Investors were treated with a surprise on the afternoon of Friday, April 6. Buffett’s Berkshire Hathaway bought at total of 39 million shares of Burlington Northern Santa Fe (BNI) for $3.2 billion. Berkshire is the largest single shareholder of BNI owning 10.9 percent of the shares outstanding.
Some maybe scratching their heads in amazement, thinking it can’t be. A railroad is a far cry from his other common household name stock holdings like Coca-Cola, Wal-Mart and Anheuser-Bush. For years Buffett has talked about buying companies he can understand, that have a sustainable long term competitive advantage, good management at an attractive price. The common stocks he bought in the past most often centered around consumer products with brand names. With his purchase of Burlington Northern, is Buffett swaying from his circle of competence and changing his stock selection process?
On the surface, a railroad does not seem to fit the Buffett model. However on closer inspection Burlington Northern fits like a glove in Berkshire’s common stock portfolio and here’s why.
Understand the Business
Burlington Northern owns one of the largest railroad systems in the U.S. They have 32,000 miles of track, own 6,300 locomotives and have 220,000 freight cars. They transport: coal, agriculture products, and intermodal. Not many moving parts here. Rail is an easy business to understand but not a simple one to operate–a perfect Buffett combination.
Sustainable Long Term Competitive Advantage
Buffett likes to think about competitive advantage in this way: if he had $10 billion, how could he hurt the company? In fact he said that if he was giving $100 billion and told to hurt Coca-Cola, he would have to give the money back. He couldn’t think of a way to harm a company whose brand is so entrenched in consumer’s minds.
If given $10 billion how would he hurt BNI? I think he came to the conclusion that he couldn’t. How do you compete with a company that operates 32,000 miles of track, has been decreasing overhead and has the lowest prices on delivering low-sulfur coal from the Powder River Basin? As the U.S. turns to alternative fuel like ethanol, BNI should benefit since they are one of the largest grain haulers in the U.S. Also, ethanol can’t be transported by traditional pipeline due to tainting by corrosive waters and other chemicals; rail service is the only way to go which will increase the company’s bottom line.
In addition Burlington Northern is:
- the largest transporter of aircraft parts by rail in the United States.
- the largest transporter of beer and wine by rail in the United States.
- serves more of the nation's major grain-producing regions than any other railroad.
- one of the largest grain-hauling railroads in the United States.
Due to their extensive network of tracks, the intermodal business should see an increase in earnings and revenue. Since BNI operates in the western half of the U.S, goods delivered to ports in the West Coast (Seattle, WA, Los Angeles and Long Beach, CA.) can easily be transported via the company’s current track system. Due to the cost of higher gas prices, traffic congestion and driver shortages; rail is becoming a cheaper and quicker alternative form of transporting goods. The average Burlington Northern intermodal train moves the equivalent of what 220 trucks could move at a rate of 760 miles per day—200 miles more than single-driver truck service. During the peak season between Thanksgiving and Christmas, Burlington Northern moved more than 50 million packages for UPS.
Good Management
Matthew Rose has been in the conductor’s seat (as Chairman, President and CEO) since the end of 2000. Under his management, Rose and his team have been able to increase shareholder value by:
- Increasing operating margins from 29.7 percent in 2001 to 31 percent in 2006
- Increasing net profit margins from 8.8 percent in 2001 to 13 percent in 2006
- Increasing ROE from 10.4 percent in 2001 to 18 percent in 2006
- Shares outstanding have decreased from 391 million at the end of 2000 to 358 in 2006
- Generated Free Cash Flow of over $1 billion in 2006
Attractive Price
Buffett paid an average of $81.50 per share. While I don’t know what projections he used to come up with that price, I have been able to come pretty close in my own calculations of an attractive price. Over the next five years, based on growth in all three facets of the company’s earnings segments, I projected Burlington Northern to grow EPS by 12.5 percent per annum which is lower than most analysts’ five projections of 14 percent. Over the past five years the stock has been trading at a P/E high of 23 and a low of 11. I used a conservative P/E of 13, which is closer to the five year low. Based on Buffett requiring at least a 10 percent ROI, an attractive price to buy the stock would be between $79-$80 per share, a little lower than his average cost.
Conclusion
Burlington Northern seems to be a play on a theme that Buffett and Munger have been shifting towards over the past several years–energy. It fits right in the stock portfolio’s energy holdings with Conoco Phillips and PetroChina. It also makes sense given Berkshire’s current MidAmerican Energy holdings. If fuel prices remain high, alternatives like coal and ethanol will certainly rise. The hauler of choice would be Burlington Northern.
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Charles Mizrahi is the managing partner of CGM Partners, LP. He is also editor and publisher of Hidden Values Alert newsletter, which focuses on finding stocks trading significantly lower than their underlying business value. His latest book is Getting Started in Value Investing (Wiley 2007) is available on Amazon.com and in fine bookstores. Email: charles@hiddenvaluesalert.com Webpage: www.HiddenValuesAlert.com
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The increasing margins/ROE/profitability over the last few years have very likely been due to the strong economy, higher demand for commodities and increasing price of gas which has made rail transport more favorable. And the free cash flow of $1B gives a price/FCF of 30!!! Not cheap.
With all due respect, I highly doubt the reasons you suggested prompted WB to buy the stock. The competitive advantages of BNI have always been there. Why buy the stock now? Specially since it has already TRIPPLED in price since 2003!!!.
Based on common valuation yardsticks, the stock is not cheap for a railroad business. Again, I think very likely there are other deeper reasons for the buy.
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I believe the reasons are:
- BNI is in an investment/upgrade phase which will last 3-5 years. Excluding capex, adding back share repurchases, BNI is currently selling at around 10-12 times cash flow.
- The capex investments will lead to higher volumes.
- BNI have been and will be able to increase prices as long as imports from China continue to grow faster than rail capacity. let's be precise and say this situation will last many years...
- With these assumptions - volume and price/unit growth, BNI at 80 dollar translates into a price to cash flow of 5-6 in say 5 years time. I believe this is why Buffett is buying.
- Add to this an aggressive share repurchase program.
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what is Buffett's other pick?
In my opinion it is MA
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Maintenance cap-ex is very high for railroads (15% of sales on average according to Morningstar). That's money that needs to be spent every year just to maintain the existing business.
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Sgeranpa- regarding your comment on why Buffett bought BNI, you said: "I think very likely there are other deeper reasons for the buy". I humbly disagree. Buffett's stock selections have been anything but deep. From Coca-Cola (greatest brand in the world at a discount) to PetroChina (cheap as compared to other oil companies) Buffett's reasons have been far from complex.
There are only 6 carriers with little geographic overlap. This alone makes for the kind of company Buffett likes. If we speculate on the tie in with energy, it's not too much of a stretch.
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