In my previous two articles, I summarized the structural industry changes that were leading up to Berkshire Hathaway (BRK.A)(BRK.B)’s acquisition of Burlington Northern Santa Fe. Given there are a few major players in the North America railroad industry, a natural question one may ask is, “Why BNSF?” This article is an attempt to analyze the purchase of BNSF from both a business quality perspective and a valuation perspective.
While it is tempting to fixate on the competitive advantages obtained by the railroad industry as a whole, such as the newly developed pricing power and being more environmentally friendly than trucks, these competitive advantages are shared by all major railroads, not just particular to BNSF.
In searching for the most important factors, I stumbled onto a BNSF unit train that was loaded with tank cars filled with crude oil. A little further research revealed that BNSF actually ships a large quantity of crude oil and LNGs. In talking to Becky Quick on March 4, 2013, just prior to the shareholder meeting, Buffett said:
“BNSF is well situated with respect to where oil has been found. We (BNSF) are carrying 10% of the oil that is moving in the lower continental United States. We’ve got about 7 unit trains a day and a unit train is about 100 cars and there are six or seven hundred barrels per car. We’ve got seven of them moving everyday but that number of unit trains is going to increase as production increases further in the Bakken particularly. Rail has turned out to be a pretty good way of moving oil in this economy because there are such differences in what oil is worth in given refineries and rail is more flexible than pipelines in terms of moving oil around.” He further mentioned that “incidentally oil moves faster on trains than it is on pipeline and in a certainly more flexible manner and the oil producers are pretty happy with the oil services they are getting.“
Now here is something interesting, BNSF serves about 30 percent of U.S. oil refineries and it is one of only two major carriers, along with Canadian Pacific Railway Ltd. (CP), with tracks into the Bakken region. Its main competitors, such as Union Pacific, have to exchange carloads with BNSF or Canadian Pacific to move oil to refineries on its network. Common sense would suggest that it is far more profitable if oil stays on a railroad’s tracks for the full trip than if otherwise.
If I have to guess, Buffett brilliantly observed prior to the purchase of BNSF the in-progress U.S. energy-independence secular trend and in particular, the guaranteed increase in shipping demand for hydraulic fracturing sand, pipe and crude in the Bakken region. The result? Oil production in the Bakken region has more than tripled since his purchase of BNSF, which has led to a corresponding surge in demand for the shipping of oil.
In addition to the oil factor, with a dominant position in the West, BNSF has also benefited from very strong growth in coal shipments, grain exports, and surging imports of consumer goods from China, which often arrives at the west coast. However, these benefits are also shared by its biggest competitor in the west, Union Pacific (UP).
From the valuation perspective, BNSF was almost the cheapest among all the major players when Buffett started accumulate its shares. Below are some charts from JPMorgan’s research reports back in 2005:
From the above charts, we can tell that although BNSF had the best revenue growth, second to best EPS growth, ROIC and EPS growth among the big railroad players, it was trading at the lowest P/E multiples. This is probably because historically, BNSF has been trading at a lower multiple compared to its peers, so the analysts were less enthusiastic about the business at 12.5 times earnings, which served Buffett very well when he first started accumulating shares of BNSF.
In making the BNSF investment decision, the Oracle shrewdly observed the structural industry change, he was prescient on the impeding surge of oil shipping demand and he paid a fair price for a wonderful business.
One may think the above explanations sound too simple to be true. Indeed, it is simple yet incredibly hard, like almost all other Buffett’s investments. Knowledge accumulation and the right temperament are key determinants in making such investment decisions. The BNSF study provides another great example of this combination and I hope the readers have found this article series helpful.