Two years ago Warren Buffett and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) completed the purchase of rail company Burlington Northern Santa Fe. Typical to most of his investments he remained mysterious in his reasoning. The Columbia University professor Bruce Greenwald who specializes in value investing questioned the deal; labeling it “crazy” and “an energy play” (I reprinted his complete response at the bottom of the article).
However, since then the purchase has looked nothing short of an exceptional deal. A close competitor to Burlington in Union Pacific recently reported a profit of $3.3 billion for 2011 and that was nearly double the $1.8 billion the company made in 2009. We can expect something similar from Burlington also as the company paid some $3.5 billion in dividends to Berkshire Hathaway this past year and still managed to spend the same amount on capital expenditures. When Buffett paid $100 per share for the shares he didn’t already own that implied a valuation of $34 billion. Being able to pluck $3.5 billion from the company and still spend for a great expansion in 2011 reveals exactly how cash-flow rich the company has become.
But these outsized returns bring us back to the comments by Bruce Greenwald. Oil prices have steadied around $100 a barrel this year. This has likely kept the company very profitable. Another consideration worth noting is that manufacturing activity has grown robust in the U.S. The U.S. has become more competitive compared to other countries, but the reason has varied by country.
In the case of Japan the purchasing power of the dollar has collapsed as it was once worth some 114 yen in 2003 and now is valued about half as much at 76 yen. China’s case is slightly different as their currency hasn’t appreciated nearly as much, but wages skyrocketed (on a percentage basis) relative to U.S. wages. You have to look no farther than today’s Wall Street Journal which conveys these remarkable trends. The paper noted that Carlisle Companies, a conglomerate that makes tires and other goods, is moving its tire production back to the U.S. from China.
Trains generally traffic goods that are of low value and heavy. This would contrast with finished products such as iPods which when shipped from China often come in the hull of an airplane. So trains will be one of the first to benefit from serious manufacturing activity returning to the U.S. and that appears to be the case. Had the Detroit car companies gone out of business, Burlington and Union Pacific would’ve lost a good deal of business. Now those very companies are thriving and pushing profit margins that are the highest in years if not decades.
Buffett has felt very strongly against the dollar for several years. He argued in a 2003 article in Fortune that our ballooning trade deficit would make us terribly poorer. Since that time the trade deficit has only deteriorated. But also since that time our economy has slowly recovered manufacturing jobs as the dollar has depreciated just to his prediction. Seemingly every day you read about some company be it Caterpillar moving plants from Canada to the U.S. or Toyota and other Japanese companies moving plants to the U.S. from Japan as the yen appreciates.
This all bodes well for train companies, as who better to traffic the steel, rubber and other goods from one point of the U.S. to the other? Rail companies will gain from an increase in exports and exports, but will probably have the most to gain when raw materials need to be moved around the U.S. But if the success of the rail companies is truly attributable to elevated oil prices then one must be concerned about the troubles of the refineries.
Oil refineries from the U.S. east coast to Europe and China have all been squeezed by high oil prices and relatively low gas demand. Many have shut down or are in the process of doing so, and when that happens gas prices may likely increase, further curtailing demand and ultimately oil prices. Given the regulation of gas prices in China, the Chinese government will react differently. Instead of simply shutting down refining capability they will notch up gasoline prices 3.6%. Though not a significant increase it will certainly feed negatively into demand.
Regardless of where oil prices go, there should be little contest that the Burlington deal was a good one for Buffett and Berkshire shareholders. Maybe not so much for the Burlington shareholders who had to forfeit their shares.
Josh Zachariah
Comments by Bruce Greenwald:
It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers — and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.
Buffett’s paying 18 times ($100 per share), and at $75 he was paying 16 times. Our calculation is he was paying 21 times.
Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.
The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.
There is nothing special about the railroads. It’s entirely an energy play.
If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.
We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.
It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75 per share, we thought there were better oil plays. At $100 per share we think he has lost his mind.
However, since then the purchase has looked nothing short of an exceptional deal. A close competitor to Burlington in Union Pacific recently reported a profit of $3.3 billion for 2011 and that was nearly double the $1.8 billion the company made in 2009. We can expect something similar from Burlington also as the company paid some $3.5 billion in dividends to Berkshire Hathaway this past year and still managed to spend the same amount on capital expenditures. When Buffett paid $100 per share for the shares he didn’t already own that implied a valuation of $34 billion. Being able to pluck $3.5 billion from the company and still spend for a great expansion in 2011 reveals exactly how cash-flow rich the company has become.
But these outsized returns bring us back to the comments by Bruce Greenwald. Oil prices have steadied around $100 a barrel this year. This has likely kept the company very profitable. Another consideration worth noting is that manufacturing activity has grown robust in the U.S. The U.S. has become more competitive compared to other countries, but the reason has varied by country.
In the case of Japan the purchasing power of the dollar has collapsed as it was once worth some 114 yen in 2003 and now is valued about half as much at 76 yen. China’s case is slightly different as their currency hasn’t appreciated nearly as much, but wages skyrocketed (on a percentage basis) relative to U.S. wages. You have to look no farther than today’s Wall Street Journal which conveys these remarkable trends. The paper noted that Carlisle Companies, a conglomerate that makes tires and other goods, is moving its tire production back to the U.S. from China.
Trains generally traffic goods that are of low value and heavy. This would contrast with finished products such as iPods which when shipped from China often come in the hull of an airplane. So trains will be one of the first to benefit from serious manufacturing activity returning to the U.S. and that appears to be the case. Had the Detroit car companies gone out of business, Burlington and Union Pacific would’ve lost a good deal of business. Now those very companies are thriving and pushing profit margins that are the highest in years if not decades.
Buffett has felt very strongly against the dollar for several years. He argued in a 2003 article in Fortune that our ballooning trade deficit would make us terribly poorer. Since that time the trade deficit has only deteriorated. But also since that time our economy has slowly recovered manufacturing jobs as the dollar has depreciated just to his prediction. Seemingly every day you read about some company be it Caterpillar moving plants from Canada to the U.S. or Toyota and other Japanese companies moving plants to the U.S. from Japan as the yen appreciates.
This all bodes well for train companies, as who better to traffic the steel, rubber and other goods from one point of the U.S. to the other? Rail companies will gain from an increase in exports and exports, but will probably have the most to gain when raw materials need to be moved around the U.S. But if the success of the rail companies is truly attributable to elevated oil prices then one must be concerned about the troubles of the refineries.
Oil refineries from the U.S. east coast to Europe and China have all been squeezed by high oil prices and relatively low gas demand. Many have shut down or are in the process of doing so, and when that happens gas prices may likely increase, further curtailing demand and ultimately oil prices. Given the regulation of gas prices in China, the Chinese government will react differently. Instead of simply shutting down refining capability they will notch up gasoline prices 3.6%. Though not a significant increase it will certainly feed negatively into demand.
Regardless of where oil prices go, there should be little contest that the Burlington deal was a good one for Buffett and Berkshire shareholders. Maybe not so much for the Burlington shareholders who had to forfeit their shares.
Josh Zachariah
Comments by Bruce Greenwald:
It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers — and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.
Buffett’s paying 18 times ($100 per share), and at $75 he was paying 16 times. Our calculation is he was paying 21 times.
Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.
The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.
There is nothing special about the railroads. It’s entirely an energy play.
If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.
We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.
It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75 per share, we thought there were better oil plays. At $100 per share we think he has lost his mind.
