A Mixed Third Quarter for Berkshire

Wide-moat-rated

Third-quarter (and year-to-date) revenue increased 0.1% (4.4%) year over year to $59.1 ($165.9) billion. That said, results look weaker if we assume Berkshire owned Precision Castparts all along, with third-quarter (year-to-date) revenue decreasing 3.9% (0.3%) year over year.

On the profitability front, third-quarter pretax operating earnings increased 6.7% year over year to $7.4 billion but would have been down 2.4% had Precision Castparts been included in results for both periods. For the first nine months of 2016, pretax operating earnings increased 2.0% year over year to $19.6 billion (but would have been down 6.4% on an adjusted basis). The contribution from investments and derivatives were much weaker year over year, leaving third-quarter (year-to-date) pretax earnings down 25.2% (11.7%) year over year. On an adjusted basis, pretax earnings were down 28.5%, while year-to-date results declined 16.8%.

Book value per Class A equivalent share was $163,783 at the end of the third quarter--up 8.4% year over year and 2.4% when compared with the second quarter of 2016. This was slightly higher than our forecast, which had book value per share increasing to $162,409, and even more impressive considering the large gain Berkshire booked on the Kraft-Heinz deal during the prior year's quarter. The company closed out the September quarter with $84.8 billion in cash on its books, up from $72.7 billion at the end of the June quarter. Despite the extra cash on hand, the firm did not buy back any shares during the third quarter (or the first nine months of 2016).

Looking more closely at Berkshire's insurance operations, two of the firm's four insurance segments--Geico and Berkshire Hathaway Primary Group (BHPG)--posted earned premium growth during the third quarter. From an underwriting perspective, Geico (with a 97.9% combined ratio), General Re (92.8%), and BHPG (88.3%) posted positive results, while Berkshire Hathaway Reinsurance Group (BHRG) had its profitability (101.0%) dragged down by losses in its retroactive insurance business. On a combined basis, Berkshire's insurance operations generated a combined ratio of 96.4% during the third quarter, worse than results for both the second quarter of 2016 (95.3%) and the prior year's quarter (93.9%). On a year-to-date basis, the firm's overall combined ratio of 96.2% is a step back from last year's 95.6% result. We expect things to look slightly better as time progresses and would expect to see a more marked improvement were Geico to see a return to a more normalized level of profitability. We also think that results will improve once the reinsurance group starts cutting costs out of the system as Ajit Jain takes full control of BHRG and General Re.

Geico's third-quarter earned premium growth of 11.9% was stronger than last year's (and the second quarter's) 11.2% rate of growth. The increase reflected voluntary auto policy-in-force growth of 5.2% and increased premiums per auto policy of 6.9% during the past 12 months. The lumpy recovery in Geico's combined ratio continued during the third quarter, which was a step down from the 97.6% level reported during the second quarter, and was reflective of a 240-basis-point decline in profitability when compared with the third quarter of 2015. 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%-94%.

The company's loss ratio at 82.4% remained elevated, compared with 80.5% in the prior year's period and around 76% historically. While claims frequencies for property damage and collision coverages, as well as for bodily injury coverage, were relatively unchanged during the first nine months 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 ticked up during the quarter as well, hitting 15.5%, compared with 15.1% in the prior year's period and 14.8% during the second quarter of 2016, which was the lowest result we can ever remember seeing for any quarter.

As for General Re, the reinsurer posted negative earned premium growth once again, with premiums declining 1.1% (driven entirely by a 5.9% year-over-year decline in property/casualty premiums). 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. Although 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 with negative earned premium growth during the third quarter, as a 13.2% decline in property/casualty earned premiums more than offset a 28.7% increase in life/annuity premiums when compared with the prior year's period. Improvements in General Re's profitability (with a combined ratio of 92.8%) did not translate into better results for BHRG, which posted a loss during the period, dragged down by losses in its retroactive insurance business. That said, the two businesses were in the black on a combined basis, which is about the best that any insurer can do while in the midst of 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 third quarter to $91.0 billion, up 3.8% from $87.7 billion at the beginning of 2016. 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 has come 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 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, 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 (BHE) reported a 1.0% increase (2.9% decline) in third-quarter (year-to-date) revenue, primarily due to lower regulated electric and natural gas revenues 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 8.1% (3.5%) during the third quarter (first nine months of the year), with the subsidiary's pretax profit declining just 80 basis points to 23.5% for the first three 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 11.2% (10.9%) increase in third-quarter (year-to-date) 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, third-quarter (year-to-date) revenue would have been up 2.1% (1.6%) year over year. Mixed sales performance across the spectrum of companies contributed to the group's unadjusted top-line growth during the period. Third-quarter (year-to-date) pretax earnings increased 45.5% (22.7%) 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, with pretax margins being lifted 75-100 basis points given the higher-margin contribution provided by Precision Castparts.

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 third-quarter (year-to-date) revenue increasing 13.7% (11.8%) and pretax earnings expanding 6.4% (6.6%). While pretax margins during the first nine months of 2016 dropped 130 basis points to 27.8%, due primarily to 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 third quarter was $163,783. Berkshire also closed out the period with $84.8 billion in cash on its books. After excluding operating cash, as well as cash the firm is likely to earmark for capital expenditures, equity investments, and smaller bolt-on acquisitions, and the $20 billion that CEO Warren Buffett likes to have on hand as a backstop for the insurance business, Berkshire should have at least $50 billion in excess cash available for future acquisitions and/or share repurchases.

While Berkshire did not buy back any shares during the third quarter (or first nine months) of 2016, CEO Warren Buffett did confirm to us during the company's last annual meeting that he would aggressively buy back stock if its dipped down 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 third-quarter book value per share, Buffett should be willing to buy back stock at prices below $196,540 ($131.03) per Class A (B) share, which is about 9% below current trading levels.

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