Tuesday, March 5, 2013

Berkshire Hathaway: Conundrums in Buffett's Letter

Having read Warren Buffett's letters for many years, I was puzzled after my initial reading of the 2012 Shareholder Letter. It is different in style and tone from the previous letters.  Waiting a bit and rereading helped me reach a couple of conclusions.  The letter from front to back probably reflects the author's changing emotional state during the writing of the lengthy letter.

With a beginning containing apologies and "bad news," the conclusion of the letter where Mr. Buffett reprises "Owner Related Business Principles" shows the Chairman at his optimistic, incisive and feisty best.  Overall, it was a really good, fundamental business year, and shareholders who can hold without the comfort of a dividend should be well rewarded.  There are a few cautions, however.


The typical comment about BRK is that it is a property-casualty ("P-C") insurance company at its core.  That is true, to an extent.  The share of net income attributable to shareholders provided by the Insurance operations was 30% in 2012, down from 36% in the prior year and from almost 40% in 2010.  The decline in the net income contribution share in 2012 was driven by a sharp decline in the y-o-y investment income contribution share from the Insurance operations. It's no surprise that an insurance analyst is among the BRK bulls appearing on the panel at the Annual Meeting.  BRK's Insurance operation's performance and financial strength have been  extraordinary, almost magically consistent by industry standards.  In the Chairman's words these businesses "shot the lights out" in 2012, and that is not an understatement.

Berkshire Hathaway Reinsurance ("BH Re") is run by the rightly, oft-praised Ajit Jain.  BH Re generated $35 billion in 2012 float, comprising 48% of the float provided by all the businesses in the segment.  It also swung from an underwriting loss in 2011 to a $304 million profit in 2012, quite an achievement.

General Re produced a float of $20 billion and generated an underwriting profit of $355 million.  The P-C industry is characterized by classic underwriting cycles.  When conditions are flush, companies chase new business by taking on more risk with inadequate premiums; if economic conditions deteriorate and extraordinary losses hit, combined ratios go haywire.  Books shrink and the adjustment of premiums to appropriate levels takes some time.  In 37 of the past 45 years, the P-C industry's combined ratios have exceeded 100%, which is another way of saying that premiums failed to cover claims plus expenses.

BRK's reinsurers seem to not participate in the industry game of chasing business, which is why the Chairman seems to call out the Jain and Montross on a regular basis.

GEICO's year-end float was some $400 million higher than 2011 at $11.6 billion in 2012.  However, its underwriting profit was $680 million on a GAAP basis, but $1.1 billion excluding the effects of an industry-wide change in accounting standards that didn't affect cash or the fundamental numbers; the adjusted underwriting profit was 91% above the prior-year level.  Vehicle losses from Hurricane Sandy were more than three times higher for GEICO than the losses from Katrina.  The Chairman "rubs his eyes" at these numbers, and I have to scratch my head.  They are quite extraordinary.

The insurance businesses earned $34,545 million in premiums in 2012, compared to $32,075 in 2011, an incremental $2,470 million in earned premiums.  Against this, insurance losses and adjustment expenses were $20,113 million in 2012, compared to $20,829 million in 2011, a decline of $716 million.  This cushion allowed the businesses to absorb a significant increase in underwriting expenses and higher life, annuity and health benefit payouts to produce an underwriting profit of $1,625 million in 2012 compared to a profit of $248 million in the prior year.  Yes, they did shoot the lights out.

An Ernst and Young study about the effects of the low interest rate environment on insurer portfolios says that the fixed income portion of the portfolios will continue to be under pressure. Ernst and Young estimate that bond yields in the general accounts of P-C insurers could decline by 50 basis points from current levels, over three years. For most companies, this signal would flash yellow.

I strongly suspect that one of the reasons that Todd Combs and Ted Wechsler were brought on as new investment managers was to manage the fixed income portfolio aggressively to mitigate these kinds of pressures on the fixed income portfolios.  These are big stakes, given the size of BRK's insurance businesses.

However, the way BRK is structured, there are many layers of liquidity to support the businesses. If indeed the general accounts of other insurers are pressured, and they were to pull back from writing new, or renewing old, business, this would be an ideal scenario for BRK's businesses to gain share with the appropriate premium levels.  I can see why insurance analysts are bullish, particularly on the opportunities for GEICO.

Regulated, Capital-Intensive Industries

Let's get right to my point: the acquisition of BNSF was a gem of a pickup.  Pre-acquisition, it was a well managed company that consistently invested in its capital-intensive rail system, making it efficient and modern.  From BRK's acquisition criteria, it is an easy business to understand, with motivated management interested in leveraging growth and margin opportunities under the Berkshire umbrella. 

Since 2009 revenues have grown from $16,850 million to $20,835 million in 2012.  The net margin rate has increased by 160 basis points over the same period to 16.2% in 2012.  The Chairman talks about his Powerhouse Five non-insurance businesses: BNSF, Mid-American, Marmon, Iscar and Lubrizol.  They together earned $10.1 billion, pre-tax in 2012, slightly more than 6% above their 2011 earnings as a group. 

BNSF earned 53% of the total pre-tax earnings of the Powerhouse Five, recording pre-tax income of $5377 million, for a margin rate of 25.8% that appears to be easily the highest among the group. 

The Marmon Group seems like an extraordinarily profitable business with scale and opportunities for growth and margin expansion. It too appears to be a candidate for writing a business school case on how to manage a sprawling number of companies in three distinct segments.  For the Chairman and Charlie Munger to give their blessing by acquiring them says all that needs to be said.  Marmon's 2012 revenue was $7,171 million, on which it earned $1,137 million pre-tax, which is a margin rate of 15.9%. 

Rounding out the Powerhouse Five are Iscar and Lubrizol, which together should account for about $2.3 billion in pre-tax income for 2012, if my estimates are correct; the bulk of this amount should come from Iscar, but I couldn't find the breakout for these two businesses. Lubrizol was a great company for a long time, and I knew it working as a security analyst in Cleveland where a research colleague of mine regularly reported on its strong performance.  It should be another fine acquisition for BRK. Iscar also seems like a great business.  Both of these businesses should improve in 2013, particularly as Lubrizol is probably reshaping itself a bit. 

MidAmerican Energy is a solid collection of businesses, the majority of which won't knock anyone's socks off.  70% of consolidated 2012 revenue of $11,747 million comes from the two regulated utilities, PacificCorp and MidAmerican Energy; the utilities account for 50% of the consolidated operating profit of $1,958 million in 2012.  

MidAmerican's utility revenues have declined slightly each year since 2010, and the operating margin has been range bound between 7-8%.  The stronger performing businesses have been Natural Gas Pipelines and Northern Powergrid, which have higher rates of profitability on a much smaller revenue base.  Owning this business for a BRK investor gives cash flows that can be redeployed by Messrs. Buffett and Munger, along with an economically sensitive element to the portfolio mix.  Beyond that, it's hard to say much or to get excited about this collection of businesses.  The Chairman made some comment about owning a large chunk of solar energy capacity through the utilities: c'mon, really?  

We're going to stop here and break the analysis into at least one more post.  So far, we've seen an extraordinarily well managed and profitable property-casualty business portfolio that had an extraordinary year.  We've seen one recent acquisition, BNSF, which has been hitting on all cylinders. The Marmon Group is a terrific business in the Manufacturing, Services and Retailing segment of BRK.  Iscar and Lubrizol are fine businesses too, and Lubrizol's prospects should improve as it continues under the Berkshire umbrella.  

So, the Shareholder Letter begins with the Chairman apologizing for sub-par performance and for not making a mega-acquisition in 2012.  In the face of what we've talked about, what gives?  We'll continue later. 

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