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Is Burlington Northern the New Coke?

(Guest Commentary by Rick Konrad – November 6, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  As I mentioned yesterday, Rick has been a regular guest commentator for a few years now (usually every third Wednesday of the month) but is now offering his insights every first Wednesday of the month as well!  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will give us his quick perspective on the waning strength of the US economy and US Dollar.  In addition, Rick will provide his insights - at length - of Warren Buffett's purchase on Burlington Northern (BNI).  While Rick sees value in BNI and the railroad industry in general, he also asserts that this is more of a "capital preservation" transaction for Berkshire Hathaway than an aggressive growth/income transaction such as Coca-Cola in the late 1980s.  This is a must-read. Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see "Everything We Hear is an Opinion; Everything We See is a Perspective" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

Much of the value investing world's focus this week has been on the extraordinarily large and significant deal that Warren Buffett has made on behalf of Berkshire Hathaway in the Burlington Northern railroad.

Certainly, this investment has created a huge amount of controversy, not only because of its size, but also because many people view this as having some implications as far as commodity prices or even the future of the US economy. As WEB said in a CNBC interview:

"Berkshire's $34 billion investment in BNSF is a huge bet on that company, CEO Matt Rose and his team, and the railroad industry," Buffett said in a statement.

"Most important of all, however, it's an all-in wager on the economic future of the United States. I love these bets," he said.

Though few readers will remember this, a similar controversy arose at the time (1988) that Buffett, then hardly known to the public, had made a disproportionately large investment in Coca-Cola.

In the 1988 Berkshire letter to shareholders, the Coca-Cola purchase was noted as a one-liner: “In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola.  We expect to hold these securities for a long time.” At the time, the Coke purchase of some $600 million represented the single largest purchase WEB had made to date, and at market value, was the third largest marketable securities position that was owned, slightly smaller than Capital Cities Broadcasting/ABC and GEICO. By 1989, the Coke position was augmented with another $400 million, and became the single largest holding.

At the time Buffett had joked about his decision-making:

This Coca-Cola investment provides yet another example of the incredible speed with which your Chairman responds to investment opportunities, no matter how obscure or well-disguised they may be. I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each.

In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.

 I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes…. Of course, we should have started buying Coke much earlier, soon after Roberto and Don began running things. In fact, if I had been thinking straight I would have persuaded my grandfather to sell the grocery store back in 1936 and put all of the proceeds into Coca-Cola stock. I've learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years.

I can recall that at that time, many investors questioned the wisdom of paying what at the time looked like a fairly substantial premium to the existing market for this company. After all, Coke was hardly a depressed stock with a stock price that had grown by about 18% a year, well ahead of the overall market since 1980.Free cash flow had grown every year, a concept that few analysts discussed at the time. In fact, in the decade preceding WEB's purchase, Coke's free cash flow had compounded at a 21% CAGR. Though the P/E multiple seemed high at about 14 times, most analysts focused on earnings rather than the underlying value of the brand. The value of that investment in Coke, needless to say, has grown spectacularly, about 24 times including dividends.

How should we be thinking about Buffett's latest big “bet?”

There are two camps forming.  In simple terms… those that think it is a great deal given long-term transportation and pricing dynamics and those that remain skeptical of the price paid, the FCF generated and ROIC of this business.

Let's describe BNI's business. Burlington Northern (known to most of us old-timers as Beanie) operates one of the largest North American rail networks with about 32,000 miles in 28 states and two Canadian provinces.

The operational positives: BNI operates the premier US intermodal franchise with a very large West Coast presence and what is regarded as a decent service proposition. The company moves more intermodal shipments than any other railroad through its international, domestic, truckload/intermodal marketing company, and expedited/LTL (less than truck load-relatively small freight) offerings. Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes. The method reduces cargo handling, and so improves security, reduces damages and losses, and allows freight to be transported faster. Reduced costs versus over road trucking is the key benefit for intra-continental use. BNI stands to improve its intermodal results and growth as import volumes increase. The long term picture here is quite positive in that volumes of intermodal should grow faster than GDP over the long run. Intermodal pricing should strengthen as the economy recovers and the Truckload (TL) market tightens from its current over-capacity and give-away pricing.

There has been considerable comment on the energy benefits of using rail. TCI, a UK based activist investment manager made a presentation to a Congressional committee on rail transportation to discuss their involvement with CSX, another large rail carrier and their views on the railroad industry in general. Here is a copy of that transcript:

To quote from their study:

We are excited about the prospects for the US railroad industry. Railroads can, and must continue to, play a critical part in meeting America's growing freight transportation needs. Railroads are the cheapest, most efficient and most environmentally friendly form of land-based freight transportation, and they don't require taxpayer dollars, a public-policy panacea if ever there was one.

As valuable as railroads are to America today, their potential is even greater, and that is what we should all find truly exciting. Over the last 100 years, the industry has transformed itself from one operating under heavy regulation to one that competes in the free market. This transformation has taken decades, and while rail market share has nearly halved as they have lost share to trucks, it has brought enormous benefits to shippers – since Staggers rates are down while volumes, service and investment are up.

However, as the railroads were trying to adapt to the dynamic competitive market, many opportunities were left unexplored. As we look into the coming decades, we see the potential for US railroads to capture these opportunities.

The lobby for the railroad, the Association of American Railroads has demonstrated the carbon footprint benefits of rail transport versus trucking in a handy carbon calculator:

Who wins this battle? As you can see, there is a strong rivalry that exists with the transportation sector as intermodal involves railroads and trucking companies. The scalability of the rail industry leaves a lot to be desired in my opinion. Class 1 railroads currently have 95,000 miles of track, and it would be virtually impossible to expand the system without major population disruptions. Additionally, the existing rail network has very little extra capacity. As far as water transportation, the champ as far as economic movement of tonnage, the United States has just 26,000 miles of navigable waterway channels.

In contrast, the United States has built 4 million miles of highways, including the interstate highway system. A tremendous amount of freight moves over those highways, and that is unlikely to change significantly. There is an inherent flexibility and on-time deliverability that is part of trucking. Some 70% of all freight in this country is carried by truck.

Another Buffetteer friend of mine noted in a recent e-mail his discussions with some of his trucking managements:

“I own two truckers, HTLD and KNX, and obviously ask them about the competitive threat from rail roads.  I have also been watching the volumes at the intermodal carriers like JB Hunt and CH Robinson for years.  My conclusion has always been that a) trains only go certain places, and b) they are subject to significant quality problems whenever volumes surge.  The truckers all tell me that “yes trains are very competitive on certain long haul routes (like 1000 miles), but that trains go to very few warehouses or stores and that somebody has to move the intermodal container the last leg on the road”.  I have also noticed that whenever freight volumes pick up the service quality suffers, and then a lot of long haul business gets pushed back on to trucks.  Most lean operators cannot deal with late shipments, even if they are cheaper.  At the end of the day, trains are sequential – you cannot accelerate a late shipment around other cars in the system.” 

“Railroads have two other factors most of us value investors have long avoided – aggressive unions and customers with a lot of bargaining power.  The unions have long resisted changes that would improve costs.  These changes come, but usually only after a very acrimonious process.  Finally, the federal government's role is to set an acceptable return on capital (this is where the historical vs. replacement cost comes in).  This function was basically set up to protect the coal power companies from price gouging by the railroads, which was a real problem back in the robber-baron days.  So every time the railroads talk about raising rates the utilities scream bloody murder.  It is amazing how responsive a politician is to a utility claiming every voter's bill is going up if a railroad raises prices.”

Another potential problem that I see in the rivalry with truckers is their lobbying power. The trucking industry employs some 3.5 million drivers. It is estimated that there are over 500,000 trucking companies in the U.S. Of that figure 96% operate 28 or fewer while 82% operate 6 or fewer trucks. The transportation industry paid $37.4 billion in federal and state highway-user taxes. Commercial trucks make up 12.5 percent of all registered vehicles, but paid 36.5 percent of total highway-user taxes in 2006, the last available figure. By way of contrast, there are only 7 Class I railroads in the US employing all of 164,000 employees.

One of my fears, based both on my friend's observations about the relationship between rails and their utility customers as well as a recent Deutsche Bank analyst report is the notion of re-regulation. As Justin Yagerman at DB observes:

“While we expect Washington to act prudently and protect the nation's long-term transportation interests by encouraging railroad expansion project investment, stranger things have happened than Washington taking a short-sighted view or acting irrationally.”

Shippers have generally been happy with improved rail service since de-regulation of this industry transpired in the early 1980s, but a significant minority are getting the attention of Washington, complaining of predatory pricing.

Senator Jay Rockefeller of West Virginia has been drafting legislation to alter the regulation of railroads as he believes,”captive shippers suffered unfairly as federal regulators weighed in on the side of railroads in the deregulation era.”

As I said, the trucking lobby is quite powerful, not to mention coal dependent utilities. As a result of a very weak TL market, shippers have moved more economically sensitive freight to TL providers due to very low TL rates and in many cases cheaper fuel surcharges due to aggressive carrier pricing. So the long term picture for growth may be impressive, the near term has resulted in some freight diversion of intermodal traffic to the trucks. Shippers are rebidding business to take advantage of the capacity underutilization on both sides.

On the utility and the coal side, BNI has access to the Powder River Basin, a competitive advantage that provides it a fairly reliable recurring revenue stream. It is the single largest source of coal mined in the United States, and contains one of the largest deposits of coal in the world.

Here are some statistics on the current production and future use of coal from the EIA, the government's energy information administration.

The EIA expects coal supply to increase at about a 1% CAGR until 2030 with Western coal taking share from Appalachian coal. Between 2000 and 2007, BNI double its Powder River basin transport of coal to over 100 million tons.

BNI will be re-pricing some of its legacy coal contracts over the next several years likely at rates in excess of inflation. At least, recent history encourages this type of pricing evolution. As well, additional Powder River projects continue to develop. Though there appears to be a significant stock-piling of coal at most utilities at present which may influence the demand for more coal shipments, the long term picture remains quite positive, I believe. There are over 17,000 megawatts of coal plants under construction in 19 states which represent about 70 million tons of annual coal demand.

Earnings and profitability of Burlington Northern and all Class I railroads for that matter has improved significantly in the last decade. The boom years of 2003-05 created a renaissance in thinking as the industry focus shifted from just moving volume to actually improving profitability. The industry has improved revenue per carload by some 10% compounded over the last five years with its renewed focus on pricing discipline and shifting to a fuel surcharge scheme to maintain margins and pass through costs. Here is a look at yearly changes in revenues per carload in the last few years:






















This sort of pricing power seems to resemble “branding power” more so than what most of us regard as a quasi- government regulated service.

Combine this with some decent cost controls: parking of locomotives, layoffs of employees, reduced dwell times, and improving fuel efficiency and suddenly, railroads look a lot more interesting.

Capital expenditures remain an issue in this industry. Though some of the Buffetteers have visions of toll bridges in their heads, there are few toll bridges that require 13-19% of revenues to be spent on capital expenditures. Though some believe that BNI has accelerated its capital expenditure program and may be able to reduce its spending in some future years, heavy utilization of railbeds with heavy loads at high speeds takes its toll. Maintenance capex will remain significant in my opinion.

This is inherently a very capital intensive business with fairly low asset turnover by American industry standards. Asset turnover (sales/ assets) have reached a high of 0.49 in the most recent year but have generally been around 0.35. This is a result of what historically has been poor pricing power and heavy capex needs. Consequently return on assets has never been terribly impressive. However, not unlike the Coca-Cola example, there has been free cash flow generation every year of the last decade.

Of note, BNI management (along with most other rails' managements) has provided good return of capital to shareholders. For BNI, return of capital through dividends and net share buybacks has amounted to 40-50% of cash flow from operations in recent years. This is a decent trait for management to have developed…this will now upstream directly to Berkshire's Omaha HQ.

Please have a look at this comparison of BNI versus a number of other railroads over the last ten years. Data is courtesy of Reuters Knowledge:

Returns on invested capital have been fairly impressive. For BNI, the return on invested capital has been between about 8% and 14%. Please, note that these returns figures have not been adjusted for the value of the operating leases.  This adjustment would bring the returns down to a more realistic, high single digit level. Remember, that this return on capital is partially a function of historical costs which represent century old acquisition costs for much of the railbed property, not the $100 per share that Berkshire is laying out.

An excellent presentation by BNI management will also provide some perspective as to the drivers of the business.

So which camp are we in? Do we like the deal or not?  With all due respect, we think that Buffett has gone into a value preservation mode rather than a capital growth mode. He will likely be earning in my estimation, somewhere around 7-8% on his capital in this investment over the next ten years. Mind you, this is a lot more interesting than rolling cash at current rates. As well, cost of capital at Berkshire is often negative as a corollary of the insurance float.

The greatest risks relate to assumptions of pricing power continuing at the same pace. When competing against a much larger, more politically savvy group of truckers, rails are subject to potential freight diversion. Competition will likely remain fierce. Politically, the climate to upset de-regulation of many industries needs to be considered. Again, WEB is hardly a political neophyte and certainly has many friends in Washington, particularly given his pronouncements re executive compensation or estate taxes.

As one of my friends described it, “This is a $26 billion equity / $18 billion debt bet to get $2 billion in free cash, financed partly with just over $10 billion new Berkshire shares which had previously been undervalued. The degree of undervaluation just got smaller.”

We remain faithful and loyal Berkshire shareholders. The “master” may be seeing much more value than I am.

The rare use of Berkshire stock as currency in this deal suggests to some people that WEB sees special value or upside to BNI. I think it was the only way to accommodate small shareholders to provide a tax-free exchange and hence, the 50-1 split on the B stock, again as an accommodation. Buffett has had one terribly sour experience in using stock before, the purchase of Dexter Shoe in 1993. Quoting Footwear News on October 1993:

“The Dexter Shoe Co., a branded resource some retailers call the most powerful, privately owned company in the industry, was gobbled up by Warren E. Buffett-led Berkshire Hathaway Inc. last week for a nifty $416 million .”

“In a deal that surprised many industry observers, Dexter chairman Harold Alfond, who founded the company here on Lake Wassokeag 36 years ago, and company shareholders approved the all-stock transaction that will, technically, merge Dexter and Berkshire.”

“Although Dexter is private and does not disclose sales figures, industry estimates peg sales at about $300 million, with more than 9 million pairs of men's and women's casual and athletic shoes sold last year. Also, out of hundreds of vendors, Nordstrom named Dexter one of five "Partners of the Year" last year. “

“In disclosing the merger, Buffett, Berkshire's chairman, said he expected Dexter to operate "under existing management."

That investment, “that branded resource” operated under its existing management for very few years as the business no longer was economic and the brand value was allowed to erode. Sometimes even the master misjudges the economics. The 25,000 shares of stock provided the selling shareholders far more value than the brand and the firm ever did.

As I indicated, the Burlington Northern will likely provide an acceptable return on the capital employed and decent free cash flow to upstream. But I don't believe we are looking at a Coke 24- bagger by any stretch.

Disclaimer: I, my family or clients own a position in Berkshire Hathaway. Some clients own positions in some of the railroads mentioned in the accompanying spread-sheets.

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