Berkshire Hathaway reported results for the first quarter following the close of trading today. While Berkshire reported a loss in terms of GAAP net income for the quarter, the underlying results for the operating business are actually quite solid given the global economic recession. Berkshire’s operating earnings per share declined 11.8% to $1,100 per A Share, down from $1,247 in the first quarter of 2008. Net earnings per share were recorded as a loss of $900 per A Share compared to profits of $607 per A Share in the first quarter of 2008.
Since the “headline numbers” reflected in GAAP net income fail to adequately describe the underlying health of the operating businesses, let’s take a closer look at Berkshire’s results for the quarter.
“Headline Numbers” Are Misleading
Berkshire reports operating earnings each quarter in addition to the GAAP presentation of net earnings. This is done in order to allow investors to focus on the underlying health of the operating companies without regard to the timing of realized gains and losses as well as the impact of mark to market accounting on Berkshire’s derivatives positions. By providing operating earnings, Berkshire is not trying to suggest that investment gains and losses are not relevant to Berkshire’s intrinsic value. Although long term investment gains and losses are relevant, the timing of these gains and losses during a specific accounting period holds no special meaning and management does not attempt to “time” the realization of gains and losses to manage earnings.
Investments and Derivatives Gains and Losses
Berkshire’s Q1 net earnings includes capital losses of $241 million as well as mark to market losses on derivatives positions of $986 million. I have previously explained why I disregard the mark to market changes for the derivatives positions due to the long term nature of the derivatives as well as the fact that the equity put derivatives are “European options” which cannot be exercised until the expiration date. The credit default positions, however, appear to be seriously impaired based on Buffett’s comments at the annual meeting and information in the 10Q report. The credit default positions account for the majority of the mark to market loss in Q1.
Normally, an equity investment such as ConocoPhillips would not impact earnings until the position is disposed of through a sale. However, accounting rules have forced Berkshire to take a $2,012 million hit to GAAP net earnings in Q1 because the company has indicated that the position is likely to be sold at a price below original cost. From the press release that accompanied the 10Q, it appears that Berkshire intends to use the losses on the Conoco position to offset realized capital gains in prior tax years, thereby obtaining a tax benefit. The company intends to recover approximately $690 million in federal capital gains taxes paid in 2006 by realizing losses on Conoco.
As Buffett has admitted, the ConocoPhillips investment last year has turned out to be a serious mistake. The position was acquired at a time when oil prices were near record highs. The majority of the loss on the position was already reflected in Berkshire’s book value as of December 31, 2008, so the fact that the loss is now being realized as an impairment does not imply a further hit to book value. While the loss itself is obviously real, the accounting treatment of the loss is arbitrarily causing GAAP net income to show the loss this quarter. Had Berkshire not declared an intent to liquidate the position for tax reasons, the portion of the Conoco position that was not sold during the quarter would have remained an unrealized loss and would not have impacted net income for the quarter.
Insurance Business Posts Solid Results
Berkshire’s insurance businesses posted solid results for the first quarter. In aggregate, net underwriting profits increased to $219 million from $181 million in the first quarter of 2008. GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group all posted underwriting gains while General Re posted a small underwriting loss. Although GEICO posted lower underwriting profits compared to the prior year, the number of in force policies increased by 430,000 over the course of the quarter as customers switched to GEICO to save money during the recession. It appears that GEICO’s advertising expenditures have registered with consumers eager to save some money on a non discretionary purchase.
Net investment income increased by 28.8% to $1,033 million compared to $802 million in the first quarter of 2008. These results reflect earnings from Berkshire’s large investments in Goldman Sachs, General Electric, and Wrigley in Q4. These investments, and other smaller investments initiated on similar terms in recent months should bring in approximately $2 billion per annum which is far higher than the returns on the cash that Berkshire was holding previously.
Utilities and Energy
MidAmerican posted net earnings attributable to Berkshire of $203 million for the quarter. This is a 35.8% decline in reported income compared to the $316 million reported in the first quarter of 2008. However, Berkshire booked a $56 billion pretax loss associated with the Constellation Energy common stock investment and a $125 million noncash stock based compensation charge in connection with Berkshire’s acquisition of MidAmerican in 2000. Putting these charges aside, the health of the underlying utility business appears to be solid. As Buffett said at the annual meeting, the utility business is relatively insulated from the worldwide recession and, along with the insurance business, provides Berkshire with relatively stable sources of earnings regardless of the economic climate.
Manufacturing, Service, and Retailing
Berkshire’s manufacturing, service, and retailing segment suffered a 47% decline with net earnings for the quarter reported at $258 million compared to $487 million in the first quarter of 2008. In fact, the comparison would have been even worse if one accounts for the fact that Marmon contributed to earnings for the entire quarter in 2009 and for less than half of March in 2008.
The news may be grim, but the silver lining is that none of the reporting segments posted losses. In addition, there was some surprising strength in certain areas. For example, although Shaw’s revenues declined by 18.1%, earnings increased by 7.8% due to improvements in operating margins resulting from lower raw material costs.
All Things Considered, Not a Bad Quarter
Considering the turmoil of the first quarter and the fact that GDP most likely shrank significantly, I consider Berkshire’s operating results to be relatively strong. While the headlines will show net losses from a GAAP perspective, my view is that it is necessary to look beneath the headline numbers to get a grasp of the real condition of the business. When you do that, what becomes quickly apparent is that Berkshire’s insurance and utility businesses did very well during the quarter and the non insurance operating companies posted reasonable results even if they fell short of last year’s results.
It is also worth noting that the decline in book value experienced during the first quarter is probably entirely offset by the gains in Berkshire’s investment portfolio so far in the second quarter as I wrote yesterday.
During times like this, it pays to have high quality businesses and Berkshire has demonstrated the ability to operate profitably even in the worst of times. I’m sure that Warren Buffett would have preferred to avoid the mistake related to ConocoPhillips and surely he would have preferred to write the equity puts at a lower strike price. The reality is that no one can achieve perfection, particularly in this type of economic climate.