Berkshire Puts Difficult 2011 to Rest

Over the weekend,  Berkshire Hathaway (BRK.A) / (BRK.B) reported what we consider to be fairly solid fourth-quarter and full-year results for 2011 (given all that has taken place over the last year), including yet another increase in the firm's book value per share. Strong overall results from Berkshire's regulated, capital-intensive businesses--Burlington Northern Santa Fe (BNSF) and MidAmerican Energy--as well as from its manufacturing, service, and retailing operations--more than offset the mixed results that came out of its insurance operations.

Total firm revenue increased 5% during the fourth quarter of 2011 (versus the comparable year-ago period), and was up 6% on an annual basis, despite poor results from Berkshire's insurance and finance operations throughout much of the year. Still benefiting from improved performance in most of its noninsurance operations, as well as from the timing of the BNSF and Lubrizol deals, pretax earnings for Berkshire's operating businesses ended up flat on a year-over-year basis. Net earnings attributable to Berkshire were, however, impacted by investment and derivative gains and losses, which were a boon for earnings in 2010, while detracting from last year's results. As a result, net earnings attributable to Berkshire during the fourth quarter of 2011 amounted to $3.1 billion (down 30% from $4.4 billion during the fourth quarter of 2010), and were $10.3 billion for the full year (down 21% from 2010). Berkshire's book value per Class A share was $99,860 at the end of the fourth quarter, a 5% gain year-over-year, and a 3% increase from the third quarter of 2011.

A difficult catastrophe year for Berkshire (as well as for many other insurance companies) led to mixed results at the firm's insurance operations. Early in 2011, the company was hit by losses due to the earthquake and tsunami in Japan, an earthquake in New Zealand, and an elevated number of severe tornadoes in the United States. More recently, widespread flooding in Thailand has caused increased claims activity. During last year's annual meeting, Chairman and CEO Warren Buffett warned investors that adverse claims activity made it unlikely that Berkshire would generate an underwriting profit in 2011. Thankfully, this prediction proved incorrect, as the firm was able to post a very narrow insurance profit, yielding after-tax underwriting income of $154 million. Most of the profit was driven by GEICO, whose domestic auto insurance policies generally have much less catastrophe exposure (even though results declined substantially when compared with 2010). However, the firm lost money at Berkshire Hathaway Reinsurance Group, an unsurprising result considering that the unit's earnings are volatile, and driven substantially by catastrophes incurred.

Given that insurance can at times be a variable business, with profits fluctuating substantially in some periods, a lean year for Berkshire in 2011 does not overly concern us. We're also not worried about the long-term earnings power of Berkshire's insurance operations overall. Indeed, the fact that the company was able to generate an underwriting profit during what was a difficult year for the industry speaks to the overall strength of the business. It was also encouraging to see Berkshire report it had more than $70 billion in float at the end of 2011 (compared with $66 billion at the end of 2010).

Berkshire's noninsurance business continued to carry the weight, with BNSF, Marmon, and the firm's other manufacturing, service, and retailing operations all posting revenue increases in the midteens (and pretax earnings growth of around 20%) last year. BNSF benefited from increased pricing (tied primarily to fuel surcharges) and volumes, with operating and other expenses rising at a slower rate than revenue.

At MidAmerican Energy, which is the third-largest individual contributor to Berkshire's operating earnings (behind its insurance operations and BNSF), pretax earnings increased 8% during 2011, even though revenue was flat year over year. MidAmerican also expanded its presence in both wind and solar power last year, made possible by the fact that the firm retains all of its earnings (unlike most other utilities, which pay out much of what they earn each year).

As for Berkshire's manufacturing, service, and retailing operations, revenue and operating earnings continue to improve at Marmon, whose end markets continue to recover off the lows seen during 2008 and 2009. Of the 11 major sectors Marmon operates in, 10 posted earnings gains last year, with pretax earnings for the subsidiary as a whole increasing 22% during 2011.

Meanwhile, Berkshire's "other businesses"--which are composed of a wide range of firms (many of which are economically sensitive), including Shaw Industries, Benjamin Moore, Fruit of the Loom, Dairy Queen, and See's Candies--reported a 19% increase in pretax earnings last year, despite the ongoing weakness in the U.S. economy.

On a separate note, Berkshire closed out the fourth quarter of 2011 with around $37 billion in cash. Buffett also announced that the company had repurchased about $67 million of stock last year, having only been in the market for a few days before the price of the shares advanced beyond the limit he established with the company's board of directors.

Some may recall that Berkshire announced in late September that it had authorized a share-repurchase program to buy back Class A and B shares at prices no higher than a 10% premium to the firm's book value per share. While Buffett has been vague about how much cash he would be willing to spend buying back stock, he has noted that repurchases would not be made if they reduced Berkshire's consolidated cash balance below $20 billion. 

We think this has been an effective way for Buffett to create a floor under Berkshire's stock price, as investors know he will buy back shares at prices below 110% of the firm's book value (which stood at $99,860 per Class A share at the end of the fourth quarter). Based on Friday's closing price of $120,000 for Berkshire's Class A shares, though, the stock is currently trading at a price-to-book multiple of 1.2 times, leaving them comfortably above Buffett's buyback target of less than 1.1 times book.

The Oracle of Omaha also announced in his annual letter to shareholders that Berkshire has identified a successor (along with two back-up candidates) for his role as CEO. While the name of the successor was not revealed, we believe it is likely Ajit Jain, Tony Nicely, or Matt Rose. Ajit Jain, who runs Berkshire's reinsurance group, has long been considered Buffett's top pick for the job, and understands risk (across a wide range of industries) probably better than just about anyone else at Berkshire. That said, Jain has made it clear on several occasions that he does not want the top job, which opens up the door for Nicely, who runs GEICO, and Rose, who heads up BNSF.

Although we believe these three are the top candidates to replace Buffett in the CEO role, we don't expect Berkshire to reveal the name of Buffett's successor until he has left the firm. We'd also be surprised if we saw any additional investment manager hires in the near term, as Buffett seems pleased with the work of both Todd Combs and Ted Weschler since they came on board.

Morningstar Premium Members gain exclusive access to our full Berkshire Analyst Report, including fair value estimate, consider buy/sell prices, bull and bear breakdowns, and risk analysis. Not a Premium member? Get these reports immediately when you try Morningstar Premium free for 14 days.