The interesting thing about 10-Q
Writing regularly on Berkshire Hathaway (NYSE:BRK.A) (NYSE: BRK.B) can sometimes be a challenge as the company periodically goes through periods of inactivity in its investments and M&A operations. For an investor, it’s not necessarily a bad thing when operations and stock selection are good to start with and don’t need to change. One of Buffett’s best qualities is ignoring calls from “Swing, you tramp!” from the crowd. As you can see on my past items, Berkshire experienced a frustrating period of inactivity in 2019 and 2020 as its cash pile continued to grow while earning near-zero interest rates. In 2021, the company significantly increased its share size redemptions, buying $27 billion that year. Buffett started swinging even more in Q1 2022when the company spent more than $50 billion on new investments, including in energy companies such as Chevron (CLC) and Occidental Petroleum (OXY). Berkshire too announcement the agreement to acquire another insurer Allegheny Corp. for $11.2 billion in cash. This case firm in October, after the end of the quarter just published.
Since then, the company has entered a new period of calm. In Q3, redemptions were just $1 billion and equity investment cooled. Berkshire spent about $9 billion on new stock purchases and sold about $5.3 billion worth of stock in Q3. Berkshire’s cash balance rose again to $105 billion at the end of the quarter, although $11.2 of that amount was spent in October on Allegheny. Operationally, insurance underwriting is having a tough year, with $3.4 billion impacted by Hurricane Ian ($2.7 billion after tax). At least higher interest rates contribute to income from insurance investments. BNSF faces higher fuel and personnel costs as shipping volumes decline. Manufacturing, services and distribution have held up well so far, except in consumer-related activities where margins have fallen. Berkshire Hathaway Energy continues to be the star with even bigger tax subsidies for wind energy this quarter. The real estate business integrated into this utility division has seen a serious slowdown, however, which could be a harbinger for some of Berkshire’s other businesses.
Overall, the quarter was exactly what one would expect with an economy on the verge of recession. I have no concerns about Berkshire’s ability to weather a downturn, but I won’t spend much time this quarter on detailed analysis or assessment. Instead, I want to review a big change in Berkshire’s financial reporting that will lead to increased operating profits. Berkshire has exceeded 20% ownership of Occidental Petroleum and now accounts for it using the equity method.
Berkshire also accounts for its ownership of Kraft Heinz (KHC) this way. Berkshire also owns 20.3% of American Express (AXP) but does not use the equity method due to an agreement with the Federal Reserve to vote with board recommendations and not exercise influence on operations.
If Berkshire had owned the 20.9% stake in Oxy over the past year and accounted for it using the equity method, reported operating income would have been about $1.7 billion higher. after-tax dollars, or about 7% of Berkshire’s year-to-date operating profit.
This change in accounting policy does not impact the intrinsic value of Berkshire or its interests in Oxy. Warren Buffett has always viewed Berkshire’s share of his investees’ earnings as “transparent earnings” with economic value to Berkshire, even if they are not reported under the equity method because ownership is less than 20%. Buffett even used to include a transparent earnings calculation in his annual shareholder letters like this one from 1994. If you look at the chart in that letter, you’ll see that those unreported transparent earnings were almost as much as the revenue. declared.
Oxy’s move to the equity method is only an accounting change, but it serves to make reported operating profits more representative of Berkshire’s true economic earning power. Investors should be aware of this shift when comparing performance from different time periods.
So how does the equity method work?
Until this quarter, Berkshire’s holdings in Oxy were marked-to-market on the balance sheet. Dividends from Oxy were recorded in the income statement as investment income, while changes in the share price from quarter to quarter were recorded in the income statement as gains and investment losses.
Going forward, the value of Oxy is recorded on the balance sheet as investments using the equity method. This value is calculated by taking Berkshire’s original cost of its Oxy stock, adding Berkshire’s share of Oxy’s earnings (20.9% of Oxy’s reported net income) and subtracting dividends received. (Dividends are always declared as investment income.)
Revenue, less dividends, will now appear on the summary income statement in the “Non-controlling companies” line. It will therefore be recorded in Berkshire’s operating profit and will not impact investment gains and losses.
Due to Oxy’s reporting schedule, equity earnings will be recognized one quarter late. Berkshire therefore recorded no earnings from Oxy shares this quarter, but will include its share of Oxy 3Q earnings (to be released 8/11) in Berkshires Q4 results.
Future impact on Berkshire’s revenue
Analysts estimate Oxy to earn $2.45 per share this quarter and $8.25 over the next four quarters. Assuming a quarterly dividend of $0.13 per share, 915 million shares outstanding, 20.9% ownership of Berkshire and a 21% tax rate, Berkshire will post an additional operating profit of 350 million in Q4 and $1.17 billion in 2023.
The change adds about 5% to 4Q and 3% to 2023 operating earnings per share. Berkshire. They could go down if Oxy increases its dividend, but that would mean more investment income in Berkshire’s accounts.
Not much happened in Q3 to change the intrinsic value of Berkshire Hathaway, but Occidental’s 20.9% ownership now forces Berkshire to use the equity method to account for this investment. This will boost the value of Berkshire’s reported operating earnings, a key quarterly metric that Buffett has focused Berkshire shareholders on for the past few years. This change must be taken into account when comparing the operating result of 2023 with previous years. 2023 will also see increased revenues from wholly-owned Allegheny and a larger stake in Pilot Flying J. These are real economic additions to Berkshire’s earning power. Combined with Oxy’s accounting change, Berkshire is continuing its transition to be valued more on its operating profits than on its equity investments.