- Berkshire Hathaway saw operating income fall even as revenue rose slightly.
- An over-supplied reinsurance market pressure insurance operations while its railroad and energy unit suffered significant margin compression.
- A sum of the parts analysis suggests fair value is roughly $120.
On Friday afternoon, Berkshire Hathaway (NYSE:BRK.B) reported its first quarter results. Warren Buffett likes to announce prior to the weekend so that investors have some time to dissect the numbers before the market opens again, which fits his emphasis on long-term investing. There have been countless examples of stocks that trade in one direction on an earnings headline before reversing as investors digest all of the components of the report. To stop investors from trading solely on the news and perhaps acting too rashly, Buffett gives investors a weekend to examine results before deciding whether they want to buy or sell shares. This quarter comes at an interesting time for Berkshire. While shares are sitting at an all-time high, the S&P has outperformed them over the past five years, which is the first time this has happened on Buffett's watch. While it has never been wise to actively bet against Buffett, this quarter could have put to rest some of the concerns that Berkshire has become too big to grow. Unfortunately, this quarter may embolden critics even more. As a side note, all per share data is for "B" class shares, which are more liquid, but the analysis also fully applies to class "A" shares (NYSE:BRK.A).
In the first quarter, Berkshire reported revenue of $45.5 billion, which was up 3.6% from last year but below expectations of $47.1 billion (all financial and operating data available here). While not bad, 3.6% growth isn't particularly strong either. With its diversified businesses that sell everything from underwear to manufactured homes, its growth rate is more closely linked to nominal GDP growth as this quarter showed. Operating earnings, which exclude volatile investment and derivative income, fell a disappointing 6.6% to $3.53 billion, mainly dragged down by weakness at its insurance unit, though its railroad, utility, and energy division saw lower earnings as well.
Insurance premium revenue was roughly flat at $9.4 billion, but insurance expenses rose by $700 million to $8.7 billion. Berkshire has a major reinsurance operation, and reinsurance rates have been under tremendous pressure. A lot of capital, much of it from hedge funds, has increased the supply in the market, and a lack of major catastrophes has emboldened firms to cut rates further. These trends have made reinsurance a much lower margin business and will drag on Berkshire's insurance earnings for some time. Ironically, a significant catastrophe would probably be good for the company in the long term. While a major storm will bring losses to Berkshire, it will shake out the fast money and help return the market to normalcy.
There was also troubling margin compression at the railroad, utility, and energy division. Revenue grew by $1.35 billion to $9.75 billion, yet pre-tax income actually fell by $38 million. The weather likely played a role in elevating costs, but I would have liked to see some profit growth given the solid sales increase. Buffett is famed for his decentralized approach to management, and the managers of these businesses delivered imperfect numbers. I anticipate a return to profit growth in the second quarter, but investors should follow these numbers closely. Bad weather can cause delays and increase maintenance, and this cost pressure should dissipate. The railroad should also see increased capacity utilization as it adds railcars that can transport railcars. Increasing oil transportation should help propel growth in coming quarters. More oil and better weather should make the rest of the year better for this unit.
Of course, Berkshire maintains a virtually flawless balance sheet. The company has a cash position of $42 billion well above the $20-$25 billion Buffett likes to keep on hand at all times to fend off any potential liquidity crunch. This excess cash position gives Berkshire the capacity to make a major acquisition if an attractive opportunity arises. Its fixed income holdings were up slightly to $29.1 billion, and equity holdings were also up slightly to $116.2 billion. Importantly, the insurance float increased by about $1 billion to $77 billion. With the depressed reinsurance market and an increasingly competitive auto market, it will be difficult to keep growing the float. The float funds a major portion of Berkshire's investments and essentially has a negative carrying cost since the company consistently generates underwriting profits. For Berkshire to continue to perform well, it must continue to grow the float, which is increasingly difficult due to its size and market trends.
Book value increased by about 2.6% to about $93.40 per share. Shares are now trading about 38% above book value, which is a somewhat stretched valuation. Needless to say, shares are not the bargain they once were. The market is currently valuing the company $88 billion more than its book value. Using a price to book metric is increasingly difficult for Berkshire. Some businesses, like insurance, can be appropriately measured against book value, while others like Dairy Queen can trade at a far different value than book value as investors focus on a multiple to net income or cash flow. As a consequence, I separate the value of Berkshire's investments and its operating companies.
Berkshire's operations are diverse and essentially are a well-run microcosm of the company, making a 15x P/E is reasonable. Essentially, Berkshire's operations are worth around $190 billion. The gross value of Berkshire's excess cash and investments is $187 billion. The company does carry $72 billion in notes payable, and the $65 billion insurance float does get paid back at some point. As the float has no carrying cost and a probable duration of about 10 years, I discounted the liability rather than subtracting the entire $65 billion.
In total, Berkshire is worth about $300 billion or $120 per share. Simply put, the stock is a bit stretched at current prices. Long-term investors might not want to sell as Buffett has consistently delivered value over the long term. However, now is not the time to buy Berkshire stock. Valuation is a bit stretched, and this quarter was a bit messy. I would wait for a pullback to $120 before buying shares. From here, the risk is to the downside not the upside.