Wide-Moat Berkshire's 3Q Results Meet Our Expectations

With wide-moat  Berkshire Hathaway's (BRK.B) results for the third quarter of 2013 coming in about where we expected, we are maintaining our fair value estimate for the firm. Revenue increased 13% year over year to $46.5 billion, despite poorer results overall from the firm's insurance operations during the period, which speaks to the value provided by Berkshire's diversified portfolio. 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 24% increase in pretax earnings (to $7.4 billion) and a 29% increase in net earnings (to $5.1 billion). Stripping out the impact of investments and derivatives, operating earnings increased 8% year over year to $3.7 billion (or $2,228 per Class A equivalent share).

Berkshire's book value at the end of the third quarter was $126,766 per Class A equivalent share--up 14% year over year, but reflective of only a 3% increase sequentially. While this was lower than our forecast of $127,816, 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 $1.2 billion (or $730 per Class A equivalent share) during the third quarter. With Berkshire's common stock trading at prices above the 1.2 times book value threshold required by the firm for share repurchases, there were no share repurchases during the period. Berkshire closed out the third quarter with a consolidated cash balance of $42.1 billion, up from $35.7 billion at the end of the second quarter. The company also received $5.1 billion at the beginning of October as Mars/Wrigley repurchased the $4.4 billion 11.45% note that was issued to Berkshire in 2008 to finance their deal. Given the lack of securities with a similar risk profile and yield, this will have a negative impact on investment income.

Looking more closely at the firm's insurance operations, three of the four insurance lines--GEICO, General Re, and Berkshire Hathaway Primary Group--posted a decline in underwriting profits year over year, and Berkshire Hathaway Reinsurance Group posted a larger-than-expected underwriting loss, even after adjusting for seasonality. BHRG continues to feel the effects of the termination of the Swiss Re contract at the end of last year, and has also been negatively affected by an increase in catastrophes this year that have driven up claims benefits. These two things combined led to a $206 million loss for the reinsurance unit during the quarter. On top of that, there continues to be pressure on margins across all four of Berkshire's insurance lines, mainly due to a slowdown in premium growth and unfavorable claims experience. Looking at the firm's insurance operations in aggregate, premium growth was 5% when compared with the prior year's period, with pretax earnings declining 57% year over year.

The largest source of decline in the firm's pretax insurance earnings came from BHRG. Earned premiums from the Swiss Re contract declined $560 million during the third quarter, and the company posted a $29 million loss due to flooding in Europe. Unfavorable foreign-exchange movements resulted in a loss of $186 million as well, compared with a loss of $118 million during the third quarter of 2012. While earned premium growth was essentially flat at General Re, underwriting margins declined because of increased claims activities. The reinsurance unit sustained approximately $400 million of losses related to a hailstorm in Europe during the third quarter and flooding in Europe during the second quarter. On a positive note, General Re's life/health segment produced a $59 million gain on favorable mortality experience in the U.S. and international markets.

While GEICO posted another quarter of consistent growth on the top line, claims expenses also went up more than expected, which eroded margins by around 300 basis points during the period. Earned premiums grew 11% year over year to $4.7 billion, reflecting an increase in voluntary policy-in-force and improved pricing. The growth trends were healthy and in line with our expectations. While GEICO continues to have one of the best combined ratios in the industry, the uptick during the third quarter was somewhat surprising (especially in relation to what we've seen so far this quarter from other auto insurers). It is unclear at this point whether GEICO is relaxing its underwriting practices or if it's simply a one-off incident, but we'll be keeping a close eye on future trends in auto claims to make sure that this isn't the start of a pattern for the low-cost auto insurer.

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 12% increase year over year in pretax earnings during the third quarter. Burlington Northern Santa Fe, which continues to be one of the largest contributors to Berkshire's overall profitability (outside of its insurance operations), reported only a 3% increase in pretax earnings during the period, as operating expenses basically rose in line with revenue (both of which were up 6% year over year) and the company saw a rise in its interest expense (due to higher average outstanding debt balances year over year). Much like in past periods, BNSF benefited from increased rail volumes (especially in industrial products, which includes petroleum shipments) and higher average revenue per car/unit, both of which are likely to continue in the near term. Unlike past periods, operating expenses rose in tandem with revenue, with higher materials costs being the main culprit. We continue to envision 5% annual growth in revenue and pretax earnings for BNSF in 2013.

Berkshire also reported solid results for MidAmerican Energy Holdings, which saw its top line increase 10%, and pretax earnings rise 8%, as weaker results from MidAmerican Energy Company (which handles MEHC's Midwestern operations) and MidAmerican Pipeline Group were offset by better performance from PacifiCorp and Northern Powergrid. Also of note was the strong performance from MEHC's real estate brokerage unit (HomeServices of America), which posted a 48% increase in third-quarter revenue, and an 81% increase in pretax earnings. Although some of this was tied to acquisitions that HomeServices has done during the last year, it reflects an increase in closed brokerage transactions and higher average home prices. Berkshire also noted that it expects to provide about $3.5 billion of the $5.6 billion price tag associated with MEHC's purchase of NV Energy, with the remainder covered by cash on hand at the energy subsidiary, along with the issuance of senior unsecured debt. Our utilities analyst assigns a 75% probability to a first-quarter 2014 close for the deal. Overall, we continue to be impressed by the positioning of MEHC relative to its peers, believing that its past performance, current portfolio mix, and future growth opportunities separate it from the rest of the pack.

Berkshire's manufacturing, service, and retail operations, which include both Marmon and McLane, overall saw a 15% increase in revenue, but only a 10% increase in pretax earnings, when compared with the third quarter of 2012. Marmon, which had been a standout performer coming into 2013, has struggled somewhat this year as declining commodity prices have taken their toll on its operations. That said, the 2% revenue decline the firm reported during the third quarter was an improvement over the last two quarters, when revenue fell 3% and 4%, respectively, with the company facing less-onerous hurdles as it closes out the year and starts up 2014. Marmon has also been astute with cost controls, with pretax earnings up 4% year over year during the third quarter (and up 2% on a year-to-date basis). The weaker performance at Marmon has been offset by better results at McLane, as well as from Berkshire's other manufacturing, service, and retail operations. The company's finance and financial products division also looks to be on better footing, with total pretax earnings rising 45% year over year on significantly better performance from Clayton Homes (Berkshire's manufactured housing and finance subsidiary), where pretax earnings more than doubled to $119 million year over year, on improved sales (with units sold up 9% year to date), lower loan-loss provisions, and increased net interest income. While the economy has been recovering in fits and starts, it is encouraging to see some of Berkshire's more economically sensitive operations posting such solid results.

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