Berkshire Hathaway's Vast Earnings Beat: I'm Buying

Berkshire Hathaway (BRK.A) (NYSE:BRK.B) just released its second quarter earnings. The company beat by $12 billion on revenue and delivered $10.4 billion in operating income. The company’s insurance operations experienced a large increase in cash flows, and its stock portfolio increased significantly in value, helped by big gains in Apple (AAPL) stock. Overall, it was a strong release.

Heading into the second quarter release, Warren Buffett made waves by announcing that he was buying short-term treasuries in large volumes. This was taken by some as evidence that he was taking the opposite side of Bill Ackman’s short treasuries trade, although Buffett bought short term securities while Ackman shorted the 30 year.

At any rate, Buffett’s treasury purchases are certainly not slowing down Berkshire’s results. The company delivered growing earnings in the second quarter, driven by capital gains as well as improved operating performance. It was a good showing.

The big question now is, “is Berkshire worth the price it trades for today?” BRK.B has made impressive gains over the last two years, rising much more than the markets as a whole in the same period. In this article I will make the case that Berkshire Hathaway stock is still worth the investment today, despite being near an all-time high. I’ll also share some risk factors facing the company that investors need to know about before they can make an informed investment in it.

Earnings Recap

In its second fiscal quarter, Berkshire Hathaway delivered the following results.

• $92 billion in revenue, up 21.3%.

• $10.4 billion in operating income, up 7%.

• $36.2 billion in net income, up from a loss.

• $16.5 in earnings per share (“EPS”), up from a loss.

Overall, it was a fairly strong quarter. Revenue and earnings both increased, and both beat analyst estimates. Obviously, a lot of that was due to the appreciation seen in Berkshire’s stock portfolio. As Buffett and Munger have pointed out many times, GAAP accounting rules factor asset price changes into net income, resulting in earnings figures that don’t reflect operating performance. Nevertheless, the gain in operating income shows that Berkshire is doing well with or without stock price gains. An impressive showing by any standard.

Recent Investments

A big part of why Berkshire Hathaway is able to deliver strong earnings consistently is because it has an excellent investment team. As you probably know, Berkshire is headed by Warren Buffett, one of the most renowned investors of all time. Less well known are Ted Weschler and Todd Combs, who manage part of Berkshire’s insurance float. Ted is a market-beating investor in his own right, having grown his Roth IRA to $250 million in about 30 years (given the contribution limits this implies a 30% CAGR return over several decades).

So, Berkshire has a great investment team, which contributes to its strong results over the long term. Today, the investments continue, with some notable buys being:

• $10 billion worth of short term treasuries (more such buys were promised).

• Continued purchases of Occidental Petroleum (OXY) shares.

• Continued purchases of five Japanese trading houses, which have collectively netted Buffett a 44% CAGR return since inception.

Although Buffett was a net seller of equities in Q2, the money being earned is not sitting in a bank account. It’s going into short term treasuries, which today have a shot at earning positive real returns. As I wrote in a recent Tweet, all treasury maturities currently have yields higher than the CPI inflation rate. Should this situation persist, Buffett’s ongoing treasury purchases will turn out to have been wise moves.

Valuation

Having looked at Berkshire Hathaway’s recent earnings and acquisitions, we can now turn to its valuation. I’ll use a discounted cash flow approach here because multiples can be misleading for a company like Berkshire with so many wildly fluctuating stocks on its balance sheet– assets that impact earnings and book value simultaneously.

In the most recent six month period, Berkshire reported $21.7 billion in operating cash flows and 2.174 billion shares outstanding. That yields $9.98 in operating cash flow per class B share. According to Seeking Alpha Quant, the company had $10.1 billion and $11.6 billion in operating cash flows in the prior two quarters. That gives us $43.4 billion in operating cash flow over the last 12 month period, or $19.96 per share.

If you discount Berkshire’s operating cash flows at the 10 year treasury yield (4.1%), assuming no growth and no risk, you get a $486 price target, or 38.8% upside. If you add a 4% risk premium and assume no growth, you get a $250 price target, which is significant downside. The table below shows a range of fair value estimates with different levels of cash flow growth assumed (based on historical averages).

As you can see, you get a range of estimates from $315 (slight downside) to $657 (significant upside). The average of these four estimates is $482, which is 37% upside. On the whole, I tend to think that Berkshire Hathaway is a good value right now.

Risks and Challenges

As we’ve seen, Berkshire Hathaway just put out a strong earnings release, and has a modest valuation. Given these facts, its stock would appear to be a buy. However, the company does face many significant risks and challenges, including:

• Insurance risks. Berkshire’s insurance operations are always exposed to risk, as they by definition involve insuring people and businesses against contingencies. When the risks people are paying to protect themselves from are realized, Berkshire has to pay out claims. For example, Berkshire’s property insurance business will have to pay out a lot of money if a Hurricane destroys property in Florida. This is always a risk for Berkshire, one that it typically manages well, though some think climate change could result in an increase in severe weather events, which would result in more claims having to be paid out.

• Succession. Warren Buffett won’t be at the helm of Berkshire Hathaway forever. Eventually, Greg Abel will take over, and it’s not clear what will happen to Berkshire’s investments once that occurs. Abel is an operations man in the energy part of Berkshire’s insurance business. He is not known for making stellar investments across the entire universe of publicly listed stocks, like Buffett is. Ted Weschler, a portfolio manager in the insurance division, is known for such skill, but he won’t be CEO when Buffett departs, he’ll continue managing money for Berkshire’s insurance companies. Presumably, post-Buffett Berkshire will not have companies clamoring to be bought out like it does now–that advantage largely comes from Buffett’s reputation. Therefore, the acquisition side of Berkshire Hathaway probably won’t perform as well when Buffett is gone, compared to how it performs now.

• Regulatory risk. A large part of Berkshire Hathaway is insurance, a space that is notoriously strictly regulated. Financial regulations have forced Berkshire to divest businesses in the past. For example, the company owned whole banks until the Bank Holding Company Act came along and made it too onerous for the company to do so. If such regulations were to come to insurance, then Berkshire might have to divest some of its businesses.

The Bottom Line

The bottom line on Berkshire Hathaway’s most recent earnings release is that it was a very strong showing. Featuring a wide revenue beat and strong operating earnings, it left investors with much to celebrate. As someone who has been holding Berkshire Hathaway Class B shares for two years now, I see no reason to sell based on the results Berkshire put out. In fact, I think the recent results argue for the stock being a good buy.