Financial Analysis of Berkshire Hathaway : Berkshire Hathaway (NYSE: BRK.A, NYSE: BRK.B) is a conglomerate holding company headquartered in Omaha, Nebraska, United States, that oversees and manages a number of subsidiary companies. The company averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years, while employing large amounts of capital, and minimal debt.[1] Berkshire Hathaway stock produced a total return of 76% from 2000-2010 versus a negative 11.3% return for the S&P 500.[2]
Warren Buffett is the company's chairman and CEO. Buffett has used the "float" provided by Berkshire Hathaway's insurance operations (paid premiums which are not held in reserves for reported claims and may be invested) to finance his investments. In the early part of his career at Berkshire, he focused on long-term investments in publicly quoted stocks, but more recently he has turned to buying whole companies. Berkshire now owns a diverse range of businesses including railroads, candy production, retail, home furnishings, encyclopedias, vacuum cleaners, jewelry sales; newspaper publishing; manufacture and distribution of uniforms; as well as several regional electric and gas utilities.
Berkshire Hathaway, Inc. (NYSE:BRK) is a holding company that, through its insurance subsidiaries actively invests its float, or the money taken in from premiums before claims are paid out. Berkshire owns stock in a diverse group of over 50 public and private companies in various industries ranging from manufacturing and retail, and energy to finance.

On November 3, 2009, an agreement was reached between Buffett's Berkshire Hathaway agreed to purchase Burlington Northern Santa Fe (BNI), the second largest railroad company in the United States for $34 billion in cash and stock.[1] This deal represents the largest in Buffett's career, as he announced the deal is "an all-in wager on the economic future of the United States." The deal was officially completed on February 12, 2010; however, the massive deal does not come without potential costs. Early in 2010 Berkshire lost its top credit ratings from Moody's (MCO) and Fitch as well as S&P.

On February 4, 2010 Berkshire lost its final AAA rating from S&P, after downgrades by both Fitch and Moody's rating agencies.[2] However, despite the loss of these credit ratings, investors have shown an incredible amount of faith in Berkshire and Buffett. On February 23, 2010 the price of credit default swaps (essentially the cost of insruance against default) fell to its lowest levels since September 2008.[3] In other words, although the credit rating agencies believe that Buffett and Berkshire have a higher chance of default, investors have chosen to ignore or look past its credit rating and feel that Berkshire is at an even stronger position now than before it lost its AAA rating. This is an incredible show of confidence in Berkshire, and a result of Buffet's incredible reputation.

Contents
1 Business Overview
1.1 Business and Financial Metrics
1.2 Business Segments
1.2.1 Insurance (60.2% of 2009 Net Income)
1.2.2 Utilities and Energy (12.5%)
1.2.3 Manufacturing, Service, and Retailing (13.14%)
1.2.4 Finance and Financial Products (5.83%)
1.2.5 Other Income (-2.44%)
1.2.6 Investment and Derivative Gains/Losses
2 Trends and Forces
2.1 Warren Buffett as a proven and patient value investor
2.2 Warren Buffett's All In Wager
2.3 Berkshire's massive size limits the potential for outsize returns
2.4 Berkshire competes with private equity purchasers for acquisitions of wholly owned subsidiaries
3 Competition
4 Footnotes
As part of the deal, Buffett was able to secure an $8 billion loan from J P Morgan Chase (JPM) and Wells Fargo (WFC), paying somewhere between 1% and 2% above the LIBOR rate.[4] With the three month LIBOR hovering near 0.25% at the time of the deal, this constitutes what many believe to be an incredibly cheap loan.

Business Overview

The company is famously managed by Warren Buffett, who was named Chief Executive Officer (CEO) of the year for 2008 by Morningstar, an independent investment research firm.[5] Buffet has compounded Berkshire's book value (a key valuation metric of the company) over 24% annually for nearly 43 years.[6] Buffett has accomplished this incredible feat by successfully reinvesting Berkshire's float in wholly-owned private companies as well as publicly traded stocks like Coca-Cola, Wells Fargo (WFC), American Express, and Procter & Gamble Company (PG).

Buffett has achieved Berkshire's success by a combination of superior underwriting and investments in companies with durable competitive advantages. However, Buffett himself has cautioned investors about the hindrances of Berkshire's enormous size and the difficulties achieving the same out-sized returns going forward. Also, because Berkshire has a significant number of insurance policies as well as significant investments in many different sectors including banks and manufacturing firms, its portfolio and the company's profits are exposed to risk in the event of prolonged and widespread economic downturn. Warren Buffet's successor as the head of Berkshire after Buffet's eventual departure has not yet been announced, and has caused concern about whether the company will continue to outperform the market.

Berkshire Hathaway's performance in 2009 has fallen dramatically from its historical performance, generally due to the market collapse that began with the 2008 Financial Crisis. Further complicating the matter were the long term put options on the S&P 500 (SPX), FTSE 100 Index (FTSE), Dow Jones Euro Stoxx 50 Index (SX5E), and the Nikkei 225 Index (N225) Buffett sold in March of 2008.[7] Buffett has since admitted the move was a mistake, and the subsequent decline in global markets has forced Berkshire to post losses on its financial statements; however, since the options are European style options, the company does not actually have a cash loss.


Business and Financial Metrics
Berkshire typically earns roughly half of its revenue from its insurance businesses, and as such its ability to underwrite efficiently and accurately is critical to its business success. Berkshire's underwriting discipline has led to a negative cost of float (i.e. underwriting gains/losses as a percentage of insurance float) between 2006 and 2009. No-cost or negative cost of float allows the company to enjoy investment income and gains without having to pay claims in excess of premiums taken in. In other words, the company operates at an underwriting profit, such that it takes in more in premiums than it pays out in claims.

In 2009, Berkshire Hathaway's total net earnings from its insurance business was $5.1 billion, with $1.0 billion represented by its underwriting gains.[8] Its underwriting gain has decreased steadily since 2007, as it declined from $2.2 billion in 2007 to $1.8 billion in 2008, and finally down to $1.0 billion in 2009.[8] Berkshire Hathaway anticipates that price competition in most of its insurance markets will continue to reduce underwriting profits in the future. Berkshire Hathaway’s net earnings from its non-insurance businesses, which include businesses in industries such as manufacturing, utilities, and financial services, was $3.1 billion in 2009.[8] Combined, Berkshire Hathaway posted a net income of $8.06 billion in 2009.

Berkshire Financials (In Millions) 2006[9] 2007[9] 2008[9] 2009[8]
Total Revenues 98,539 118,245 107,786 112,493
Total Expenses 81,761 98,084 100,212 100,941
Net Income 7,144 8,548 3,224 8,055
For the second quarter of 2010, Berkshire posted a net income of $1.97 billion, a 40% decline from the year ago period.[10] The company attributed a significant portion of the decline to derivative losses. However, operating profit increased to $3.07 billion for the quarter.

For the third quarter of 2010, Berkshire posted a net income of $2.99 billion, which was a slight decline from its 2009 third quarter net income of $3.24 billion.[11] Berkshire said its manufacturing, service and retail businesses helped drive the increase in profit, as these segments did better in the latest period when compared to the previous year, which was a reflection of the stabilization of the economy.

Business Segments
Berkshire Hathaway reports earnings from six different segments: i) Insurance earnings, both underwriting profit as well as investment income, ii) Utilities and Energy, iii) Manufacturing, service, and retailing, iv) Finance and financial products, v) Other income, and vi) Investment and derivative gains/losses.



Berkshire Hathaway's 2009 revenue broken down by segment.[8]
Insurance (60.2% of 2009 Net Income)
Berkshire Hathaway has four business involved in the insurance and reinsurance businesses: 1) GEICO, 2) General Re, 3) Berkshire Hathaway Reinsurance Group and 4) Berkshire Hathaway Primary Group. The company earns revenues from its insurance business in two ways. First, it can earn an underwriting profit, meaning it collects more in premiums than it pays out. Second, it can invest its float, or money that it receives upfront but has yet to pay out. These two ways are essentially how the insurance business works. In 2009, the company posted an underwriting gain of $1.0 billion, and investment earnings of $4.1 billion, which combined made up 60.2% of Berkshire Hathaway's 2009 net income.[8]

Utilities and Energy (12.5%)
Berkshire Hathaway has a number of utility and energy subsidiaries that make up this segment, most notably which is the MidAmerican Energy Company, which operates an international energy business. In 2009 earnings from this segment were $1.2 billion, a decline from its 2008 earnings of $1.9 billion.[12] The main driver for this loss was a $1.0 billion decline in MidAmerican Energy's domestic revenues, driven mostly by lower regulated natural gas and electricity sales in 2009.

Manufacturing, Service, and Retailing (13.14%)
Berkshire Hathaway owns a number of manufacturing, service, and retail brands from a wide range of industries. Notable companies included in this segment are Marmon Holdings, the McLane Company, Shaw Industries, and a variety of other companies such as Fruit of the Loom, Acme, and many others. Net earnings for this segment declined to $1.1 billion in 2009, compared to its 2008 earnings of $2.3 billion.[13] The company attributed this decline to the global economic recession, as consumers reduced purchases across the board in terms of demand, hurting Berkshire's businesses.

Finance and Financial Products (5.83%)
Berkshire Hathaway's Finance and Financial Products segment is represented by its manufactured housing and and finance business (Clayton Homes). It also performs furniture transportation equipment leasing. In 2009, this segment earned $494 million, a slight increase from its 2008 earnings of $479 million.[14] This increase in earnings comes in spite of the fact that overall revenues are down; the increase in earnings is actually a result of significant cost cutting by Clayton Homes. Furthermore, Clayton Homes' manufactured housing loan programs are at a competitive disadvantage compared to traditional single family home mortgages, because single family home mortgages are currently receiving government subsidies on interest rates. Manufactured factory-built homes generally do not qualify for this subsidy. However, this subsidy is not expected to persist long term, and even under this disadvantage the company believes Clayton Homes will keep operating profitably.

Other Income (-2.44%)
The Other Income segment covers the parent holding company and other support subsidiaries that, for the most part, have little or no business activity. These may include legal costs, corporate overhead, etc. In 2009, there was a net cost of $207 million for this segment, compared to its 2008 level of $129 million in costs.[8] Traditionally this segment's earnings is always negative, as it has no revenue generation, only expenses.

Investment and Derivative Gains/Losses
Investment gains and losses affect Berkshire Hathaway's earnings, but the true impact of these are not felt until they are realized, meaning the actual investment is sold. For example, if Berkshire Hathaway invests in a stock, and the stock price rises, it recognizes a gain, but it has not actually "realized," or gotten the extra cash from the stock price rising until it sells the stock. Only then does the gain become realized and the Berkshire Hathaway actually holds more cash than it paid. Berkshire Hathaway's 2009 investments had a gain of $486 million, compared to its 2008 investment loss of $$4.65 billion.[15] The large turnaround was mostly due to unrealized losses on long dated put options on a number of equity indices that Buffett sold in 2008, which had a loss of $5.0 billion.[15] However, in 2009 as these equity markets improved and rebounded, the $5.0 billion loss that was recognized in 2008 turned into a $2.7 billion gain in 2009.

Trends and Forces

Warren Buffett as a proven and patient value investor
Buffett's track record as a value investor and sheer financial strength has earned him an incredibly valuable reputation within the financial industry. The value of this reputation can be seen through Buffett's deals with General Electric Company (GE) and Goldman Sachs Group (GS). Both companies came to Buffett, and he came away with very favorable deals in both instances, getting preferred stock that earn a 10% dividend as well as billions in warrants from both companies.[16][17] He was approached first by these companies both because of his reputation as well as the fact that he simply had the funds that most investors did not at the time. Although both Goldman Sachs and GE are planning to buy back the preferred shares in 2011 due to improving market conditions, Buffett's ability to secure these favorable deals allowed him to profit in times of crisis. In private equity deals, Buffett's reputation also earns him an advantage, as he tends to keep companies together rather than selling off parts of companies.

Because of his long term proven success and fundamental role he plays within Berkshire Hathaway, some Berkshire Hathaway owners have expressed concern about Buffett's succession based on his advanced age. Buffett, 79, has led the capital allocation decisions of the company since present management took over in 1965, and he has announced that the Board of Directors has determined a very short list for a successor CEO. The company intends to split the current CEO role into two roles: CEO (covering operations) and Chief Investment Officer (cover capital allocation and investment decisions). Buffett has indicated that there is a short list of candidates for CIO. Some have speculated that GEICO chief Tony Nicely, reinsurance guru Ajit Jain, or GEICO's investment star Lou Simpson will succeed Buffett as CEO.

Warren Buffett's All In Wager
On February 12, 2010 Berkshire Hathaway completed a deal to purchase Burlington Northern Santa Fe (BNI), the second largest railroad company in the United States for $34 billion in cash and stock.[1] This deal represents the largest in Buffett's career, as he announced the deal is "an all-in wager on the economic future of the United States." As part of the deal, Buffett secured an $8 billion loan from J P Morgan Chase (JPM) and Wells Fargo (WFC), paying somewhere between 1% and 2% above the LIBOR rate.[4] With interest rates at all time lows at the time, many considered this an incredible deal that only Buffett's reputation would afford.

Despite successfully pulling off the deal, the massive deal does not come without potential costs. Early in 2010 Berkshire lost its top credit ratings from Moody's (MCO) and Fitch as well as S&P due to the increased debt from the $8 billion loan. Whether the benefits from this deal ultimately outweigh the costs remains to be seen, but this deal will certainly be one of the defining moments of Buffett's career.

Berkshire's massive size limits the potential for outsize returns
Building Berkshire's book value depends on the company's ability to reinvest the large sums of cash flowing into the company and the over $40 billion already in its coffers. The company generates cash flow and float of some $150 million per week,[18] which is typically reinvested in either fixed-income securities, equities, or private companies. As the stock and the flow of cash at Berkshire grows, the company's returns will continue to approach those of the market as it becomes increasingly difficult for Berkshire's to sustain its historical returns of over 20% per year.[19]

Berkshire competes with private equity purchasers for acquisitions of wholly owned subsidiaries
Berkshire's favored investment is in large, privately-held businesses. As such, the company competes with private equity money to find target acquisitions, and increased activity in the space has led to heightened competition and fewer deal opportunities. Berkshire differentiates itself and attracts sellers of businesses by offering them long-term ownership, the hallmark of the company's investment strategy. Often sellers are family or individual owners looking to monetize their interest in a closely-held business. They seek a buyer who, unlike most private equity firms, does not look toward an "exit" of the business and are less likely to interfere with how it is currently managed. Berkshire must maintain its investing track record to continue attracting deals at favorable prices.

Competition

Some competitors of its bread-and-butter insurance operations include State Farm Insurance, Allstate (ALL), Progressive (PGR), Zurich Insurance (ZSA-JO), and Nationwide Corp Group.
 
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