Derivatives Affect Otherwise Strong 2Q at Berkshire

 Berkshire Hathaway (BRK.A) (BRK.B) reported good underlying results for the second quarter of 2010. Derivative losses were a culprit weighing on reported bottom-line earnings and book value, but the quarter was most notable for a continuing recovery across Berkshire's many operating subsidiaries and further strong results in insurance operations.

Earnings per Class A equivalent share fell nearly 50% from a year ago, as Berkshire's "derivative gains/losses" line item shifted gears from a $2.4 billion gain in the second quarter of 2009 to a $2.2 billion loss in the second quarter of 2010. This element of its income statement is pretty volatile from quarter to quarter, but earnings across Berkshire's insurance and diverse set of operating subsidiaries continued to climb higher.

Berkshire's insurance operations have made a significant contribution to the company's operating cash flow in recent years, which grew even through the recession. In the second quarter of 2010, net earned premium rose 6% from a year ago, led by further gains within GEICO and Berkshire Hathaway Reinsurance Group. Growth in the latter is notable amid weakness in reinsurance market premium rates and likely reflects valuable market share gains amid heightened appreciation for credit quality in reinsurance markets.

Underwriting income across all the insurance operations rose to its second-highest level in the past three years as income rose in all four of Berkshire's major insurance groups and pretax underwriting income in GEICO tripled from the second quarter of 2009. Berkshire Hathaway Reinsurance Group incurred a little over $200 million in catastrophe losses from the Chilean earthquake and the Deepwater Horizon disaster but still posted an underwriting profit for the first half of the year. Soft premium rates and underwriting restraint have depressed volume in Berkshire's primary insurance lines, but positive loss development (revisions to previous loss estimates) and other factors led to a 145% gain in underwriting income this year. Investment income in insurance was basically flat with a year ago, but all in all, it was another good quarter and first half for Berkshire's insurance groups.

Berkshire's non-insurance operating subsidiaries are quite economically sensitive, and weighed on overall results amid the recession and furtive recovery we've had in recent years. But they produced their second consecutive quarter of improving profitability and income growth in the second quarter. Sales and service revenue across these subsidiaries climbed to its highest level since early 2008. A notable contribution came from recreational vehicle manufacturer Forest River, whose revenue doubled from a year ago. Forest River is very sensitive to consumer discretionary spending, and this could be a good sign for the economy as a whole. Pretax income from Berkshire's manufacturing, service, and retailing enterprises nearly tripled from the second quarter of 2009, while the aggregated operating margin rose for the second consecutive quarter. The second quarter was also notable for the first full quarterly contribution from Berkshire's acquisition of Burlington Northern, whose results are included in Berkshire's statements along with utility operations. Burlington Northern contributed over $600 million in net earnings, as its revenues rose 23% over economically depressed conditions a year ago.

With respect to Berkshire's derivatives, the firm has entered into a number of contracts effectively insuring other capital market participants against longer-term risk in equity markets and credit obligations. In the four quarters ended in the first quarter of 2010, changes in the estimated value of these positions contributed over $5.5 billion in gains to Berkshire's bottom line, amid the recovery in equity and credit markets. But in the second quarter of 2010, their contribution swung to a significant loss of nearly $2.2 billion, the largest quarterly decline for this line item since the fourth quarter of 2008. The loss was led by Berkshire's European put options on four major equity indexes. But these are non-cash charges, at least for now, as no payment is required on those contracts until at least 2018. In turn, the volatility of their estimated value is driven by the use of option pricing models, and the book value of the positions can shift gears from losses to gains, and vice versa, very easily. Berkshire does have to post collateral on a few of those contracts, but the increase in required collateral thus far in 2010 (to $173 million) is easily funded in light of Berkshire's overall capital strength. At June 30, Berkshire's shareholder equity totaled $147.5 billion, and it held about $28 billion in cash and cash equivalents.

At the bottom line, Berkshire's book value may have declined modestly from the first quarter, but the firm's overall results look very strong absent the (estimated) derivatives impact.