Friday, May 8, 2009

Berkshire's 1Q Earnings Announcements

First the basics on how earnings are reported in US GAAP.  This is a big picture, non accountants overview.  They get split into two parts -- one labeled net income and the other labeled other comprehensive income (OCI).  The idea is to put normal stuff in the first bucket or items that have some finality -- like cash losses.  The other bucket gets things like unrealized capital gains and losses, which will fluctuate and make it more difficult to see how the firms operations are trending.

This treatment of unrealized capital gains and losses is not in the least controversial.  For Berkshire, the infamous long term put options would logically fall into OCI (other comprehensive income) -- since they are intended to be held for over a decade, and quarterly movements are noise.

Instead of trying to change accounting, Berkshire has developed a very simple non GAAP metric that it refers to as operating earnings.  Every quarter it puts out a statement opening with operating earnings and reconciling to GAAP.  Operating earnings exclude derivatives as well as other financial "bets" like currency trades.  They are, in fact, operating earnings, which is really what GAAP net income would like to be, if it weren't trying to be uniform across all businesses.    

Right now the volatility of the derivative book they totally overwhelms the changes in the core business earnings.  The Berkshire release saves investors and the media from having to make these adjustments themselves.

This quarter was a bit different.

1.  The earnings release was a week after the annual meeting.

2.  A "preview" of earnings was released, with the emphasis on operating earnings. They were down modestly from $1.9 billion to $1.7 billion.  Given the economy, not bad.

3.  The final published figures contained additional losses of $2 billion ($3 pre tax).  This is based on unrealized capital losses, but since Berkshire has announced that it will sell enough COP stock to get a $600 million tax refund, it labeled these losses as OTTI (Other Than Temporary Impairment) losses.  This means that they can be booked in net earnings BEFORE the stock is sold.  

4.  This huge OTTI clears the decks regarding realized capital losses for the remainder of the year.

The headline numbers should really be Berkshire's non GAAP 'Operating Earnings'.  It is the best way to make sense of the results, and any competent stock analyst would perform a similar set of adjustments.  

The press never seems to read and report on Berkshire's released operating earnings.  This year, it's all that was available when the quarter was discussed at the annual meeting.

Plus, Buffett threw in the kitchen sink by booking the OTTI when 1Q is old, old news.   This is as close as you are going to see Buffett come to spinning bad news. Nothing misleading about it, and in fact, it gives a more accurate picture.  At least the operating earnings.  Taking the OTTI losses as early as possible is something that most CEO's would like to do and Buffett can afford it.  Equity markets hate uncertainty and booking bad news ASAP tends to be good for the stock price.  Buffett may not care very much, but now the foundations have to sell some Berkshire on a regular basis, and there is an economic motivation to keep the stock price at a fair value. 

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