By Callum Turcan
Berkshire Hathaway Inc (BRK.A) (BRK.B) reported fourth quarter and full-year results on Saturday February 22, and we appreciate the firm’s performance across most of its business lines, keeping in mind that losses at its insurance-underwriting business during the fourth quarter weakened its company-wide performance. That being said, the insurance business can be volatile at times, which is why we appreciate Berkshire’s large railroad, utility, consumer goods, and other business segments. On the topic of Berkshire’s insurance-related exposure to the ongoing COVID-19 epidemic (which has since spread from China (FXI, MCHI, KWEB) to the rest of the world, shutting down economies in South Korea (EWY), Italy (EWI), and elsewhere), insurance firms fundamentally altered the structure of their policies after the 2002-2003 severe acute respiratory syndrome (‘SARS’) outbreak to exclude epidemic coverage from most policies (save for insurance policies that explicitly cover those situations) according to the WSJ.
Shares of Berkshire Class B stock are included in our Best Ideas Newsletter portfolio with a top-weighting, and over the past few months shares of BRK.B has begun converging towards our fair value estimate of $229 per share. Berkshire Class B shares could move towards the top end of our fair value range estimate of $275 per share, particularly if the company figures out where to invest its enormous cash pile.
Earnings Overview
From 2018 to 2019, Berkshire’s GAAP revenues grew by 3% to $254.6 billion and its GAAP diluted EPS per average equivalent Class B share surged to $33.22 in 2019 versus $1.63 in 2018. However, that’s largely because Berkshire reported a massive swing in its ‘investment and derivative contract gains (losses)’ line-item to a gain of $72.6 billion in 2019 versus a loss of $22.5 billion in 2018. This is why Berkshire’s fabled CEO and Chairman Warren Buffett stresses the importance of Berkshire’s ‘operating earnings’, with that statement included in its earnings press releases. From 2018 to 2019, Berkshire’s operating earnings dropped by 3% to $24.0 billion due to declines at its ‘insurance-underwriting’ and ‘other’ segments, offsetting gains at its ‘railroad, utilities and energy’, ‘insurance-investment income’, and ‘other businesses’ segments on a year-over-year basis.
The company remained a free cash flow cow in 2019, generating $38.7 billion in net operating cash flow (up over 3% year-over-year) while spending $16.0 billion on capital expenditures (up 10% year-over-year). Share buybacks rose more than three-fold year-over-year, hitting $4.9 billion in 2019 and please note Berkshire does not have a common dividend policy at this time.
Investors are curious as to what Berkshire wants to do with its enormous cash-like pile given that the firm keeps adding substantial cash to its balance, which stood at ~$128.0 billion at the end of 2019 as you can see in the upcoming graphic down below. Please keep in mind this doesn’t include Berkshire’s investments in fixed maturity securities ($18.7 billion at the end of last year), equity securities ($248.0 billion), or equity method investments ($17.5 billion). Additionally, Berkshire carries material liabilities relating to its insurance businesses, along with $103.4 billion in total debt (inclusive of short-term debt) at the end of last year.
Image Shown: A look at Berkshire’s fortress-like balance sheet with key line-items underlined in red. Image Source: Berkshire – 2019 Annual Report with additions from the author
Investment Portfolio Overview
At the end of 2019, the top ten holdings within Berkshire’s equity security portfolio included American Express (AXP), Apple (AAPL), Bank of America (BAC) which is also a holding within our Dividend Growth Newsletter portfolio, Bank of New York Mellon (BK), Coca-Cola (KO), Delta Air Lines (DAL), JPMorgan Chase (JPM), Moody’s (MCO), U.S. Bancorp (USB), and Wells Fargo (WFC). Additionally, Berkshire owns a major equity stake in Kraft Heinz (KHC) and due to Berkshire being part of a control group, that asset is listed as an equity method investment. Other major holdings at the end of 2019 include Charter Communications (CHTR), Goldman Sachs (GS), Southwest Airlines (LUV), United Airlines (UAL) which changed its name back in June 2019 (from United Continental Holdings), and lastly, one of our favorites in our Best Ideas Newsletter portfolio, Visa (V).
Berkshire’s Apple holdings have been very good to its investment portfolio, and please note we removed long-time Apple holding on January 13, 2020 (link here), after an epic run in shares of AAPL. We let our winners run over the top end of our fair value range estimate (which for AAPL, sits at $305 per share as of this writing), and generally speaking, we tend to remove shares of our big winners once their technicals turn against them.
Excluding Kraft Heinz but including Berkshire’s ‘others’ segment (which includes its large investment in Occidental Petroleum (OXY) through preferred stock and warrants, a deal we covered in detail here), these positions had a cost basis of $110.3 billion and carried a $248.0 billion market value at the end of 2019.
Warren Buffett and Berkshire’s Vice Chairman Charlie Munger have a stellar track record when it comes to stock selection; however, the duo have repeatedly noted that it has been quite hard locating both needle-moving (relative to Berkshire’s enormous size) and undervalued opportunities in the current environment given where US equities are trading at. Investors have been clamoring for Berkshire to put more of its cash and cash-like pile to use, yet the firm has held off. Arguably, that’s due in part to Berkshire “simply waiting” for a major market correction to take advantage of. As we’ve said often in the past and will repeat here again, companies with (ideally sizable) net cash balances are a lot more attractive than companies with net debt positions.
Operations Update
Warren Buffett is apparently a big fan of wind energy, and that’s clearly laid out in his 2019 Annual Letter to shareholders. Berkshire entered the utility market back in 2000 by acquiring a controlling stake in Berkshire Hathaway Energy Company (‘BHE’). According to its 2019 Annual Report, Berkshire “currently” owns 90.9% of BHE’s outstanding common stock. Here’s a lightly edited excerpt from Berkshire’s CEO’s latest annual letter:
We’ll start with the topic of electricity rates. When Berkshire entered the utility business in 2000… the company’s residential customers in Iowa paid an average of 8.8 cents per kilowatt-hour (kWh). Prices for residential customers have since risen less than 1% a year, and we have promised that there will be no base rate price increases through 2028. In contrast, here’s what is happening at the other large investor-owned Iowa utility: Last year, the rates it charged its residential customers were 61% higher than BHE’s… The extraordinary differential between our rates and theirs is largely the result of our huge accomplishments in converting wind into electricity.
In 2021, we expect BHE’s operation to generate about 25.2 million megawatt-hours of electricity (MWh) in Iowa from wind turbines that it both owns and operates. That output will totally cover the annual needs of its Iowa customers, which run to about 24.6 million MWh. In other words, our utility will have attained wind self-sufficiency in the state of Iowa. In still another contrast, that other Iowa utility generates less than 10% of its power from wind…
Of course, wind is intermittent, and our blades in Iowa turn only part of the time. In certain periods, when the air is still, we look to our non-wind generating capacity to secure the electricity we need. At opposite times, we sell the excess power that wind provides us to other utilities, serving them through what’s called “the grid.” The power we sell them supplants their need for a carbon resource – coal, say, or natural gas.
According to BHE’s website, approximately half of BHE’s revenues come from Nevada (~19%), Iowa (~18%), and Utah (~14%) combined. BHE also generates ~7% of its revenues from the UK and another ~5% from Canada. We wrote a note a few months back covering BHE’s international growth strategy (link here), noting that:
Going forward, Berkshire Hathaway is making investments in wind farms, including the $0.2 billion Rattlesnake Ridge Wind development in Alberta, Canada (EWC). That project will add 118 MW of electricity generation capacity to the region and will be owned by BHE Canada, a subsidiary of Berkshire Hathaway Energy. UK-based Renewable Energy Systems is developing the wind farm. Electricity produced from the facility will be sold under long-term power purchase agreements, and a large corporate customer in Canada has already secured the majority of the wind farm’s expected output (according to Bloomberg). Additionally, BHE Canada and Renewable Energy Systems are seeking demand for another wind farm endeavor, the proposed 399 MW Forty Mile Wind Farm that would also be located in Alberta.
BHE Canada and its partner plan to start construction of the Rattlesnake Ridge Wind development this year, and the goal is to have the facility up and running by December 2021. Additionally, work continues to proceed on the proposed Forty Mile Wind Farm development. Furthermore, please note that Berkshire’s railroad, utilities and energy business segment reported 6% year-over-year operating income growth in 2019.
Berkshire owns Burlington Northern Santa Fe (‘BNSF’), a Class I US railroad operator, and please note that “BNSF derives significant amounts of revenue from the transportation of energy-related commodities, particularly coal”. Given that US railroad operators have been facing some troubles due to the ongoing decline in domestic coal consumption, a reduction in agricultural exports (namely the sharp declines in export volumes to China), and the slowing industrial economy at-large, it’s conceivable that a meaningful amount of the aforementioned operating income growth is coming from Berkshire’s utility businesses.
Concluding Thoughts
While BRK.B lagged the S&P 500 (SPY) in 2019, we continue to like the firm as a top holding in our Best Ideas Newsletter portfolio due to its nice net cash position and slate of high quality businesses. Sometimes the insurance business can be tough, but long-term, those operations support a promising cash flow growth outlook for Berkshire. Due to the rising exogenous shocks facing the US economy and the global economy at-large, we think having exposure to more defensive names with nice net cash balances is a prudent move. We made some more big changes to our newsletter portfolios on February 24, 2020, that members can read about here—->>>>
Data Sheet on Stocks in the Insurance Industry
Tickerized for companies in the SPDR S&P Insurance ETF (KIE)
Related: AAPL, AXP, BAC, BK, BRK.A, BRK.B, CHTR, DAL, EWC, EWI, EWY, FXI, GS, JPM, KO, KHC, KWEB, LUV, MCHI, MCO, OXY, UAL, USB, V, WFC
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Callum Turcan does not own shares of any of the securities mentioned above. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include out-of-the-money S&P 500 (SPY) put options dated September 18, 2020, at a strike price of $250 per contract. Berkshire Hathaway Inc (BRK.A) (BRK.B) Class B shares and Visa Inc (V) are both included in Valuentum’s simulated Best Ideas Newsletter portfolio. Bank of America Corporation (BAC) is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.