In 2010 Warren Buffett (Trades, Portfolio) bought Burlington Northern Sante Fe Railroad (BNSF). It was well positioned to benefit from the fracking boom and generated substantial cash flow for Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
However, the subsequent collapse in oil prices has turned BNSF from a crown jewel into a (probably temporary) trouble spot for Berkshire. With the oil and gas-driven boom over (for now) and coal shipments steadily declining, railroads are trading cheaper than they have in years. So, is now a good time for an investor to follow Buffett’s footsteps and buy stock in a railroad?
The table below shows some of the largest railroads traded on major U.S. stock exchanges.
(Data via Morningstar.com, Yahoo! (YHOO, Financial) Finance, and SEC filings)
Most railroads are trading at below market multiples based on trailing and forward earnings, and most pay above average dividends.
There is a lot to like about railroads. Railroads are pretty much the only way to move large volumes of heavy freight across long distances so they have a natural monopoly when it comes to some kinds of transportation. The U.S. is a large country and a significant importer so railroads are critical for moving freight from coastal ports to inland distribution centers. For smaller volumes, lighter freight and shorter distances, the trucking industry is a huge competitor.
Barriers to entry are high. It would be virtually impossible for someone to start a new Class I freight railroad today as it would require extraordinary levels of upfront investment and would likely be virtually impossible to assemble all of the track mileage needed to operate. The chart below from RailServe.com shows the total amount of route mileage that the Class I freight railroads operate.
Route miles have steadily decreased since peaking at the turn of the century before last. Class I railroads have been selling off lower density routes to Class II and Class III railroads but even taking into account those sales total route miles have decreased to approximately 137,000 miles. Essentially the railroads we have now are the railroads that we will have for the foreseeable future.
The map below shows the routes owned by the Class I railroads.
We can see that there is very little overlap, and most railroads are facing only two to four other competitors for major routes and perhaps one or two competitors for smaller routes.
The high barriers to entry and the oligopolistic nature of the railroad business should make the business attractive to investors except that there is one problem.
Railroad are capital intensive
The railroad business is extremely capital intensive. Railroads are forced to spend billions of dollars each year on upgrading and maintaining tracks as well as buying and maintaining new locomotives and rolling stock. The amount of money almost always increases each year and the capital expenditures railroads incur run ahead of their depreciation and amortization charges by almost 100%.
In the table below we show the depreciation and amortization charges for the Class I railroads compared to their cash capital expenditures for the past five years.
(Note: We converted CNI’s reported results to U.S. dollars using a conversion rate of .78 Canadian dollars to U.S. dollars.)
Over the past five years, the industry spent $58 billion on capex but only saw a $27 billion charge from depreciation and amortization. Whether this is an issue for investors depends on what the money is being spent for. If it’s mostly maintenance capital expenditures that are necessary to keep the business running, then it will make the stock of railroad companies appear cheaper than it is on a P/E basis. If the capital expenses are mainly for growth, then it’s not a very big deal as the money being spent today will translate into far higher earnings in the future.
During my research reading several railroad industry trade publications it seemed the vast bulk of the money being spent was maintenance capex. Money needed to keep the business running smoothly with growth in line with the economy. There is one area that I would classify as growth capex, and this is the money being spent on Positive Train Control or PTC. Every major railroad is spending about $300 million per year give or take (UNP $375 million, CSX $300 million, NSC $246 million, etc.) on PTC.
Positive Train Control is a system where the train receives information about its location, where it is allowed to travel and how fast it is allowed to go. Equipment on a train enforces this and will not allow a train to perform unsafe movement such as going too fast or traveling to an area where it is not allowed. I’d classify this as growth capex because it will allow the railroads to run more efficiently and safer in the future, which should translate into more profitable operations than today.
So what is the real earnings power of a railroad?
Valuing the railroads as Buffett would
To see how we should properly value a railroad let’s use Buffett’s idea of owner earnings. Owner earnings is similar to free cash flow but since this article has a Buffett theme we'll stick with owner earnings. In his 1986 letter to shareholders Buffett defined owner earnings as
“If we think through these questions, we can gain some insights about what may be called 'owner earnings.' These represent (a) reported earnings plus (b) depreciation, depletion, amortization and certain other noncash charges such as Company N’s items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment, etc., that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”
I randomly chose to look at Norfolk Southern Railroad (NSC, Financial). My calculation of owner earnings for fiscal year 2015 is below.
We took net income and added back depreciation and amortization, added back noncash charges and an $83 million benefit from a reduction in working capital. We subtracted $2.1 billion in maintenance capital expenditures (reported cap ex less $246 million in positive train control spending). That leaves us with $683 million in owner earnings.
Right now Norfolk Southern has a market cap of $25.25 billion. Using fiscal year 2015 earnings of $1.556 billion would give the stock a P/E of 16.22. If you used owner earnings the P/E would jump up to 36.96! Now I’m sure we could quibble over the maintenance capex figure and make good arguments over classifying some additional spending as growth capex and thus exclude it from our calculations. But even if we allow for say a $500 million swing NSC is still expensive based on owner earnings. The point isn’t that my numbers are exact; the point is that there is a vast gulf between reported net income and owner earnings (and free cash flow).
Summary
When using owner earnings (or free cash flow) railroads don’t appear to be very cheap. They are stable businesses and do pay attractive dividends so they might appeal to investors looking for income. While some of the dividends aren’t current covered by free cash flow they should be once oil prices rebound and rail traffic picks up. For example prior to the oil and gas downturn NSC generated cash from operations of $2.8 billion in fiscal year 2014 with capex of $2.1 billion and paid $687 million out in dividends leaving $47 million in cash left over. It’s also important to remember that railroads are selling investment, land and other property and equipment in dribs and drabs every year so that is another source of cash flow that is available to cover dividends and buybacks.
Right now railroads simply don’t appear cheap enough to warrant an investment. Investors looking for steady income may find them an acceptable investment. Railroads are certainly unlikely to be disrupted by competition and disappear the way Radio Shack, Blockbuster, Circuit City and countless other American businesses have so investors willing to sacrifice low absolute returns may find the prospect of steady dividends from a railroad to be attractive.
Disclosure: We hold no positions in CNI, CP, CSX, KSU, NSC, or UNP.
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