Berkshire Posts Solid 2Q in Difficult Environment

Wide-moat rated  Berkshire Hathaway (BRK.B) released results for the second quarter of 2013 that were pretty much in line with our expectations. Second-quarter revenue increased 16% year over year to $44.7 billion on improved operating results from each of Berkshire's main segments. Excluding the impact of gains on investments and derivatives, revenue increased 12% year over year. With expenses rising at a slower rate than revenue, and most of the gains from investments and derivatives falling straight down to the bottom line, Berkshire reported a 49% increase in pretax earnings (to $6.9 billion) and a 46% increase in net earnings (to $4.5 billion). Stripping out the impact of investments and derivatives, operating earnings increased 5% to $3.9 billion. Net earnings per Class A equivalent share were $2,763.

Book value per Class A equivalent share at the end of the second quarter was $122,900--up 15% year over year, but reflecting only a 2% increase when compared with the first quarter of 2013. While this is lower than our forecast of $124,100 for the period, we had not adjusted the firm's equity for the purchase of additional interests in Iscar and Marmon, which reduced book value per share by $730 during the second quarter. With regards to its cash holdings, Berkshire closed out the period with $35.7 billion in cash and cash equivalents, down from $49.1 billion at the end of the first quarter of 2013, as the company laid out $12.3 billion for its investment in Heinz, as well as another $2.1 billion for additional stakes in Iscar and Marmon, during the second quarter.

Unlike the fourth quarter of 2012, Berkshire did not buy back any shares during either the first or second quarter of 2013. For those who may not recall, the company repurchased 9,475 Class A shares and 606,499 Class B shares for $1.3 billion in December of last year after increasing the threshold for share repurchases from 1.1 to 1.2 times book value. With Berkshire's book value per Class A share at $122,900 per Class A share (or $82 per Class B share) at the end of the most recent period, Buffett would now be willing to step in and buy back stock at prices up to $147,480 per Class A share (or $98 per Class B share), implying a floor on the company's shares that is about 15% below current prices.

Looking more closely at the firm's operating businesses, underwriting margins in the insurance group fell 14% on a year-over-year basis, largely due to flat premium growth in Berkshire's reinsurance operations, as well as from increased claims. We're not overly surprised that reinsurance underwriting was flat as most of the company's peers operating in the market have reported similar results. A dearth of catastrophe claims in the first half of 2013 has led to lower renewal pricing, and the excess capital carried in the global reinsurance industry is also weighing on prices. In our view, it will take time, or a major catastrophe event, to work off the pile of excess capital that exists in the reinsurance sector.  

The largest source of decline in the firm's insurance earnings came from Berkshire Hathaway Reinsurance Group, or BHRG. On the revenue side, BHRG continues to feel the effects of the termination of the Swiss Re contract at the end of last year. Earned premiums from this contract fell to $462 million in the second quarter of 2013 from $814 million in the same period last year, with most of the remaining $579 million in the run-off unearned premium to be realized in the second half of this year. BHRG also posted a loss of $40 million from the floods in Europe. Shifting foreign exchange rates reduced income as well, with currency gains falling from $172 million in the second quarter of last year to $28 million this year. Despite a 5% year-over-year increase in earned premiums, underwriting margins were also lower at General Re during the second quarter. The firm's property-casualty segment reported a small underwriting loss, mostly the result of $124 million in claims from European floods, but also from long tail casualty/workers' compensation claims. Its life/health segment, though, swung from a loss last year to a profit this year, due to lower than expected mortality in both the U.S. and international markets.

Not surprisingly, GEICO was the one bright spot in Berkshire's insurance operations, building on gains that were reported during the first quarter of 2013. Earned premiums continued to climb, up 11% from the second quarter of 2012. Policies-in-force continued to rise, up 8% over the past year even in the face of price increases that have led to higher average premiums per policy. The combined ratio--insurance expense divided by earned premiums--fell to a very strong 92.7%, which was 3.5 points better than results for the second quarter of 2012. While these are very impressive results, we think gains of this magnitude will level off as competition heats up. Other auto insurers that have reported so far this quarter have signaled their intent to become more price competitive (and potentially increase their ad spending), which will likely cut into GEICO's margins and share increases. While it remains to be seen if the competition is up to the task, the actions they will take will likely have an effect on GEICO.

Much as they have the last couple of years, Berkshire's noninsurance operations continue to be a source of stability for the firm, reporting a 10% increase in pretax earnings year over year during the second quarter. Burlington Northern Santa Fe, which continues to be one of the largest contributors to pretax earnings at Berkshire outside of its insurance operations, reported a 9% increase in pretax earnings during the period, as increased rail volumes (especially in industrial products, which includes petroleum shipments) and higher average revenue per car/unit led to a 5% increase in revenue, with operating expenses increasing 4% when compared with the second quarter of 2012. Berkshire also reported solid results for MidAmerican Energy Holdings, which saw its top line increase 11%, and pretax earnings rise 34%, primarily because of higher pricing and volumes, and lower expense overall (mainly due to the non-recurrence of litigation and damage claims that hit the firm during the second quarter of 2012).
 
With regards to Berkshire's manufacturing, service and retail operations, which include both Marmon and McLane, the group overall saw a 16% increase in revenue, but only a 6% increase in pretax earnings, when compared with the second quarter of 2012. Marmon, which has been a standout performer over much of the last three-plus years, has struggled since the start of the year (as declining commodity prices have taken their toll), with revenue declining 4% in the first quarter of 2013 and down 3% during the second quarter, and pretax profits being basically flat during the first six months of the year (when compared to the same period in 2012).

The weaker performance at Marmon has been offset by better results at McLane, which reported a 26% increase in second-quarter revenue, and a 56% increase in pretax earnings, spurred on by acquisitions and the addition of new customers.

Revenue from Berkshire's other businesses in the segment rose 10%, with pretax earnings rising at a much slower rate of 4%, as expenses rose at a much faster rate than revenue.

Berkshire's finance and financial products division also looks to be on better footing, with revenue up 10% year over year and pretax earnings up 11%, as both Clayton Homes (manufactured housing and finance) and CORT Business Services (furniture rental) posted solid results. 

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