Here is a fun fact: Burlington Northern Santa Fe is Berkshire Hathaway (BRK.A)(BRK.B)’s largest acquisition so far with a $44 billion price tag. Buffett claimed that he has stretched to the last nickel for this one.
Here is another fun fact: I was ignorant of the above fact until yesterday.
How I wish that I had found out about this earlier as I was immediately intrigued by this acquisition. Not because Buffett paid $44 billion for it, but because it was for a railroad. My search for an explanation turned out to be disappointing. While there are a lot of articles out there about the BNSF acquisition, none of them provided me with a satisfactory answer. Therefore, I decided to embark upon what proved to be the most time-consuming case study I have ever done, with tremendous trepidation.
Before we get into the details, I feel obligated to admit that I am not a railroad expert and this article is nothing more than a novice value investor’s attempt to reverse engineer Buffett’s rationale for buying BNSF.
With the above qualification, I’d like to start the BNSF adventure. As this will be a fairly lengthy article if put together as one piece, it may serve the readers better to dissect it into a few parts. In the first part of the case study, I’d like to establish the thesis for BNSF using Buffett’s own words. Fortunately, the Oracle laid out his thesis nicely during an interview with Charlie Rose:
CHARLIE ROSE: But you just pulled out the big elephant gun.
WARREN BUFFETT: Well, we may have used most of our powder on that one.
CHARLIE ROSE: You said I stretched to the last nickel for this one.
WARREN BUFFETT: Yes.
CHARLIE ROSE: Why did you do it?
WARREN BUFFETT: Well, I felt it was an opportunity to buy a business that is going to be around for 100 or 200 years, that’s interwoven with the American economy in a way that if the American economy prospers, the business will prosper. It is the most efficient way of moving goods in the country. It is the most environmentally friendly way of moving goods, and both those things are going to be very important.
But the biggest thing is the U.S. is going to do well. I mean, we can’t move the railroad to China or India. They haven’t figured out how to do that. So you know, it’s sort of like if you remember that song about New York — we have to make it here or we can’t make it anywhere.
CHARLIE ROSE: Frank Sinatra.
WARREN BUFFETT: But it does move 400 — it moves a ton of goods 470 miles on one gallon of diesel. It replaces — a train replaces 280 trucks on the road. It emits far less into the atmosphere that’s damaging than trucking, and it moves — I’m talking about the whole rail industry — it moves 40 percent of the goods
CHARLIE ROSE: And you have new ports of entry like Houston that are bringing a lot of goods...
WARREN BUFFETT: Oh, sure.
CHARLIE ROSE: through the Panama canal.
WARREN BUFFETT: And we’re going to have more people in this country and they’re going to be using more goods over time. And sure, there’s a bad year from time to time. In the next 100 years, there will probably be 15 bad years, and I don’t know what order they’ll appear, but I also know the railroads will be essential to the country.
CHARLIE ROSE: Now, when you called Charlie Munger and said I’m thinking about this, did he say right on, Warren? Or did he say, how about this?
WARREN BUFFETT: Well, if Charlie said "right on, Warren," I would figure I had the wrong number. No, that would be a wrong number.
CHARLIE ROSE: That’s not the likely reply.
WARREN BUFFETT: That might be my wife or my, you know — but Charlie gave kind of a low-level grumble, and that is a real endorsement from Charlie.
CHARLIE ROSE: But I mean, he also pointed out, it is said, that, you know, there was — this was a regulated industry.
WARREN BUFFETT: Sure.
CHARLIE ROSE: This was an industry that was capital-intensive.
WARREN BUFFETT: Very capital-intensive.
CHARLIE ROSE: This was an industry...
WARREN BUFFETT: You spend money...
CHARLIE ROSE: That was unionized.
WARREN BUFFETT: It was unionized. You spend money in this business of money to repair track, add capital-intensive, and it is regularly every day. You’re spending a lot rolling stock, whatever it may be. So it’s regulated, and it will continue to be regulated, and it will continue to be capital-intensive.
I think that what the service provided by railroads is so important in many ways. I mean, it’s the right way to move goods around the country to the extent that you can do it. And it’s far, far more attractive in terms of global warming than using trucks, for example. So it will be here, and if we get a reasonable return on the added capital investment — because it will take added capital investment — we’ll do OK.
CHARLIE ROSE: Reasonable return is good enough?
WARREN BUFFETT: Reasonable return is good enough, Charlie. I mean, 50 years ago, I was looking for spectacular returns, but I can’t — I can’t get them. We have — we have eight or $10 billion to invest every year.
And we’re in the utility business, and it’s the same thing there. When we build electric generation or something of the sort, we shouldn’t expect a spectacular return. We’re building things that are essential to society, and people need our services. They really don’t have any choice in the case of the electric utilities, for example, and sometimes in case of rail. And we should get a decent return on that. Enough to encourage us to keep putting money into the business, but we’re not entitled to spectacular returns.
CHARLIE ROSE: You carry coal?
WARREN BUFFETT: Well, that’s a big one in terms of tonnage, yes.
CHARLIE ROSE: And if, in fact, we wean ourselves off coal, is that a big problem?
WARREN BUFFETT: Well, we will wean ourselves off coal over time. We can’t change 40 percent of electric generation that goes — that comes from coal. We can’t change that next week or next month or next year, but we will reduce it over times, and we should reduce it over time.
CHARLIE ROSE: And you can add other things to carry and changes will be...
WARREN BUFFETT: There will be more grain to move, and there will be more all kinds — chemicals — or whatever it may be. There will be more things moving around this country 10 or 20 or 30 years from now.
CHARLIE ROSE: Knowing your idea about moats, is that no one is likely to get into the railroad business?
WARREN BUFFETT: If they wanted to reproduce the Santa Fe, it might take $100 billion or so.
CHARLIE ROSE: And 100 billion years.
WARREN BUFFETT: They’d have to be a real sport.
CHARLIE ROSE: And they are also modernized today, are they not?
WARREN BUFFETT: Enormously. Enormously. The railroads — take a railroad like BNSF. They’re moving far more ton miles of product with less in the way of people, less in the way of fuel. Railroads have become far more efficient over the years. There were a million and a half people employed in the rail industry after World War II. Now there are about — less than 200,000 in the United States, and they’re moving far more goods. So it’s really become efficient. You watch those 130-unit trains double stacked...
CHARLIE ROSE: You had other railroad companies in your portfolio.
WARREN BUFFETT: Right.
CHARLIE ROSE: You’re selling them?
WARREN BUFFETT: I’ve already sold them. Yes. I’ve done that just to facilitate the transaction. I think they’re good investments, but I would have held them if this hadn’t happened.
In addition to the Charlie Rose interview, Buffett also explained the BNSF business model nicely in the 2009 letter to shareholders:
“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. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant.
We see a 'social compact' existing between the public and our railroad business, just as is the case with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to the compact should – and we believe will – understand the benefit of behaving in a way that encourages good behavior by the other. It is inconceivable that our country will realize anything close to its full economic potential without its possessing first-class electricity and railroad systems. We will do our part to see that they exist.
In the future, BNSF results will be included in this 'regulated utility' section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.”
As it is always the case, the Oracle made it sound so easy. Essentially, BNSF is a capital intensive, heavily regulated and unionized business that provides services to society that are efficient, more environmental friendly than trucks, and irreplaceable. It has a wide moat based on extremely high barrier to entry due to very high asset replacement cost, and it will earn a satisfactory return on investment.
But why railroads? Why did Buffett choose BNSF over Union Pacific or CSX? Why did Buffett start buying it in 2005, not 1995? How did Buffett establish the position in five years? Is BNSF a great business? Is $44 billion a wonderful price or a fair price?
To be continued.