time soon, so we continue to expect to see a fair amount of lumpiness in Geico's return to a more normalized level of profitability, which has historically been around 93.7%.

What is important to note, though, is the fact that the company's loss ratio (which has generally averaged around 75.9%) improved to 79.7% from 83.9% in the fourth quarter and 80.1% in the first quarter of last year. This in the face of increased storm losses during the first quarter, which actually increased in April of this year and are likely to keep claims higher in the near term. While claims frequencies for property damage and collision coverages decreased in the 4%-5% year over year, and were relatively unchanged for bodily injury coverage, during the first quarter, average claims severities were higher for both physical damage and collision coverages (in the 3%-5% range) and bodily injury coverage (up 6%-8%). Underwriting expenses continue to track down, though, as the ever increasing size and scale of Geico's business allowed it to keep its first-quarter expense rate below 16.0%.

As for General Re, the reinsurer returned to the negative earned premiums trend that had been in place for most of last year, reporting a 7.2% quarterly decline in earned premiums, with both its property/casualty and life/health operations reporting less business year over year. Both General Re and BHRG continue to constrain the volume of reinsurance that they are underwriting, given the excess capacity that exists in the reinsurance market and the fact that neither firm feels that the pricing in the marketplace is attractive enough to profitably underwrite additional business. While we continue to have earned premium growth in negative territory for both firms over the next five years, we've always been quick to point out that there could be some lumpiness in reported results, as both firms have shown a knack for finding profitable business, even in times like we're facing right now where reinsurance pricing is unattractive.

This was the case during the first quarter for BHRG, which posted a 23.0% increase in property/casualty earned premiums (primarily attributable to the quota-share contract they have in place with Insurance Australia Group), and also picked up $580 million in new business by underwriting additional retroactive reinsurance contracts during the period. That said, the firm posted an underwriting loss during the period, primarily due to losses recorded on past retroactive reinsurance contracts, as well as the impact of historically low interest rates and a more volatile equity market on the life/health business. We continue to believe that General Re and BHRG are also competitively advantaged from their positions within Berkshire's overall business empire, having the luxury of walking away from reinsurance underwriting when an appropriate premium cannot be obtained, which is something that cannot be said for their peers.

Even with this headwind, Berkshire's insurance float increased during the first quarter of 2016 to $89.0 billion, up 1.5% from $87.7 billion at the end of 2015. We expect further gains in float to be much harder to come by as we move forward, though, with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth in the firm's float over the past decade coming from its two reinsurance arms). We continue to believe that Geico will be an important contributor to earned premium growth, as well as to the growth of float, with underwriting profitability likely to improve in the coming quarters. BHPG should also continue to be an important contributor, especially considering the growth potential that exists for the newly formed Berkshire Hathaway Specialty Insurance unit. Given these conditions, earned premium growth is likely to resemble a barbell longer term, with Geico and BHPG on the outer ends and the reinsurance arms barely noticeable in the middle.

Berkshire's non-insurance operations typically offer a more diversified stream of revenue and pre-tax earnings for the firm, helping to offset weakness in any one area, but 2016 looks to be another challenging year for the firm. We already had a sense of how bad things likely were for BNSF late last week, when Berkshire released preliminary first-quarter after-tax earnings that had the railroad, utilities and energy segment down 16.4% year over year. We had expected BNSF to report a poor quarter, having already seen weak results from CSX, Union Pacific and Norfolk Southern in the face of declining coal volumes—with CSX seeing a 30% drop in coal volumes, Union Pacific reporting a 34% decline, and Norfolk Southern posting a 23% drop. BNSF's coal shipments, which accounted for one fifth of its freight volumes and revenue last year, declined 33% on a volume basis, with freight revenues declining 39%. Total revenue for BNSF declined 14.9% year over year, with pre-tax earnings falling 24.8% as a result. We don't expect things to improve much in the near term.

Normally a beacon of stability, Berkshire Hathaway Energy (BHE) reported a 4.9% decline in first-quarter revenue, primarily due to lower regulated electric and natural gas revenues at MidAmerican, NV Energy, Northern Powergrid and the company's natural gas pipeline operations (much of which can be tied to lower input costs). While pre-tax earnings were down 4.5% on a firmwide basis, BHE's pre-tax profit margin remained flat at 13.8% of revenue. Going forward, we continue to believe the firm's U.S. regulated utilities--PacifiCorp, MidAmerican Energy, and NV Energy--will receive constructive rate case outcomes and earn somewhere close to their current allowable returns on equity in the near to medium term. This would put annual revenue growth in the 2%-3% range over the next five years. For Northern Powergrid, we've incorporated the U.K.'s most recent price review into our model, assuming the division generates mid-single-digit revenue growth going forward. As for BHE's pipeline and renewables businesses, we see revenue growing at a low- to mid-single-digit rate through 2020.

On a consolidated basis, we expect BHE's overall EBITDA to grow 5.2% on average during 2016-20, with EBITDA margins of around 40%. Our assumptions about revenue and profitability for the subsidiary's regulated utilities put our value for these operations at around 5.4 times our 2016 EBITDA estimate, which is basically in line with our valuations for similar high-quality utilities with favorable regulatory structures and above-average growth opportunities. Our valuation also implies that BHE's pipeline group is worth 10 times EBITDA (on an EV-to-EBITDA basis), in line with peer multiples and indicative of the higher earned returns that the pipelines are able to realize on average compared with returns for the regulated utilities.

With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 12.9% increase in first-quarter revenues, aided by the inclusion of Precision Castparts in the group's results. Excluding the contribution from Precision Castparts, first-quarter revenue was up just 3.3%. Mixed sales performance across the spectrum of companies--McLane (up 1.4%), Manufacturing (up 19.1% but down 8.0% when excluding the contribution from Precision Castparts), and Service and Retailing (up 30.3% as the segment benefits from both organic growth and the inclusion of the Van Tuyl and Detlev Louis Motorad acquisitions in quarterly results this past year)--contributed to the group's top-line growth during the period. Pre-tax earnings increased 6.9% year over year. We continue to expect Berkshire's manufacturing, service and retail division to see a meaningful lift in operating results this year from the inclusion of Precision Castparts (and to a lesser extent Duracell) in overall results.

Results for Berkshire's finance and financial products division--which includes Clayton Homes (manufactured housing and finance), CORT Business Services (furniture rental), Marmon (rail car and other transportation equipment manufacturing, repair and leasing) and XTRA (over-the-road trailer leasing)--were also up year over year, with first-quarter revenue increasing 11.1% and pre-tax earnings expanding 7.7%. While pre-tax margins dropped down to 27.7% (from 32.1% in the fourth quarter of 2015 and 28.6% in the prior year's period), due primarily to decreased earnings from investment securities and the company's investment in Berkadia, we expect things to normalize some over the remainder of the year. We continue to expect revenue to grow at a mid-to-high-single-digit rate during the remainder of our five-year forecast, with pre-tax margins likely to remain below 30%, given the potential that exists for nearer-term weakness in each of the businesses that are represented in this segment.

As we noted above, book value per Class A equivalent share at the end of the first quarter was $157,369. The company also closed out the period with $58.3 billion in cash on its books. With CEO Warren Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, and the firm's non-insurance operations generally needing between $3 billion and $5 billion in operating cash on hand, Berkshire looks to have an excess cash balance of more than $30 billion. We view this as dry powder for future acquisitions or share repurchases. While Berkshire did not buy back any shares during the first quarter of 2016, Buffett did confirm to us during the annual meeting that he would aggressively buy back stock if its dipped down below 1.2 times book value, even if the firm had not yet reported its end of quarter book value per share to shareholders. Based on end of first-quarter book value per share, Buffett should be willing to buy back stock at prices below $188,843 ($125.90) per Class A (B) share, which is about 14% below current trading levels. 

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Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.