Boring Portfolio Berkshire Hathaway's Improving Results

Berkshire's second-quarter results show improvement, despite the drop in earnings from operations. Operating cash flow continued its strong positive trend, and operating profits also improved. The company had a big income tax bill in the quarter, which may indicate that it, like Wesco, sold off part of its stake in Freddie Mac.

By Whitney Tilson
August 28, 2000

Berkshire Hathaway (NYSE: BRK.A) recently released results for the second quarter, and I liked what I saw. The numbers show slight improvement -- at last! -- and the earnings report makes the most optimistic statements I've read in quite some time. Today, I'll examine the company's operating cash flow and other non-insurance matters; next week, I'll discuss the insurance businesses

At first glance, Berkshire Hathaway's results look quite poor, since "Earnings from operations before purchase-accounting-adjustments," reported in the news release, declined 20% year-over-year and 22% sequentially. But a closer look at the Interim Report to Shareholders shows an improving picture. The two areas I focus on are "Net cash flows from operating activities" (page 3) and "Operating profit before taxes" (page 7).

Operating cash flow
Operating cash flow was positive $667 million in Q2, versus negative $895 million in Q2 '99 and positive $276 million last quarter, $1.562 billion and $391 million improvements, respectively. This continues a strong positive trend for a fourth consecutive quarter, after five of the six quarters before that had shown declines in year-over-year operating cash flow. This graph shows the improvement:

graph

Note that some of the large quarter-to-quarter gyrations in cash flow are due to factors such as variations in when Berkshire pays taxes versus how they're accrued on the income statement and the impact of occasional large insurance contracts. For example, due to what I suspect was the liquidation of Gen Re's equity portfolio, Berkshire paid $1.757 billion in taxes in the first half of 1999, but only accrued $618 million on the income statement, whereas in the second half, the difference between these two numbers narrowed significantly ($458 million paid versus $234 million accrued).

This caused cash flow to drop substantially in the first half of the year, but didn't reflect any deterioration of Berkshire's operations. Conversely, the spike in cash flow in Q3 '99 can be partly explained by this notation in the Q2 99 Interim Report: "Premiums earned during the third quarter 1999 will include approximately $1.2 billion from [a large retroactive insurance] agreement but there will be little effect on earnings." Thus, quarter-to-quarter gyrations in Berkshire's cash flow are normal and not especially meaningful. I think the trends over longer periods, however, are very meaningful, so the surge in operating cash flow over the past year to its highest level ever is a strong bullish signal.

Operating profits
In addition to rising cash flow, an analysis of pre-tax operating profits by segment shows improvement, most importantly for GEICO and General Re. These are Berkshire's largest subsidiaries by far, accounting in the second quarter for 21% and 28%, respectively, of Berkshire's revenues. Both of these subsidiaries have incurred steep losses recently, which have weighed heavily on Berkshire's stock.

Non-insurance business segments
Berkshire's many non-insurance businesses generated $166 million of pre-tax earnings in Q2, up 3% from the year-ago period and 6% from Q1 (excluding a one-time charge at Dairy Queen).

Has Berkshire been selling its Freddie Mac stock?
A final thought for you hard-core Berkshire junkies: though it doesn't affect my opinion about the stock, I think it will be interesting to see if Berkshire has been following Wesco's lead in dumping Freddie Mac stock, a long-term holding for both companies. In the first half of this year, Wesco Chairman Charlie Munger sold 46% of Wesco's Freddie Mac holdings, which had accounted for nearly 50% of Wesco's value. Given that Wesco is 80.1% owned by Berkshire Hathaway, I think he would be unlikely to make this major sale without Buffett's agreement, which leads me to believe that Buffett may also be selling the Freddie Mac stock that Berkshire Hathaway owns independently of Wesco. (At year-end 1999, Wesco held 28.8 million shares of Freddie Mac, accounting for 48% of the 59.6 million shares that were reported in Berkshire's annual report.)

I suspected as much when Buffett and Munger at their respective annual meetings refused to share their thoughts on Freddie Mac, saying they had a policy of not discussing current positions -- though they were happy to talk at length about other holdings such as Coca-Cola and Gillette. The final bit of evidence is that Berkshire Hathaway paid $628 million in cash for income taxes in Q2, vs. a mere $13 million in Q1 (of Wesco's Freddie Mac sales this year, 74% were in Q2). Other factors could be driving this jump, but I suspect Freddie Mac sales are part of it.

Next week, I'll take a closer look at the second-quarter results from Berkshire's insurance segments, which have been largely responsible for the stock's weakness over the last year and a half. Until then, join the discussion on the Berkshire Hathaway and the Boring Stocks discussion boards.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, go to Tilson Fund's website.

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8/28/2000 as of ~5:30:00 PM EDT
Ticker Company Day Chg % Chg Price
APCCAMER POWER CONVERSION11/162.87%$24.63
BRK.BBERKSHIRE HATHAWAY'B'110.58%$1,900.00
COSTCOSTCO WHOLESALE CORP1/80.38%$33.06
CSLCARLISLE COS3/160.42%$44.50
GTWGATEWAY INC3/80.54%$66.55

  Day Week Month Year
To Date
Since
10/1/1998
Annualized
Boring .80% .80% 3.87% -2.80% 37.64% 18.20%
S&P 500 .51% .51% 5.82% 3.05% 48.87% 23.15%
S&P 500(DA) .51% .51% 5.82% 3.05% 50.58% 23.88%
NASDAQ .69% .69% 8.06% .03% 140.32% 58.22%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
2/9/1999200GTW36.278$66.5583.45%
4/20/1999460APCC14.477$24.6370.10%
8/13/1996200CSL26.325$44.5069.04%
9/13/1999220COST34.551$33.06-4.31%
12/31/199812BRK.B2,278.333$1,900.00-16.61%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
2/9/1999200GTW$7,255.50$13,310.00$6,054.50
4/20/1999460APCC$6,659.25$11,327.50$4,668.25
8/13/1996200CSL$5,264.99$8,900.00$3,635.01
9/13/1999220COST$7,601.14$7,273.75($327.39)
12/31/199812BRK.B$27,340.00$22,800.00($4,540.00)
  Cash: $10,490.51  
  Total: $74,101.76  

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.