Even in Face of Difficulty, Berkshire Impresses

There was little in wide-moat Berkshire Hathaway's (BRK.B) fourth-quarter and full-year results that would alter our long-term view of the firm. We do not expect to make any changes to our $235,000 per Class A share ($157 per Class B share) fair value estimate, or in our moat rating.

Fourth-quarter pretax operating earnings declined 19.2% when compared with the prior year's period, as investment and derivative gains/losses declined from $1.9 billion in the fourth quarter of 2013 to $311 million in the current year's period (as Berkshire was hit with both realized and unrealized losses on its equity investment portfolio during 2014). This contributed to a 2.4% decline in pretax operating earnings for the full year. Excluding the impact of the investment and derivative gains/losses (as well as other eliminations and adjustments), the company's pretax operating earnings increased 2.9% during the fourth quarter, with the same measure up 5.5% for the full year.

We remain impressed with Berkshire's ability to continue to increase its book value per Class A equivalent share--which rose 8.3% year over year to $146,186--even when faced with difficulties. While the firm's end-of-year book value per share was slightly below our expectations (of $147,433), much of the difference can be attributed to changes in Berkshire's equity investment portfolio during the year. The company closed out the fourth quarter of 2014 with $63.3 billion in cash on its books, up from $62.4 billion at the end of September and $48.2 billion at the end of 2013. With CEO Warren Buffett preferring to keep around $20 billion in cash on hand as a backstop for Berkshire's insurance operations, and the cash allocated to its other operations assumed to be off-limits for acquisitions, the firm entered 2015 with about $38 billion in dry powder that could be allocated to deals (including acquisitions like the Van Tuyl Group that were initiated during the fourth quarter).

Fourth-quarter revenue increased just 2.6% to $48.3 billion, which left full-year revenue growth at 6.9% (and full-year revenue at $194.7 billion). This was slightly below our forecast of $196.3 billion for all of 2014. Excluding the impact of investments, derivatives, and eliminations, fourth-quarter and full-year revenue increased 6.8% and 8.9%, respectively.

As we noted above, fourth-quarter and full-year pretax operating earnings declined 19.2% and 2.4%, respectively, when compared with the prior year's period, but were up 2.9% and 5.5%, respectively, when excluding the impact of investments, derivatives, and eliminations. Reported net earnings per Class A equivalent share were $2,529 during the fourth quarter, which represented a 16.7% decline year over year. Full-year earnings were $12,092 per Class A equivalent share, an increase of 2.0% when compared with 2013. Excluding the impact of investments, derivatives, and eliminations, fourth-quarter and full-year earnings per Class A equivalent share increased 5.3% and 9.3%, respectively.

Looking more closely at Berkshire's operating businesses, the firm's insurance operations reported a 6.2% increase in earned premiums during the fourth quarter, with stronger sales from Geico (up 9.9%) and Berkshire's specialty insurance operations (up 30.7%) more than making up for weakness at General Re (down 2.0%) and Berkshire Hathaway Reinsurance (down 8.9%), with the latter continuing to be impacted by a sharp decline in premiums from the Swiss Re contract and the property catastrophe business. While Geico posted another quarter of consistent growth on the top line, claim expenses also went up more than expected, which eroded margins by about 40 basis points relative to the 2013 level. That said, the auto insurer’s 94.3% combined ratio for 2014 remained one of the best in the industry, with pretax underwriting profit increasing 3% year over year, thanks mainly to its low-cost distribution model. Premium growth was exceptionally strong at Berkshire Hathaway Primary, primarily attributable to volume increases from Berkshire Hathaway Specialty, NICO Primary, BHHC, and Guard. While the claims environment for this particular group of insurers has been favorable the past three years, they do write sizable amounts of liability and workers' compensation business, which can have extended claim tails. Premium growth was also fairly strong at Geico, reflecting an increase in in-force policies and pricing actions, both of which were healthy and in line with our expectations.

Berkshire's reinsurance operations continue to struggle with a weak pricing environment, which keeps them from underwriting business (given the unfavorable risk/reward trade-off). As a result, both BHRG and General Re saw a decline in underwriting profits over 2013 levels, with the largest contributor to the decline in the pretax reinsurance earnings coming from BHRG. In particular, earned premiums from BHRG's Swiss Re contract declined $1.3 billion million during 2014. As a result, pretax underwriting gains from the Swiss Re contract declined from $351 million in 2013 to $283 million last year. BHRG's property catastrophe business also saw a decline in premiums, falling 14.0% year over year to $688 million. While the decline in premiums and underwriting profits might, at first glance, reflect poorly on Berkshire reinsurance operations, we view it as a positive for the firm, as it demonstrates its ability to exercise strong underwriting discipline in an unfavorable pricing environment. Looking ahead, we believe soft reinsurance pricing will continue to dampen the demand for new businesses, something that we expect to have an impact on Berkshire's diverse reinsurance businesses in the year ahead.

Berkshire's insurance float increased to $83.9 billion overall from $77.2 billion at the end of the fourth quarter of 2013, reflective of an 8.6% increase year over year. Further gains in float are likely to be much harder to achieve, though, especially with Berkshire likely to limit the amount of reinsurance business it underwrites (given the poor pricing environment for the reinsurers right now). In fact, with floats drifting downward for a number of runoff contracts in the reinsurance business, which offset the gains in float from Geico and the commercial insurance operation, Berkshire is likely to experience a gradual decline in float in future years. At the end of 2014, Berkshire Hathaway Reinsurance accounted for 51% (up 3% from 2013 level) of the company's total float, with General Re at 23% (down 3% from 2013 level), Geico at 16% (same as 2013 level), and the remaining primary insurance operations at 10% (same as 2013 level). Much of the growth in Berkshire's float over the past decade has come from its reinsurance operations.

Much as they have the past few years, Berkshire's noninsurance operations continue to be an added source of stability for the firm. BNSF continues to perform well, despite a slow start to the year (as adverse weather conditions impacted its operations), a sharp drop in crude oil prices during the fourth quarter (which has the potential to impact its transport of crude oil from the Bakken Shale region), and congestion at U.S. West Coast ports (which has had an adverse effect on the railroad's intermodal volume). Fourth-quarter and full-year revenue increased 7.3% and 5.6%, respectively, which is impressive given the slow start to the year at BNSF. Full-year revenue growth (which was better than our forecast of 4.0%) was composed of a 1.8% increase in volume and a 3.5% increase in pricing. We continue to be cautious on BNSF, given the impact that significantly lower crude oil prices, as well as the slowdown at the U.S. West Coast ports, could have on volumes this year. We also believe that price increases will be a bit more difficult to come by, given the drop in crude oil prices (which will for the most part be passed along to customers). The good news for BNSF is that it's unlikely to see a repeat of last year's difficult first quarter, as most of the adverse weather so far during 2015 has been east of the company's main territory.

Berkshire has made up for most of the weakness at BNSF this past year with stronger results from Berkshire Hathaway Energy, which not only benefited from the NV Energy acquisition, but also augmented solid results from PacifiCorp and MidAmerican Energy with stronger than expected results from Northern Powergrid and Berkshire Hathaway HomeServices. Fourth-quarter revenue increased 34.3% and was up 38.2% for the full year, when including the NV Energy deal, and rose 13.0% and 12.5%, respectively, when looking at results on a more comparable basis. Fourth-quarter and full-year pretax earnings were up 99.6% and 50.1%, respectively, on a reported basis, but when excluding the impact of the NV Energy deal were actually down year over year as several of the subsidiaries operating units--including PacifiCorp and MidAmerican Energy--posted declines in pretax profits during the fourth quarter, and the firm's real estate brokerage business continues to spend heavily on "Berkshire Hathaway HomeServices" rebranding activities. With the NV Energy deal closing in mid-December 2013, the company should see more normalized results in the year ahead.

With regards to Berkshire's service and retail operations, which include McLane, Marmon's engineered components and retail technologies units, Iscar, and Lubrizol, the group overall recorded a 3.3% increase in fourth-quarter revenue, with full-year top-line growth at 4.5% (below our expectations of 6.5% for the full year). McLane's full-year revenue growth of 1.5% was lower than our 3.0% forecast, but understandable given the tougher sales environment for its grocery operations. Pretax earnings declined 10.5% when compared with 2013, but the year-ago period did include a pretax gain of $24 million related to the sale of McLane's logistics business. Excluding the impact of that transaction, pretax earnings fell 5.8% to $435 million, reflective of a less-than 1% margin for the business (which is about normal for food and beverage distributors). Berkshire's manufacturing operations reported a 7.3% increase in annual revenue, with pretax earnings increasing 14.4% to $4.8 billion (reflective of a 13.1% margin). Service sales were up strongly last year as well, increasing 9.5% over 2013 levels, while pretax margins held steady at 12.2% (representing a 10.0% increase in pretax earnings year over year). As for the firm's retailing operations, Berkshire saw a decline in pretax margins to 7.8% (from 8.8%) during 2013, despite a 3.1% increase in sales. The earnings declines in 2014 were primarily attributable to lower earnings from Nebraska Furniture Mart (which incurred higher costs related to the buildout of a new store and warehouse facility) and Pampered Chef (which suffered from lower sales year over year).

Results for Berkshire's finance and financial products division, which includes Clayton Homes (manufactured housing and finance), Cort Business Services (furniture rental), Marmon (rail car and other transportation equipment manufacturing, repair and leasing) and Xtra (over-the-road trailer leasing), were also up year over year, but much of this was due to the reclassification of Marmon's transportation equipment manufacturing, repair and leasing businesses from the firm's manufacturing, service and retail operations. Full-year revenue increased 6.8%, and pretax earnings were up 17.6%, with Clayton Homes actually making a significant contribution to pretax earnings (due to lower loan loss provisions on installment loan portfolios, lower interest expense on borrowings, and improved manufacturing results). Earnings from Marmon's transportation equipment manufacturing, repair and leasing businesses were also up strong, with full-year pretax profit up 17.5% when compared with the prior year's period. These results helped offset somewhat weaker earnings from the segment's other finance activities, which include Cort's furniture leasing business, interest and dividends from a portfolio of investments and earnings from a joint venture that Berkshire maintains in a commercial mortgage servicing business.

As we noted above, book value per Class A equivalent share at the end of the fourth quarter was $146,186--up 8.3% year over year and 1.1% when compared with the third quarter of 2014. The company also closed out the period with $63.3 billion in cash on its books. With Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, Berkshire now has an excess cash balance of around $38 billion (with only a small portion of this total dedicated to deals that were announced during the fourth quarter of 2014). The company did not buy back any shares during the past year, but did retire 2,107 Class A shares and 1,278 Class B shares as part of an asset swap transaction with Graham Holdings at the end of June. Given Berkshire's book value per share at the end of the fourth quarter, and the company's current share repurchase authorization, which allows the firm to buy back stock at prices no higher than a 20% premium over book value, Buffett should be willing to buy back stock at prices up to $175,423 per Class A share (or $117 per Class B share), implying a floor on the company's common stock that is about 20% below where shares are trading right now.

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