OMAHA, Neb. — Warren Buffett's company reported a 40 percent drop in second-quarter profit Friday because the improvement at Berkshire Hathaway Inc.'s operating companies couldn't overcome $1.4 billion in paper losses on derivative contracts.
Berkshire's strong performances from its railroad, insurance and manufacturing businesses was overshadowed by the plummeting value of the Omaha company's derivatives – many of which are tied to the value of four major stock markets.
"To me, the overall picture is strong," said Andy Kilpatrick, the stockbroker-author of "Of Permanent Value, the Story of Warren Buffett." "I do think the derivatives mask the underlying thing a lot."
Berkshire reported $1.97 billion net income, or $1,195 per Class A share. That's down from $3.3 billion, or $2,123 per share, a year ago. Its revenue grew 7 percent to $31.7 billion.
Buffett has said operating earnings are a better measure of how the company is performing in any given period because those figures exclude derivatives and investment gains or losses. Berkshire said its operating earnings soared 73 percent to $3.1 billion, or $1,866 per share, in the quarter, up from $1.8 billion, or $1,147 per share, last year.
Analysts, who excluded investment and derivative gains or losses from their estimates, expected $1,360.44 profit per share on average, according to Thomson Reuters. Two analysts submitted revenue estimates that averaged $30.79 billion.
Berkshire executives typically do not comment on quarterly earnings reports, and they did not respond to an interview request on Friday.
Buffett warned after he first wrote most of the derivatives contracts in 2007 that their value would vary widely quarter to quarter, and his prediction has held true.
For instance, a $1.01 billion derivative loss contributed to a 77 percent drop in net income during 2008's third quarter. Unrealized derivative losses of $986 million also contributed to a $1.5 billion loss in the first quarter of 2009.
Last year's second-quarter profit was inflated because the value of Berkshire's derivative contracts tied to equity indexes soared as the stock market improved in 2009. Berkshire recorded a mostly unrealized $1.5 billion gain on its derivatives in last year's second quarter.
The true value of the derivatives won't be clear for at least several years because they don't mature until an average of 11 years from now, but Berkshire is required to estimate their value every time the company reports earnings. Buffett has told investors he believes the contracts will ultimately be profitable because the premiums are being invested.
Most of Berkshire's derivatives don't require the company to post collateral, but at the end of June, Berkshire had posted $173 million collateral on its derivatives. That's up from $28 million at the end of the first quarter.
But Berkshire finished the quarter with $28 billion cash, so it has the resources needed for collateral.
Berkshire's report does detail several bright spots at several of the company's roughly 80 subsidiaries. Berkshire officials said the improvement at the company's subsidiaries shows the economy has been stabilizing in the first half of 2010.
"We are hopeful that recent economic improvements will continue over the remainder of 2010 and beyond," Berkshire said in its report.
Berkshire's insurance unit contributed $462 million in underwriting profit, up from $66 million last year.
Burlington Northern Santa Fe railroad added $603 million in its first full quarter as part of Berkshire as it saw increases in industrial, agricultural and consumer product shipping.
The freight railroad's profitable quarter was part of a significant improvement in Berkshire's manufacturing, retail and service businesses, which generated $671 million net income in the quarter, up from $239 million a year ago.
Fractional private jet leasing firm NetJets rebounded from a $348.5 million pretax loss a year ago to produce a $114.5 million pretax profit in this year's second quarter.
And Berkshire also said it saw significant improvement at its Forest River RVs business, Iscar tool makers, Fruit of the Loom clothing and Johns Mansville, which makes insulation and roofing products.
Berkshire owns clothing, insurance, furniture, utility, jewelry and corporate jet companies. Berkshire also has big investments in companies including Coca-Cola Co. and Wells Fargo & Co.
Berkshire Hathaway Inc.: http://www.berkshirehathaway.com
(This version CORRECTS that Berkshire's earnings did not fall short of analysts' estimates because analysts exclude derivative and investment losses.)