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Stock Analyst Update

Berkshire's Results Marred by Kraft, Equity Sell-Off

The Kraft Heinz impairment and equity market sell-off hurt the wide-moat firm, but we're leaving our fair value estimate in place.

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With wide-moat  Berkshire Hathaway's (BRK.A)/(BRK.B) fourth-quarter and full-year operating results being more or less in line with our expectations, we are leaving our $360,000 ($240) per Class A (B) share fair value estimate in place. Full-year operating revenue increased 3.3% to $247.8 billion. Including the impact of investment and derivative gains/losses, Berkshire's top line decreased 6.9% to $225.4 billion. With expenses increasing at a slower rate than revenue and the company seeing a marked improvement in insurance underwriting profitability (aided by the lapping of a difficult catastrophe year in 2017), full-year pretax operating earnings (excluding the impact of investment and derivative gains/losses and other events) increased 36.4% year over year to $29.2 billion. Including the impact of investment and derivative gains/losses and other adjustments, full-year net earnings (aided by a reduction in the U.S. corporate income tax rate from 35% to 21%) declined 91.1% to $4.0 billion.

Book value per Class A equivalent share, which the firm has historically pointed to as a good proxy for measuring changes in Berkshire's intrinsic value, increased just 0.4% year over year to $212,503, affected by a $3.0 billion noncash loss arising from an impairment of Berkshire's equity interest in Kraft Heinz and a $20.6 billion loss associated with changes in unrealized capital gains on the insurer's investment holdings. The company closed out 2018 with $111.9 billion in cash and cash equivalents, up from $103.6 billion at the end of the third quarter, which should have left Berkshire with around $90 billion in dry powder to be used for investments, acquisitions, share repurchases, and dividends. While the company engaged in very little acquisition activity last year, Berkshire dedicated $43 billion (funded by $19 billion of equity sales) to marketable equities last year and spent another $1.3 billion on share repurchases.

Looking more closely at Berkshire's insurance operations, Geico and Berkshire Hathaway Primary Group posted earned premium growth during the fourth quarter and full year, while Berkshire Hathaway Reinsurance Group (which has fully combined the operations of General Re and the old BHRG) saw a large decline in earned premiums, despite posting a 36.2% increased in earned premiums during the fourth quarter, owing to the large retroactive reinsurance policy that the group underwrote with AIG in early 2017. As for underwriting profitability, given the lapping of a "perfect storm" of hurricanes and other natural disasters during the third quarter of 2017, Geico, General Re, and BHPG all reported solid underwriting results during 2018, while BHRG's combined ratio (115.1%) remained on par with what we saw during 2017 (115.5%). While BHRG and General Re have effectively merged their operations, Berkshire had been reporting results for the combined entities in a way that had allowed us to continue to differentiate the results of these two firms when talking about their written and earned premium and underwriting results. This has changed with the company's recent 10-K filing, so going forward we expect to only be forecasting results for the combined firms, segmented out by its property/casualty, retroactive insurance, life/health, and periodic payment annuity business lines.

Geico's relentless pursuit of growth during 2016-17, which had come at the expense of profitability, all but ended last year, with the firm posting a sustained improvement in underwriting results during the first, second, and third quarters and results settling in around more normalized levels during the fourth quarter of 2018. The company's annual loss ratio, in particular, dropped to 78.8% (from 86.6%) during the year--well below the average loss ratio of 84.5% put up during 2016-17. While Geico's earned premium growth of 13.3% remained elevated relative to historical norms, fourth-quarter earned premium growth was in line with the 10.7% average annual earned premium growth rates that the auto insurer was putting up in the five-year period before 2017. At this point, Geico's earned premium growth is being driven more by price increases, as opposed to a relentless pursuit of new business, which is likely to continue to have a positive impact on profitability in the near term.

Geico's combined ratio of 92.7% last year put the firm back in the black after a difficult hurricane-affected 2017. Our current expectations have the auto insurer's combined ratio returning to a more normalized 95% annually, with the firm's fourth-quarter combined ratio of 94.5% coming in more in line with our long-term projections. In response to an increase in claims during 2016, much of the rest of the industry stepped back from underwriting and increased pricing to compensate for losses, which led to impressive underwriting results for many of Geico's peers. As it is the nature of insurance pricing to overshoot in both directions, we generally expect to see mean reversion on underwriting profitability over time, which is what we are already starting to see with peers like narrow-moat-rated Progressive. In Geico's case, since the firm was late to take pricing, taking advantage of the reluctance of peers to underwrite during 2016-17 to take share, the snapback to mean reversion will be quicker. That said, the company continues to have one of the lowest expense ratios (13.9% during 2018) in the industry, which gives it some wiggle room on pricing and losses and loss expenses.

With regards to Berkshire's reinsurance arms, General Re (by our estimates) posted another abnormal period of earned premium growth of 28.2% (28.3%) year over year during the fourth quarter (full year), driven by both growth in its Asian and Australian markets and favorable foreign currency exchange (due to a weaker U.S. dollar). BHRG, on the other hand, was always going to face an uphill battle this past year, given the large retroactive reinsurance policy it underwrote with AIG in early 2017, with earned premium growth up 44.9% during the fourth quarter of 2018 but down 56.1% (based on our estimates) for the full year. Going forward, we expect General Re and BHRG to constrain the volume of reinsurance they are underwriting, given the excess capacity in the reinsurance market. While we have earned premium growth in flat to negative territory for both firms over the remainder of our five-year forecast, we have always been quick to note that there could be some lumpiness in reported results, as Berkshire's reinsurance arms have a knack for finding profitable business even when reinsurance pricing is unattractive. We expect tight expense controls (and a lack of extremely adverse events over a multiyear period) to allow General Re and BHRG to keep their combined ratios below the 100% mark, which is what Berkshire seems to be angling for right now, with the combined ratios for the two firms combined dropping from 115.2% in 2017 to 107.0% last year.

BHPG posted an 18.0% (13.6%) increase in earned premiums year over year during the fourth quarter (full year), led by solid growth at Berkshire Hathaway Specialty Insurance, GUARD, NICO Primary, and Berkshire Hathaway Home Companies. The division's combined ratio of 91.7% during 2018 was weaker than the levels of underwriting profitability we've been accustomed to seeing from the unit, with the average annual combined ratio during 2013-17 being 87.7%. BHPG's combined ratio of 94.8% during the first quarter of 2018 was its worst quarterly showing (that did not include major catastrophe losses) since the first quarter of 2013 (when it posted a 92.4% combined ratio), with both elevated loss and expense ratios, driven primarily by its commercial liability and workers' compensation insurance offerings, driving the poorer results. Meanwhile, third-quarter results were affected by $75 million in estimated losses related to Hurricane Florence, which if excluded from results would have left BHPG's combined ratio closer to 90.8% last year--still elevated but more in line with our long-term forecast for the unit. We continue to believe that BHPG can generate earned premium growth of 13%-15% with a combined ratio hovering between 89% and 91%, which is reflective of the higher costs associated with faster-growing businesses like its BHSI unit.

Earned premium growth across Berkshire's insurance platform led to a 4.0% sequential and 7.2% year-over-year increase in the company's insurance float to $122.7 billion at the end of the December quarter. Going forward, we expect gains in insurance float to be much harder to come by, especially with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth in the company's float over the past decade coming from its two reinsurance arms). We continue to believe that Geico and BHPG will be the more consistent generators of insurance float for Berkshire as we move forward, especially given the growth potential that exists for BHPG's specialty insurance unit, but we would note that these are short-tail businesses, with the float generated by these operations tending to be invested in less risky and more liquid investments with smaller return profiles. That said, we wouldn't be surprised to see General Re and BHRG, which are long-tail businesses whose float can be invested in riskier longer-term holdings, pick up some additional float from time to time.

Berkshire's noninsurance operations typically offer a more diversified stream of revenue and pretax earnings for the firm, helping to offset weakness in any one area (and most noticeably the insurance segment this past year). We already had a sense of how things were likely to look for BNSF, given that the other Class I railroads reported earnings late last month. While Union Pacific is usually a good proxy for BNSF, given that both focus on the Western U.S. market and have similar shipment profiles, there was some difference in their results during the most recent period. For starters. BNSF's fourth-quarter (full-year) revenue growth of 10.1% (11.5%) was better than the 5.6% (7.5%) top-line growth that Union Pacific put up during the same period(s). BNSF's revenue growth last year reflected a 6.2% increase in average revenue per car/unit (including fuel surcharges) and a 4.1% increase in volume. Union Pacific, meanwhile, saw average revenue per car/unit rise 3.9% during 2018 on higher fuel surcharge revenue and core pricing gains, with total volume increasing 3.7%.

While pretax operating income increased 4.6% (8.5%) year over year during the fourth quarter (full year), BNSF's operating ratio declined slightly from 65.6% to 66.9% year over year at the end of 2018, with wage inflation and increased head count, along with the timing of higher fuel surcharges, playing a material role. Union Pacific's 62.7% operating ratio during 2018 was also elevated (compared with an operating ratio of 61.8% during 2017), due to network congestion and mix shifts, as well as the timing of higher fuel surcharges. With our railroad analyst maintaining a long-term operating ratio target of 56% for Union Pacific, driven by that railroad's fast-tracking of its precision scheduled railroading rollout, we're keeping our long-run operating ratio target of 60%-62% for BNSF in place, assuming that the firm will have to work harder to improve its own operating system. BNSF's full-year net income increased 31.8% when compared with the year-ago period due to a lower effective tax rate of 24.0% during 2018, compared with 37.4% during 2017.

Normally a beacon of stability, Berkshire Hathaway Energy reported a 1.0% (6.0%) increase in fourth-quarter (full-year) revenue and a 13.8% year-over-year decrease in annual pretax earnings (exclusive of the corporate interest adjustment) due primarily to increased depreciation, maintenance, and other operating expenses, as well as less favorable rate case across its utilities and pipeline portfolios. BHE has typically been the least volatile of Berkshire's subsidiaries, given that the regulated utilities operate in an environment where in exchange for their service territory monopolies, state and federal regulators set rates that aim to keep customer costs low while providing adequate returns for capital providers. The only meaningful change in these operations tends to occur when BHE does an acquisition, with this subsidiary tending to be one of Berkshire's most aggressive when it comes to doing deals, or when it is coming off particularly strong/weak results year over year. In this case, it was more of a perfect storm of rising operating and interest costs, compounded by changes in rate structures across the portfolio.

With regards to Berkshire's manufacturing, service and retail operations, which now include the company's old finance and financial products operations, the group overall recorded a 4.6% increase in full-year revenue and a 12.6% increase in pretax earnings, even with McLane continuing to take it on the chin in its grocery business, where it has seen a significant amount of pricing pressure and an increasingly competitive business environment for much of the past two years. The MSR division's full-year top-line results fell pretty much in line with our near- and long-term forecasts, which call for mid-single-digit annual revenue growth during 2018-22 (exclusive of acquisitions). Pretax operating margins of 8.7% during the full year were affected by the inclusion of the finance and financial products division (which had pretax margins of 23.2% coming into the fourth quarter of 2018), but given that we've been forecasting operating margins for both Berkshire's MSR and finance and financial products units to expand by 20 basis points on average annually over the next five years, we don't expect much to change based on the reclassification of operating results.

Book value per Class A equivalent share at the end of the fourth quarter was $212,503, affected by a $3.0 billion noncash loss from an impairment of intangible assets (arising almost entirely from Berkshire's equity interest in Kraft Heinz) and a $20.6 billion loss from a reduction in the amount of unrealized capital gains tied to the insurer's investment holdings, offset by $24.8 billion in operating earnings last year as well as $2.8 billion in realized capital gains from the sale of investment securities. The company also closed out the period with $111.9 billion in cash and cash equivalents 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 noninsurance operations generally needing $3 billion-and $5 billion in operating cash, as well as carve-outs for capital expenditures, Berkshire still has around $90 billion available to dedicate to investments, acquisitions, share repurchases, and/or dividends.

Berkshire spent just over $1.3 billion on share repurchases during 2018, acquiring 1,217 Class A shares for $367 million ($301,500 per Class A share) and 4.7 million Class B shares for $978 million ($207 per Class B share). While this did little to alter the company's share count or affect its excess cash balances, it did provide us with some insight into the prices that Buffett would probably be willing to pay to buy back shares. In mid-July, when Berkshire altered its share-buyback program to allow the firm to repurchase shares when Buffett and vice chairman Charlie Munger believed "the repurchase price is below Berkshire's intrinsic value, conservatively determined," we were left wondering what sort of discount to book value the two men would require to put money to work.

When Buffett noted in late August that the firm had bought back some stock during the month, we looked back at where the shares had traded and could not see too many days where the stock traded below 1.43 times book value per share, which seemed to be a high buyback threshold for us, given that the shares have traded at 1.45, 1.35, and 1.45 times trailing book value per share on average during the previous 5-, 10-, and 15-year time frames. Our best guess had been that Buffett would ultimately be looking for prices closer to 1.35 times trailing book value per share to buy back stock, which is what happened during the fourth quarter. That said, given the amount of cash that Berkshire continues to hold and the fact that the equity markets sold off hard during the fourth quarter, we were surprised to see that the company bought back more share in August than it did in October and December.

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