Monday, April 22, 2019

Berkshire Earnings Hit by Hurricane Losses

by Greggory Warren


Wide-moat rated Berkshire Hathaway (BRK.A) (BRK.B) third-quarter results were primarily impacted by losses related to hurricanes Harvey, Irma, and Maria, as well as the earthquakes in Mexico. Given the more broadly diversified nature of the company’s portfolio, however, the $2.8 billion in catastrophe-related losses were less impactful than they would have been if Berkshire were a stand-alone insurance company.

As we noted at the beginning of the fourth quarter, our valuation of Berkshire already included the possibility of large natural catastrophe losses (even with the exact timing of these events being impossible to predict), so we do not expect to make a meaningful change our $290,000 ($193) per Class A (B) share fair value estimate even with these reported catastrophe-related losses.

Third-quarter (year-to-date) revenue increased 2.9% (10.9%) to $60.5 ($183.2) billion. Excluding the impact of investment and derivative gains (losses), third-quarter (year-to-date) revenue increased 7.2% (and 11.7%). With expenses increasing at a higher rate than revenue, third-quarter operating earnings declined 29.0% when compared with the year-ago period, leaving year-to-date operating earnings down 15.7%. Net earnings, which include the impact of investment and derivative gains (losses), were down 43.5% and 30.4% during the third quarter and first nine months of the year, respectively.

Book value per Class A equivalent share, which serves as a good proxy for measuring changes in Berkshire’s intrinsic value, increased 14.4% year over year to $187,435 (slightly better than our own estimate of $187,088)–with the strong performance of its equity investment portfolio contributing greatly to results during the past year. The company closed out the third quarter of 2017 with $109.3 billion in cash and cash equivalents, up from $99.7 billion at the end of June and $86.4 billion at the start of the year. The company did not repurchase any shares during the first nine months of 2017.

Looking more closely at Berkshire’s insurance operations, all four of the firm’s insurance segments–Geico, General Re, Berkshire Hathaway Reinsurance Group, or BHRG, and Berkshire Hathaway Primary Group, or BHPG–posted earned premium growth during the third quarter. From an underwriting perspective, though, everyone but BHPG posted a loss during the period, as catastrophe-related losses from hurricanes Harvey, Irma, and Maria, as well as the earthquakes in Mexico had an impact on results. The $2.8 billion in reported losses was at the upper end of our projection of anywhere from $1.5 billion to $3.0 billion in total insured losses for Berkshire’s insurance operations from the hurricanes during the period.

In particular, Geico reported $500 million in losses related to Harvey and Irma, less than our projection for $800 million in losses (with $500 million coming from Harvey and $300 million tied to Irma). Meanwhile, reinsurance losses ended up being higher than our projections, with General Re seeing $835 million in losses tied to Harvey, Irma, and Maria, as well as the earthquakes in Mexico, with BHRG reporting $1.45 billion in losses for its exposure to the four events. As for BHPG, the group’s loss and loss adjustment expenses for the quarter included $225 million in charges related to the three hurricanes.

On a combined basis, Berkshire’s insurance operations once again generated an operating loss, with its firmwide combined ratio of 116.5% adding to results of 100.2% and 101.7% during the second and first quarters, respectively. At this point, Berkshire’s insurance operations are on pace to report its first full calendar year with an underwriting loss since 2001, a year that was negatively impacted by the 9/11 terrorist attacks. That said, its 15-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 16.5% (17.7%) during the third quarter was the strongest quarterly result we can ever remember Geico putting up (which is what we also said after the second quarter). Our own forecast had called for earned premium growth of 13%-15% during the third quarter, similar to what we saw during the fourth quarter of 2016 and first quarter of 2017. A consequence of Geico’s aggressive underwriting, though, has been a rather abnormal spike in the company’s loss ratio, which was impacted even further during the third quarter by hurricane-related losses.

Geico’s average loss ratio of 85.8% (84.1% 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 third-quarter loss ratio of 91.9% (85.3% when excluding the hurricane-related losses) continues to be a step in the wrong direction toward getting the auto insurers loss ratio back down to more historical norms. Berkshire’s CEO Warren Buffett noted during this year’s annual meeting that first-year business, which comes with both acquisition costs and a higher loss ratio, tends to run almost 10 points higher than renewal business, which would explain the rather dramatic rise in Geico’s loss ratio during the past year. But with the company continuing to hit the gas pedal on underwriting it gets harder and harder to determine when we might see loss ratios return to more normalized levels.

While Geico’s combined ratio of 105.5% (100.6%) during the third quarter (first nine months) of 2017 put the firm into the red, backing out the hurricane-related losses actually leaves the auto insurer’s combined ratio at 98.8% (98.2%). Much of Geico’s ability to keep its (non-hurricane impacted) underwriting profitability in the black, despite aggressively underwriting business, has been tight expense controls, as well as the benefits of increased scale. The firm’s 13.6% (14.4%) expense ratio during the period is the lowest we can ever remember seeing; just for some perspective, Geico’s average expense ratio of 14.9% during the past year is 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 17.4% year over year), primarily attributable to new business and increased participations for renewals. This was also the case for BHRG during the third quarter, which posted (24.1%) earned premium growth; although almost all of this was driven by a big increase in retroactive reinsurance underwriting. We’re not expecting this to be the start of a trend. Both General Re and BHRG have been constraining (and will continue 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 thinks that the pricing in the marketplace is attractive enough to profitably underwrite additional business. We continue to have earned premium growth in negative territory for both firms over the next five years, but have been quick to point out that there could be some lumpiness in reported results, as both firms have shown a knack for finding profitable business, even in times like we’re facing right now where reinsurance pricing is unattractive.

Despite having pulled back from a lot of super-catastrophe underwriting the past few years, Berkshire’s exposure to hurricane- and earthquake-related losses during the third quarter was slightly more than we had been anticipating. General Re’s $835 million in catastrophe-related losses pushed its combined ratio out to 130.9% during the third quarter, and left the firm on pace to post an underwriting loss during 2017 (something that the reinsurer has not done since 2005). BHRG also reported an underwriting loss during the period, with its $1.45 billion in losses tied to hurricanes Harvey, Irma, and Maria as well as the earthquakes in Mexico, pushing its combined ratio to 157.7% and basically guaranteeing that the reinsurer would close out the year with an underwriting loss.

That said, there is the deferred charge amortization related to BHRG’s retroactive reinsurance agreement with AIG earlier this year (and reinsurance contract written in December 2016) to be considered, but even backing that out would leave results struggling to stay in the black given the drag from the catastrophe-related losses. While we have long believed that a string of major catastrophe losses, like we’ve seen this year, could serve as a catalyst for some of the excess capital that has been in the reinsurance business, which would help improve pricing to more normalized levels, Buffett noted back in September that he doesn’t expect pricing to improve materially in the aftermath of this year’s hurricanes and other natural disasters.

As for BHPG, the segment posted a 13.7% (9.1%) increase in earned (written) premiums year over year during the third quarter, led by solid growth at Berkshire Hathaway Specialty Insurance, GUARD, and Berkshire Hathaway Home Companies. That said, the collection of BHPG insurers could not avoid the impact of the three hurricanes, with the segment reporting pretax underwriting gains of $52 ($421) million in the third quarter (first nine months) of 2017, down 72.6% (2.5%) year over year. Excluding the impact of the segment’s $225 million in catastrophe-related losses, BHPG’s third-quarter (year-to-date) combined ratio would have been 85.0% (86.8%), more on par with the 87.2% average ratio we saw during 2012-16 and the 87.7% ratio produced during 2007-16.

Earned premium growth across Berkshire’s insurance platform led to a 5.6% sequential, and a 24.2% year-over-year increase in the company’s insurance float, estimated to be $113 billion at the end of the September quarter. Going forward, we expect further gains in 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 firm’s float over the past decade coming from its two reinsurance arms). That said, we continue to believe that Geico will be an important contributor to earned premium growth, as well as to the growth of float, and BHPG should also continue to be an important contributor, given the growth potential that exists for the newly formed Berkshire Hathaway Specialty Insurance unit.

Berkshire’s non-insurance 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 period). 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. While Union Pacific is usually a good proxy for BNSF, given both firms’ focus on the Western U.S. market, the competing railroad was negatively impacted by Hurricane Harvey, including the temporary closure of seven plastics plants (which impacted industrial products volumes) and the loss of 1,700 miles of roadway (which were out of service after the storm and dropped average train speed), with the impact of the storm reducing Union Pacific’s operating ratio by 70 basis points (to 62.8%), during the third quarter.

Over the past several years, BNSF has been beset by a shortfall in coal volume that started in the first quarter of 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 have looked much better so far during 2017, with coal and industrial products volumes increasing 12.4% and 2.2%, respectively, during the first nine months of the year (when compared with the same period in 2016). While overall volumes were up 6.0% during the first three quarters of 2017 (when compared with the year ago period), the 1.9% increase in coal volumes during the third quarter was a surprise, but some of this could be due to coal volumes starting to rebound to more normalized levels in the back half of 2016, which also explains the company’s projection for overall volumes to continue moderating in the fourth quarter of 2017.

Third-quarter (year-to-date) revenue was up 2.8% (8.5%), 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 4.7% (11.2%) as well during the third quarter (first nine months of 2017) when compared with the year-ago period. BNSF’s operating ratio of 63.2% (66.1%) during the third quarter (first three quarters of 2017) was also an improvement on the 63.6% (66.4%) levels reported in the year-ago period (and the 66.3% operating ration BNSF produced during 2016), but still off Union Pacific’s adjusted 62.1% (63.2%) results for the period.

Normally a beacon of stability, Berkshire Hathaway Energy, or BHE, reported a 3.3% (4.7%) increase in third-quarter (year-to-date) revenue, and a 1.3% (2.7%) increase in pretax earnings. 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, when it was 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 believe that Alliant Energy remains a compelling pursuit, albeit an expensive one (currently trading at a more than 15% premium to our own fair value estimate), and would be surprised to see BHE kicking the tires on Pinnacle West and NiSource.

With regards to Berkshire’s manufacturing, service and retail operations, the group overall recorded a 4.8% (5.3%) increase in third-quarter (year-to-date) revenue, and a 0.1% (4.7%) 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 divisions year-to-date results fall 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 7.9% (7.5%) during the third quarter (first nine months of 2017) were slightly better than our forecast, which had operating margins expanding by 20 basis points annually over the 7.0% level the segment reported 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 11.5% (7.2%) during the third quarter (first nine months of 2017), and pretax earnings increasing 1.5% (declining 5.0%) due primarily to lower interest and dividend income from investments, higher railcar repair and storage costs, and lower earnings from CORTs furniture rental business. Ultimately, though, the finance and financial products segment is a mere rounding error for Berkshire overall results, accounting for just 5.8% of pretax earnings on average the past five calendar years.

As we noted above, book value per Class A equivalent share at the end of the third quarter was $187,435. The company also closed out the period with $109.3 billion in cash and cash equivalents on its books. Buffett likes to keep around $20 billion on hand as a backstop for the insurance business, and the firm’s non-insurance operations generally need between $3 billion and $5 billion in operating cash, so Berkshire still has more than $60 billion available to dedicate to investments, acquisitions (including the Pilot Flying J deal announced at the beginning of October), and share repurchases (or dividends). As we noted above, Berkshire did not buy back any shares during the first nine months of 2017, but based on the company’s end-of-third-quarter book value per share, Buffett should be willing to buy back stock at prices below $224,922 ($149.95) per Class A (B) share, which is about 20% below Friday’s closing price on the shares.

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