We are downgrading our recommendation on the shares of Berkshire Hathaway Inc. (BRK.A) (BRK.B) to Neutral from Outperform based on heavy catastrophe losses (cat losses) incurred during the first quarter of 2011 and the expectation of more cat losses from hurricanes during the second half of the year, which will likely weigh on the insurance segment’s bottom line.
Berkshire’s property and casualty insurance business has been the engine behind its growth. Berkshire’s insurance business (which accounted for approximately 40% of the company’s 2010 operating income) maintains capital strength at exceptionally high levels. This strength differentiates Berkshire’s insurance companies from their competitors. Collectively, the aggregate statutory surplus of Berkshire’s U.S. based insurers was approximately $94 billion at year end 2010, up from $64 billion at 2009 end.
All of Berkshire’s major insurance subsidiaries are rated “AA+” by Standard & Poor’s and nearly all are currently rated “A++” (superior) by A.M. Best, with respect to their financial condition and operating performance. Its insurance business has been able to increase float (money held between the time when policyholders submit payment and when funds are eventually paid out to settle claims) to $65 billion from $28 billion over the past decade. This float has been effectively used by Warren Buffett to make profitable investments. Given Berkshire’s sound underwriting practices, we believe its insurance companies are capable of generating significant float in the future.
However, due to catastrophe losses of $1.7 billion caused by the earthquakes in Japan and New Zealand, as well as cyclone and floods in Australia, the subsidiaries of Berkshire Hathaway Reinsurance Group and General Re suffered massive underwriting losses. Moreover, since catastrophe activity is expected to remain at high levels during he second half of the year (June to December), the company might even face additional cat losses, which, in turn, might keep insurance segment results under pressure.
Berkshire’s economically sensitive non-insurance businesses – utilities & energy, and manufacturing, service & retail – are eventually headed for a recovery after a sharp earnings decline in 2009 due to the weak economy. The utilities and energy business is supposed to bring key growth with increased revenues expectation from BNSF, the railway which Berkshire acquired in February 2010. During the first quarter, revenues from BNSF increased more than twice year over year. According to Buffett, railroads represent the future and it is bound to grow with growth in population and GDP. He expects that this railroad will increase Berkshire’s normal earning power by nearly 40% pre-tax and by well over 30% after-tax.
Berkshire believes that demand for utilities will be strong in future and drive significant earnings growth for the company. Total revenue for manufacturing, service & retail increased 7.8% in the first quarter, reflecting improved results across most of the units due to better economic conditions and higher consumer demand.
However, the major concern about Berkshire remains its succession plan. The remarkable success of Berkshire Hathaway is nearly wholly attributable to Warren Buffett and Charles Munger. Though Buffett has put in place a succession plan, there remains a lack of clarity with respect to it. In our view, it is quite likely that Berkshire’s exceptional performance will deteriorate under a new management. It is simply statistically improbable that any new management of this behemoth conglomerate will be able to successfully continue Buffett and Munger’s long-term market out-performance.
BERKSHIRE HTH-A (BRK.A): Free Stock Analysis Report
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