From a humble start as a Massachusetts-based textile mill, Warren Buffett built Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) into one of the world's largest conglomerates. The company now owns an empire of brands that spans from the second-largest U.S. railroad to smaller businesses like Benjamin Moore paints.
Some businesses are real needle-movers, while others are mere afterthoughts that came along for the ride as part of a larger acquisition. Outside its investment profits, only four broad business lines venture into the double-digits as a percentage of its profits.
Understanding Berkshire's income statement
Unlike most companies, Berkshire Hathaway has a substantial investment portfolio that holds stakes in publicly traded companies. Due to the way accounting works, its investment profits are mostly a function of timing, as they flow into the income statement when investments are sold at a gain.
Last year was a particularly active year for Berkshire's investment portfolio. The company realized gains in Wrigley, Kraft Heinz, Dow, and Procter & Gamble. Naturally, these gains had an outsize impact on its income statement, but it would be folly to assume that they are repeatable, or that investment gains can be predicted for any given year.
For this reason, Berkshire's operating businesses are perhaps more important for understanding how the company makes its money. The four segments below are its most important to its profit and loss in any given year.
The grab bag: $5.6 billion
Last year the manufacturing, service, and retailing businesses took the top spot from Berkshire's insurance units as the leading generator of non-investment profit. This group includes large businesses and familiar names like Lubrizol, Precision Castparts, Fruit of the Loom, Duracell, NetJets, Pampered Chef, and Dairy Queen. I could go on and on...this segment is truly massive!
Collectively, these businesses generated revenue of $120 billion just last year. About 40% of this category's revenue comes from McLane, a distributor that sells goods to grocery stores and the general food service industry, but profit margins are minuscule, making it a considerably smaller source of profit than sales.
Precision Castparts, a manufacturer of complex metal components used primarily in airplanes and power industries, is a leading driver of its profits in the category. It was acquired in 2015, setting the record for the largest acquisition in Berkshire's history.
Unfortunately, Berkshire shares very little about the individual companies in this group. In the 2016 annual letter to shareholders, Buffett explained that it only discloses the required minimum, for various reasons:
We have far too many companies in this group to comment on them individually. Moreover, their competitors -- both current and potential -- read this report. In a few of our businesses, we might be disadvantaged if outsiders knew our numbers. Therefore, in certain of our operations that are not of a size material to an evaluation of Berkshire, we only disclose what is required.
Buffett is more than pleased with this group as a whole, noting that the underlying businesses are rather profitable. The group collectively earned 24% after taxes on their net tangible capital, "despite their holding large quantities of excess cash and carrying very little debt," Buffett wrote in his 2016 letter to shareholders.
The risk business: $5 billion
When Buffett took control of Berkshire Hathaway, he immediately began to redirect the cash generated by its textile mills into new industries with better long-term prospects. Insurance rapidly became a core Berkshire Hathaway business, and to this day, it remains a key source of both revenue and profits.
Insurance profits are generated in two ways: From underwriting profits (earned when premiums exceed losses and expenses) and investment income (earned by investing the float generated by its insurance businesses).
Investment income from a vast stock and bond portfolio generates roughly 73% of its insurers' post-tax income, while underwriting profits make up the other 27%. It is incredibly rare for insurers to be as profitable as Berkshire's, as the industry generally loses money on its underwriting with the hope of making up for underwriting losses with investment gains.
GEICO, for example, has been profitable in every year since 2000 on an underwriting basis. In contrast, its largest competitor, State Farm, has consistently generated billion-dollar underwriting losses. I'd argue that Berkshire's insurance companies are the crown jewels of its operating companies given their robust profitability and the fact they generate more than $105 billion of float that Buffett and his portfolio managers can invest as they please.
The train set: $3.6 billion
Acquired by Berkshire in 2009, BNSF is the second-largest railroad by volume and revenue. It's also a very important driver of profits for Berkshire Hathaway, generating $3.6 billion of profit in 2016, despite a downswing in commodity prices that negatively affected railroad earnings industrywide.
Keep in mind that the railroad's profits are somewhat overstated compared to their actual cash profitability. In the last three years, total free cash flow has tallied to $7.6 billion compared to net income of $13.6 billion.
Railroads require consistent billion-dollar investments to maintain their rails. Thus, less than 60% of its earnings have come out in the form of cash in the last three years. That's neither good nor bad; it's just the reality of the railroad business, and something to keep in mind when comparing its profits in railroads to its capital-light insurance profits, for example.
Berkshire's power plants: $2.3 billion
Berkshire Hathaway Energy is a reliable generator of profit, earning $2.3 billion in 2016 primarily from regulated utilities. Buffett likes the utility industry for the simple fact that it allows Berkshire to deploy billions of dollars in capital expenditures and collect an almost royalty-like stream of income from the power they produce over time.
Most local power markets allow for the existence of a monopoly to produce and sell power to all consumers and businesses in the area. Profits are therefore almost guaranteed. And when you're as cash-rich as Berkshire is -- the company had more than $96 billion of cash last quarter -- having a reliable place to invest billions of dollars at a reasonable rate of return is a very valuable asset.