Berkshire Hathaway Stock: Back to Basics (NYSE: BRK.A) (NYSE: BRK.B)
Buffett the buyer takes a break
Berkshire Hathaway (NYSE:BRK.A) (NYSE: BRK.B) created an exciting buzz in the first quarter, spending more than $50 billion in new equity investments in addition to about $3 billion in buybacks. I wrote about this in my last Berkshire article, “Buffett The Buyer Is Back“. With 2Q results now we see that Berkshire has returned to its typical low level of investment activity. The company made about $6.2 billion in new stock purchases and sold about $2.3 billion. Buyback activity also declined to around $1 billion, likely due to higher stock prices early in the quarter. Berkshire made no buybacks until June, at an average price of $276.75 per B share. Buybacks appear to have continued into July at slightly higher prices, with the company spending around $0.5 billion additional through 7/23 based on the number of shares on the front page of the 10-Q.
Net investing and redemption activity roughly balanced Berkshire’s free cash flow of $4.8 billion in Q2. The balancing is also consistent with the negligible change in the insurance float. After devoting more of the cash pile to dividend-paying investments in the first quarter, Buffett now seems content to earn the higher interest rates now available on Berkshire’s remaining $101 billion cash balance. .
With investment activity back to normal, we need to look to Berkshire’s operating company results for a good sense of performance. Overall earnings have held up well, but margins are starting to squeeze. Demand could also weaken in some companies. My estimate of the company’s intrinsic value hasn’t changed much over the past year, but thanks to the decline in the stock price, it now looks about 13% undervalued. But before we get to that, let’s take a look at the company’s operational performance.
Insurance investment income is doing very well, up 56% compared to 2Q 2021 thanks to both new equity investments in 1Q and higher interest rates on the cash balance. Underwriting performance is more mixed. Due to the rapid evolution of inflation and GDP, the sequential changes from the 1st to the 2nd quarter could tell us more, this is how I will present the results. Year-over-year comparisons are in the 10-Q if you want to see them.
GEICO represents more than half of Berkshire’s insurance business. Unfortunately, it continues to struggle with high car and parts costs, resulting in higher costs per claim. They are managing underwriting expenses well, but the cost of claims is the big drag, driving the combined ratio up 3.1 percentage points from the first quarter, resulting in a larger underwriting loss. It is also concerning that although premiums earned have increased slightly, premiums written have declined significantly, which does not bode well for premiums earned in the coming quarters.
As we have seen in recent quarters, Berkshire’s other primary insurance business continues to be the strongest performer in the group. The division improved its underwriting profit and continues to increase written and earned premiums. Reinsurance business has erratic results, so we cannot interpret quarterly fluctuations too much. However, economic conditions appear to be a key factor in the better underwriting performance this quarter. A stronger dollar reduces the cost of foreign claims and higher interest rates reduce the cost of claims in future years when discounted to present value.
Overall, I have to lower my insurance industry rating due to GEICO’s poorer performance which now deserves a C- below average. The other primary businesses deserve an A+ for growth and reinsurance deserves an A for disciplined long-term performance.
BNSF faces reduced volumes this year due to supply chain issues and a slowing economy.
The good news is that the railroad was able to raise prices to more than cover their much higher fuel costs. Although the operating expense ratio increased year over year, it decreased sequentially.
BNSF could still improve its cost performance against its peers, but it’s on track and earning an upgrade.
Berkshire Hathaway Energy
BHE is also experiencing gross margin and operating cost pressures this year, leading to lower operating income. These short-term issues can be overlooked when considering smart strategic moves by Berkshire, including the purchase of long-distance gas pipelines and a 25% stake in an LNG terminal from Dominion Energy (D). The utility also continues to invest heavily in wind power generation. Whatever you think of renewables, wind assets benefit from a production tax credit that makes BHE’s overall tax rate even more negative this year than last. The tax credit is sufficient to increase BHE’s overall income despite the decline in operating income.
BHE could be in line for more subsidies through the Inflation Reduction Act. The company owns 25% of the Quad Cities power plant, with the balance owned and operated by Constellation Energy (CEG). Nuclear power also qualifies for production tax credits under the Act, although it is unclear what impact the 15% minimum corporate tax provision under the Act BHE Act. The utility is also piloting small modular reactor technology in Wyoming in partnership with Bill Gates.
Finally, Berkshire recently purchased Greg Abel’s 1% personal stake in BHE for $870 million, bringing Berkshire’s stake to 92%.
I will remain focused on the long-term strategic direction of BHE, which earns it the top spot among Berkshire companies.
Two of the three manufacturing segments are holding up well. Industrial and construction products both show higher sales and revenues compared to last year as well as sequentially compared to 1Q. In industry, Precision Castparts is finally developing thanks to a recovering aeronautics industry. Lubrizol has recovered from the weather-related shutdown and fire that hurt it in 2021. Marmon also grew in the first half despite a weak second quarter caused by the exit of its railcar rental business in Russia.
Manufactured home seller Clayton Homes accounts for nearly half of the Building Products group and is increasing sales and profits year over year and sequentially. The unit also finances these homes and enjoys higher interest rates with no signs of rising defaults. While this group traditionally suffers from a recession, Berkshire is not yet seeing an impact.
The consumer goods manufacturing segment is now feeling the pressure of inflation. Revenues are up but margins and profits are down. Footwear and apparel order volumes are down as retailers eliminate excess inventory. RV maker Forest River has seen strong growth, but is now seeing signs of slowing with higher gas prices.
With two out of three segments holding up well despite changes in the economic environment, Industry has maintained its good rating compared to my last report.
Service and Retail
The Service group and McLane recorded better sales than last year. Retail trade slowed in 1Q, but improved further in 2Q. Margins are lower than a year ago, but essentially stable quarter over quarter. As a result, the group’s total revenue improved sequentially. The Service group sees a recovery in travel demand at FlightSafety and NetJets. Berkshire Hathaway Automotive is the largest company in retail and is enjoying higher prices and margins despite falling unit sales.
Berkshire has picked a good group of companies that look well positioned to weather the current volatility.
I have reviewed my sum-of-the-parts model in detail in previous articles. Last year’s report describes the methodology in more detail. This is highly dependent on the valuation of peer companies across Berkshire’s various businesses. The resulting intrinsic value estimate has been remarkably stable since then, in a narrow range of $490,000 to $500,000 per A-share. The earnings power of operating companies has increased, but their counterparts have suffered multiple contractions. The value of equity investments is between my mid-2021 and late-2021 estimates. Equity prices are down from a year ago, but Berkshire has invested significantly more cash in this area, especially in the first quarter of 2022. Finally, the insurance business (excluding income from the equity portfolio) is valued the same as a year ago, but the underwriting income is down, offset by a higher earning capacity on the cash balance.
The aggregate fair value is estimated at $330.69 per B share or $496,031 per A share. This is a premium of approximately 13% to the stock’s closing price on the day before the release. results.
Berkshire Hathaway’s operating company performance has held up well so far in 2022 with stronger earnings despite margin compression in some areas. The money invested last quarter in equity investments is paying off in the form of higher dividend income. The cash balance also earns more through higher interest rates. The only criticism concerns the performance of GEICO which is still incurring losses and writing fewer new policies. If Berkshire can make this unit perform as well as its other primary insurance businesses, that will provide a nice boost to my estimate of intrinsic value.
Although the intrinsic value did not change much, the share price performance in the first half of the year created a buyable valuation gap. I wouldn’t be surprised to see Warren Buffett continue the stock buybacks that resumed in June and other investors should consider buying as well.