After strongly outperforming the S&P 500 through July, Berkshire (BRK.A, BRK.B) treaded water for a few months but then began to notably underperform the SP500 since Berkshire announced Q3 earnings on Nov 1. The culprit? Not only did Q3 earnings miss the consensus estimate, but, even worse, that surprise caused the few analysts who cover Berkshire to lower future earnings forecasts. We think that in their rush to not get fooled again, they overreacted.
Berkshire reported $3,662M of what it calls "Operating earnings" for Q3. The consensus had been for $3,864 M in Q3. In fact, Q3 consensus had risen from $3,711 M in late 2012. Berkshire missed consensus more than once in 2012, but Q3 was Berkshire's first earnings miss of 2013. The misses in 2012 caused Berkshire to underperform for most of 2012, showing the power of these quarterly "Operating earnings" on the stock. The stock began to outperform when Mr. Buffett began discussing (and then implementing) stock buybacks.
So, the recent earnings cuts reversed the magic of the buybacks. What next? We think analysts over-reacted and a Q4 earnings beat will help Berkshire make up lost ground against the market, maybe even getting back to its 2013 high valuation of 1.40x Book Value. It now sits at about 1.30x BV, so there is potential for a nice excess return over the next few months.
Here Are The Numbers
After the Q3 miss, analysts cut Q4 "Operating earnings" by 7% to $3,485 M (down 5% Q/Q from the $3,662 M in Q3). They also cut 2014 "Operating earnings" by 2% to $15,674 M. Beyond those numbers, it seems clear that the market is now waiting for the next shoe to drop, and fears a string of weaker earnings from Berkshire.
Yes, Q3 Operating Earnings Did Miss
Analysts were surprised by weak underwriting profit at both BH-Re and GenRe, with the magnitudes depending on which analyst you talk to. Overall, insurance missed by $250M or more, depending on the analyst. BNSF's profit also missed consensus, by as much as $70M, again depending on the analyst. After some positive offsets in other businesses, the overall Q3 "Operating earnings" miss was $250M. Importantly, the insurance miss was due to catastrophe losses from hail-storms in Europe and foreign exchange losses, as the US$ was very weak in Q3 versus both the Euro and the Pound. Catastrophe losses are not really repeatable and foreign exchange losses may very well turn into gains in a quarter or two. GEICO had a good Q3. Its profits fell Y/Y due to a very tough comp, since 3Q2012 had no catastrophe losses. But, GEICO's units and pricing were both strong and its earned premiums rose almost 12% Y/Y.
The BNSF miss was also due to a tough comp in 3Q2012, and also in Q1 and Q2 of 2013. Q1 and Q2 of 2013 both showed double-digit profit growth, and some analysts expected similar growth for Q3. Unfortunately, the tough comp vs 3Q2012 made double-digit profit growth impossible. The tough comp occurred because the expense line item "Materials and other expenses" was understated by about $100M in 3q2012. BNSF's 3Q2013 10Q said "Materials and other expenses increased as a result of favorable prior year environmental and personal injury accrual adjustments and higher property taxes and material expense." That expense item rose by $100M Y/Y in 3Q2013. It usually rises by $30 - $60M Y/Y.
Q4 Should Produce A Positive Surprise
We think analysts over-reacted and Q4 earnings may well rise slightly from Q3, versus the 5% Q/Q decline analysts now model. There are a few reasons, which we will highlight here and discuss in more depth in a future update:
- Insurance is a wild-card. Analysts know this and model insurance earnings to rebound Q/Q, so we are not expecting a surprise there. But, GEICO's strong unit and pricing growth would produce a good surprise if the loss ratio comes down.
- Analysts expect BNSF's earnings to be flat from Q3 to Q4, but we think they could rise by at least $70M. BNSF's revenue should be fine, given strong unit volumes quarter-to-date. Volatile fuel markets may be the biggest driver of a positive surprise. BNSF charges a fuel surcharge based on lagging fuel prices. The price of fuel rose significantly in Q3, so BNSF was paying more for its fuel in Q3, but its surcharge will not rise until Q4. Conversely, fuel costs have fallen right back down in Q4, so BNSF is paying less for fuel in Q4, but it is receiving the higher surcharge. As we look through years of BNSF's quarterly data, there is evidence that BNSF's margins do benefit when fuel prices rise quickly and then fall quickly.
- Analysts expect earnings from "Utilities & Energy" segment to fall by $165 M from Q3 to Q4, but we think they could fall only $65 M. The $100M difference comes mainly from a charge at Pacificorp that Berkshire hid in 4Q2012. Berkshire's 2012 10K stated "In 2012, (PacifiCorp's) operating expenses included charges of $165 million related to litigation, fire and other damage claims." Looking through the quarters makes us think the vast majority of that was in 4q2012. One analyst has the segment's pre-tax profits falling by $260 M from Q3 to Q4, similar to the $230 M fall from 3Q2012 to 4Q2012. But, if there was a pre-tax charge exceeding $100 M in 4Q2012, the real Q/Q decline was, and should be again this year, much smaller.
A $70 M surprise by BNSF plus a $100 M surprise by "Utilities & Energy" would add up to a 5% earnings surprise on the current Q4 consensus of $3,485 M. There are other potential positives in the other businesses, but BNSF and "Utilities & Energy" are the main positives. We will quantify more details in future updates. A positive earnings surprise should reverse analysts' recent earnings cuts, and market action over the last year for Berkshire indicates that could reverse Berkshire's recent underperformance, and perhaps return it to a valuation of 1.40x BV.