Berkshire Posts Mixed Results as Expenses Rise

Wide-moat-rated

Second-quarter (first-half) revenue increased 6.0% (15.3%) to $57.5 ($122.7) billion. Excluding the impact of investment and derivative gains (losses), second-quarter (and first-half) revenue increased 7.3% (and 16.5%). With expenses increasing at a higher rate than revenue during the second quarter, operating earnings declined 10.6% during the period, leaving first-half operating earnings down 8.0%. Net earnings, which includes the impact of investment and derivative gains (losses) were down 14.8% and 21.4% during the second quarter and first half of the year, respectively.

That said, we remain impressed with Berkshire's ability to increase its book value per Class A equivalent share--which rose 14.3% year over year to $182,816 (better than our own estimate of $182,525)--aided primarily by the strong performance of its equity investment portfolio during 2017. The company closed out the second quarter with $99.7 billion in cash on its books, up from $96.5 billion at the end of March and $86.4 billion at the end of 2016.

While the firm has dedicated around $13 billion to different opportunities since late June, including the company's $9 billion all-cash bid for Oncor, Berkshire still has plenty of dry powder to dedicate to investments, acquisitions, and share repurchases (or dividends). Stripping out the capital that has yet to be laid out for the deals that have been announced, as well as the $20 billion CEO Warren Buffett likes to keep around on hand as a backstop for the insurance business, and another $3 billion-$5 billion for operating cash, Berkshire looks to have an excess cash balance of more than $60 billion. The company did not repurchase any shares during the first half of 2017.

Looking more closely at Berkshire's insurance operations, all four of the firm's insurance segments--Geico, General Re, Berkshire Hathaway Reinsurance Group, or BHRG, and Berkshire Hathaway Primary Group, or, BHPG--posted earned premium growth during the second quarter. From an underwriting perspective, every segment but BHRG posted positive results during the period, with combined ratios ranging from a high of 86.8% at BHPG to a low of 122.4% at BHRG. On a combined basis, Berkshire's insurance operations once again generated an operating loss, with its firmwide combined ratio of 100.2% being on par with the 101.7% level we saw during the first quarter of 2017, and a steep decline from the 95.3% combined ratio the segment posted during the second quarter of last year.

We continue to be concerned with Geico's relentless pursuit of growth, given that it has come at the expense of profitability the past several years. The auto insurer's earned (written) premium growth of 16.0% (16.7%) during the second quarter was the strongest quarterly result we can ever remember Geico putting up. Our own forecast had called for earned premium growth of 12%-14% during the second quarter, similar to what we saw during the fourth quarter of 2016 and first quarter of 2017. We had hoped to see the firm take advantage of the price increases we'd seen at Progressive and Allstate during the second quarter to push through some price increase of their own, believing that higher prices would both limit growth and improve profitability. Unfortunately, we only got one of those two outcomes.

The unintended consequence of Geico's aggressive underwriting has been a rather abnormal spike in the company's loss ratio. Buffett noted during this year's annual meeting that first-year business, which comes with both acquisition costs and a higher loss ratio, tends to run almost 10 points higher than renewal business, which would explain the rather dramatic rise in Geico's loss ratio during the past year. However, with the company continuing to hit the gas pedal on underwriting it gets harder and harder to determine when we might see loss ratios return to more normalized levels. This is the real drive of any recovery, as claims frequencies for property damage and collision coverages were relatively flat during the first six months of 2017, while claims for bodily injury increased 3% (claims for personal injury declined 2%). Average claims severities were higher for both physical damage and collision coverages (in the 4%-5% range) and bodily injury coverage (up 4%-6%), but this was basically in line with what we've seen in past periods.

Geico's average loss ratio of 83.4% during the past year was worse than the 78.7% average level seen during 2012-16 and the 77.0% level seen during 2007-16. A loss ratio of 84.3% during the second quarter was a step in the wrong direction toward getting the auto insurer's loss ratio back down to more historical norms. Even so, Geico's combined ratio of 98.4% (97.9%) during the second quarter (first half) of 2017 kept its operations in the black. Much of this has been due to its tight expense controls, as well as the benefits of increased scale, with the firm's 14.0% (14.9%) expense ratio during the period being the lowest we can remember seeing. For some perspective, Geico's average expense ratio of 15.4% during the past year is meaningfully better than the 17.0% level seen during 2012-16 and the 17.5% ratio seen during 2007-16.

As for General Re, the reinsurer posted another abnormal period of earned premium growth (of 13.6% year over year), primarily attributable to new business and increased participations for renewals. This was also the case for BHRG during the second quarter, which posted (8.1%) earned premium growth. All of the earned premium growth, however, was driven by just two contracts. We're not expecting this to be the start of a trend. Both General Re and BHRG have been constraining (and will continue to constrain) the volume of reinsurance 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 now when reinsurance pricing is unattractive.

Having expected things to look more normal in the second quarter, with earned premiums declining for both General Re and BHRG, and the two companies squarely focused on keeping their combined ratios below 100%, we only ended up being right on one count. From a profitability perspective, General Re pushed itself back into the black again during the second quarter, posting a combined ratio of 98.4%, much of which was driven by its life/health lines. Unfortunately, BHRG fell short of our goal of keeping its combined ratio below 100%, which is what you'd like to see from any insurer dealing with a highly competitive pricing environment. The reinsurer's combined ratio of 122.4% was a let down from the 105.1% level posted during the first quarter, and the 88.9% combined ratio put up during the second quarter of 2016. A fair amount of this came from adverse currency exchange, as well as from deferred charge amortization related to the firm's agreement with AIG (and another retroactive reinsurance contract written in December 2016).

As for BHPG, the segment posted a 16.4% increase in earned premiums year over year, led by strong growth at Berkshire Hathaway Specialty Insurance, GUARD, and Berkshire Hathaway Home Companies. The collection of BHPG insurers produced pretax underwriting gains of $232 ($421) million in the second quarter (first half) of 2017, producing a combined ratio of 86.8% (87.7%), on par with historical norms. BHPG has traditionally been Berkshire's most profitable insurance group, with combined ratios averaging 87.2% during 2012-16 and 87.7% during 2007-16. Earned premium growth across Berkshire's insurance platform led to a 1.9% sequential and 18.9% year-over-year increase in the company's insurance float, estimated at $107 billion at the end of the June quarter. We expect further gains in float to be much harder to come by as we move forward, 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 comes 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, and BHPG should also continue to be an important contributor, given the growth potential that exists for the newly formed Berkshire Hathaway Specialty Insurance unit.

Berkshire's non-insurance 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 period). We already had a sense of how good things were likely to look for BNSF, given that the other Class I railroads reported earnings late last month, especially Union Pacific, which is BNSF's most comparable peer. The railroad has been beset by a shortfall in coal volume that started in the first quarter of 2016 (when volume dropped 33% year-over-year), with volume falling 21% last year, as well as a falloff in industrial products (driven primarily by the decline in crude oil prices), with volume falling 6% and 8%, respectively, in 2015 and 2016. Things looked better in the first quarter of 2017, with coal and industrial products volumes increasing 19% and 1%, respectively, year-over-year, and continued during the second quarter, increasing 21% and 4%, respectively. Overall volumes were up 9% during the second quarter, up from 6% in the first quarter and negative 9% in the year ago period.

This was fairly comparable with Union Pacific, which reported 5% year-over-year carload volume growth during the June quarter, led by a 17% increase in coal volume and a 15% increase in industrial products carloads. Second-quarter (first-half) revenue was up 14.5% (11.6%), aided by both the improvement in volumes and higher average revenue per car/unit (attributable to higher fuel surcharge revenue and business mix changes, as well as increased rates per car/unit). Second-quarter (first-half) pretax earnings increased 24.2% (15.5%), respectively, when compared with the same period in 2016. The railroad's operating ratio of 66.0% (67.6%) during the second quarter (first half) was an improvement on the 67.6% (68.0%) levels reported in the year-ago period (and the 66.3% operating ratio BNSF produced during 2016), but still well off Union Pacific's more impressive 61.8% (63.4%) results for the period. Looking forward, BNSF is guiding to solid volumes in the second half, but comparisons to the prior-year period will be more challenging than they were in the first half.

Normally a beacon of stability, Berkshire Hathaway Energy, or BHE, reported a 7.5% (5.5%) increase in second-quarter (first-half) revenue, and a 0.6% (4.0%) increase in pretax earnings. The utilities and energy segment has always 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 occur when BHE does an acquisition, like the recent bid for Oncor (which we expect to be dilutive, given the premium price that the company is paying for the assets). The subsidiary was coming off weaker top-line results in the first half of 2016 (primarily due to lower regulated electric and natural gas revenues at PacifiCorp, NV Energy, Northern Powergrid, as well as the company's natural gas pipeline operations, tied to lower input costs), which explains the stronger revenue growth and pretax earnings results this year.

With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 4.0% (5.6%) increase in second-quarter (first-half) revenue, and a 12.8% (7.5%) increase in pretax earnings, even with McLane taking it on the chin in its grocery business, which has seen a significant amount of pricing pressure and an increasingly competitive business environment the past several quarters. This falls pretty much in line with our near- and long-term forecasts, which call for mid-single-digit annual revenue growth during 2017-21 (exclusive of acquisitions). As for profitability, operating margins of 8.0% (7.3%) during the second quarter (first half) were slightly better than our forecast, which had operating margins expanding by 20 basis points annually over the 7.0% level the segment reported during in 2016. Meanwhile, 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 somewhat mixed, with revenue increasing 2.2% (4.9%) during the second quarter (first half), and pretax earnings falling 12.9% (8.2%) due primarily to lower interest and dividend income from investments, higher railcar repair and storage costs, and lower earnings from CORT's furniture rental business.

As we noted above, book value per Class A equivalent share at the end of the second quarter was $182,816. The company also closed out the period with $99.7 billion in cash and cash equivalents on its books. With Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, the firm's non-insurance operations generally needing between $3 billion and $5 billion in operating cash, and the company committing $13 billion to different opportunities since late June (including the company's $9 billion all-cash bid for Oncor), Berkshire still has more than $60 billion available to dedicate to investments, acquisitions, and share repurchases (or dividends). Berkshire did not buy back any shares during the first half of 2017, but based on the company's end of second-quarter book value per share, Buffett should be willing to buy back stock at prices below $219,379 ($146.25) per Class A (B) share, which is about 18% below Friday's closing price on the shares.

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