I recall very clearly late in 2008 when my admiration for Warren Buffett as an investor reached even higher levels than ever before. For 2005, 2006 and 2007 I watched as Buffett sat with tens of billions of dollars on the Berkshire Hathaway balance sheet earning virtually nothing. Then all through 2008 Buffett was able to invest that cash at progressively higher rates of return.
Make no mistake, Buffett was not like Michael Burry or Steve Eisman and saw the huge financial collapse coming. I remember very vividly watching him on CNBC in mid 2007 where he said he thought a recession was unlikely. But he was waiting for a big opportunity, not sure when, why or how that opportunity would arrive.
It takes incredible discipline to sit and wait. I’m sure there were plenty of decent opportunities that Buffett passed on while waiting, but having cash when nobody else does is the best way to amplify your returns.
Given my level of admiration for Buffett I was somewhat annoyed when I read this from Bruce Greenwald immediately after Buffett completed the $26 billion acquisition of Burlington Northern:
“I know you own Berkshire Hathaway, so I have to ask you what you think about Buffett’s purchase of Burlington Northern.
It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.
Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times. Our calculation is he was paying 21-times.
Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.
The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.
There is nothing special about the railroads. It’s entirely an energy play.
If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.
We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.
It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75/share, we thought there were better oil plays. At $100/share we think he has lost his mind.
When I read to myself I thought the following:
- Buffett has likely been reading Burlington Northern annual reports and railroad trade publications for 50 years
- Buffett is the greatest investor of all time
- Buffett has been sitting on this $30 billion for the better part of a decade looking for an elephant and this is what he thinks an elephant looks like
- Given that Buffett is the greatest investor and likely knows Burlington better than anyone on the planet is the likely conclusion to be drawn here that
1) Buffett has lost his mind ?
2) Or maybe Greenwald isn’t able to see what Buffett sees ?
That was actually a rhetorical question. I was pretty sure that number 2 was the correct answer.
So I thought it was interesting this weekend when Barron’s provided an update on the Burlington acquisition:
“The Burlington deal looks like one of Buffett's best, done in November 2009, when the economy was just starting to recover and there was little competition from private-equity or other buyers. Berkshire offered a 33% premium, paying $26.4 billion for the 77.4% of the company that it didn't already own. That initially looked overly generous, at about 20 times then-current estimates of 2010 profits. Yet Burlington's earnings -- and those of the rest of the railroad industry -- surged in 2010 and are expected to increase another 15% or so this year. Burlington could earn $3 billion after taxes in 2011 -- it netted $706 million in the third quarter. So, Berkshire paid only about 11 times projected 2011 profits for Burlington. Burlington probably is worth $40 billion to $45 billion now.”
With oil now at $90 and potentially heading higher the competitive advantage Burlington has over trucking transport of goods is likely to lead to continued earnings growth for many years into the future.
So what do you think Bruce ? Did Warren go crazy with this acquisition ? Or were you just not able to see what Buffett was seeing ?