Underneath Berkshire Hathaway's Headline Numbers

Berkshire Hathaway (BRK.A) reported results for the first quarter following the close of trading Friday. While Berkshire reported a loss in terms of GAAP net income for the quarter, the underlying results for the operating business are actually quite solid given the global economic recession. Berkshire’s operating earnings per share declined 11.8% to $1,100 per A Share, down from $1,247 in the first quarter of 2008. Net earnings per share were recorded as a loss of $900 per A Share compared to profits of $607 per A Share in the first quarter of 2008.

“Headline numbers” are misleading

Since the “headline numbers” reflected in GAAP net income fail to adequately describe the underlying health of the operating businesses, let’s take a closer look at Berkshire’s results for the quarter.

Berkshire reports operating earnings each quarter in addition to the GAAP presentation of net earnings. This is done in order to allow investors to focus on the underlying health of the operating companies without regard to the timing of realized gains and losses as well as the impact of mark to market accounting on Berkshire’s derivatives positions.

By providing operating earnings, Berkshire is not trying to suggest that investment gains and losses are not relevant to Berkshire’s intrinsic value. Although long term investment gains and losses are relevant, the timing of these gains and losses during a specific accounting period holds no special meaning and management does not attempt to “time” the realization of gains and losses to manage earnings.

Investments and Derivatives Gains and Losses

Berkshire’s Q1 net earnings includes capital losses of $241 million as well as mark-to-market losses on derivatives positions of $986 million. I have previously explained why I disregard the mark-to-market changes for the derivatives positions due to the long term nature of the derivatives as well as the fact that the equity put derivatives are “European options” which cannot be exercised until the expiration date. The credit default positions, however, appear to be seriously impaired based on Buffett’s comments at the annual meeting and information in the 10Q report. The credit default positions account for the majority of the mark to market loss in Q1.

ConocoPhillips Impairment

Normally, an equity investment such as ConocoPhillips (COP) would not impact earnings until the position is disposed of through a sale. However, accounting rules have forced Berkshire to take a $2,012 million hit to GAAP net earnngs in Q1 because the company has indicated that the position is likely to be sold at a price below original cost.

From the press release that accompanied the 10Q, it appears that Berkshire intends to use the losses on the Conoco position to offset realized capital gains in prior tax years, thereby obtaining a tax benefit. The company intends to recover approximately $690 million in federal capital gains taxes paid in 2006 by realizing losses on Conoco.

As Buffett has admitted, the ConocoPhillips investment last year has turned out to be a serious mistake. The position was acquired at a time when oil prices were near record highs. The majority of the loss on the position was already reflected in Berkshire’s book value as of December 31, 2008, so the fact that the loss is now being realized as an impairment does not imply a further hit to book value. While the loss itself is obviously real, the accounting treatment of the loss is arbitrarily causing GAAP net income to show the loss this quarter.

Had Berkshire not declared an intent to liquidate the position for tax reasons, the portion of the Conoco position that was not sold during the quarter would have remained an unrealized loss and would not have impacted net income for the quarter.

Insurance Business Posts Solid Results

Berkshire’s insurance businesses posted solid results for the first quarter. In aggregate, net underwriting profits increased to $219 million from $181 million in the first quarter of 2008. GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group all posted underwriting gains while General Re posted a small underwriting loss. Although GEICO posted lower underwriting profits compared to the prior year, the number of in force policies increased by 430,000 over the course of the quarter as customers switched to GEICO to save money during the recession. It appears that GEICO’s advertising expenditures have registered with consumers eager to save some money on a non-discretionary purchase.

Net investment income increased by 28.8% to $1,033 million compared to $802 million in the first quarter of 2008. These results reflect earnings from Berkshire’s large investments in Goldman Sachs (GS), General Electric (GE), and Wrigley (WWY) in Q4. These investments, and other smaller investments initiated on similar terms in recent months should bring in approximately $2 billion per annum which is far higher than the returns on the cash that Berkshire was holding previously.

Utilities and Energy

MidAmerican posted net earnings attributable to Berkshire of $203 million for the quarter. This is a 35.8% decline in reported income compared to the $316 million reported in the first quarter of 2008. However, Berkshire booked a $56 billion pretax loss associated with the Constellation Energy (CEG) common stock investment and a $125 million noncash stock based compensation charge in connection with Berkshire’s acquisition of MidAmerican in 2000.

Putting these charges aside, the health of the underlying utility business appears to be solid. As Buffett said at the annual meeting, the utility business is relatively insulated from the worldwide recession and, along with the insurance business, provides Berkshire with relatively stable sources of earnings regardless of the economic climate.

Manufacturing, Service, and Retailing

Berkshire’s manufacturing, service, and retailing segment suffered a 47% decline with net earnings for the quarter reported at $258 million compared to $487 million in the first quarter of 2008. In fact, the comparison would have been even worse if one accounts for the fact that Marmon contributed to earnings for the entire quarter in 2009 and for less than half of March in 2008.

The news may be grim, but the silver lining is that none of the reporting segments posted losses. In addition, there was some surprising strength in certain areas. For example, although Shaw Group’s revenues declined by 18.1%, earnings increased by 7.8% due to improvements in operating margins resulting from lower raw material costs.

All Things Considered, Not a Bad Quarter

Considering the turmoil of the first quarter and the fact that GDP most likely shrank significantly, I consider Berkshire’s operating results to be relatively strong. While the headlines will show net losses from a GAAP perspective, my view is that it is necessary to look beneath the headline numbers to get a grasp of the real condition of the business. When you do that, what becomes quickly apparent is that Berkshire’s insurance and utility businesses did very well during the quarter and the non insurance operating companies posted reasonable results even if they fell short of last year’s results.

It is also worth noting that the decline in book value experienced during the first quarter is probably entirely offset by the gains in Berkshire’s investment portfolio so far in the second quarter as I wrote yesterday.

During times like this, it pays to have high quality businesses and Berkshire has demonstrated the ability to operate profitably even in the worst of times. I’m sure that Warren Buffett would have preferred to avoid the mistake related to ConocoPhillips and surely he would have preferred to write the equity puts at a lower strike price. The reality is that no one can achieve perfection, particularly in this type of economic climate.

Disclosure: Author owns shares of Berkshire Hathaway

Comments

[Ravi Nagarajan:]

All:

The editors put a couple of incorrect tickers in this article.

HURN is the ticker for Huron Consulting but is placed next to MidAmerican Energy under the “Utilities and Energy” heading. MidAmerican is a subsidiary of Berkshire and not publicly traded. Under Manufacturing, Service, and Retailing, there is a ticker of SGR next to Shaw, but this is a different company: The Shaw Group Inc, with is unrelated to Berkshire’s Shaw subsidiary.

Please ignore these tickers as they are unrelated to Berkshire.

Ravi

May 10 07:19 AM

[SA Editor J...:]

Fixed. Sorry about the mistaken tickers.
-Ed.

May 10 09:29 AM

[Make Money:]

Thanks Ravi. I enjoy your analysis. I am a long term holder of BRK. Buffett indicated that he invested heavily in corporate bonds, but, no detail. Any info/analysis?
By the way, a similar stock that I follow and has invested heavily is Fairfax Financial. You may want to follow and do the analysis here and would find this worth holding for the long haul.
Rajan

May 10 11:22 AM

[Kevin Hollins:]

Excellent post, and a useful case study as to why GAAP figures are a starting point, but insufficient by themselves.

May 10 01:25 PM

[Ravi Nagarajan:]

I hear what you're saying. However, if you look at Berkshire's long term track record, it is clear that they are conservative in reserving and the insurance businesses routinely generating underwriting profits over long periods (meaning cost free float). I wrote up some details on this after the BRK 2008 report came out:

www.rationalwalk.com/?...

See here for a spreadsheet containing historical cost of float for the past ten years:

www.rationalwalk.com/w...

Ravi




On May 10 06:39 PM WAKEUP wrote:

> "Berkshire’s insurance businesses posted solid results for the first
> quarter." O.K., but I can tell you, as a veteran of the insurance
> wars, that the results of ANY insurance company, over anything other
> than a protracted period of time are virtually worthless. This is
> directly related to the fact that insurance companies, particularly
> those who write commercial coverages, all hold very substantial amounts
> of their money in reserve for, among other things, something called
> IBNR (Incurred But Not Reported) losses. There is a good reason all
> this money is held in reserve: Commercial risks are so loaded with
> potential losses at any moment in time that it is practically impossible
> to predict with anything close to accuracy what might happen to all
> that reserve money. Millions, even billions of dollars in losses
> can develop literally overnight, any night. For this, and other significant
> reasons, unless you are looking at a minimum of fifteen years' worth
> of data, I wouldn't invest any money in any insurance company. Come
> to think of it, on reflection, I STILL wouldn't invest any money
> in any insurance company, now, because of the crazy accounting methods
> insurance companies are allowed to get away with, currently. These
> accounting methods amount to nothing more than a shroud of secrecy.
> Buyer, beware.

May 10 08:03 PM

[Ravi Nagarajan:]

I did not see any details in the 10Q but you are correct that Buffett made this comment at the annual meeting. I wasn't clear at the meeting whether he was referring to Berkshire or his personal account when he said that he was buying corporate bonds.


On May 10 11:22 AM Make Money wrote:

> Thanks Ravi. I enjoy your analysis. I am a long term holder of
> BRK. Buffett indicated that he invested heavily in corporate bonds,
> but, no detail. Any info/analysis?

May 10 08:04 PM

[U338129:]

Ravi,

Good post. Long-term, I have no problem seeing the value in Berkshire the company. My only concern with being a Berkshire shareholder is the ultimate dilemma of "post-Buffett-traumati...

The moves Berkshire has made (outside of COP) during this downturn remind me of what Buffett was able to do in the 70s/80s. The benefits of the most recent capital allocations will be substantial for years to come in my opinion. Plus, with other companies going away, Berkshire companies are sure to gain market share one would think (it's already happening for Geico).

Only pessimistic thing going in my opinion is the Buffett question. Gates coming out recently saying he had a lifetime commitment helped to be honest. However, the last time rumors spread about Buffett's health the stock sunk dramatically in a very short time.

Any thoughts on the "post-Buffett" scenario?

May 15 09:34 AM

[Ravi Nagarajan:]

As you've pointed out, the last time Buffett health rumors surfaced (in 2000), the stock was hammered but at that time, there were other factors pressuring the stock as well. In my opinion, Buffett cannot be replaced. However, Berkshire has a plan in place that does not rely on replacing Buffett. Instead, his job will be divided into two with a CEO coming from one of the subsidiaries and one or more investment officers who have records that Buffett and Munger are comfortable with. I think that Buffett's son and Gates presence on the board should help keep the culture intact.

I don't see any "Buffett premium" in today's quotation for Berkshire but there is no question that he cannot be replaced in terms of value provided to the company. Berkshire's intrinsic value would be lower w/o Buffett, but today's steep discount of price to IV provides investors with a margin of safety.

May 15 11:37 AM

[U338129:]

Fair enough. Thanks, Ravi.

May 15 12:17 PM