Berkshire Closes Out 2013 on a Solid Note

There was little in wide-moat  Berkshire Hathaway's (BRK.A) (BRK.B) fourth-quarter and full-year results that would alter our long-term view of the firm. We are leaving our fair value estimate in place.

Fourth-quarter aftertax operating earnings increased 34.2% year over year, contributing to a 20.2% increase for 2013. Including the impact of investment and derivative gains, Berkshire reported a 9.6% increase in fourth-quarter net earnings, with full-year earnings rising 31.4%.

Results for 2013 once again demonstrated the value of Berkshire's diversified portfolio, as solid and consistent results from the firm's noninsurance operations helped smooth out some of the volatility seen in its insurance operations during the year.

Berkshire's book value per Class A equivalent share was $134,973 at the end of 2013--up 6.5% sequentially and reflective of an 18.2% increase year over year (higher than our full-year forecast of a 15.0% gain). With the S&P 500 Total Return Index up 32.4% during 2013, this marked just the 10th time in the past 49 years that Berkshire has trailed the benchmark. It also broke the company's long-standing streak of never having a five-year period of underperformance relative to the benchmark. All told, though, Berkshire has increased its book value per share at a compound annual rate of 19.7% from 1965 to 2013, compared with a 9.8% annualized total return for the S&P 500.

With Berkshire's common stock trading at prices above the 1.2 times book value threshold required for stock buybacks, the company did not repurchase any shares during 2013. Berkshire closed out the year with a consolidated cash balance of $42.6 billion, relatively unchanged from the third quarter of 2013 and from the end of 2012. Major acquisitions during the last year included Heinz (into which Berkshire invested $8.0 billion for Heinz preferred stock and another $4.3 billion for a 50% equity stake in Heinz), and NV Energy (which closed in December 2013 at a cost of $5.6 billion).

Looking more closely at Berkshire's insurance operations, three of the firm's four insurance lines--GEICO, Berkshire Hathaway Reinsurance, and Berkshire Hathaway Primary Group--posted underwriting profits during 2013, despite some of these operations posting higher claims experience (especially in the reinsurance side of the business) at different times during the year. General Re was the only underperformer, impacted by significantly lower underwriting profits on the property/casualty side of the business as the reinsurer was negatively affected by catastrophe losses attributable to a hailstorm and floods in Europe.

Berkshire's insurance float also increased to $77.2 billion from $73.1 billion last year, reflective of a 5.6% increase year over year. Further gains in float are likely to be much harder to come by, though, especially with Berkshire likely to limit the amount of reinsurance business it underwrites (given the poor pricing environment for the reinsurers right now). At the end of 2013, Berkshire Hathaway Reinsurance accounted for 48% of the company's total float, with General Re at 26%, GEICO at 16%, and the remaining primary insurance operations at 10%. Much of the growth in Berkshire's float over the past decade has come from its reinsurance operations.

GEICO is now the second-largest auto insurer in the United States, relying primarily on direct selling to consumers, a model that has traditionally provided it with cost advantages over some of its competitors. Premium growth was relatively strong for the auto insurer during 2013, with premiums written increasing 11.4% year over year, and earned premiums rising 10.9% during the year. This growth was driven by a 7.8% increase in voluntary auto policies-in-force and, to a lesser degree, higher average premiums per policy--trends that have been relatively healthy and in line with our expectations. Although GEICO continues to post consistently solid top-line growth, claims expenses have ticked up over the past year, with the firm's loss ratio increasing to 76.7% in 2013 (compared with 75.9% in 2012). Even after this slight uptick in the loss ratio, GEICO continued to maintain one of the best combined ratios in the industry, with pretax underwriting profit increasing 65.7% year over year.

Looking more closely at Berkshire's reinsurance operations, underwriting profits at Berkshire Hathaway Reinsurance more than tripled during 2013, despite the fact that that the firm continued to post losses in its retroactive insurance operations. The company also had a 20% quota-share contract with Swiss Re (covering substantially all of that firm's property/casualty risks) wind down during the year. That said, soft reinsurance pricing has dampened the demand for new businesses, something that we expect to have an impact on General Re as well in the year ahead. Berkshire Hathaway Primary Group, which is composed of a wide collection of independently managed insurance businesses, had a good year as well, with pretax underwriting profits increasing 34.6% year over year.

Also of note was Warren Buffett's comments on Ajit Jain's latest venture into commercial insurance, Berkshire Hathaway Specialty Insurance, which is being run by Peter Eastwood (formerly of AIG) and has been instantly accepted by both major insurance brokers and corporate risk managers. The expectation is that this business will start being a major contributor to Berkshire's insurance operations in the next several years, generating volume in the billions.

Much as they have during the past several years, Berkshire's noninsurance operations continue to be a source of stability for the firm, reporting a 10.4% increase year over year in pretax earnings during 2013. The company's so-called "Powerhouse Five"--Burlington Northern Santa Fe, MidAmerican, Iscar, Lubrizol, and Marmon--generated a record $10.8 billion of pretax earnings last year, up 8.0% over 2012 levels.

BNSF, which (at $5.9 billion) continues to be one of the largest contributors to Berkshire's overall profitability (outside of its insurance operations), reported a 10.2% increase in pretax earnings during 2013. BNSF benefited from increased rail volumes (especially in industrial products, which include petroleum shipments, and consumer products) and slightly higher average revenue per car/unit, both of which are likely to continue in the near term. The company spent around $4 billion on capital expenditures during 2013, double its depreciation charge and a single-year record for any railroad, with management expecting to spend considerably more on capital improvements in 2014.

Berkshire also reported solid results for MidAmerican, which posted a 9.9% increase in pretax earnings for the full year. Weaker relative results from MidAmerican Energy Company (which handles MEHC's Midwestern operations), MidAmerican Pipeline Group, and Northern Powergrid were more than offset by stronger performance from PacifiCorp and HomeServices of America (Berkshire's real estate brokerage operations). PacifiCorp, which will benefit from the inclusion of NV Energy in its results during 2014, posted stronger results last year due to increased pricing and fewer one-time charges (tied to litigation, fire and other damage claims during 2012). Excluding those charges, the improvement in pretax earnings year over year was relatively modest at PacifiCorp. The same could not be said for HomeServices of America, which posted a 36.7% increase in full-year revenue and a 69.5% increase in pretax earnings. While some of this was tied to acquisitions that HomeServices has done over the past year, it also reflects an increase in closed brokerage transactions and higher average home prices.

With regards to Berkshire's manufacturing, service and retail operations, which include Iscar, Lubrizol, and Marmon, the group overall saw a 10.0% increase in pretax earnings during the year. Marmon, which had been a standout performer coming into 2013, struggled somewhat over the past year because of its exposure to declining commodity prices. Despite posting a 2.7% decline in revenue last year, Marmon still managed to post a 3.4% increase on pretax earnings due to an increasing focus on niche products and markets (which carry higher margins), and ongoing efforts to improve operating efficiency and productivity. With Marmon facing slightly less onerous hurdles in 2014, we expect the division to post stronger operating results in the year ahead.

Even though Berkshire includes Iscar and Lubrizol in its "Powerhouse Five" grouping, the firm is relatively light with details on either firm. From what we could gather from the annual report, pretax earnings at Iscar and Lubrizol were roughly unchanged from 2012, which is surprising given the number of bolt-on acquisitions in these operations over the last year.

This means that the weaker performance at Marmon, and the relatively unchanged performance at Iscar and Lubrizol, have been offset by better results at McLane (Berkshire's wholesale distribution business), as well as from the company's other manufacturing, service, and retail operations. McLane's business is extremely low-margin, and can be influenced heavily by fuel surcharges (which tend to elevate revenue but get washed out at the operating income level). Full-year revenue for the wholesaler of $45.9 billion represented a 22.7% increase year over year, driven primarily by price increases, the addition of new customers, and the acquisition of Meadowbrook Meat Company in late 2012 (which added around $6 billion in annual revenue to the firm). Pretax earnings of $486 million represented a 20.6% increase year over year, most of which can be attributed to the Meadowbrook acquisition, and a gain on McLane's sale of its Brazil-based logistics business. Berkshire also benefited from stronger pretax earnings growth in its other manufacturing businesses, particularly from its recreational vehicles (Forest River), building products, and apparel businesses during the year.  

The company's finance and financial products division also seems to be on better footing, with total pretax earnings rising 16.2% year over year on significantly better performance from Clayton Homes (Berkshire's manufactured housing and finance subsidiary), where pretax earnings increased 63.1% year over year to $416 million, on improved sales (with units sold up 9% year to date), lower loan loss provisions (reflecting comparatively lower foreclosures volume and loss rates), and increased net interest income. With the economy (and, more importantly, the job market) continuing to recover in fits and starts, it is encouraging to see some of Berkshire's more economically sensitive operations still posting such solid results.

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Note: A correction was made to this article since original publication. GEICO is now the second-largest, not the third-largest, auto insurer in the United States.