At the 2007 Wesco Annual shareholder meeting, Charlie Munger was asked about Berkshire’s purchase of a stake in Burlington Northern (BNI, Financial). Munger commented as follows, “Railroads – now that’s 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.
Bill Gates figured this out years before us – he invested in a Canadian railroad and made eight hundred percent. Maybe Gates should manage Berkshire’s money. This is a good example of how hard it is to change one’s mind and change entrenched thinking, but at last we did change. The world changed and, way too slowly, we recognized this.”
Since that purchase two years ago, Berkshire has added to its position and the stock is basically trading at the same price it was two years ago. Is it time for investors to get on board?
Company Description
Burlington Northern Santa Fe Corporation is a holding company. Through its subsidiaries, BNI is engaged primarily in the freight rail transportation business. BNSF Railway Company (BNSF Railway) is the Company’s principal operating subsidiary. BNSF Railway operates various facilities and equipment to support its transportation system, including its infrastructure and locomotives and freight cars. It also owns or leases other equipment to support rail operations, including containers, chassis and vehicles.
BNSF Railway operates one of the railroad networks in North America with approximately 32,000 route miles of track, excluding multiple main tracks, yard tracks and sidings, approximately 23,000 miles, of which are owned route miles, including easements, in 28 states and two Canadian provinces.
In 1980, the Staggers Act was signed that largely deregulated the railroad industry since the passage of the 1887 Interstate Commerce Act. Not surprisingly, the industry underwent significant consolidation over the next 20 years bringing the number of class I railroads (a railroad company with over $320 million revenues) from 30 businesses to seven today. In the United States, Burlington and Union Pacific effectively hold a duopoly over the western half of the country, while CSX and Norfolk Southern hold a duopoly over the eastern half of the United States.
Thesis
North American railroads own assets that are practically impossible to replicate. Even though there are tremendous barriers to entry, railroads generally failed to earn a return on their investment greater than their cost of capital. BNI, however has successfully generated returns on equity over 18% for the past few years and generated an average free cash yield of 7% for nearly ten years.
The competitive advantage of any railroad is its geography: BNI operates in defensive industries such as coal and agriculture. Additionally, Wyoming’s Powder River Basin is considered the cheapest form of energy in the country. With domestic power plants coming online, it is unlikely that demand for coal is going to decrease any time soon.
While it has a strong presence in the Powder River Basin, BNI also has the Southern Transcon line from Los Angeles to Chicago, which is well-positioned to respond to strong U.S. demand for Asian goods shipped by intermodal containers.
Furthermore, as Morningstar highlights, BNI stands to benefit from the repricing of older contracts that are approaching expiration. Old contracts were signed before the rail renaissance of the past few years, and many agreements predate the widespread use of effective fuel surcharges. Two thirds of coal contracts expire within four years, presenting an opportunity for BNSF to expand earnings by instituting higher contract prices in today's favorable rail market.
Valuation and Conclusion
With a weak economy, yes, revenues have fallen as have earnings. When the economy turns is anyone’s guess. As Munger mentioned above, these are capital intensive businesses. However, are P/E ratios and EBITDA multiples the right way to analyze Burlington?
To truly appreciate why Berkshire believes in the business and would not look at for five years, one has to understand the replacement value of railroad. Right of way was given away to railroads during the 1800’s to incent construction to develop the western half of the United States and to increase commerce. That will never happen again as long as we live (and beyond). You can absolutely buy the “right of way” in the middle of Nevada for probably a few thousand dollars per mile, but your track will never connect to the Port of Los Angeles and so it’s useless.
In order to recreate a railroad, the following costs would have to be accounted for: 1) material; 2) labor and 3) the real estate below the railroad. From analyst estimates, the first two costs would suggest value BNI at least 50% higher than where it is today. The real estate, even with the meltdown, cannot be estimated. Thus, BNI cannot be replicated. Is it any surprise that Berkshire owns nearly 20% of stock?
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.
Bill Gates figured this out years before us – he invested in a Canadian railroad and made eight hundred percent. Maybe Gates should manage Berkshire’s money. This is a good example of how hard it is to change one’s mind and change entrenched thinking, but at last we did change. The world changed and, way too slowly, we recognized this.”
Since that purchase two years ago, Berkshire has added to its position and the stock is basically trading at the same price it was two years ago. Is it time for investors to get on board?
Company Description
Burlington Northern Santa Fe Corporation is a holding company. Through its subsidiaries, BNI is engaged primarily in the freight rail transportation business. BNSF Railway Company (BNSF Railway) is the Company’s principal operating subsidiary. BNSF Railway operates various facilities and equipment to support its transportation system, including its infrastructure and locomotives and freight cars. It also owns or leases other equipment to support rail operations, including containers, chassis and vehicles.
BNSF Railway operates one of the railroad networks in North America with approximately 32,000 route miles of track, excluding multiple main tracks, yard tracks and sidings, approximately 23,000 miles, of which are owned route miles, including easements, in 28 states and two Canadian provinces.
In 1980, the Staggers Act was signed that largely deregulated the railroad industry since the passage of the 1887 Interstate Commerce Act. Not surprisingly, the industry underwent significant consolidation over the next 20 years bringing the number of class I railroads (a railroad company with over $320 million revenues) from 30 businesses to seven today. In the United States, Burlington and Union Pacific effectively hold a duopoly over the western half of the country, while CSX and Norfolk Southern hold a duopoly over the eastern half of the United States.
Thesis
North American railroads own assets that are practically impossible to replicate. Even though there are tremendous barriers to entry, railroads generally failed to earn a return on their investment greater than their cost of capital. BNI, however has successfully generated returns on equity over 18% for the past few years and generated an average free cash yield of 7% for nearly ten years.
The competitive advantage of any railroad is its geography: BNI operates in defensive industries such as coal and agriculture. Additionally, Wyoming’s Powder River Basin is considered the cheapest form of energy in the country. With domestic power plants coming online, it is unlikely that demand for coal is going to decrease any time soon.
While it has a strong presence in the Powder River Basin, BNI also has the Southern Transcon line from Los Angeles to Chicago, which is well-positioned to respond to strong U.S. demand for Asian goods shipped by intermodal containers.
Furthermore, as Morningstar highlights, BNI stands to benefit from the repricing of older contracts that are approaching expiration. Old contracts were signed before the rail renaissance of the past few years, and many agreements predate the widespread use of effective fuel surcharges. Two thirds of coal contracts expire within four years, presenting an opportunity for BNSF to expand earnings by instituting higher contract prices in today's favorable rail market.
Valuation and Conclusion
With a weak economy, yes, revenues have fallen as have earnings. When the economy turns is anyone’s guess. As Munger mentioned above, these are capital intensive businesses. However, are P/E ratios and EBITDA multiples the right way to analyze Burlington?
To truly appreciate why Berkshire believes in the business and would not look at for five years, one has to understand the replacement value of railroad. Right of way was given away to railroads during the 1800’s to incent construction to develop the western half of the United States and to increase commerce. That will never happen again as long as we live (and beyond). You can absolutely buy the “right of way” in the middle of Nevada for probably a few thousand dollars per mile, but your track will never connect to the Port of Los Angeles and so it’s useless.
In order to recreate a railroad, the following costs would have to be accounted for: 1) material; 2) labor and 3) the real estate below the railroad. From analyst estimates, the first two costs would suggest value BNI at least 50% higher than where it is today. The real estate, even with the meltdown, cannot be estimated. Thus, BNI cannot be replicated. Is it any surprise that Berkshire owns nearly 20% of stock?
