Buffett on Berkshire's Q1: Understanding the Underlying Business Results

| About: Berkshire Hathaway (BRK.A)

Berkshire Hathaway (NYSE:BRK.A) reported the company’s net worth during the first quarter of 2011 increased 1.7% with book value equal to $97,062 per A share as of 3/31/11. The $2.7 billion increase in shareholders’ equity was due primarily to $1.5 billion in net earnings and a $426 million increase in foreign currency translation (net of tax) and a $716 million increase in unrealized appreciation of investments (net of tax), led by a 5% increase in American Express’ (NYSE:AXP) stock during the quarter.

During the first quarter, Berkshire’s operating revenues chugged 12% higher to $33.7 billion which included a $4.5 billion contribution from Burlington Northern Santa Fe (BNSF). Burlington’s first quarter revenues increased 17% compared to the prior year, reflecting higher average revenue per car/unit in all four business groups as well as an 8% increase in car/units handled.

Marmon’s revenues increased 20% to $1.7 billion during the quarter as ten of Marmon’s eleven business sectors generated increased revenue, reflecting continued recoveries in many of Marmon’s end markets. (In the first quarter, Berkshire acquired 16.5% of Marmon’s outstanding stock for $1.5 billion in cash, boosting Berkshire’s ownership in Marmon to 80.2 %.) All Berkshire’s other business units reported revenue gains with the exception of MidAmerican and the finance and financial products segment where revenues dipped 3% and 7%, respectively.

Operating earnings declined 28% during the first quarter to $1.6 billion with net earnings down 58%, primarily due to a swing, to an $82 million loss on investment and derivatives compared to a $1.4 billion holding gain on Burlington in the prior year period.

In discussing first quarter results at the annual meeting, Buffett talked about the $337 million loss which had to be taken on part of his Wells Fargo (NYSE:BWF) investment due to the loss having to be classified as an other-than- temporary impairment loss. He said accounting rules required this loss to be run through the profit and loss statement even though it had already been reflected on the balance sheet.

At the same time, the $3.4 billion in total unrealized gains on Wells Fargo had to be ignored in the profit and loss statement. Berkshire determines its gains and losses on a specific identification basis. Had gains and losses been determined based on average cost, Berkshire would not have been required to record an other-than-temporary impairment charge with respect to the investment in Wells Fargo.

These “fuzzy” accounting rules are why Buffett advises investors to ignore gains and losses on investments and derivatives on a quarterly basis. It is more important to focus on the operating earnings and gains in book value and intrinsic value when evaluating Berkshire’s financial results. However, Buffett cautions that news headlines will focus only on the “all deceptive figure” of net income and not on what is important to understanding Berkshire’s underlying business results.

On the operating side, the railroad, utilities and energy group increased earnings 79% to $908 million, which included a full year of Burlington Northern Santa Fe’s results compared to just a portion of last year’s earnings from the period when BNSF was acquired. The railroad business is expected to have a very good year this year with the industry’s competitive advantage growing by the day as oil prices increase.

The manufacturing, service and retailing group increased earnings 17% to $558 million as all businesses, with the exception of housing, have been getting better quarter by quarter since the fall of 2009. With Berkshire owning more than 70 companies, they represent a good cross-section of the U.S. economy.

On the other hand, the insurance operations suffered the second worst quarter ever for the insurance industry (behind Hurricane Katrina in the third quarter of 2005) with industry-wide damages estimated around $50 billion. Berkshire generally covers 3%-5% of industry damages.

While the first quarter felt the brunt of extraordinary earthquakes, the worst part of the year (hurricane season) for reinsurers is still to come. Around the globe, there were major catastrophes which hit the reinsurance industry hard especially in the Asia/Pacific region, including the earthquake in New Zealand, the Australian floods and cyclone Yasi, and the major earthquake and tsunami in Japan. Berkshire’s estimated losses incurred from these events totaled $1.7 billion, of which approximately $700 million came from their 20% quota share of Swiss Re’s business.

As a result, Berkshire booked an $821 million insurance underwriting loss in the first quarter compared to a $226 million gain in the prior year period. Subsequent to quarter end, the tornados in the South will result in losses for GEICO. While GEICO doesn’t insure homeowners (only acts as an agent for homeowner insurance), they will suffer losses from the estimated 25,000 cars which will put in claims as GEICO has 9% market share for U.S. auto insurance.

Nevertheless, GEICO had a tremendous first quarter with auto policies in force increasing 46% to 318,676. In the annual report, Buffett had written how the real value of GEICO’s economic goodwill is about $14 billion even though Berkshire is carrying the goodwill on its books at only $1.4 billion due to accounting rules.

With GEICO off to a strong start in the first quarter, it is easy to see why Buffett said the company’s value is likely to be much higher ten and twenty years from now. GEICO is gaining market share every day with a very significant percentage of its customers having been with the company for 10 years or longer.

Buffett joked that the cost of holding the annual meeting could be defrayed if just 66 of the 40,0000 shareholders at the meeting would sign up with GEICO at the booth during the annual meeting, as this would increase GEICO’s value by $100,000 (since each new policyholder generates $1500 in goodwill value).

In the annual report, Buffett also had written that he expected Berkshire’s normalized pre-tax earning power to be around $17 billion and $12 billion after tax, assuming breakeven insurance operations. For the past eight years, Berkshire’s insurance operations had done better than breakeven. However, in 2011, given the magnitude of the first quarter catastrophe losses, as well as the potential for additional losses from the upcoming hurricane season, it appears that for the first time in nine years, Berkshire will have an underwriting loss.

This doesn’t change Buffett’s expectation that over time the insurance operations will break even, and Berkshire will get the benefit of the free use of float. However, the cost of float for the first quarter, as represented by the ratio of the underwriting loss to average float, was about 2%. Float approximated $69 billion as of 3/31/11, a 4.5% increase since year end.

Insurance investment income dipped 4% to $952 million in the first quarter, and Buffett expects that investment income will go down even more since the 12% Swiss Re investment was called, the 10% Goldman Sachs (NYSE:GS) preferred stock was called subsequent to quarter end, and the 10% General Electric (NYSE:GE) preferred stock is expected to get called later this year.

As a result, Berkshire will be losing three high-yielding investments to be replaced by relatively low yields currently available from new investment opportunities. As of quarter end, Berkshire held $38 billion in cash, not including the $5 billion received from Goldman Sachs after the quarter closed. The cash is earning virtually nothing today, but over time Buffett expects Berkshire’s investment income will grow even though it will drop this year.

Berkshire’s railroad, utility and energy businesses are capital intensive with $1.5 billion spent on capital expenditures during the first quarter of 2011. Capital expenditures for the remainder of 2011 are estimated at $5.9 billion for MidAmerican and Burlington to be funded from cash flow from operations and debt proceeds. Aggregate borrowings of the railroad, utilities and energy businesses were about $31.8 billion as of 3/31/11, including $11.9 billion of borrowings of BNSF.

Berkshire’s balance sheet continues to reflect significant liquidity and a strong capital base of $160 billion. Excluding utility and finance investments, Berkshire ended the first quarter with $153.2 billion in investments ($92,891 per share) allocated approximately 40.4% to equities ($61.9 billion), 22.2% to fixed-income investments ($34.0 billion), 12.4% to other investments ($18.9 billion-including preferred stocks), and 25% in cash ($38.4 billion).

Free cash flow declined 6% during the first quarter to $2 billion, primarily due to a 27% increase in capital expenditures. During the first quarter, Berkshire was a net seller of approximately $1.1 billion in fixed-income investments and a net purchaser of $825 million in equities. Berkshire’s financial strength allows Buffett to make significant investments which should provide substantial future returns.

Buffett is seeking acquisitions in the $5-$20 billion range. In March, Berkshire announced it was acquiring Lubrizol (LZ), an innovative specialty chemical company, for approximately $9 billion in cash with the deal expected to close in the third quarter of 2011. Lubrizol reported 2010 sales and earnings of $5.4 billion and $732 million, respectively.

At the annual meeting, Buffett also said he currently is looking at a couple of other deals in the $9 billion range, although cautioning that these deals right now are just a “gleam” in his eye.

Berkshire appears attractively valued currently trading at approximately $120,000 per share for the A shares and $80 per share for the B shares. Based on current business fundamentals, I expect Berkshire’s A shares to trade between $103,000-$154,000 per share and the B shares to trade between $69-$103 per share.

We attended Berkshire Hathaway’s annual meeting on 4-30-11 and our complete notes from the meeting can be found at our website.

Disclosure: Hendershot Investments holds a long position in each stock presented. The content in this article should not be taken as investment advice or construed as a recommendation to buy or sell any security. Ideas expressed may not be suitable for every account, depending on an individual’s investment objective, risk-tolerance and financial situation. Information presented here was obtained from sources believed to be reliable but accuracy and completeness and opinions based on this information are not guaranteed. It should not be assumed that investments discussed will be profitable or will equal the performance of securities listed here or recommended in the past. All data, information and opinions expressed are subject to change without notice. Further information on companies mentioned is available upon request.