A Mixed Quarter for Berkshire Hathaway

Wide-moat-rated

Second-quarter (and first-half) revenue increased 6.0% (6.9%) year over year to $54.5 ($106.9) billion. That said, results looked somewhat weaker if we assume that Berkshire owned Precision Castparts all along, with second-quarter (first-half) revenue increasing just 1.3% (1.8%) year over year. On the profitability front, second-quarter pretax operating earnings increased 7.4% year over year to $6.5 billion, but would have been down 2.3% had Precision Castparts been included in results for both periods. For the first half of 2016, pretax operating earnings decreased 0.7% year over year to $12.2 billion (but would have been down 8.6% on an adjusted basis). The contribution from investments and derivatives were stronger during the second quarter (and first half of the year), which left total pretax earnings up 26.1% (2.5%) year over year. On an adjusted basis, second-quarter pretax earnings were up 14.4%, while first-half results declined 5.1%.

Book value per Class A equivalent share was $160,009 at the end of the second quarter--up 6.9% year over year and 1.7% when compared with the first quarter of 2016. This was slightly lower than our forecast, which had book value per share increasing to $160,516. The company closed out the June quarter with $72.7 billion in cash on its books, up from $58.3 billion at the end of the March quarter, with much of the difference due to the $8.3 billion Berkshire received after Kraft Heinz redeemed its preferred stock. Despite the extra cash on hand, the firm did not buy back any shares during the second quarter.

Looking more closely at Berkshire's insurance operations, two of the firm's four insurance segments--Geico and Berkshire Hathaway Primary Group, or BHPG--posted earned premium growth during the second quarter. From an underwriting perspective, though, all of them posted positive results during the period, with combined ratios ranging from a high of 88.5% at BHPG to a low of 99.9% at General Re. On a combined basis, Berkshire's insurance operations generated a combined ratio of 95.3% during the second quarter, better than the 96.9% result posted during the first quarter of 2016 and the 100.5% combined ratios reported during the prior year's period. On a year-to-date basis, the firm's overall combined ratio of 96.1% is a slight improvement on last year's 96.5% result. We expect things to continue to look slightly better as the year progresses, and would expect to see a more marked improvement should Geico see a return to more normalized levels of profitability and the reinsurance group starts cutting costs out of the system ahead of Ajit Jain's takeover of control over both Berkshire Hathaway Reinsurance Group, or BHRG, and General Re.

Geico's second-quarter earned premium growth of 11.2% was stronger than last year's 10.6% rate of growth, but a bit short of the first quarter's 12.3% result. The increase reflected voluntary auto policy-in-force growth of 4.2% and increased premiums per auto policy of 7.1% during the past 12 months. The lumpy recovery in Geico's combined ratio continued during the second quarter, with the 97.6% level reported during the period an improvement over last year's 99.1% level, but reflective of a 200-basis-point decline in profitability when compared with the first quarter of 2016. As we've noted in past periods, it has paid to be a bit cautious on Geico's recovery, as a slowly improving U.S. economy, fueled by lower gas prices, has left more drivers on the road and increased the potential for accidents. On top of that, the problem of distracted drivers using smartphones to talk, text, or even watch videos while driving is not going away any time soon, so we continue to expect to see a fair amount of lumpiness in Geico's return to a more normalized level of profitability, which has historically been around 93.7%.

The second quarter saw another uptick in the company's loss ratio, which has generally averaged around 75.9%. At 82.8% during the period, it was only slightly better than last year's 83.6% level, and a big step back from the 79.7% result that Geico reported during the first quarter of 2016. While claims frequencies for property damage and collision coverages decreased in the 1%-2% year over year, and were relatively unchanged for bodily injury coverage, during the first half of 2016, average claims severities were higher for both physical damage and collision coverages (in the 4%-6% range) and bodily injury coverage (up 5%-7%). Underwriting expenses continue to track down, though, as the ever increasing size and scale of Geico's business allowed it to keep its second-quarter expense rate at 14.8%--the lowest result we can ever remember seeing for any quarter.

As for General Re, the reinsurer posted negative earned premium growth once again, reporting a 7.0% year-over-year in earned premiums during the second quarter, with both its property/casualty and life/health operations reporting less business year over year. Both General Re and BHRG continue to constrain the volume of reinsurance that they are underwriting, given the excess capacity that exists in the reinsurance market and the fact that neither firm feels that the pricing in the marketplace is attractive enough to profitably underwrite additional business. While we continue to have earned premium growth in negative territory for both firms over the next five years, we've always been quick to point out that there could be some lumpiness in reported results, as both firms have shown a knack for finding profitable business, even in times like we're facing right now where reinsurance pricing is unattractive.

It was no big surprise to see BHRG return to negative earned premium growth during the second quarter, despite seeing a 17.1% increase in property/casualty earned premiums (primarily attributable to the quota-share contract they have in place with Insurance Australia Group), as a 45.2% decline in life/annuity earned premiums drove results down 16.5% when compared with the prior year's period. That said, both BHRG and General Re posted an underwriting profit during the period, which is about the best that any insurer can do while it's amid a poor pricing environment. We continue to believe that Berkshire's reinsurance operations are competitively advantaged from their positioning as part of a broader business entity, which has historically provided them with the luxury of walking away from reinsurance underwriting when an appropriate premium cannot be obtained, which is something that cannot be said for their peers.

Berkshire's insurance float increased once again during the second quarter to $90.0 billion, up 2.6% from $87.7 billion at the end of 2015. We expect further gains in float to be much harder to come by as we move forward, though, 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 Berkshire Hathaway Specialty Insurance unit. Given these conditions, earned premium growth is likely to resemble a barbell longer term, with Geico and BHPG on the outer ends and the reinsurance arms barely noticeable in the middle.

Berkshire's noninsurance operations typically offer a more diversified stream of revenue and pretax earnings for the firm, helping to offset weakness in any one area, but 2016 looks to be another challenging year for the firm. We had expected Berkshire's railroad operator, BNSF, to report a poor quarter, having already seen weak results from

Normally a beacon of stability, Berkshire Hathaway Energy, or BHE, reported a 5.4% (5.1%) decline in second-quarter (first-half) revenue, primarily due to lower regulated electric and natural gas revenue at PacifiCorp, NV Energy, Northern Powergrid, and the company's natural gas pipeline operations (much of which can be tied to lower input costs). That said, pretax earnings were up 2.6% during the second quarter (and down just 0.8% during the first half of the year), with the subsidiary's pretax profit declining just 140 basis points to 21.0% for the first two quarters of 2016. We expect to see some moderation in results as we move forward, with BHE once again providing the positive diversification traits that we've seen from the business in past periods.

With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 9.0% (10.8%) increase in second-quarter (first-half) revenue, aided by the inclusion of Precision Castparts in the group's results. Had Berkshire owned the aircraft component and energy-production equipment producer all along, second-quarter (first-half) revenue would have been up 0.4% (1.4%) year over year. Mixed sales performance across the spectrum of companies--McLane (down 2.0%), Manufacturing (up 28.1%) and Service and Retailing (up 1.4%)--contributed to the group's unadjusted top-line growth during the period. Second-quarter (first-half) pretax earnings increased 11.5% (12.2%) year over year, when including the contribution of Precision Castparts (and to a lesser extent Duracell) in overall results. We continue to expect Berkshire's manufacturing, service, and retail division to see a meaningful lift in operating results as the rest of the year progresses.

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, with second-quarter (first-half) revenue increasing 10.6% (10.8%) and pretax earnings expanding 6.0% (6.7%). While pretax margins during the first half of 2016 dropped 100 basis points to 28.6%, primarily because of decreased earnings from investment securities and the company's investment in Berkadia, we expect things to normalize some over the remainder of the year. We continue to expect revenue to grow at a mid-to-high-single-digit rate going forward, with pretax margins likely to remain just below 30%, given the potential that exists for nearer-term weakness in each of the businesses that are represented in this segment.

As we noted above, book value per Class A equivalent share at the end of the second quarter was $160,009. Berkshire also closed out the period with $72.7 billion in cash on its books. With CEO Warren Buffett liking to keep around $20 billion on hand as a backstop for the insurance business, and the firm's noninsurance operations generally needing between $3 billion and $5 billion in operating cash on hand, Berkshire looks to have an excess cash balance of more than $45 billion. We view this as dry powder for future acquisitions or share repurchases. While Berkshire did not buy back any shares during the second quarter (or first half) of 2016, Buffett did confirm to us during the company's last annual meeting that he would aggressively buy back stock if it dipped below 1.2 times book value, even if the firm had not yet reported its end-of-quarter book value per share to shareholders. Based on end-of- second-quarter book value per share, Buffett should be willing to buy back stock at prices below $192,011 ($128.01) per Class A (B) share, which is about 12% below current trading levels.

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