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):
- Enterprise Value to 2010 unlevered free cash flow (think of this as a better alternative to P/E ratios):
- BNI = 29x
- UNP = 24x
- NSC = 18x
- 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.