Berkshire Hathaway posted significantly higher operating profits for the third quarter of 2010 mainly due to the contribution of Burlington Northern Santa Fe, which was acquired in February, along with improved results in the company’s diverse collection of economically sensitive businesses which have seen improved conditions this year. However, while operating earnings increased 35.6 percent from the prior year period to $2.8 billion, net earnings declined to $3 billion for the quarter which represents a 7.7 percent drop from the prior year period. The decline in net earnings was due to a small loss in Berkshire’s overall derivatives portfolio compared to a large gain in the third quarter of 2009. Berkshire’s book value per share increased to $90,823 representing a 4.8 percent increase for the quarter. Book value is at a record high.
We will cover a number of topics in this article, but the growing scope of Berkshire’s activities is making it difficult to comprehensively discuss all facets of the business in an article of reasonable length. Therefore, we have decided to focus on three main areas at this time: (1) Derivatives and Investment results; (2) Manufacturing, Service and Retail subsidiaries and (3) A “special focus” on NetJets.
To assist readers interested in a broader view of third quarter results as well as trends since the start of the recession, we have prepared a supplemental report (available in the resources section at the end of this article) covering many aspects of Berkshire’s results since the beginning of 2008 and containing the data and sources for all exhibits in the article. Time permitting, we may provide additional coverage of Berkshire’s insurance businesses, Burlington Northern Santa Fe, and MidAmerican in separate articles in the coming days. None of these areas are covered in the narrative of this article, although data does appear in the supplemental report.
Derivatives — Always Surprising, Frequently Misunderstood
We have written about Berkshire Hathaway’s misunderstood derivatives portfolio several times in the past, including in the coverage of second quarter results. Many Berkshire observers believed that the derivatives portfolio would realize substantial gains in the third quarter due to the rise in equity index values to which Berkshire’s put option contracts are linked. However, Berkshire posted a $700 million mark-to-market loss on the contracts for the quarter. How could this be?
Due to the impact of lower interest rates, the Black-Scholes model produced lower values for the put index option contracts which, combined with the impact of the weaker U.S. Dollar on foreign index contracts, had an impact that more than offset the positive force of higher index values. The $700 million loss on the equity index puts was partly offset by gains on the credit default obligation derivatives resulting in an after tax mark-to-market loss of $95 million for the derivatives book overall.
As we have written many times in the past, the quarterly movement in Berkshire’s derivatives valuation has next to no meaning on overall economic results or the intrinsic value of the company as a whole. This is particularly true for the equity index puts which may not be exercised until the option expiration date. The weighted average life of all such contracts was 10.7 years as of September 30, 2010. Furthermore, even if the options are in the money at expiration, Berkshire will have had the use of the option premium for a long period of time thereby offsetting any ultimate loss.
Investment Gains & Losses — Little Meaning in Quarterly Data
Investment and derivatives gains and losses have a major impact on Berkshire Hathaway’s results each quarter. Realized investment gains and losses and the mark-to-market impact of the derivatives position impacts earnings directly, but ultimately has little predictive value from quarter to quarter. The exhibit below shows the contribution of realized investment gains/losses, impairments, and derivatives on Berkshire’s results on an after-tax basis:
As we can see, derivatives introduce a large amount of volatility to quarterly results, but realized investment gains and losses also play a role. In addition, impairments played a significant role in Q4 2008 and Q1 2009 mainly due to the ConocoPhillips investment.
The exhibit below shows Berkshire’s unrealized gains and losses for each quarter over the past three years. These gains and losses do not impact Berkshire’s earnings statement but impact book value through other comprehensive income. As we can see, unrealized gains and losses have roughly followed the action in the stock market over the last few years.
The bottom line is that while investment results are a major driver of Berkshire’s value, there is little meaning associated with swings in Berkshire’s derivatives portfolio, the timing of realized gains, and the quarter-to-quarter volatility in unrealized gains. As a result, it is best to look at Berkshire’s results in investing on an annual basis over a period of years. We provide this illustration mainly to show how these figures introduce volatility into Berkshire’s results that often influence headlines but distort actual business progress.
Manufacturing, Service, and Retail
Since our theme for this article is to examine Berkshire’s results over the course of the recession and subsequent recovery, we will pay particular attention to the company’s diverse set of businesses in the manufacturing, service, and retail segment. Here we have a treasure trove of data that no doubt informs Warren Buffett’s view of the economy.
The exhibit below presents pre-tax earnings (in millions) for each reporting segment over the past eleven quarters:
The chart clearly shows the impact of the recession on this group’s earnings power since the start of 2008. Pre-tax earnings have nearly reached the level posted in the second quarter of 2008, although results were down slightly in the third quarter of 2010 from the second quarter. We should note that Shaw Industries was absorbed into the “Other Manufacturing” group starting in Q1 2010. Much more information on these businesses can be found in the supplemental report.
A Special Focus on NetJets
In the exhibit above, we can see that the “Other Service” segment has achieved quite a turnaround since the depths of the recession. This is mainly due to the major improvement at NetJets that has taken place since the start of 2010. The improvement has not come without drama and controversy. We have covered NetJets extensively over the past year, particularly in the time since David Sokol took over as Chairman and CEO.
Profitability Restored, But Painfully
Mr. Sokol took over management of NetJets in August 2009 and was able to put in place changes that Warren Buffett has credited with restoring the company to profitability and putting it on a sustainable track for future growth. However, a series of controversies have accompanied the turnaround in reported financial results. The rancor has increased significantly since August when Fortune published a story on Mr. Sokol which we discussed in some detail. Shortly after the Fortune story was released, Mr. Sokol complained about “deceit” among employees and former employees that he claimed were threatening to damage the brand and business model.
The widespread concern surrounding this situation is understandable given Mr. Sokol’s status as a likely candidate to assume the CEO position at Berkshire at some point in the future. There seem to be two major criticisms related to Mr. Sokol’s leadership: (1) His actions on cost cutting could harm the brand and (2) Writedowns taken in 2009 exaggerate the actual financial improvement in 2010. We examine both issues below.
Brand Destruction or Record Satisfaction?
Employees allege that Mr. Sokol’s decisions have impaired the brand. We have limited visibility into customer satisfaction at NetJets other than the fact that Mr. Buffett thought it was important enough to include a statement in Berkshire’s second quarter earnings release referring to “record” levels of customer satisfaction.
While we were able to obtain some additional details regarding the survey, we do not know the specific methodology that was used, the sample size, or other relevant data. NetJets created the survey internally and compiled the results. We have not attempted to contact NetJets customers or to engage in any primary research on this question so it is not possible to draw many further conclusions. However, in our view, Mr. Buffett’s statements regarding customer satisfaction and safety carry a great deal of weight given his own reputation and the fact that he and his family use NetJets exclusively. Thus far, no credible evidence has emerged to suggest that a major brand impairment exists at NetJets.
Profit Recovery Aided by Writedowns?
The second criticism of the recovery at NetJets is that massive non-cash writedowns and restructuring charges in 2009 have set a “low bar” for profit comparisons going forward. NetJets did in fact take massive writedowns of $676 million in 2009 which represented the bulk of the company’s $711 million pre-tax loss. On a “cash” basis, NetJets posted a much more modest loss of $35 million in 2009. This is a question more ripe for analysis compared to the more subjective issue of customer satisfaction.
The analyst is hindered in obtaining clear data on NetJets due to the fact that Berkshire Hathaway does not report on NetJets as a segment but instead includes results in the “Other Service” group. As a result, there are no clear tables in Berkshire’s quarterly and annual reports revealing revenues and profits. However, we have been able to painstakingly piece together most of this information from Berkshire’s narrative reporting on NetJets over the past three years.
The exhibit below shows revenues, pre-tax profit/loss, non-cash writedowns, and pre-tax profits excluding writedowns for the past eleven quarters. Note that we were not able to find quarterly profit/loss results for the second, third, and fourth quarters of 2008 and we have instead reported results for the three quarters in aggregate. For extensive notes on our sources and calculations, please refer to the excel spreadsheet found in the resources section at the end of this article.
From this exhibit, we can see that pre-tax losses were heavy for 2009, with the bulk of the damage in the second, third, and fourth quarters. However, the vast majority of the losses were non-cash charges associated with write-downs of excess aircraft. Only a modest writedown was taken at the end of 2008 and writedowns in 2010 thus far have been minimal.
Were the writedowns taken to create a “big bath” effect in which subsequent periods would have easier “comparisons”? We can say that writedowns of some amount were almost certainly justified. The need for writedowns is plausible based on the rapid decline in the fractional aviation market as reported in numerous industry sources as well as evidenced by NetJets revenue decline that began at the end of 2008 and accelerated alarmingly before a recovery at year end. We also know that the resale value of private aircraft plummeted during the recession bolstering the case for writedowns.
The question is one of timing and magnitude. Should management have taken writedowns earlier in 2008, or might have they been delayed? Did they all have to be taken in the periods shown above? Was the size of the writedowns appropriate based on the underlying economics?
Keeping in mind the fact that we cannot definitely know the rationale behind the timing of the writedowns based on Berkshire’s publicly released financials, consider the following two charts for some guidance on the question. The first chart shows the revenue data from the table and the second shows the non-cash writedowns:
These charts visually illustrate what may not immediately jump out from the tabular data. NetJets suffered a severe slump in revenues in 2009 – the business quite literally fell off a cliff. We can see that the writedowns did not begin in earnest until the second quarter although revenues had fallen dramatically in the first quarter. We cannot read management’s mind, but it seems plausible that they decided at the end of the first quarter of 2009 to monitor the situation to see if the revenue drop was permanent or temporary prior to taking more significant writedowns. We can see that writedowns did in fact accelerate in the second, third, and fourth quarter as revenues stabilized at a low level and then recovered by year-end.
The timing and magnitude of writedowns such as those taken by NetJets is subject to numerous judgment calls by management and is not something outsiders have the ability to monitor. Even if NetJets were a standalone public company, it is doubtful that disclosures would reveal the specific methodology used to arrive at the impairment amount. Within Berkshire, NetJets is required to release even less information. The bottom line: We cannot be sure as outside observers whether the impairments were appropriately timed. However, from the data available, it does not appear obvious that any “big bath” maneuver took place after Mr. Sokol took over in August 2009.
The jury is very much still out on NetJets. A recovery is obviously underway but the overall financial results since Berkshire’s acquisition remain very poor. We will need to monitor NetJets over the course of a full economic cycle to determine whether staggering losses again emerge in the next downturn. At this point, we are inclined to give Mr. Sokol the benefit of the doubt based on results that have been delivered and, even more so, on the weight of Mr. Buffett’s frequent explicit endorsements of Mr. Sokol’s achievements.
The Rational Walk has prepared a supplemental report that provides a detailed summary of Berkshire’s results in all operating segments from Q1 2008 to Q3 2010. The report contains the following items: (a) Quarterly Financial Summary; (b) Manufacturing, Service, and Retail summary; (c) NetJets Drilldown; (d) Investment and Derivatives Gains/Losses; (e) Price vs. Book Value data; and (f) Additional Charts. Additional data and coverage of Berkshire can be found in The Rational Walk’s Berkshire Hathaway Briefing Book which was published in February 2010 following the release of Berkshire Hathaway’s 2009 annual report.
The spreadsheet is available in Excel 2007 and Excel 2003 formats:
Disclosure: The author of this article owns shares of Berkshire Hathaway.