Burlington…not so Buffett-like

November 3, 2009

So I thought I’d do a little number crunching on Buffett’s Burlington deal. What does that tell us? That Buffett is paying a full price for a business with mediocre returns on capital, that he’s betting on growth, not value.

Valuation (based on share prices of $100 for Burlington, $59 for Union Pacific, and $48 for Norfolk Southern):

  • Return on capital employed (based on 2010 operating income and year-end ’10 balance sheet estimates.
    • BNI = 11%
    • UNP = 10%
    • NSC = 10%

(I’m using Stifel Nicolaus estimates for 2010)

The cash flow characteristics of the business aren’t very good. From 1999 to 2009, BNI poured 68% of operating cash flow back into capital expenditures. That’s cash flow that doesn’t go to shareholders.

Nor are the returns fantastic. Because operating a railroad requires so capital, the return on capital employed is only mediocre.

And the business is not without risk. High fixed costs mean railroads generate increasing returns during upswings, but decreasing returns during downturns.

As an asset, railroads do seem well-positioned. And Burlington Northern particulary so.

1. Increasing fuel costs hit truckers harder than railroads, so that works in their favor.

2. As my Reuters colleague John Kemp points out: “Burlington’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with ‘carbon capture and store’ technology to curb the carbon-dioxide emissions.”

He’s talking about Burlington’s track near the Powder-River Basin in Wyoming and Montana. PRB coal has lower sulfur content than Appalachian coal. To the extent we increase coal-fired power generation in the U.S., we’re likely to do it on a “clean” basis, giving PRB coal (and those who ship it) a competitive advantage.

3. Most important: Pricing. As volumes have increased the last few years, railroads have been able to increase their prices. Buffett is betting this will continue.

But again, given the high price he’s paying, Buffett needs a lot of things to go right for this deal to generate meaningful returns for shareholders.

More than anything, I bet he’s anxious about sitting on $25 billion worth of cash. Yields on short-term investments are at rock-bottom rates thanks to the Fed, and Buffett has gone on record that he’s worried about inflation.

12 comments

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Buffett has rarely used Berkshire stock as acquisition currency, so the fact that he’s willing to use it to fund 40% of the purchase of BNI at a 30% premium suggests he doesn’t think Berkshire stock is particularly cheap.

Given the steep drop in their freight volumes, BNI earnings have held up better than I would have thought but I think it is tough to make a case that buying BNI at $100 will produce strong returns without a big rebound in the U.S. economy. Buffett acknowledged that this morning on CNBC.

Posted by DP | Report as abusive

BNI’s capital expenditures aren’t going to run at current rates indifinitely. They’ve been running a huge track expansion program for many years now to make up for a longer period time of stagnation. Maintenance on track isn’t nearly as expensive as laying it.

This is also true of UNP, of course.

Also, as DP alludes to, he’ll still have most of the $25B in cash left as the lion’s share is paid for in A and B shares.

You could also see it as an indirect oil play to benefit from increased rail use if oil regains its highs, although that would be a second or third tier rationale for buying a rail company.

Posted by Andrew | Report as abusive

As a % of operating cash flow has been relatively stable between 60 and 70% since 1999, though would be interesting to hear how much longer any CapEx projects have to go.

You’ve got the share/cash components mixed up. 60% of the purchase price is cash, nearly $16 billion. That will use up 60% of Berkshire’s $25 billion cash hoard.

Posted by Rolfe Winkler | Report as abusive

whoops!

Posted by Andrew | Report as abusive

You didn’t come out and say it, Rolfe, so I will. Mr. Buffett is buying a company for reasons that don’t make any sense unless government policy (cap-and-trade, “clean” coal with carbon-sequestration) changes. I guess he figures he’s got that one in the bag.

I don’t mind him buying something–but it’s nauseating to see him continually wrap his moves in the mantle of patriotism. He’s doing it because he “believes in America,” ha! He’s doing it because he thinks his friends in Washington will help him raise prices. . .

He’s just another looter.

Posted by But What do I Know? | Report as abusive

Rolfe…I think this deal might be a big hedge against future inflation, or put another way a big bet on oil prices rising. When oil prices go up, rail benefits relative to trucking given it’s a more fuel-efficient means of transport. Thus, at the margin, incremental demand leaks from trucking into rail. Given the fixed costs in rail, this incremental revenue can drive nice gains in incremental margins and cash flow.

That said, you need a stronger economic environment long-term than the present one to help boost that incremental demand for rail transport. WB has said, and is now making the biggest bet of his career, that America will grow again. He seems to be signaling he thinks it will happen sooner rather than later.

When you combine that framework with a business with high barriers to entry and limited compeition it kind of starts to make sense, at least to me. Rail is a decent (not great) but stable business highly insulated from competition. It can also serve as a backdoor inflation hedge as its returns on capital could improve from decent to good if we return to a 1970s type of environment.

It’s no secret that WB is worried about inflation, so this is my guess at how he might ponder this deal’s benefits over the longer term in that witty head of his…

Really enjoy the blog.

Posted by Tony | Report as abusive

In addition to the above (less capex %) has anyone considered how much debt he can inject into the company in a few years time once capex expenditures and debt markets stabilize?

Posted by Aarish | Report as abusive

You need trains to transport coal. He knows that we are stuck with using cheap energy. Maybe the no-atmospheric-global-warming proponents are right ? CapEx projects must have positive NPV’s, or the least negative values when aggregated.

Posted by Casper | Report as abusive

[...] Burlington… not so Buffett-Like – Rolfe Winkler [...]

Tony….I agree with you for the most part. Seems to me a railroad is a solid tangible asset that’s better to hold than cash. Eric Sprott has made the point, quite cogently, that spiraling inflation OR deflation is bad for cash. With inflation, your purchasing power disappears. With violent debt deflation, paper money dies along with your bank. (Buffett’s $25 billion ain’t FDIC guaranteed…)

Seeing the sheer level of support that’s required to keep this market propped up (and understanding that that support can’t last forever without dire monetary consequences on either side), I see why Buffett might want to deploy his cash.

It’s just the price that puzzles me. I mean, 28x EV to UFCF? And it’s not like this isn’t a somewhat risky business. Yes, high barriers to entry I grant you.

But the operating leverage cuts both ways. I’m a long-term bear, given the aggregate debt stock that has to be paid down along with demographics. Seems to me a business so capital intensive won’t do so well in that environment.

Seems to me all equity prices (and the entire economy) is artificially inflated by low rates that anyone who wants to deploy cash HAS to chase risk…

Posted by Rolfe Winkler | Report as abusive

I wonder how high-speed rail works into this. I’d assume that any gov’t funding into a project would go to current railroads. True high speed rail would require an entirely new roadbed but it would probably go nearby that of a current RR as an expansion of the present right-of-way. A demo project of true high-speed rail (not current RR on steroids like Metrolink) would be cheapest to build away from the East, in BNI territory, a Chicago to Minneapolis route has been mentioned.

You mentioned the fixed costs of rail. Living within sight of UP track, I can testify that maintenance on this heavily used commuter route is continual and it carries nowhere near the load either in number/length of trains or weight of the western coal freight routes. Now if someone could come up with a substitute for wood ties, say with recycled material of some kind, THAT just might be an investment opportunity!

All this said, the capacity of a RR compared to a major highway is amazing…think of such a narrow corridor with a foundation of two steel rails, ties and ballast compared to the huge width and vast materials that go into a similar stretch of interstate highway. Whatever the future holds, my bet would be on rail over road. The sad part is that we had a dense rail system that was almost entirely ripped up but only because of cheap oil.

Posted by CB | Report as abusive

CB: wooden ties are replaced with some sort of concrete ties when maintenance allows where I am these days.

Posted by Andrew | Report as abusive

[...] how Buffett-like is Buffett’s purchase of Burlington Northern (BNI)?  (Rolfe Winkler, Atlantic Business, Reuters, Manual of Ideas, Breakingviews, [...]

first, its an asset play; burlington is the largest private landholder in the US; second, with peak oil approaching or past, moving goods by truck will become prohibitively expensive

[...] how Buffett-like is Buffett’s purchase of Burlington Northern (BNI)? (Rolfe Winkler, Atlantic Business, Reuters, Manual of Ideas, Breakingviews, [...]

[...] is no shortage of motives assigned to Buffett’s motivations for the deal.  They include:  anxiety about sitting on cash, a general economic play, a bet on another stimulus, a bet on coal, a bet on a turn in the rail [...]

[...] is no shortage of motives assigned to Buffett’s motivations for the deal.  They include:  anxiety about sitting on cash, a general economic play, a bet on another stimulus, a bet on coal, a bet on a turn in the rail [...]