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Heinz True Up Masks Lackluster Quarter for Berkshire

A one-time gain from the Kraft-Heinz deal obscured mixed operating results from Berkshire Hathaway in the third-quarter, writes Morningstar’s Gregg Warren.

Wide-moat-rated

Third-quarter revenue increased 15% year over year to $59.0 billion on mixed operating results from the company's main operating segments. Excluding the impact of investments and derivatives, revenue increased 1% year over year. Berkshire posted an $8.3 billion in investment and derivative gain (due primarily to a $6.8 billion noncash holding gain to true up its Heinz holding as part of the Kraft-Heinz deal) during the third quarter of 2015, compared with a loss of $118 million in the year-ago period. Through the first nine months of 2015, unadjusted revenue was up 9%, putting top-line growth at the upper end of our full-year forecast of mid- to high-single-digit revenue growth.

With revenue rising at a faster rate than expenses, the company reported a 109% increase in third-quarter pretax earnings to $14.1 billion and a 104% decrease in net earnings to $9.4 billion. Stripping out the impact of investments and derivatives, operating earnings decreased 4% to $2.8 billion. Net earnings per Class A equivalent share were $5,737 (up from $2,811 during the prior year's period). Year to date, net earnings per Class A equivalent share were $11,323, up 18% year over year.

Book value per Class A equivalent share at the end of the third quarter was $151,083--up 5% year over year (and 1% compared with the second quarter of 2015). This leaves the firm well-positioned to close out the year with book value per Class A share of around $155,000 (reflective of a 6% year-over-year increase). Berkshire closed out the third quarter with $66.3 billion in cash on its books, up 6% year over year and basically flat on a sequential basis.

Looking more closely at Berkshire's insurance operations, only two of the firm's four insurance lines--Geico and Berkshire Hathaway Primary Group--posted earned premium growth during the third quarter. General Re reported another quarterly decline in earned premiums primarily because of pricing pressure within the property and casualty markets. In particular, the firm continues to constrain the volume of reinsurance it is underwriting, given the excess capacity that exists in the market and the fact that pricing is not attractive enough to profitably underwrite additional business. Excluding the impact of its retroactive insurance business, Berkshire Hathaway Reinsurance Group actually posted an improvement in earned premiums, with a 31% increase in property and casualty premiums more than offsetting a 26% decline in life and annuity premiums. From a profitability perspective, Berkshire’s insurance operations had a pretax underwriting gain of $643 million compared with an underwriting gain of $976 million during the third quarter of 2014. The decline in underwriting gain was primarily due to weaker results from each of Berkshire's insurance segments, with the exclusion of BHPG (which posted a 19% increase in underwriting income during the third quarter).

While Geico posted another quarter of consistent growth on the top line, claim expenses remained high relative to historical levels because of an increase in claims frequencies and severity in several of its major coverages. The auto insurer’s loss ratio of 80.5% was 230 basis points higher than the year-ago quarter but reflected a 310-basis-point improvement from the second quarter of 2015--signs to us that underwriting standards are starting to tighten up and pricing actions have not yet affected written and earned premium growth, which were up 12% and 11%, respectively, year over year. Geico's growth trends and profitability were much healthier (and more or less in line with our expectations), and we believe that they will continue to improve as the firm refines its underwriting practices further and takes additional pricing actions aimed at getting its loss ratio back to more normalized levels.

Berkshire’s insurance float increased to $86.2 billion from $83.9 billion at the end of 2014, reflective of a 3% increase during the nine-month period. We expect further gains in float to be much harder to come by as we move forward, especially with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth in the firm's float over the past decade coming from its two reinsurance arms). We continue to believe that Geico will be an important contributor to earned premium growth, as well as to the growth of float, with underwriting profitability likely to improve in the coming quarters. BHPG should also continue to be an important contributor, especially considering the growth potential that exists for the newly formed Berkshire Hathaway Specialty Insurance unit. We do, however, continue to project more meager results from the company's insurance operations overall during the next couple of years, as we expect results to be far less robust in its reinsurance arms.

Berkshire's noninsurance operations typically offer a more diversified stream of revenue and pretax earnings for the firm, helping offset weakness in any one area. After posting stronger results during the first quarter, BNSF has gone through two difficult quarters in a row, with third-quarter revenue declining 5% year over year even as pretax earnings increased 11% during the period. Year to date, revenue was down 3%, but pretax earnings were up 18% (primarily due to significantly better results during the first quarter of 2015 when compared with the same period a year ago). The year-to-date decrease in revenue reflected a 5% decline in average revenue per car/unit (which was affected by a 50% decline in fuel surcharges year over year) offset by a 1% increase in volumes. Despite solid improvements in the firm's ag product volumes, BNSF has been affected so far in 2015 by softening demand for energy-related products (read: oil and coal), as well as weaker consumer products volumes (affected by port labor disruptions on the West Coast). We view this volume glut as a near-term glitch in BNSF's performance and one that is affecting most of its peers as well, and continue to expect the railroad's operating ratio (which was 70% year to date through the first nine months of 2015) to resume the path that would put its profitability more in line with Union Pacific longer term.

Berkshire Hathaway Energy came into 2015 with slightly higher hurdles, having benefited from the addition of NV Energy last year, as well as solid results from its other regulated utilities--PacifiCorp, MidAmerican Energy, and Northern Powergrid. That said, the firm did benefit this time around from both the AltaLink purchase (which closed in December 2014), as well as continued acquisitions and better operating performance from its real estate arm--Berkshire Hathaway HomeServices. While third-quarter revenue was up only marginally year over year, top-line growth increased 5% year to date. Pretax earnings increased 10% compared with the third quarter of 2014, with year-to-date pretax profits increasing 7% as a result. Going forward, we continue to envision BHE's U.S. regulated utilities receiving constructive rate-case outcomes, which would put annual revenue growth in the 2%-3% range over the next five years. For Northern Powergrid, we assume the division generates mid-single-digit revenue growth. As for the firm's pipeline and renewables businesses, we see revenue growing at a low- to mid-single-digit rate during 2015-19. This should all contribute to consolidated annual EBITDA growth of 6%-7% over the next five years, with EBITDA margins hovering around 40%.

With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 10% increase in third-quarter revenue, which translated into 11% top-line growth year to date. Mixed sales performance across the spectrum of companies--McLane (up 1% during the third quarter), Manufacturing (down 4%) and Service and Retailing (up 76% as the segment benefits from both organic growth and the inclusion of the Van Tuyl and Detlev Louis Motorad acquisitions in quarterly results)--contributed to the group's top line. This had a positive impact on third-quarter pretax earnings, which were up 6% and 5%, respectively, on a quarterly and year-to-date basis. As for the company's finance and financial products division, revenue expanded at a 3% rate compared with the prior year's period (with year-to-date top-line growth at 7%), and pretax earnings rose 29% (19%).

As we noted above, book value per Class A equivalent share at the end of the third quarter was $151,083--up 5% year over year and up just 1% compared with the second quarter of 2015. The company also closed out the period with $66.3 billion in cash on its books. With Warren Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, and assuming that the rest of the businesses need at least 2% of revenue as operating cash, and Berkshire committing $22.5 billion as part of the Precision Castparts deal (expected to close in the first quarter of 2016), we believe that the firm has an excess cash balance of around $20 billion. We view this as dry powder for future acquisitions or share repurchases. Berkshire did not buy back any shares during the first nine months of 2015. Given the company's current book value per share, as well as its ongoing 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 $181,300 per Class A share (or $121 per Class B share), implying a floor on the company's common stock that is about 11% below where Berkshire's shares are trading right now.

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The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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