Analysis of Berkshire Hathaway Earnings - 3Q 2020
Berkshire Hathaway (BRK/A, BRK/B) reported very interesting quarterly earnings even if you do not own the stock because Berkshire can 1) provide a broad look at the economic impacts of COVID-19 due to its many operating businesses and; 2) is managed by two of the greatest investors and capital allocators of all time.
Berkshire bought back a record $9 billion of its own stock in 3Q (see chart 1) bringing the year-to-date (YTD) total to $15.7 billion with purchases likely continuing in October. Until an announcement in mid-2018, Berkshire had limited repurchases to when the stock was trading at less than 1.2 times price to book (P/B). While that constraint is now relaxed, it is still a good indicator of the general range when aggressive repurchases will likely be seen. Berkshire’s P/B was 1.1 times at the beginning of July and is currently 1.2 times (see chart 1). Berkshire only intends to repurchase shares when the “repurchase price is below Berkshire’s intrinsic value, conservatively determined.” The P/B ratio is used as a proxy for gauging Berkshire’s intrinsic value, but Warren Buffett and Charlie Munger’s judgement about its intrinsic value versus other available uses of capital could differ from that simple measure.
While still trailing the S&P 500 return year-to-date, Berkshire gained 19.7% in 3Q versus 8.9% for the S&P 500. Berkshire retains a fortress balance sheet with cash and equivalents at $135.2 billion versus $146.6 billion at the end of June, which provides flexibility to take advantage of opportunities including repurchasing its own stock. Berkshire has stated that there would be no stock repurchases if it would cause cash levels to fall below $20 billion.
Berkshire’s quarterly earnings of over $30 billion rose 82% versus the same quarter in 2019 but that is largely a function of the rally in stocks and their investment portfolio in 3Q, since unrealized gains from their portfolio are included in their earnings. Almost 46% of Berkshire’s portfolio of publicly traded equity securities consists of shares in Apple Inc. (AAPL) with a value of $111.7 billion as of September 30. AAPL shares rose by 27% in 3Q and almost 59% YTD. Operating earnings, which removes the distortion from market changes and better reflects the earnings power of the firm, for the quarter declined by -32% versus 2019. Providing one illustration of the value of the impact from the increased pace of share repurchases, per share operating income for 3Q fell less versus 2019 at -30% (see Table 1). The impact from COVID continued to be felt in 3Q and is also reflected in the operating earnings for the first nine months of 2020 which declined -14% versus the same period in 2019.
A further look into the different operating segments shows the weakness was primarily in the insurance, railroad and the manufacturing, service and retailing group which contains Berkshire’s aerospace companies. Utilities and energy had a strong quarter and have grown earnings YTD as well (see Table 2).
Insurance: Investment income was lower in 3Q primarily due to lower income from short-term investments. With interest rates at historic lows and not likely to move higher soon, investment income is likely to remain relatively depressed. As noted in our short review of Berkshire’s 2Q earnings, insurance earnings should moderate as claims would likely rise with more people driving again and the planned rebate of premiums. The premium rate reductions from GEICO were a significant contributor to the 3Q underwriting loss and are expected to weigh on results through 1Q 2021. In addition, Berkshire’s insurance suffered losses due to Hurricanes Laura and Sally in the third quarter.
The two most important concepts in insurance investing are “float” and underwriting profit. In simple terms, float is created for insurance companies because insurance premiums are paid before any claims are made by the insured. Insurance companies can invest the float, sometimes for years, before insurance losses are paid. Berkshire has a history, unlike a number of insurance companies, of earning an underwriting profit meaning that their float costs them nothing and actually makes them money in addition to allowing them to earn a profit off of investing the float. An underwriting profit means that the insurance premium exceeds all insurance claims and expenses. While COVID certainly impacted their results, Berkshire continued to earn an underwriting profit for the first nine months of 2020. Berkshire’s float has increased to approximately $135 billion on September 30, 2020 from $129 billion on December 31, 2019.
Railroad: Berkshire owns the Burlington Northern Santa Fe (BNSF) railroad operating in the U.S. and Canada. COVID continued to impact volumes in 3Q and YTD leading to declines in year-over-year (Y/Y) operating earnings comparisons for both time periods. Berkshire’s -8% decline in 3Q railroad operating income looks directionally correct when compared to other publicly traded railroads that we analyzed. In fact, BNSF outperformed the -9.1% and -11.3% 3Q operating profit declines from Union Pacific Corp. (UNP) and CSX Corp. (CSX).
Utilities and Energy: This business provided the steady and growing earnings which one would expect from what primarily consists of regulated utilities and pipeline companies. A couple of their utilities benefited from improved income tax benefits along with other factors that flattered 3Q relative to 2019. Interestingly, this group also operates Berkshire Hathaway HomeServices (BHHS), the largest residential real estate brokerage firm in the U.S. As we wrote recently, housing is a major strength of the U.S. economy so it was not a surprise that BHHS has shown sharply higher earning both in 3Q and YTD.
Manufacturing, Service and Retailing: This segment consists of many diverse businesses, so this analysis will focus on a couple of the major themes when looking at this segment. In our previous report about the Berkshire annual meeting, we flagged that Berkshire’s aerospace exposure remained significant despite the sale of their publicly traded airline holdings earlier in the year. In fact, Berkshire took a $10 billion impairment charge on the Precision Castparts (PCC) business due to its exposure to the COVID-disrupted aerospace industry in 2Q. Berkshire’s wholly owned entities PCC, FlightSafety and NetJets all continued to post lower earnings due to the impact of COVID on aerospace demand. Not surprisingly given their business serving the aircraft manufacturers, PCC continues to be hard hit with pre-tax earnings -80% in 3Q versus 2020. While much of this segment was impacted greatly by COVID-related demand destruction, demand for the furniture leasing via CORT remains depressed and foodservice deliveries to restaurants due to closures has hurt the results for McClane. It seems likely that this group will continue to experience some struggles for at least the rest of the year as infections have spiked again globally.
While it was not enough to offset the negative drag from the businesses listed above and others, Berkshire did have some businesses in this segment that benefitted from some trends in 3Q. Housing related businesses like Clayton Homes, Shaw, Johns Manville, Acme Building Products, Benjamin Moore and MiTek saw benefit from the housing boom and posted higher earnings for 3Q and YTD. Their home furnishing businesses which includes the Nebraska Furniture Mart also saw a nice tailwind from housing and COVID-related demand.
Other: This segment includes the earnings of companies that must be accounted for under the equity method due to size of ownership and influence on management. The most notable in 3Q is Kraft Heinz (KHC) which posted strong results in the quarter after a poor start to the year. The large 3Q loss in the segment is primarily attributable to foreign currency exchange rate losses from bonds issued by Berkshire Hathaway and denominated in British Pounds, euros, and Japanese Yen. The decline in the U.S. dollar in 3Q caused significant mark-to-market losses, but this is not really a concern as Berkshire has significant assets and earnings denominated in these foreign currencies. For example, Berkshire owns the Northern Powergrid business in the U.K. Also as we discussed in a previous note, Berkshire bought roughly $6 billion worth of Japanese equites earlier in the year which on average have an expected dividend yield of 4.7%. On the other side of the ledger, Berkshire borrowed about $5.9 billion in Japanese Yen at an average interest rate of 0.6%.
Summary: Quarterly results are generally not very meaningful for Berkshire since it is managed for long-term performance and not to meet quarterly hurdles. This ability to take advantage of time arbitrage has served the company and shareholders well over the years. The goal in looking at the quarterly results is to see if the segments are generally operating as expected and consider the capital allocation decisions made by Warren Buffett and Charlie Munger.
Clearly the major capital allocation decision made recently was the increase in the amount of share repurchases. This signals to us that they believe the price of Berkshire Hathaway to be below their estimate of intrinsic value. If they are correct (and we have no reason to doubt them), then the purchases are a value-creator for the remaining shareholders. The repurchases also signal that they are not finding many other opportunities with what they judge as better risk versus reward for investing capital.
Berkshire continues to retain its fortress balance sheet and a very diversified mix of businesses as discussed in our report, so shareholders should take comfort in knowing that the firm continues to be managed to survive any economic shocks thrown at it. This conservative management style may relatively “hurt” profits when times are good but positions the firm to take advantage of significant opportunities when disruptions or crisis provide them. Certainly, it might be a reasonable criticism that Berkshire should have been more aggressive in utilizing its cash hoard even on stock buybacks in March, but that view needs to be tempered with the luxury of 20/20 hindsight vision.
Full disclosure: I am a long-time shareholder of Berkshire Hathaway and worked for Salomon Brothers when Warren Buffett became Chairman and CEO.
The PDF version of this report is linked here.