Berkshire Earnings Decline 24% on Derivatives

By Andrew Frye - Nov 5, 2011 11:00 AM GMT+0700
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Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., speaks during an interview at the New York Stock Exchange. Photographer: Scott Eells/Bloomberg

Warren Buffett’s Berkshire Hathaway Inc. (BRK/A) said third-quarter profit fell 24 percent as derivative bets declined in value.

Net income slid to $2.28 billion, or $1,380 a share, from $2.99 billion, or $1,814, a year earlier, the Omaha, Nebraska- based company said yesterday. Operating earnings, which exclude some investment results, were $2,309 a share, beating the $1,796 average estimate of three analysts surveyed by Bloomberg.

Buffett, 81, uses derivatives to speculate on long-term gains in stocks and the creditworthiness of corporate and municipal borrowers. The contracts tied to equity indexes, which aren’t scheduled to settle until 2018 or later, produced a loss of $2.09 billion in the period as the Standard & Poor’s 500 Index posted its biggest decline since 2008. Liabilities on the equity derivatives rose to $8.85 billion.

“He’s been in the negative position for some time now and I’m not worried yet, but it’s something to keep an eye on,” said Tom Lewandowski, an analyst with Edward Jones & Co., who has a “buy” rating on Berkshire. “Outside of the derivative losses it seems like he had a lot of broad-based growth throughout the businesses.”

Insurance, which accounted for more than 40 percent of Berkshire’s earnings last year, posted underwriting profit of $1.7 billion pretax, up from $305 million a year earlier. Berkshire Hathaway Reinsurance Group, which specializes in large risks, had a gain of $1.38 billion, compared with a loss of $237 million. The gain at car insurer Geico narrowed to $114 million from $289 million. Gains at General Re fell to $148 million from $201 million.

Burlington Northern

Burlington Northern Santa Fe, the railroad Buffett bought in a $26.5 billion deal last year, contributed $766 million in net earnings in the third quarter, compared with $706 million a year earlier. Berkshire said it will receive a $750 million distribution from the railroad this month.

The equity derivative result compares with a loss of $700 million in the same quarter a year ago. Credit-default swaps, in which Buffett bets on the solvency of borrowers, declined by $247 million after posting a $519 million gain a year earlier.

Berkshire’s collateral posting requirement tied to derivatives soared in three months to $443 million on Sept. 30 from $25 million.

Book value, a measure of assets minus liabilities, fell in the three months ended Sept. 30 to $96,876 per Class A share from $98,716 on June 30. It was the first sequential decline in book value per share since June 30, 2010.

$34 Billion

Buffett, Berkshire’s chief executive officer, sold the equity derivatives to undisclosed buyers for $4.9 billion. Liabilities on the so-called equity-index puts widen when four stock indexes fall from the levels they were at when Buffett made the contracts near the market peaks in 2006 and 2007. If the indexes are at zero when the agreements expire, the losses would be about $34 billion.

Berkshire Class A shares have slipped 3.9 percent to $115,806 in New York trading this year, compared with the decline of less than 1 percent in the S&P 500. The Euro Stoxx 50 Index, one of the four equity baskets tied to Buffett’s derivatives, has gained 5.1 percent since Sept. 30. The S&P 500, another of the four, advanced 11 percent.

Buffett drew down Berkshire’s cash hoard 27 percent in three months to $34.8 billion as of Sept. 30 to fund new investments. In the quarter, Berkshire increased common-stock bets, and spent $5 billion on Bank of America Corp. (BAC) preferred shares and about $9 billion on the takeover of Lubrizol Corp. On Sept. 26, Berkshire announced a plan to repurchase shares.

‘Burden of Cash’

“The burden of cash is back,” said Thomas Russo, a partner at Berkshire investor Gardner Russo & Gardner.

Berkshire repurchased 15 Class A shares at an average price of about $107,462 from Sept. 26 to Sept. 30. It bought back 227,669 Class B shares at an average price of $71.45. Combined, Berkshire spent about $17.9 million in the period, according to data compiled by Bloomberg.

As of Oct. 28, the firm had 1.65 million Class A equivalent shares, about 525 fewer than it had on July 28, according to Berkshire data and calculations by Bloomberg.

Buffett spent $6.9 billion on equities and $1.9 billion on fixed-maturity securities in the quarter. He sold about $675 million of stocks and $257 million of fixed-income holdings. The company hasn’t filed its third-quarter stocks statement to U.S. regulators yet. The stock portfolio was valued at $68.1 billion at the end of the quarter, up from $67.6 billion on June 30.

Net investment income, which includes stock dividends and bond coupons, fell 10 percent to $783 million at Berkshire’s insurance operations.

Equities Falter

Berkshire, which doesn’t pay a dividend, announced its first buyback in at least four decades to help spend the $1 billion of earnings Buffett has said his company generates in a typical month. It has more than 70 units that haul freight, produce power and sell goods and services from insurance to carpet. Berkshire said it won’t reduce cash holdings below $20 billion or buy back shares for more than 110 percent of book value.

“I know that that price is demonstrably less than the businesses are worth,” Buffett said at a conference on Oct. 4. “The book value happens to be an understated measure” of Berkshire’s worth, he said.

Berkshire, in preparation for Buffett’s eventual retirement, announced in September the hiring of Ted Weschler, who will join Todd Combs in overseeing a portion of investments. The two money managers, and possibly a third, will take over the portfolio after the departure of Buffett, who is also chairman and head of investments.

To contact the reporter on this story: Andrew Frye in New York at afrye@bloomberg.net.

To contact the editor responsible for this story: Dan Kraut at dkraut2@bloomberg.net.