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In this type of operating environment, reinsurers that have more diverse insurance
portfolios and serve multiple distribution channels are more likely to offset the
negatives in the market, and they should be able to target profitable opportunities as
they arise. We think General Re and BHRG fall into this category. That said,
Berkshire's reinsurance operations are also dealing with a number of runoff contracts
in the near term, so we see the ability of the two firms to generate float being
somewhat limited the next few years. With about three fourths of Berkshire's overall
float coming from its two reinsurance arms--General Re (23%) and BHRG (51%)--we
believe further increases in the overall level of the company's insurance float (which
stood at $85.1 billion at the end of the second quarter) will be more difficult to come
by.
For General Re, which reported its first decline in earned premiums in two years
during the first half of 2015, we forecast low-single-digit annual declines in earned
premiums over the next five years (down from flattish earned premium growth in our
previous forecast). We also expect the firm's combined ratio, which has deteriorated
to 98.0% this year (from 93.8% in the year-ago period) to eventually recover enough
to put its average combined ratio over the next five years at 94.9% (the same level
seen during 2010-14). BHRG's results have been a bit more difficult to forecast, given
the impact that the runoff of the Swiss Re contract has had on earned premiums and
profitability the past five years. Much as with General Re, we're not expecting much
premium growth during the next five years at BHRG (which has made a name for
itself underwriting policies with risks that most other reinsurers are unwilling or
unable to take), with top-line growth being similar to General Re's--albeit with a bit
more lumpiness in the annual results. We do expect profitability to improve over the
98.6% combined ratio the firm reported during the first half of 2015, with BHRG's
profitability overall eventually settling down below the 96.4% seen during 2010-14.
We think a far more telling signal of the level of weakness that Berkshire expects
from its reinsurance operations is the fact that Ajit Jain, who has been primarily
responsible for BHRG the past three decades, has turned most of his attention to
Berkshire's latest endeavor in insurance underwriting--Berkshire Hathaway Specialty
Insurance--which was formed in June 2013 and resides within BHPG. While not quite
as homogeneous as Berkshire's three other insurance subsidiaries, being a
conglomeration of multiple insurance operations that offer coverage as varied as
workers' compensation and commercial auto and property coverage, BHPG has been
its fastest growing, with the best combined ratio and the strongest float growth over
the past 5-, 10-, and 15-year time frames. Past results for BHPG include both
acquired and organic growth, something that we expect to continue in the years
ahead, with the division posting double-digit earned premium growth during 2015-19
as a result. We also expect the division's combined ratio to range between 85% and
90% during the next five years, allowing it to maintain its ranking as Berkshire's
most profitable insurance subsidiary.
Combining our projections for the future underwriting results of the different
insurance operations with a slightly better environment for investment income (as
interest rates eventually rise in the near to medium term), we arrive at a fair value
estimate of $83,100 ($55) per Class A (Class B) share. While our estimate of the
overall value of Berkshire's insurance operations is down 15% from our previous
valuation of $97,200 ($65) per Class A (Class B) share, this was due not only to the
weaker expectations we've built into our valuation model for the different insurance
arms, but the extraction of capital from the insurance operations to be used to
complete the Precision Castparts deal. We think Kraft Heinz and Precision Castparts,
which we value separately from the insurance operations despite being held on their
books (primarily because we continue to have financial statements to work with), are
worth $14,300 ($10) and $20,600 ($14) per Class A (Class B) share, respectively.
Volume Glut Dings BNSF
As for Berkshire's noninsurance operations, the fact that both Burlington Northern
Santa Fe and Berkshire Hathaway Energy file quarterly and annual reports with the
Securities and Exchange Commission, despite being completely enveloped in the
insurer's holding company structure, allows us to put together more robust forecasts
for their operations. We've lowered our fair value estimate for BNSF to $58,300 ($39)
per Class A (Class B) share from $61,500 ($41) due to a reduction in our near-term
assumptions for railcar volume and pricing. After posting stronger results during the
first quarter, BNSF took a step back in the second quarter, with revenue declining 6%
year over year and pretax earnings increasing just 4%. On a year-to-date basis,
revenue was down 2%, but pretax earnings were up 21%, with the year-ago period
being affected by poor weather conditions in much of BNSF's territory that affected
railcar volume and drove costs up meaningfully during the first quarter of 2014.
Lower average revenue per car/unit (due primarily to lower fuel surcharges year over
year) and relatively flat volumes (due primarily to softening demand for energyrelated products) were responsible for the decline in year-to-date revenue.
While we view the current volume glut, which has also affected most of BNSF's peers,
to be a temporary glitch in the company's long-term performance, we have revised
our near- to medium-term outlook for volume, which contributed to most of the
change in our fair value estimate. For 2015, in particular, we see overall volume
declining around 2%, down from our previous forecast of flat to slightly positive
growth in carloads hauled. Weaker near-term demand for coal (which has fallen off a
cliff this year thanks to high stockpiles from mild weather and ongoing gas
conversions at utilities and other customers) and Bakken shale crude oil (which is
down because of the significant drop in crude oil prices over the past year) should
keep volume growth under wraps next year as well. We expect things to normalize
some after 2016, with volume growth returning to 1%-2% annually. Our new forecast
has total unit volume increasing at a 0.9% compound annual growth rate during the
next five calendar years (down from 1.5% previously). While this compares
negatively with the positive 4.1% rate of volume growth BNSF generated on average
during 2010-14, it should be noted that volume during that time was recovering off
recessionary lows.
We also envision pricing being less robust overall for BNSF, with revenue per unit
increasing at a 1.6% CAGR during 2015-19 (down from 3.2% previously). Pricing is
expected to be down this year for each of BNSF's segments, with the exception being
agriculture (where we see pricing rising slightly year over year), as overall revenue
per unit is affected by weaker demand in some segments and lower fuel surcharges
overall. That said, we still believe the pricing gains achieved during the remaining
years of our five-year forecast should be enough to outpace rail cost inflation, which
of the value of Berkshire's manufacturing, service, and retail operations has increased
to $57,800 ($39) per Class A (Class B) share from $55,200 ($37). At some point, we
will roll Precision Castparts (which we expect Berkshire to add to the manufacturing,
service, and retail segment for reporting purposes) into our valuation, but as long as
we have financial data to work with, we'll continue to value it separately, much as we
did with Lubrizol during the first couple of years after that firm was acquired in 2011.
As for the company's finance and financial product division, which includes Clayton
Homes (manufactured housing and finance), CORT Business Services (furniture
rental), Marmon (railcar and other transportation equipment manufacturing, repair
and leasing), and XTRA (over-the-road trailer leasing), we've increased our estimate
of the value of this unit to $8,800 ($6) per Class A (Class B) share from $8,700 ($6).
We continue to expect revenue to grow 6% per year on average during 2015-19.
While this is better than the low-single-digit rate of growth produced annually by
Berkshire's finance and financial product segment during the past decade, we should
note that our forecast has revenue growth starting out at a high-single-digit rate this
year, then trending down to a mid-single-digit rate longer term. We continue to
expect pretax margins for the finance and financial product segment to remain
around 28% over the next five years, primarily because of the addition of Marmon's
higher-margin transportation manufacturing, repair, and leasing businesses to the
overall mix.
We Still See $10 Billion-Plus in Excess Cash by End of 3Q
Berkshire's book value per Class A equivalent share at the end of the second quarter
was $149,735. We expect it to expand to $156,460 at the end of the third quarter
and $160,372 at the end of the year. This would infer a 6%-plus year-over-year base
rate of growth for Berkshire's book value per share during the third and fourth
quarters. It also includes the impact of the insurer having to true up the cost basis of
its investment in Heinz, which was used as part of the purchase price for the Kraft
Heinz deal. Berkshire has said it expects to book a noncash gain of around $7 billion
during the current quarter to represent the increased value of the company's stake in
Heinz that was merged into Kraft Heinz. We expect part of this gain to be booked as a
deferred tax liability, with the remainder going toward shareholders' equity. Assuming
an effective tax rate of 30%, Berkshire would book a $4.9 billion increase in
shareholder's equity, equal to an increase in book value per Class A share of $2,982.
While the company closed the second quarter with $66.6 billion in cash on its books,
a fair amount of that capital has already been spoken for. Buffett has been fairly
explicit about his desire to keep around $20 billion in cash on hand as a backstop for
the insurance business. We believe the rest of the firm's operations are also likely to
require at least 2% of annual revenue on hand as operating cash, leaving Berkshire
with $43.4 billion in dry powder that could be used toward acquisitions and other
investments. Buffett already used $5.3 billion in early July to complete the Kraft
Heinz deal and is slated to use another $22.4 billion to fund the Precision Castparts
acquisition (expected to close in the first quarter of 2016). This would reduce
Berkshire's excess cash balance to $15.7 billion. While the firm has been aggressive
about buying shares of Phillips 66 PSX and other stocks during the third quarter, we
expect it to still have more than $10 billion in excess cash on its books at the end of
the third quarter.
Although the company did not buy back any shares during the first half of 2015 (and
has not bought any since the fourth quarter of 2012), its stock is getting fairly close
to the 1.2 times book value threshold that Buffett set out for share repurchases in
the third quarter of 2011. Based on the firm's book value of $149,735 ($100) per
Class A (Class B) share at the end of the second quarter, Berkshire should be willing
to buy back stock at prices up to $179,682 ($120) per Class A (Class B) share,
implying a floor on the company's common stock that is about 9% below where
Berkshire's shares are trading. Assuming the company's stock price continues to
trade at around the same levels, that threshold would be even higher by the end of
the year, where (based on our calculations) Berkshire should be willing to buy back
stock at prices up to $192,446 ($128) per Class A (Class B) share.
Greggory Warren, CFA, is a senior equity analyst for Morningstar.