In my last article of this series, I summarized the thesis of Berkshire (BRK.A)(BRK.B)’s BNSF acquisition using Warren Buffett’s own words. By now we should have a decent understanding of the major driving forces behind this investment, as general as they are. The purpose of this article is to explore the secular changes that were taking place in the railroads industry prior to the acquisition. Not surprisingly, being a great business historian himself, Buffett certainly was on the alert to acquaint himself with new conditions affecting the railroad industry.
While the history of the U.S. railroad industry is fascinating, for the purpose of this article, it is enough to know that by the 1970s, excessive regulations, intense competition from trucks and barges, and changing shipping patterns have driven railroads to the brink of ruin and the railroads were reborn after the Staggers Act of 1980, which created a more balanced and reasonable regulatory environment for railroads.
The following chart illustrates the effect of the Stagger Act.
What I found intriguing about the above chart is that from the early 1980s to the early 2000s, while productivity and volume increased dramatically, revenue and rates have actually decreased. But from around the start of the 21st century, revenue and rates first stabilized, then gradually increased. Incidentally, Buffett started to accumulate BNSF’s stock when the rates and revenues have just started to show improvements.
If I were an investor in 2004, I would be concerned with whether the rates increases were temporary or structural. And in order to answer that questions, we need to understand the forces behind the rate decreases that have lasted about a score of years as well as the reasons for the rate increases from the early 2000s.
It appears that the downward pressure on rates during the 20-year period is a result of railroad efficiency improvements and competitive pricing. According to a study (GAO-07-94) conducted by the United States Government Accountability Office, specific factors that have caused the rate decreases include:
• The rationalization of the rail network, with abandonments and creations of short line or regional railroads decreasing costs while maintaining much of the original traffic.
• The increase in trainload shipments.
• The shifts to larger-capacity rail cars and technology innovations.
Freight railroads have also cut costs by streamlining their workforces: rightsizing their rail track miles, equipment, and facilities to more closely match demand. While operating costs have decreased due to increased efficiency, the cost savings were passed on to railroad’s customers by means of rates reductions.
As Buffett followers, we all know that the number one factor Buffett looks at a business in terms of moat is pricing power. Therefore, it is no surprise here that Buffett started to accumulate BNSF’s stocks just when the confluence of a few factors gave railroads more pricing power.
The dominating factor is the popularization of double-stack rail cars and intermodal containers, coupled with increased speed of globalization. As Charlie Munger mentioned during the 2007 Wesco meeting:
“Now (railroads) is an example of changing our minds. Warren and I have hated railroads our entire life. They're capital-intensive, heavily unionized, with some make-work rules, heavily regulated, and long competed with a comparative disadvantage vs. the trucking industry, which has a very efficient method of propulsion (diesel engines) and uses free public roads. Railroads have long been a terrible business and have been lousy for investors. We did finally change our minds and invested. We threw out our paradigms, but did it too late. We should have done it two years ago, but we were too stupid to do it at the most ideal time. There's a German saying: Man is too soon old and too late smart. We were too late smart. We finally realized that railroads now have a huge competitive advantage, with double stacked railcars, guided by computers, moving more and more production from China, etc. They have a big advantage over truckers in huge classes of business.”
Another important factor that contributed to the rate increases is the consolidation in the industry that took place in the 1980s and 1990s. The following is a list of major railroads mergers and acquisitions from wikipedia:
-Union Pacific acquired the Missouri Pacific and Missouri–Kansas–Texas Railroad in the 1980s and the Southern Pacific in 1996.
-CSX was formed in 1986 from the Chessie System and the Seaboard System.
-BNSF Railway was formed in 1996 from the Atchison, Topeka and Santa Fe (the "Santa Fe") and Burlington Northern.
-Norfolk Southern was formed in 1982 from the Norfolk and Western and Southern Railway.
-Canadian Pacific acquired the Delaware and Hudson in 1991.
-Canadian National acquired the Illinois Central in 1996.
-CSX and Norfolk Southern acquired most of the Conrail freight rail assets in 1997.
The result of the consolidation is more pricing power for the largest players as they control the markets. The following graph illustrates the market share information for the largest class I railroads from 1985 to 2004:
As we can tell from the above graph. The largest four class I railroads controlled 89% of the revenue and 80% of tonnage of the railroads market in 2004, compared to below 50% in 1985. This level of concentration gave them tremendous price negotiation power.
Now it is clear that the combination of the improved penetration of intermodal containers and double stacked cars and industry consolidation changed the landscape of the railroad industry dramatically. This has caught Warren Buffett (Trades, Portfolio) and Charlie Munger’s attention. But instead of buying all the largest players, they chose Burlington Northern Santa Fe. Why?
This will be explored in the next part of this series.
To be continued…