Improved Insurance Results Lift Berkshire's Earnings
Our fair value estimate for Berkshire is unchanged after earnings were basically in line with our expectations.
As wide-moat Berkshire Hathaway BRK.A BRK.B reported second-quarter results that were basically in line with our expectations, we are leaving our $330,000 ($220) per Class A (B) share fair value estimate in place. Second-quarter (first-half) revenue, which now includes both unrealized and realized gains/losses from Berkshire's investments and derivatives portfolios, increased 19.3% (decreased 2.9%) to $68.6 ($119.0) billion. Excluding the impact of investment and derivative gains/losses and other adjustments, second-quarter (first-half) operating revenue increased 8.4% (decreased 0.8%) to $62.2 ($120.7) billion.
Operating earnings, excluding the impact of investment and derivative gains/losses, rose 67.3% (58.7%) year over year to $6.9 ($12.2) billion during the second quarter (first half) of 2018. When including the impact of the investment and derivative gains/losses, Berkshire's operating earnings rose 181.8% (30.7%) to $12.0 ($10.9) billion during the same period(s). With no share repurchase activity during the past year, net earnings per Class A equivalent share rose a similar amount to $7,301 ($6,610) for the second quarter (first half) of 2018.
Book value per share, which serves as a fairly good proxy for measuring changes in Berkshire's intrinsic value, increased 3.1% sequentially to $217,677 (from $211,184 at the end of the first quarter of 2018), which was better than our forecast of $216,464. The company closed out the June quarter with $111.1 billion in cash and cash equivalents, up from $108.6 billion at the end of March. This should have left Berkshire with around $86 billion in dry powder that can be committed to investments, acquisitions, share repurchases, and dividends. There were no meaningful commitments to acquisitions during the second quarter, and the firm did not commit any capital to share repurchases or dividends.
Looking more closely at Berkshire's insurance operations, all three of the company's insurance units--Geico, Berkshire Hathaway Reinsurance Group (which now includes National Indemnity Company, Berkshire Hathaway Life Insurance Company of Nebraska and General Re), and Berkshire Hathaway Primary Group--reported earned premium growth during the second quarter. As for underwriting profitability, both Geico and BHRG Re saw marked improvements in underwriting results, while BHPG's underwriting earnings deteriorated a bit during the period when compared with the second quarter of 2017. While BHRG and General Re have effectively merged their operations, Berkshire is reporting results for the combined entities in a way that allows us to continue to differentiate the results of these two firms when talking about their underwriting results.
Geico's relentless pursuit of growth the past couple of years, which had come at the expense of profitability, seems to have come to an end, with the firm positing a marked improvement in underwriting results during both the first and second quarters of 2018. The company's loss ratio, in particular, dropped to 77.7% during the first half of the year--well below the average loss ratio of 84.5% put up during 2016-17. Even so, Geico's earned (written) premium growth of 14.4% (13.3%) during the second quarter, and 15.0% (13.9%) during the first half of the year, remained elevated relative to historical norms. During the five-year period prior to 2017, Geico's earned premium growth averaged 10.7% per year. It then spiked up to 15.3% last year, as the company aggressively pursued business its peers were unwilling to go after. That said, while the auto insurer's first-half earned premium growth remained elevated, it is now being driven more by price increases than a relentless pursuit of new business, which has had a positive impact on profitability.
Geico's combined ratio of 91.9% (91.7%) during the second quarter (first half) of 2018 was the firm's best result since the second quarter of 2014 (when the company put up a ratio of 92.3% and 92.5%, respectively, for the quarter and first half of the year). With first-year business tending to come with acquisition costs and higher loss ratios that tend to leave total costs about 10 percentage points higher than renewal business, the company's pullback from voluntary new business sales (which declined 9.3% when compared with the first half of 2017) and its 8.7% increase in per-policy premium pricing over the past year has led to the marked improvement in Geico's loss ratio, which was 78.5% (77.7%) during the second quarter (first half) of 2018 compared with 84.3% (83.0%) in the year-ago period(s). Tight expense controls and increased scale left the firm's expense ratio at 13.4% (14.0%) during the second quarter (first half), better than last year's 14.0% (14.9%) level(s). As we move forward, we continue to expect to see a gradual reduction in earned premium growth to something closer to Geico's historical average, with its combined ratio hovering around the mid-90s by the end of our five-year forecast.
With regards to Berkshire's reinsurance arms, General Re posted another abnormal period of earned premium growth of 24.8% (30.0%) year over year during the second quarter (first half), driven by both new business and increased participations for renewals (along with favorable currency exchange) in its property/casualty and life/health units. The old BHRG unit, on the other hand, was always going to face an uphill battle this year, given the large retroactive reinsurance policy the firm underwrote with AIG last year, with earned premium growth up 8.8% (down 73.6%) year over year during the second quarter (first half) of 2018. Going forward, we expect General Re and BHRG to constrain the volume of reinsurance they are underwriting, given the excess capacity in the reinsurance market. While we have earned premium growth in negative territory for both firms over the remainder of our five-year forecast, we have always been quick to note that there could be some lumpiness in reported results, as both firms have a knack for finding profitable business (much as they have the past year), even when reinsurance pricing is unattractive. As for profitability, we expect tight expense controls (and a lack of extremely adverse events over a multiyear period) to allow both General Re and BHRG to keep their combined ratios below the 100% mark, which is what we're seeing from the combined entities right now.
As for BHPG, the insurance unit posted an 11.0% (17.2%) increase in earned (written) premiums year over year during the second quarter, and a 12.7% (17.0%) increase during the first half of the year, led by solid growth at Berkshire Hathaway Specialty Insurance, or BHSI, MedPro Group and Guard. The division's combined ratio of 88.0% (91.4%) during the quarter (first half) of 2018 put it back on the path to the levels of underwriting profitability we've been accustomed to seeing from the unit. BHPG's combined ratio of 94.8% during the first quarter was its worst quarterly showing (that did not include major catastrophe losses) since the first quarter of 2013 (when it posted a 92.4% combined ratio), with both elevated loss and expense ratios (driven primarily by its commercial liability and workers' compensation insurance offerings) driving the poorer results. This past quarter's results were more on par with the average annual ratio of 87.7% that BHPG posted during 2013-17. Going forward, we believe BHPG will generate earned premium growth in a 13%-15% range with a combined ratio between 88%-90%, reflective of the higher costs associated with growing businesses like its BHSI unit.
Despite the earned premium growth during the second quarter, Berkshire's insurance float remained relatively flat at $116.0 billion at the end of the June quarter (when compared with the first quarter of 2018). Going forward, we expect gains in insurance float to be much harder to come by, especially with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth in the company's float over the past decade coming from reinsurance). We continue to believe that Geico and BHPG will be the more consistent generators of insurance float for Berkshire as we move forward, especially given the growth potential that exists for BHPG's specialty insurance unit. We should note, though, that these are short-tail businesses, with the float generated by the two units tending to be invested in less risky and more liquid investments with smaller return profiles. That said, we wouldn't be surprised to see General Re and BHRG, which are long-tail businesses whose float can be invested in riskier longer-term holdings, pick up some additional float from time to time.
Berkshire's non-insurance operations typically offer a more diversified stream of revenue and pretax earnings for the firm, helping to offset weakness in any one area. We already had a sense of how things were likely to look for BNSF, given that the other Class I railroads reported earnings late last month. While Union Pacific is usually a good proxy for BNSF, given that both firms focus on the Western U.S. market and have similar shipment profiles, there was some difference in their results during the most recent period. For starters. BNSF's second-quarter (first-half) revenue growth of 12.0% (10.2%) was better than the 8.0% (7.4%) top-line growth that Union Pacific put up during the same period(s). BNSF's revenue growth during the first half reflected a 3.6% increase in average revenue per car/unit (including fuel surcharges) and a 5.2% increase in volumes. Union Pacific, meanwhile, saw average revenue per car/unit (including fuel surcharges) rise 4.5% (4.7%) during the second quarter (first half) on higher fuel surcharge revenue and core pricing gains, with total volumes increasing 3.7% (2.8%).
BNSF's consumer products volumes increased 4.7% (5.4%) during the second quarter (first half) of 2018 because of higher domestic and international intermodal volumes driven by continued economic growth and tightening truck capacity. Union Pacific's premium volumes saw a nice recovery, up 6.1% (3.9%) during the second quarter (first half), driven primarily by growth in international intermodal shipments. As for industrial products, volumes at BNSF increased 10.4% (9.8%) year over year during the second quarter (first half), aided by an increase in shipments of sand, petroleum products, steel, and plastics for the energy and industrial sectors. Union Pacific's industrial volumes rose 5.9% (4.0%) during the second quarter (first half), driven by growth in construction products, increased metals shipments, higher volumes of industrial chemicals and plastics, and growth in lumber shipments.
While agricultural shipments rose 9.1% (7.8%) for BNSF during the second quarter (first half) of 2018, some of this was due to stronger export and domestic grain shipments ahead of the looming trade war with China and other global economy, so our expectation is that we'll see volumes fall off some in the back half of the year. That same could not be said for Union Pacific, where volumes declined 1.4% (2.6%) during the second quarter (first half) on weaker grain shipments year over year, which could be a sign that BNSF is also capturing share in this category. As for coal, which accounts for about a fifth of BNSF's volumes and revenue, both firms saw a return to more normal coal volumes, with shipments falling 0.5% (1.4%) at BNSF during the second quarter (first half) of the year. Within Union Pacific's energy segment, which includes coal as well as some categories (like sand and petroleum products) that BNSF lumps together in its industrial products segment, coal volumes declined 10.0% during the second quarter, primarily on a lost contract (with volumes falling 3.5% during the first quarter). With coal in secular decline, as coal plant continue to be retired and natural gas and other alternatives remain competitively priced, our long-term forecast for coal volumes calls for 3.0% average annual declines in shipments for the two railroads (given their proximity to Powder River Basin coal supplies).
While operating income increased 6.9% (8.7%) year over year during the second quarter (first half of 2018, BNSF's operating ratio declined slightly from 67.6% to 68.0% year over year at the end of June, with the timing of higher fuel surcharges playing a material role. Union Pacific saw a similar degradation in its first-half operating ratio of 63.8% from last year's level of 63.5%, but was also dealing with network fluidity problems, a tunnel outage, and train crew shortages in some regions in addition to the higher fuel surcharge issue. With our railroad analyst maintaining his long-term operating ratio target of 58% for Union Pacific, we've left our long-run operating ratio target of 61% for BNSF in place. As for pretax profits, second-quarter (first-half) earnings at BNSF increased 7.7% (9.9%) when compared with the same period(s) in 2017.
Normally a beacon of stability, Berkshire Hathaway Energy reported a 9.7% (8.3%) increase in second-quarter (first-half) revenue, and a 9.7% (13.3%) decrease in pretax earnings due primarily to increased depreciation, maintenance and other operating expenses, as well as less favorable rate case across its utilities and pipeline portfolios. BHE has typically been the least volatile of Berkshire's subsidiaries, given that the regulated utilities operate in an environment where in exchange for their service territory monopolies, state and federal regulators set rates that aim to keep customer costs low while providing adequate returns for capital providers. The only meaningful change in these operations tends to occur when BHE does an acquisition, with this subsidiary tending to be one of Berkshire's most aggressive when it comes to doing deals, or when it is coming off particularly strong/weak results year over year. In this case, it was more of a perfect storm of rising operating and interest costs, compounded by changes in rate structures across the portfolio.
With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 4.6% (4.7%) increase in second-quarter (first-half) revenue, which was in line with our long-term forecast calling for mid-single-digit annual revenue growth (exclusive of acquisitions) over the next five years. As for pretax profits, second-quarter (first-half) earnings increased 13.1% (17.6%) when compared with the same period(s) in 2017, which to lifted the division's pretax margins to 8.2% for the first half of 2018, well ahead of our long-term forecast that calls for margins to improve 20-25 basis points annually over the 7.0% level that was produced during in 2017. We expect that the group will likely give some of this back as we proceed over the next year, but we may have to re-evaluate our long-term profitability forecast if the group continues to see a marked improvement in pretax margins.
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 somewhat mixed, with revenue increasing 17.3% (14.6%) year over year during the second quarter (first half) but lower pretax earnings from the railcar leasing business, due to a decline in lease revenues and higher repair costs, kept the expansion in pretax profits to 14.8% (12.4%). We continue to envision revenue increasing at a 5%-7% range over the remainder of our five-year projection period, with pre-tax operating margins in a 24%-26% range (despite the 23.9% margin the segment reported during the first half of 2018). It should also be noted that the finance and financial products segment is a mere rounding error for Berkshire's overall results, accounting for around 6% of pretax earnings on average the past five years.
As we noted above, book value per Class A equivalent share at the end of the second quarter was $217,677. The company also closed out the period with $111.1 billion in cash and cash equivalents on its books. With CEO Warren Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, the firm's non-insurance operations generally needing between $3 billion and $5 billion in operating cash, Berkshire still has (by our estimates) around $86 billion available to dedicate to investments, acquisitions, share repurchases and/or dividends. Along those lines, there were no meaningful commitments to acquisitions during the second quarter, and the firm did not commit any capital to share repurchases or dividends.
That said, we do expect to see Berkshire whittle some of its excess cash in the third quarter, as it has already dedicated $2.5 billion to the purchase of Medical Liability Mutual Insurance Company, a New York-based underwriter of medical professional liability insurance (in a deal put together by NICO in 2016), as well as another $2 billion in a term-loan deal with Seritage Growth Properties (composed of an initial loan of $1.6 billion at a fixed rate of 7%, which matures in July 2023, with an option to borrow an additional $400 million). We'll also have to see if Berkshire's shares are trading at a deep enough discount to the firm's intrinsic value (conservatively determined) for Buffett and Vice-Chairman Charlie Munger to finally start buying back stock after the company altered its share buyback program last month.
|Morningstar Premium Members gain exclusive access to our full analyst reports, including fair value estimates, bull and bear breakdowns, and risk analyses. Not a Premium Member? Get this and other reports immediately when you try Morningstar Premium free for 14 days.|
Greggory Warren does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.