Stock Analyst Update

Improved Insurance Results Lift Berkshire

Greggory Warren, CFA

While wide-moat rated  Berkshire Hathaway's (BRK.A) third-quarter results were slightly better than our expectations, we are leaving our $330,000 ($220) per Class A (B) share fair value estimate in place, given the nearer-term uncertainty surrounding its more macro-sensitive businesses. Third-quarter (year-to-date) revenue, which includes both realized and unrealized gains/losses from Berkshire's investment portfolios, increased 29.2% (7.7%) year over year to $78.2 ($197.2) billion. Excluding the impact of investment and derivative gains/losses and other adjustments, third-quarter (year-to-date) operating revenue increased 6.5% (1.5%) to $63.4 ($184.1) billion.

Operating earnings, excluding the impact of investment gains/losses, rose 99.8% (71.4%) year over year to $6.9 ($19.1) billion during the third quarter (first nine months) of 2018. When including the impact of the investment and derivative gains/losses, Berkshire's operating earnings rose 355.9% (137.4%) to $18.5 ($29.4) billion during the same period(s). Net earnings per Class A equivalent share rose a similar amount to $11.3 billion ($17.9) billion for the third quarter (first nine months) of 2018.

Book value per share, which serves as a good proxy for measuring changes in Berkshire's intrinsic value, increased 5.1% sequentially to $228,712 (from $217,677 at the end of the June), much better than our forecast of $222,847. The company closed out the third quarter with $103.6 billion in cash and cash equivalents, down from $111.1 billion at the end of the second quarter, which should have left Berkshire with around $80 billion in dry powder to be used for investments, acquisitions, share repurchases, and dividends. CEO Warren Buffett noted during the third quarter that Berkshire had repurchased some shares after the firm changed its share repurchase program in early August, but with less than $1 billion spent on buybacks during the period it had little impact on cash balances or the firm's share count.

Looking more closely at Berkshire's insurance operations, two of the company's three insurance units--Geico, and Berkshire Hathaway Primary Group--reported earned premium growth during the third quarter. Berkshire Hathaway Reinsurance Group (which now includes National Indemnity Company, Berkshire Hathaway Life Insurance Company of Nebraska and General Re) reported a mid-single digit decline in earned premiums. As for underwriting profitability, given the lapping of a "perfect storm" of hurricanes and other natural disasters during the third quarter of 2017, Geico, General Re and BHPG all reported marked improvements in underwriting results, while BHRG's underwriting earnings deteriorated a bit during the period when compared with the third 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, has ended, with the firm positing a sustained improvement in underwriting results during the first, second and third quarters of 2018. The company's loss ratio, in particular, dropped to 78.1% (from 86.1%) during the first nine months of 2018 (2017)--well below the average loss ratio of 84.5% put up during 2016-17. Even so, Geico's earned premium growth of 12.8% (14.2%) during the third quarter (first nine months 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, and had spiked up to 15.3% last year, as the company aggressively pursued business its peers were unwilling to go after. While the auto insurer's year-to-date earned premium growth remained slightly elevated, it should be noted that it is being driven more by price increases now, as opposed to a relentless pursuit of new business, which has had a positive impact on profitability. 

Geico's combined ratio of 92.6% (92.0%) during the third quarter (first nine months) of 2018 was more on par with results that the firm was putting up back in 2014. 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 pull back from voluntary new business sales and increases in per policy premium pricing over the past year has led to the marked improvement in Geico's loss ratio, which was 79.1% (78.1%) during the third quarter (first nine months) of 2018 compared with a hurricane-adjusted 85.3% (83.8%) during the year ago period(s). Tight expense controls and increased scale left the firm's expense ratio at 13.6% (13.9%) during the third quarter (first nine months), an improvement on last year's 13.6% (14.4%) level(s). As we move forward, we continue to expect see a gradual reduction in earned premium growth to something closer to Geico's historical average, given that pricing will be less of a contributor as we move forward, 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 25.4% (28.4%) year over year during the third quarter (first nine months), driven by both growth in its Asian and Australian markets and favorable foreign currency exchange (due to a weaker U.S. Dollar). BHRG, 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 down 25.4% (down 66.6%) year over year during the third quarter (first nine months) 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 multi-year 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 a 10.7% (12.0%) increase in earned (written) premiums year over year during the third quarter (first nine months of the year), led by solid growth at Berkshire Hathaway Specialty Insurance (BHSI), MedPro Group, GUARD and Berkshire Hathaway Home Companies. The division's combined ratio of 93.4% (92.1%) during the third quarter (first nine months) of 2018 was weaker than the levels of underwriting profitability we've been accustomed to seeing from the unit (with the average annual combined ratio during 2013-17 being 87.7%). BHPG's combined ratio of 94.8% during the first quarter of 2018 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 impacted by $75 million in estimated losses related to Hurricane Florence, which if excluded from results would have left BHPG's combine ratio(s) closer to 89.8% (90.8%) during the third quarter (first nine months) of 2018. Going forward, we continue to believe that the unit can generate earned premium growth in a 13%-15% range with a combined ratio between 88%-90% (which is reflective of the higher costs associated with growing businesses like its BHSI unit).

Despite the earned premium growth during the third quarter, Berkshire's insurance float remained relatively flat at $118.0 billion at the end of the September quarter (when compared with the second  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 pre-tax 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 third-quarter (year-to-date) revenue growth of 15.7% (12.1%) was better than the 9.6% (8.1%) top-line growth that Union Pacific put up during the same period(s). BNSF's revenue growth during the first nine months reflected a 6.1% increase in average revenue per car/unit (including fuel surcharges) and a 4.6% increase in volumes. Union Pacific, meanwhile, saw average revenue per car/unit (including fuel surcharges) rise 4.0% (4.5%) during the third quarter (first nine months) on higher fuel surcharge revenue and core pricing gains, with total volumes increasing 5.9% (3.8%). It should also be noted that per gallon average quarterly diesel fuel price was 34% higher during the third quarter 2018, when compared with the prior year's period.

BNSF's consumer products volumes increased 3.9% during the first nine months of 2018 due to higher domestic and international intermodal volumes driven by continued general economic growth and tight truck capacity, as well as growth in imports and containerized agricultural product exports. Union Pacific's premium volumes saw a nice recovery, up 5.6% during the first nine months of the year, driven primarily by growth in international intermodal shipments. As for industrial products, volumes at BNSF increased 13.1% (10.9%) year over year during the third quarter (first nine months), aided by an increase in shipments of rocks, sand, petroleum products, steel, and plastics for the energy and industrial sectors. Union Pacific's industrial volumes rose 9.3% (5.8%) during the third quarter (first nine months), driven by driven by stronger industrial production that impacted growth in industrial chemicals, construction products, and plastics.

 

While agricultural shipments rose 16.3% (10.5%) for BNSF during the third quarter (first nine months) of 2018, some of this could be due to stronger export and domestic grain shipments, as well as higher fertilizer and other grain products volumes, ahead of what looks to be an impending trade war with China and other global economies, so our expectation is that we'll see volumes fall off some as we move forward. The same could not be said for Union Pacific, where volumes increased 1.8% (declined 1.2%) during the third quarter (first nine months) on weaker grain shipments year over year, which could actually be a sign that BNSF is capturing share from its closest peer 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 4.6% (2.6%) at BNSF during the third quarter (first nine months) 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 3.0% during the third quarter. With coal in secular decline, as coal plants continue to be retired and natural gas and other alternatives remain competitively priced, our long-term forecast for coal volumes continues to call for 3.0% average annual declines in shipments for the two major railroads (given their proximity to Powder River Basin coal supplies).

While operating income increased 9.6% (9.1%) year over year during the third quarter (first nine months) of 2018, BNSF's operating ratio declined slightly from 63.2% to 65.2% year over year at the end of third quarter (and from 66.1% to 67.0% year over year during the first nine months), with the timing of higher fuel surcharges playing a material role. Meanwhile, Union Pacific's 61.7% (63.1%) operating ratio during the September quarter (first nine months of 2018) was basically flat when compared with the same period(s) a year ago, due to network congestion and mix shifts, as well as the timing of higher fuel surcharges. With our railroad analyst maintaining a long-term operating ratio target of 57% for Union Pacific, we're keeping our long-run operating ratio target of 61% for BNSF in place. As for pre-tax profits, third-quarter (year-to-date) earnings at BNSF increased 9.9% (9.9%) when compared with the same period(s) in 2017. 

Normally a beacon of stability, Berkshire Hathaway Energy reported a 6.6% (7.9%) increase in third-quarter (year-to-date) revenue, and a 6.3% (9.8%) decrease in pre-tax 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 3.7% (4.3%) increase in third-quarter (year-to-date) revenue, which was more or less 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 pre-tax profits, third-quarter (year-to-date) earnings increased 5.8% (13.4%) when compared with the same period(s) in 2017, lifting the division's pre-tax margins to 8.1% for the first nine months 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 reevaluate our long-term profitability forecast if the group continues to see such elevated pre-tax margins (ahead of our schedule, that is).

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 13.0% (14.0%) year over year during the third quarter (first nine months) but lower pre-tax earnings from the railcar leasing business, due to a decline in lease revenues and higher repair costs, kept the expansion in pre-tax profits to 6.9% (10.5%). 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 23.2% margin the segment reported during the first nine months 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 pre-tax earnings on average the past five years.

As we noted above, book value per Class A equivalent share at the end of the third quarter was $228,712. The company also closed out the period with $103.6 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 $80 billion available to dedicate to investments, acquisitions, share repurchases and/or dividends. Along those lines, Berkshire did whittle away at some of its excess cash during the third quarter, spending $2.5 billion on the purchase of Medical Liability Mutual Insurance Company, a New York-based underwriter of medical professional liability insurance (in a deal that was put together by NICO in 2016), as well as dedicating another $2 billion in a term-loan deal with Seritage Growth Properties (comprised 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).

Berkshire also spent close to $928 on share repurchases during the third quarter, acquiring 225 Class A shares for just over $70 million (or $312,807 per Class A share) and 4.1 million Class B shares for just over $857 million (or $207 per Class B share). While this did little to alter the company's share count, or impact its excess cash balances, it did provide us with some insight into the price that Buffett would likely be willing to pay to buy back shares. As you may recall from mid-July, when Berkshire altered its share buyback program to allow the firm to repurchase shares when Buffett and Vice-Chairman Charlie Munger believed "the repurchase price is below Berkshire's intrinsic value, conservatively determined," we were left wondering what sort of discount to book value the two men would require to put money to work. 

When Buffett noted in late August that the firm had bought back some stock during the month, we looked back at where the shares had traded and could not see too many days where the stock traded below 1.43 times book value per share, which seemed to be a high buyback threshold for us, given that fact that the shares have traded at 1.45, 1.35 and 1.45 times trailing book value per share on average during the past 5-, 10- and 15-year time frames. Our best guess had been that Buffett would look for prices closer to 1.35 times trailing book value per share to buy back stock, but given the lack of investment opportunities and the fact that cash continues to build on the balance sheet, it was not too surprising to see Berkshire buying back shares at 1.44 times end of June book value per Class A (B) share of $217,677 ($145.12). That said, Buffett has noted in the past that he would consider repurchasing shares based on book value per share information that had yet to be published, which would leave the firm's share repurchase price of 1.37 times end of September book value per Class A (B) share of $228,712 ($152.47) much closer to the threshold we were expecting for repurchases going forward.

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Greggory Warren, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.