Hurricanes had a heavy impact on Berkshire’s operating earnings, but book value continued to grow.
By Greggory Warren, CFA | 02-24-18 | 01:55 PM | Email Article

Wide-moat  Berkshire Hathaway's fourth-quarter and full-year results were in line with our expectations. We are leaving our $330,000 ($220) per Class A (B) share fair value estimate in place. Fourth-quarter (full-year) revenue increased 2.1% (8.3%) to $58.9 ($242.1) billion. Excluding the impact of investment and derivative gains/losses, fourth-quarter (full-year) revenue increased 6.3% (11.5%). 

Greggory Warren, CFA, is a financial services sector strategist for Morningstar.

With expenses increasing at a higher rate than revenue, fourth-quarter operating earnings (excluding the impact of investment and derivative gains/losses and other events) declined 23.8% when compared with the year-ago period, leaving full-year results down 17.8%. During 2017, the $2.8 billion in catastrophe-related losses that the firm booked for Hurricanes Harvey, Irma and Maria, as well as several other natural disasters, had a heavy impact on Berkshire. Had those events not occurred, the company's operating earnings would have been down just slightly year over year.  

Book value per Class A equivalent share, which serves as a good proxy for measuring changes in Berkshire's intrinsic value, increased 23.0% year over year to $211,750 (slightly below our estimate of $215,283). The write-down of the company's deferred tax liabilities (related to the Tax Cuts and Jobs Act of 2017) did, however, account for 45% of the total increase. Excluding that benefit, the company's book value per share would have been closer to $194,800 per Class A equivalent share, equivalent to a 13.2% increase year over year (in line with our forecast of high-single- to double-digit growth in book value per share during 2017-21). The company also closed out fourth-quarter 2017 with $116.0 billion in cash and cash equivalents, up from $109.3 billion at the end of September and $86.4 billion at the start of the year. By our estimates, this would leave Berkshire with around $90 billion in dry powder that could be committed to investments, acquisitions, share repurchases, and dividends.

Looking more closely at Berkshire's insurance operations, Geico, General Re, and Berkshire Hathaway Primary Group, or BHPG, posted earned premium growth during the fourth quarter, with Berkshire Hathaway Reinsurance Group, or BHRG, reverting to negative earned premium growth during the period. All four of the firm's insurance segments did, however, generate earned premium growth during the full year. From an underwriting profitability perspective, though, Geico, General Re, and BHRG all posted losses last year (as catastrophe-related losses from Hurricanes Harvey, Irma and Maria as well as several other natural disasters during 2017). This led to $2.8 billion in reported losses for Berkshire's insurance operations--Geico ($500 million), General Re ($835 million), BHRG ($1.45 billion) and BHPG ($225 million)--with the combined operations posting a full-year underwriting loss of $3.2 billion. While this marked the company's first full calendar year with an underwriting loss since 2002, it should be noted that Berkshire's 14-year track record of solidly positive underwriting profits was far more the exception than the rule for the industry.

Geico's relentless pursuit of growth continues to come at the expense of profitability. The auto insurer's earned (written) premium growth of 16.3% (15.6%) during the fourth quarter was one of the strongest quarterly results ever put up by the firm. Our own forecast had called for earned premium growth of 15%-16% during the fourth quarter. Unfortunately, there has been a rather abnormal spike in the company's loss ratio, a consequence of Geico's aggressive underwriting, which started in the fourth quarter of 2016. The auto insurer's average loss ratio of 86.6% (84.8% when excluding hurricane-related losses) during the past year was worse than the 78.7% average level seen during 2012-16 and the 77.0% level seen during 2007-16. The firm's fourth-quarter loss ratio of 87.9% continues to be a step in the wrong direction toward getting the auto insurers loss ratio back down to more historical norms. With the company still hitting the gas pedal on underwriting and taking advantage of its peers' reluctance to go after business during the past year, it becomes difficult to determine when we might actually see loss ratios return to more normalized levels.

Geico's combined ratio of 102.4% during the fourth quarter left the firm in the red for the full year. Backing out the hurricane-related losses sustained during the back half of 2017 leaves the auto insurer's combined ratio at 99.4% for the year. Much of Geico's ability to keep its nonhurricane-impacted underwriting profitability in the black, despite aggressively underwriting new business, has rested in tight expense controls as well as the benefits of increased scale. (First-year business tends to come with both acquisition costs and a higher loss ratio, which tends to leave total costs about 10 points higher than renewal business). The firm's 14.5% expense ratio during the fourth quarter is among the lowest we've seen over the past decade; just for some perspective, Geico's expense ratio of 14.4% during 2017 was meaningfully better than the 17.0% level seen during 2012-16 and the 17.5% ratio seen during 2007-16.

As for General Re, the reinsurer posted another abnormal period of earned premium growth (of 23.1% year over year) during the fourth quarter, primarily attributable to new business and increased participations for renewals. This was not the case for BHRG, which reverted to negative earned premium growth (of 39.5%) during the fourth quarter, with both its property-casualty and life-annuity businesses generating negative earned premium growth during the period. Going forward, we continue to expect General Re and BHRG to constrain the volume of reinsurance they are underwriting, given the excess capacity that exists in the reinsurance market and the fact that neither firm finds that pricing is attractive enough to profitably underwrite additional business. While we have earned premium growth in negative territory for both firms over the remainder of our five-year forecast, we have always been quick to note that there could be some lumpiness in reported results, as both General Re and BHRG have a knack for finding profitable business, even when reinsurance pricing is unattractive.

With regard to profitability, the best we can hope for these two businesses longer term is tight expense controls and a lack of extremely adverse events, which should allow both General Re and BHRG to keep their combined ratios below the 100% mark. While this did not turn out to be the case during 2017, with catastrophe-related losses leaving General Re's combined ratio at 114.4%, and BHRG's at 115.5%, we do expect both firms to strive for that goal over the remainder of our forecast period (even as they are likely to face another year of catastrophe losses before the end of our five-year projection period).

As for BHPG, the insurance unit posted a 10.7% (14.2%) increase in earned premiums year over year during the fourth quarter (full year), led by solid growth at Berkshire Hathaway Specialty Insurance, MedPro Group, Berkshire Hathaway Home Companies, and Guard. The division's combined ratio of 89.9% during 2017 was a step down from the 89.5% ratio posted in 2016, but backing out the segment's $225 million in catastrophe-related losses (booked during the third quarter) the combined ratio was 86.8%. This was more on par with the 87.2% average ratio we saw during 2012-16 and the 87.7% ratio produced during 2007-16. Going forward, we believe BHPG will generate earned premium growth in a 13%-15% range during 2018-21, with combined ratios between 88% and 90%, reflective of the higher costs that come with growing business like its BHSI unit.

Earned premium growth across Berkshire's insurance platform led to a 1.3% sequential, and a 25.0% year-over-year increase in the company's insurance float to $114.5 billion at the end of the December quarter. Going forward, we expect gains in insurance float to be much harder to come by, especially with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth in the company's float over the past decade comes from its two reinsurance arms). We continue to believe that Geico and BHPG will be the more consistent generators of insurance float for Berkshire as we move forward, especially given the growth potential that exists for BHPG's specialty insurance unit but would note that these are short-tail businesses, with the float generated by these operations tending to be invested in less risky and more liquid investments with smaller return profiles. That said, we wouldn't be surprised to see General Re and BHRG, which are long-tail businesses whose float can be invested in riskier longer-term holdings, pick up some additional float from time to time.

Berkshire's noninsurance operations typically offer a more diversified stream of revenue and pretax earnings for the firm, helping to offset weakness in any one area (and most noticeably, the insurance segment this past year). We already had a sense of how things were likely to look for BNSF, given that the other Class I railroads reported earnings late last month. Union Pacific is usually a good proxy for BNSF, given that both firms focus on the Western U.S. market and have similar shipment profiles. However, the railroad's poor network fluidity, less-than-robust core pricing, and unimpressive capture of growth in intermodal markets (both international and domestic) during the fourth quarter were not completely reflected in BNSF's results for the period.

Over the past several years, BNSF has been beset by a shortfall in coal volume that started in first-quarter 2016 (when volume dropped 33.2% year over year), with volume falling 21.1% overall last year, as well as a falloff in industrial products (driven primarily by the decline in crude oil prices), with volume falling 5.9% and 7.8%, respectively, in 2015 and 2016. Things looked much better during 2017, with coal and industrial products volumes increasing 6.3% and 5.0%, respectively, during the year. Our own forecast had called for a 6.5% increase in coal volumes, and a 2.5% increase in industrial products volumes, during 2017. Fourth-quarter (full-year) revenue was up 6.2% (7.9%) as well, aided by both the improvement in volumes and higher average revenue per car/unit, attributable to higher fuel surcharge revenue and business mix changes, as well as increased rates per car/unit. Pretax earnings increased 11.0% (11.2%) as well during the fourth quarter (full year) when compared with the year ago period. BNSF's estimated operating ratio of 64.5% (65.7%) during the fourth quarter (full year) was also an improvement on the 65.9% (66.3%) levels reported in the year-ago period, but still off Union Pacific's adjusted 62.6% (63.0%) results for the same period(s).

Normally a beacon of stability, Berkshire Hathaway Energy reported a 10.5% (6.0%) increase in fourth-quarter (full-year) revenue, and an 8.8% (0.3%) decrease in pretax earnings (exclusive of the corporate interest adjustment). The utilities and energy segment has always been the least volatile of Berkshire's subsidiaries, given that the regulated utilities operate in an environment where in exchange for their service territory monopolies, state and federal regulators set rates that aim to keep customer costs low while providing adequate returns for capital providers. The only meaningful change in these operations occur when BHE does an acquisition, with this subsidiary tending to be one of Berkshire's most aggressive when it comes to doing deals, or when it is coming off particularly strong/weak results year over year. Unfortunately, Berkshire did miss out on Oncor Electric Delivery during the third quarter, being outbid by Sempra Energy at the last moment for this prized asset within the bankrupt Energy Future Holdings. We don't expect this to be the end of BHE's pursuit of other utility- and energy-related assets, and continue to believe that the subsidiary's cash flow generation should easily support another $5 billion-$10 billion acquisition (and that purchase prices could go higher with Berkshire continuing to have plenty of cash on hand to fund deals). We view Alliant Energy as a potential target and wouldn't be surprised to see BHE kicking the tires on Pinnacle West and NiSource as well.

With regards to Berkshire's manufacturing, service and retail operations, the group overall recorded a 5.7% (5.4%) increase in fourth-quarter (full-year) revenue, and a 27.1% (9.2%) increase in pretax earnings, even with McLane taking it on the chin in its grocery business, where the firm has seen a significant amount of pricing pressure and an increasingly competitive business environment for much of the past year. The MSR division's full-year top-line results fell pretty much in line with our near- and long-term forecasts, which call for mid-single-digit annual revenue growth during 2017-21 (exclusive of acquisitions). As for profitability, operating margins of 7.3% during the full year were right in line with our forecast, which has operating margins expanding by 20-25 basis points annually over the 7.0% level that the segment produced during in 2016.

Meanwhile, 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 somewhat mixed, with revenue increasing 14.7% (9.1%) during the fourth quarter (full year), and pretax earnings increasing 0.4% (declining 3.4%) due primarily to lower interest and dividend income from investments, higher railcar repair and storage costs, and lower earnings from CORTs furniture rental business. We continue to envision revenue increasing at a 5%-6% range over the remainder of our five-year projection period, though, with pretax operating margins staying in a 25%-27% range. That said, the finance and financial products segment is a mere rounding error for Berkshire's overall results, accounting for around 6% of pretax earnings on average the past five years.

As we noted above, book value per Class A equivalent share at the end of the fourth quarter was $211,750. The company also closed out the period with $116.0 billion in cash and cash equivalents on its books. CEO Warren Buffett prefers to keep around $20 billion on hand as a backstop for the insurance business, and the firm's noninsurance operations generally need between $3 billion and $5 billion in operating cash. So, Berkshire still has around $90 billion available to dedicate to investments, acquisitions, share repurchases and/or dividends. Berkshire did not buy back any shares during 2017, making it the fifth straight year without share repurchases for the firm. Based on the company's end-of-year book value per share, Buffett should be willing to buy back stock at prices below $254,100 ($169.40) per Class A (B) share, which is a little more than 15% below Friday's closing price of $304,020 ($202.76) per Class A (B) share.

We have questioned Buffett several times during the past several years about whether the share repurchase threshold needs to be raised, given his belief that the company's intrinsic value continues to exceed its book value (with the difference only widening over time) and the fact that the company's cash balances continue to expand. He has seemingly been more and more open to this idea, as well as the idea of a dividend, noting that it will become increasingly more difficult for Berkshire to continue to sit on a large and growing cash hoard should balances reach the $150 billion level. Given that the firm's cash balances are likely to continue to grow from here, because of what we think are a lack of identifiable investment options (with equity markets at/near all-time highs and values for public and private firms extended), we expect that we'll be at that benchmark in relatively short order.

As a result, we have modeled in a special one-time cash dividend of around $25 billion midway through our five-year forecast. We're basically assuming that should Buffett decide to pay a dividend, it is likely to be one-off in nature, and based purely on bloated excess cash balances as opposed to a regular quarterly dividend. From a regulatory perspective, Berkshire's principal insurance subsidiaries alone could declare up to $16 billion as ordinary dividends during 2018 without prior regulatory approval, so we don't envision there being much pushback from the regulators should the firm decide to make a slightly larger one-time cash dividend payout in the near to medium term.

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Greggory Warren, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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