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Mixed Year at Berkshire Doesn’t Change Our View

Greggory Warren, CFA

There was little in wide-moat-rated Berkshire Hathaway's (BRK.A)(BRK.B) fourth-quarter and full-year results that would alter our long-term view of the firm. We do not expect to make any changes to our $255,000 ($170) per Class A (B) share fair value estimate or to our wide-moat rating. Fourth-quarter revenue increased 11.0% to $57.6 billion, lifting full-year revenue 6.0% to $223.6 billion. Excluding the impact of investment and derivative gains (losses), and other eliminations, fourth-quarter and full-year revenue increased 4.5% and 7.5%, respectively. With expenses running ahead of revenue during the fourth quarter, operating earnings declined 6.2% during the period, leaving full-year operating earnings up just 1.3%. Even so, gains on the company's investment portfolio, and other adjustments, led to a 14.7% increase in fourth-quarter net earnings per Class A equivalent share. Unfortunately, full-year net earnings were still down 0.1% when compared with 2015.

We remain impressed with Berkshire's ability to increase its book value per Class A equivalent share, which rose 10.7% year over year to $172,108 (higher than our own estimate of $167,878). This was aided by much stronger performance from its investment portfolio during 2016. The company closed out the year with $86.4 billion in cash on its books, up from $84.8 billion at the end of September and $71.7 billion at the end of 2015. While CEO Warren Buffett noted at the end of January that Berkshire had spent $12 billion on stocks following the U.S. presidential election, some of that amount ($4.1 billion, by our estimates) was funded by stock sales, and some of it might have been spent in January, which explains why the company's cash balances were 1.8% higher on a sequential basis. By our estimates, Berkshire came into 2017 with nearly $50 billion in dry powder it could be use for acquisitions, stock investments, or share repurchases.

Looking more closely at Berkshire's insurance operations, three of the firm's four insurance segments--Geico, General Re, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group--posted earned premium growth during the fourth quarter and the full year (with General Re being the lone holdout). From an underwriting profitability perspective, everyone but Geico posted positive results during the fourth quarter, but all four insurance segments posted positive results for the full year, with combined ratios ranging from a high of 89.5% at BHPG to a low of 98.2% at Geico (which continues to struggle with elevated loss ratios). On a combined basis, Berkshire's insurance operations were once again profitable from an underwriting perspective during 2016. Its firmwide combined ratio of 95.4% was an improvement on the 95.2% level posted during 2015, but was still a letdown when compared with the 93.5% combined ratio Berkshire reported for its insurance operations overall during 2014.

Geico's fourth-quarter earned premium growth of 13.3% was one of the strongest quarterly results the auto insurer has ever put up, with management noting that earned premium growth accelerated during the back half of 2016 as an increase in loss costs throughout the auto insurance industry dampened auto insurers' appetite for taking on new customers. While we're glad to see Geico taking advantage of opportunities, the firm has seen a marked increase in its own loss ratio the past couple of years, so unless these customers are being taken on at high enough premium rates to return its loss ratio to more normalized levels, we wonder if it's worth the effort. After posting loss ratios of 82.8% and 82.4% during the second and third quarters of 2016 (well above the firm's average annual loss ratio of 76.6% during 2010-14), Geico's loss ratio expanded to a troubling 85.1% during the fourth quarter. This left the firm's loss ratio for the full year at 82.6%, up from 82.1% during 2015. While the company has been able to offset its elevated loss ratio with reductions in its expense ratio, which fell to 15.6% during 2016 (from 15.9% in 2015), it has not been enough to keep Geico's combined ratio, which was 98.2% during 2016 (and 98.0% in 2015) from returning to more normalized levels (of 94.5% during 2010-14). As we've noted previously, it has paid to be cautious about Geico's recovery. A slowly improving U.S. economy, fueled by lower gas prices, has led to more drivers on the road and increased the potential for accidents. Add to that the problem of distracted drivers using smartphones to talk, text, or even watch videos while driving, it has not been surprising to see losses increasing for the auto insurers.

As for General Re, the reinsurer posted negative earned premium growth once again during the fourth quarter and full year, with premiums declining 6.9% and 5.7%, respectively. BHRG, on the other hand, posted a 44.8% increase in earned premiums during the fourth quarter (lifting full-year earned premium growth to 18.0%), aided by a marked increase in retroactive insurance underwriting during 2016. On the whole, General Re and BHRG have constrained the volume of reinsurance they have been underwriting, due to the excess capacity in the reinsurance market, and the fact that neither firm feels pricing is attractive enough to profitably underwrite business. While we continue to have earned premium growth in negative territory for both firms over the next five years, we've always 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 when reinsurance pricing is unattractive. (Berkshire's recent $9.8 billion reinsurance deal with AIG is a good example of this ability.) As for BHPG, fourth-quarter and full-year earned premium growth of 15.9% and 16.0%, respectively, was driven by volume increases at Berkshire Hathaway Specialty Insurance, MedPro Group, BHHC, and GUARD. The division's combined ratio of 89.5% during 2016 was a step down from the 84.7% ratio posted in 2015, though, driven primarily by a decline in favorable loss developments year over year.

Berkshire's insurance float increased to $91.6 billion during 2016, up 4.4% from $87.7 billion at the end of 2015. This moved the five- and 10-year CAGR for the firm's insurance float to 5.3% and 6.1%, respectively. We expect further gains in Berkshire's insurance float to be much harder to come by as we move forward, though, with Berkshire limiting the amount of reinsurance business it underwrites (noting that much of the growth that we've seen in the firm's float over the past decade has come from its two reinsurance arms). We continue to believe Geico will be an important contributor to earned premium growth, as well as to the growth of float, with underwriting profitability likely to improve in the next few years. BHPG should also continue to be an important contributor, especially considering the growth potential that exists for the BHSI unit. Given these conditions, earned premium growth is likely to resemble a barbell longer term, with Geico and BHPG on the outer ends and the reinsurance arms holding the middle.

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, but 2016 was another challenging year for the firm. We had expected Berkshire's railroad operator, BNSF, to report a poor year, having already seen weak results from the other Class I railroads in the face of declining coal, as well as industrial and intermodal volumes. BNSF's freight volumes declined 5.0% during 2016, with revenue per car/unit also declining 5.2%. As a result, full-year revenue and pretax earnings declined 9.7% and 16.0%, respectively. The one positive in these results is that BNSF's operating results looked much better in the back half of the year than they did in the first half. That said, the firm will continue to face pressure on coal volumes as long as natural gas prices stay low. It could also see some pressure on intermodal volumes in the coming years as West Coast port traffic gets diverted to East Coast ports through an expanded Panama Canal. Normally a beacon of stability, Berkshire Hathaway Energy reported a 6.2% decline in full-year revenue, primarily due to lower regulated electric and natural gas revenue at PacifiCorp, NV Energy, Northern Powergrid, and the company's natural gas pipeline operations, much of which can be tied to lower input costs. That said, pretax earnings were up 16.6%, with full-year margins at 23.0%. We expect to see some moderation in results as we move forward, with BHE once again providing the positive diversification traits that we've seen from the business in past periods.

With regards to Berkshire's manufacturing, service, and retail operations, the group overall recorded an 11.3% increase in full-year revenue, aided by the inclusion of Precision Castparts (from the end of January 2016 to the end of the year) in the group's results. Full-year pretax earnings increased 18.9%, with margins improving to 7.0% (from 6.6% during 2015). 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 also up year over year, with full-year revenue increasing 10.2% and pretax earnings expanding 2.0% as margins declined from 30.0% to 27.8% year over year. Of note was a major slowdown in Marmon's rail car business last year, which is expected to carry over into 2017. Even so, we continue to expect revenue to grow at a mid-to-high-single-digit rate going forward, with pretax margins likely to remain just below 30%.

As we noted above, book value per Class A equivalent share at the end of 2016 was $172,108. Berkshire also closed out the period with $86.4 billion in cash on its books. After excluding operating cash, as well as cash the firm is likely to earmark for capital expenditures, equity investments, and smaller bolt-on acquisitions, and the $20 billion that Buffett prefers to have on hand as a backstop for the insurance business, Berkshire should have at least $50 billion in excess cash available for future acquisitions, stock investment and/or share repurchases. While Berkshire didn't by back any shares during 2016 or over the past three years, Buffett did confirm to us during the company's last annual meeting that he would aggressively buy back stock if it dipped below 1.2 times book value, even if the firm had not yet reported its end-of-quarter book value per share to shareholders. Based on end-of-2016 book value per share, Buffett should be willing to buy back stock at prices below $206,530 ($137.69) per Class A (B) share, which is about 19% below current trading levels.

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