Everybody likes to be a critic! So you better believe that no one in life is ever exempt from receiving criticism. That’s right! Not even Warren Buffet is exempt.
I would like to rebuttal some of the criticisms drawn at Warren Buffett’s BNSF deal and highlight some items that might show us that it was a smart move afterall.
Though, I should mention, the criticisms of his purchase are not without merit, in fact, many experts have been quick to highlight the accounting discrepancies which overstate the true economic value of railroad assets over time which are indeed an unfortunate business reality.
Bruce Greenwald states:
”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.”
What is interesting is that Greenwald is almost speaking with a certainty that assumes Warren Buffett is completely ignorant to these items, when in fact, this is not the case. He obviously knew the economic shortcomings of BNSF before consummating the acquisition.
Buffet states:
“Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come….”
Having said all that, I would like to go on and discuss the competitive advantages that BNSF’s operation brings to the table when it becomes a wholly owned subsidiary of a parent company and NOT an isolated investment.
BNSF RECALIBRATES BERKSHIRE HATHAWAY FOR 200 YEARS OF CONTINUED GROWTH
Think of a wholly owned capital intensive business like a key railroad company such as BNSF as the irritant sandpaper that ironically makes a piece of wood smoothed out, and fine looking. The piece of wood I am referring to is Berkshire Hathaway. And in this piece of wood are smaller pieces of wood, which we’ll call subsidiary companies.
We can all agree that the long-term profits of any company dramatically depend on the intensity of competitive forces circulating in that industry as a function of the underlying market economics that structure that industry and thus dictate its growth or stagnation.
As you most likely know, these competitive forces are:
i) Power of Suppliers
ii) Power of Buyers
iii) Threat of Substitutes
iv) Current Industry Competitors
v) Threat of New Entry
And we also know, the collective strength of these forces determines the ultimate profit potential in an industry.
BSNF Insulates Berkshire’s Subsidiaries
Since Berkshire Hathaway is like a microcosm of a country’s economy – a part of its operational portfolio (though minor relative to its insurance segment but important nonetheless) is tied to the industrial and energy sector of the economy.
Right away the BNSF acquisition diversifies Berkshire’s portfolio and dilutes its insurance weighting. Secondly, it regenerates the competitive capacity of all its industrial and energy subsidiaries, especially MidAmerican, PacifiCorp, Marmon, etc.
In a market category where the products and services are undifferentiated and compete on price there needs to be some competitive strategy put into place that can perform 4 critical tasks:
i) Holds your customers captive,
ii) Creates barriers to entry,
iii) Increases your bargaining position with suppliers and buyers
iv) Offers customer value in which your competitors cannot match.
Burlington Northern Sante Fe does just this!
Holding Your Customers Captive by Restoring the Competitive Performance in a Mature Industry
Many industries will pass from rapid growth to slow growth as the industry matures. It’s a common occurrence that an influx of firms over time will dilute the profit potential of a particular industry. Therefore, a slow growth environment is a highly competitive one that requires firms to fundamentally change and transform their strategic posture.
Competition shifts toward greater emphasis on cost and service in mature industries such as industrial and energy plays because many of the buyers are mature themselves. As time passes, buyers become more sophisticated and have more supplier options due to all the new firms that have entered the industry. In this environment, these buyers are cost and service orientated.
The nature of Berkshire’s relationship with its subsidiaries should be one where the parent company will influence (maybe not to a great extent) Burlington Northern to act more favourably to the business objectives of its fellow sister companies, namely:
BNSF Creates Barriers to Entry
Because Burlington does more intermodal freight traffic than any railroad network in the world – because it can haul 1 ton of freight on 1 gallon of diesel for 495 miles – because it hauls the coal that powers 1 in every 10 American households – because it hauls 945,000 carloads of agricultural products a year – because 1 intermodal train replaces 280 trucks on the highway – because it would take 200 billion dollars to reproduce its assets – it has some great franchise value that inevitably acts as a barrier to entry.
This franchise value is tested by the fact that Burlington is able to continually raise prices and their customers just accept the premium as the cost of doing business with an unmatched extensive railroad network. While they welcome more customers, they are in a position to offer higher prices to Berkshire subsidiary competitors and in turn establish an “entry deterring price” for certain new firms that require Burlington’s channel capacities in order to rival certain Berkshire industrial and energy companies.
Increasing Bargaining Power with Suppliers & Buyers
If you think about it, its kinda crazy - Berkshire Hathaway controls the logistical network of every important buyer and supplier whose combined economic activities, are essential to the well-being and prosperity of America and its Foreign Business Partners (ie. China)
A parent company can influence the intrinsic bargaining power that its subsidiary companies have with suppliers and buyers precisely because they have captive distribution channels which can hinder rival product flow, industry information flow, increase transportation costs by high price ceilings, cause excess capacity and inventory write-downs in non-multi unit business organizations due to lower shipment priority. Because Burlington Northern ships 65% of America’s coal, this example would be more relevant to coal companies that compete with MidAmerican.
In aggregate, BNSF is a powerful supplier that over time, can squeeze out the profits of industries because it enjoys economies of scale bargaining power due to the following factors:
i) It is not obliged to contend with a superior substitute supplier; it's freight network is unrivaled
ii) It is not dominated by any one key massive buyer.
iii) Because it sells to multiple industries, no one industry respesents a significant fraction of its sales.
iv) It's service is an all important input to the buyer's business.
Additionally, Berkshire can sit on the fence now and enjoy the mutual benefits of the business relationship between China (Supplier) and America (Buyer). The higher the growth potential of a buyer or supplier – the more probably its demand for the firm’s product (transportation) will increase over time.
Over the span of 100 years, the unit operating cost per ton of hauled freight on railroads will decrease relative to its trucking peers. This has a lot to do with car stacking, fuel efficiencies, train upgrades.
BNSF is sheer value
Although Warren may have paid 17 or 21 times earnings for a capital intensive company, alternatively, you can also look at it by saying he paid $0.89 for every 1 dollar of assets for a company that breathes new competitive life into his subsidiaries.
Isolated as an investment for an Investor, it’s probably not that great. But for a CEO who wants to control certain supply chain segments so as to make his subsidiaries positioned to be lost cost, high service providers is a good business move.
I close by saying this: 1 year to us must be 1 second to God. Similarly, for a corporate organism with the size and magnitude of Berkshire Hathaway, investment timeframes must be judged not by 10 years, not even by 20, but by possibly even 100 years! We know that America will grow over time, we know that China will grow over time. But if we zero in on the essential economic cell that will facilitate their respective growth over time, it’s the good ol' fashion rail system that will make this process happen.
Check back in 100 years!
Carson for Stockrip.com
I would like to rebuttal some of the criticisms drawn at Warren Buffett’s BNSF deal and highlight some items that might show us that it was a smart move afterall.
Though, I should mention, the criticisms of his purchase are not without merit, in fact, many experts have been quick to highlight the accounting discrepancies which overstate the true economic value of railroad assets over time which are indeed an unfortunate business reality.
Bruce Greenwald states:
”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.”
What is interesting is that Greenwald is almost speaking with a certainty that assumes Warren Buffett is completely ignorant to these items, when in fact, this is not the case. He obviously knew the economic shortcomings of BNSF before consummating the acquisition.
Buffet states:
“Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come….”
Having said all that, I would like to go on and discuss the competitive advantages that BNSF’s operation brings to the table when it becomes a wholly owned subsidiary of a parent company and NOT an isolated investment.
BNSF RECALIBRATES BERKSHIRE HATHAWAY FOR 200 YEARS OF CONTINUED GROWTH
Think of a wholly owned capital intensive business like a key railroad company such as BNSF as the irritant sandpaper that ironically makes a piece of wood smoothed out, and fine looking. The piece of wood I am referring to is Berkshire Hathaway. And in this piece of wood are smaller pieces of wood, which we’ll call subsidiary companies.
We can all agree that the long-term profits of any company dramatically depend on the intensity of competitive forces circulating in that industry as a function of the underlying market economics that structure that industry and thus dictate its growth or stagnation.
As you most likely know, these competitive forces are:
i) Power of Suppliers
ii) Power of Buyers
iii) Threat of Substitutes
iv) Current Industry Competitors
v) Threat of New Entry
And we also know, the collective strength of these forces determines the ultimate profit potential in an industry.
BSNF Insulates Berkshire’s Subsidiaries
Since Berkshire Hathaway is like a microcosm of a country’s economy – a part of its operational portfolio (though minor relative to its insurance segment but important nonetheless) is tied to the industrial and energy sector of the economy.
Right away the BNSF acquisition diversifies Berkshire’s portfolio and dilutes its insurance weighting. Secondly, it regenerates the competitive capacity of all its industrial and energy subsidiaries, especially MidAmerican, PacifiCorp, Marmon, etc.
In a market category where the products and services are undifferentiated and compete on price there needs to be some competitive strategy put into place that can perform 4 critical tasks:
i) Holds your customers captive,
ii) Creates barriers to entry,
iii) Increases your bargaining position with suppliers and buyers
iv) Offers customer value in which your competitors cannot match.
Burlington Northern Sante Fe does just this!
Holding Your Customers Captive by Restoring the Competitive Performance in a Mature Industry
Many industries will pass from rapid growth to slow growth as the industry matures. It’s a common occurrence that an influx of firms over time will dilute the profit potential of a particular industry. Therefore, a slow growth environment is a highly competitive one that requires firms to fundamentally change and transform their strategic posture.
Competition shifts toward greater emphasis on cost and service in mature industries such as industrial and energy plays because many of the buyers are mature themselves. As time passes, buyers become more sophisticated and have more supplier options due to all the new firms that have entered the industry. In this environment, these buyers are cost and service orientated.
The nature of Berkshire’s relationship with its subsidiaries should be one where the parent company will influence (maybe not to a great extent) Burlington Northern to act more favourably to the business objectives of its fellow sister companies, namely:
- Introduce specialized BNSF freight contracts for Berkshire subsidiary companies that:
- Reduce transportation costs markedly and expand margins above the industry standard.
- Increase the scale and efficiency of their distribution network.
- Offer special logistical arrangements for the customers of Berkshire subsidiaries Have specialized access to key locations that house key raw materials
- Integrate the purchase of raw goods between two or more sister companies that use the same raw material so as to increase saving by volume orders
BNSF Creates Barriers to Entry
Because Burlington does more intermodal freight traffic than any railroad network in the world – because it can haul 1 ton of freight on 1 gallon of diesel for 495 miles – because it hauls the coal that powers 1 in every 10 American households – because it hauls 945,000 carloads of agricultural products a year – because 1 intermodal train replaces 280 trucks on the highway – because it would take 200 billion dollars to reproduce its assets – it has some great franchise value that inevitably acts as a barrier to entry.
This franchise value is tested by the fact that Burlington is able to continually raise prices and their customers just accept the premium as the cost of doing business with an unmatched extensive railroad network. While they welcome more customers, they are in a position to offer higher prices to Berkshire subsidiary competitors and in turn establish an “entry deterring price” for certain new firms that require Burlington’s channel capacities in order to rival certain Berkshire industrial and energy companies.
Increasing Bargaining Power with Suppliers & Buyers
If you think about it, its kinda crazy - Berkshire Hathaway controls the logistical network of every important buyer and supplier whose combined economic activities, are essential to the well-being and prosperity of America and its Foreign Business Partners (ie. China)
A parent company can influence the intrinsic bargaining power that its subsidiary companies have with suppliers and buyers precisely because they have captive distribution channels which can hinder rival product flow, industry information flow, increase transportation costs by high price ceilings, cause excess capacity and inventory write-downs in non-multi unit business organizations due to lower shipment priority. Because Burlington Northern ships 65% of America’s coal, this example would be more relevant to coal companies that compete with MidAmerican.
In aggregate, BNSF is a powerful supplier that over time, can squeeze out the profits of industries because it enjoys economies of scale bargaining power due to the following factors:
i) It is not obliged to contend with a superior substitute supplier; it's freight network is unrivaled
ii) It is not dominated by any one key massive buyer.
iii) Because it sells to multiple industries, no one industry respesents a significant fraction of its sales.
iv) It's service is an all important input to the buyer's business.
Additionally, Berkshire can sit on the fence now and enjoy the mutual benefits of the business relationship between China (Supplier) and America (Buyer). The higher the growth potential of a buyer or supplier – the more probably its demand for the firm’s product (transportation) will increase over time.
Over the span of 100 years, the unit operating cost per ton of hauled freight on railroads will decrease relative to its trucking peers. This has a lot to do with car stacking, fuel efficiencies, train upgrades.
BNSF is sheer value
Although Warren may have paid 17 or 21 times earnings for a capital intensive company, alternatively, you can also look at it by saying he paid $0.89 for every 1 dollar of assets for a company that breathes new competitive life into his subsidiaries.
Isolated as an investment for an Investor, it’s probably not that great. But for a CEO who wants to control certain supply chain segments so as to make his subsidiaries positioned to be lost cost, high service providers is a good business move.
I close by saying this: 1 year to us must be 1 second to God. Similarly, for a corporate organism with the size and magnitude of Berkshire Hathaway, investment timeframes must be judged not by 10 years, not even by 20, but by possibly even 100 years! We know that America will grow over time, we know that China will grow over time. But if we zero in on the essential economic cell that will facilitate their respective growth over time, it’s the good ol' fashion rail system that will make this process happen.
Check back in 100 years!
Carson for Stockrip.com
