Berkshire Hathaway’s recent acquisition of rail operator Burlington Northern Santa Fe Corp has generated a tremendous amount of dialogue within the investment community. For one, the deal involves Warren Buffet, Berkshire’s iconic CEO and legendary value investor. The 79 year-old sage, whose succession plan remains one of the most tightly bound secrets in the industry, invited the rail operator to join the ranks of such names as GEICO, Dairy Queen, Fruit of the Loom, and Brown Shoe Company which currently shine atop Berkshire Hathaway’s Omaha, Nebraska-based mantle.
In addition to Buffett’s obvious name recognition, the deal stands out due to its sheer enormity. Berkshire Hathaway agreed to fork over all of $26 billion to acquire the 77% stake in BNSF it doesn’t already own.
That would value Berkshire’s total ownership stake at $34 billlion (not to mention the $10 billion in
BNSF debt payments the conglomerate now assumes).
In return, Berkshire gains control of the nation’s second largest freight railroad network. In fact, BNSF is also the country’s most prolific mover of intermodal freight traffic, a practice characterized by moving freight between ship, truck, and rail within the same container. Not only does this insure that a container’s contents remain considerably secure, but it also presents a much more cost-effective means of moving freight across multiple modes of transportation.
In the end, the deal’s cost was by no means cheap. Buffett & Co. agreed to pay $100 per share for the operator, more than a 30% premium over the firm’s share price on Monday, November 3, when the deal was first announced. With shares trading at 18.2X estimated 2010 earnings, the deal does not constitute the typical Buffet- esque value play. In fact, the mere notion of ponying up a premium for any company is considered a rarity at Berkshire Hathaway, a firm who owes much of its previous success to purchasing companies at bargain-basement prices. Buffett has even willingly admitted as much, commenting on the deal, “You don’t get bargains on things like that. It’s not cheap.”
Although the investment appears puzzling from a valuation standpoint, a number of issues stand out as potential motivations for the deal. First, there is the concern over the future of the US dollar. As many are now concluding, the dollar’s recent descent presents a legitimate, growing concern to investors and businesses,
alike. In part, the Federal Reserve’s insistence upon keeping interest rates low is forcing investors to flee low-yielding bank deposits and short term investments, dumping dollars and chasing investment returns which are more likely to keep pace with inflation. One way to hedge against the dollar’s demise is to invest in real assets, whether that be precious metals, commodities, real estate, or other businesses. With that said, what better a place to make a long-term investment than in one of America’s largest rail operators? BNSF holds billions of dollars’ worth of real estate, offering the potential for long term value stability. Meanwhile, by paying out roughly a billion dollars per year in dividends, it also provides Berkshire with a steady cash flow, joining the ranks of other cash flow-rich businesses such as insurers, newspapers, and utilities which have funded Berkshire Hathaway’s prolific growth throughout the years.
Despite the relatively quick execution of the deal, Berkshire Hathaway’s decision did not arise without precedent. In recent years, Buffett’s firm had shown a propensity for rail operators, accumulating positions in Union Pacific and Norfolk Southern. When BNSF CEO Matt Rose recently expressed a willingness to negotiate with Buffett, Berkshire pounced at the opportunity and made an offer. However, even after completing the combined cash/stock purchase, Berkshire still holds roughly $20 billion in cash. Buffett had plenty of motivation to put his cash to work. Hence, when the opportunity arose, he tossed his chips into the ring.
Stretching beyond concerns about the dollar, the dealmaker for this transaction is, without a doubt, coal. Coal, that dirty, filthy fossil fuel has increasingly become the target of global warming advocates and legislators. However, by accounting for nearly one half of all of the electric generation in the US today, its presence is solidly entrenched in this country’s energy future. Fortunate for Berkshire Hathaway, one half of all the tonnage BNSF’s trains have transported thus far this year is-you guessed it-coal. In all, the total yearly tonnage of coal BNSF moves is enough to power one in every ten US homes.
According to the Energy Information Administration, a statistics office within the US Government, the US’s current recoverable coal reserves should meet a growing US demand for another 150 years. Given coal’s cheapness, abundance, and relative efficiency, it presents an extremely cost effective and convenient form of energy. Furthermore, with the largest recoverable reserves of any country buried in our own back yard, it presents a viable energy option, provided the US begins to ween itself off of its foreign oil dependency.
From a strategic standpoint, BNSF is well-positioned to benefit from our continued use of coal. Its tracks spread across 28 states and 2 provinces, mainly west of the Mississippi River, at a combined length of 32,000 miles. Its network of rail lines is heavily concentrated in the upper Great Plains, particularly in the region of the Powder River Basin, an area of southeast Montana and northeast Wyoming which supplies roughly 40% of the nation’s coal. Of note, the region is rich in sub-butiminous coal, a cleaner-burning alternative to Appalachian coal. This coal is known for being low in sulfur dioxide, a common contributor to acid rain. Lastly, BNSF’s extensive lines throughout the Great Plains, Midwest, and Pacific Northwest will allow it to serve MidAmerican Energy, an energy producer also owned by Berkshire Hathaway which happens to operate several coal-fired power plants of its own.
Currently, BNSF transports the majority of its coal to population centers of the Great Plains, including Denver, Kansas City, Chicago, St. Louis, and Dallas. However, with its wide reach, it could also feasibly provide significant amounts of coal to population centers in the Upper Northwest, Southern California, and South Texas as well. The nation’s hunger for electricity is expected to increase 25% by 2030. Factoring in our continued reluctance to build more nuclear power plants, the cost barriers to implementing green energy initiatives, and the highly variable cost of oil, our reliance on coal is likely to intensify for the foreseeable future.
In addition to this, coal exporters are also poised to benefit from the developing world’s mounting appetite for electricity, especially China and India. China, which burns more coal than the US, Europe, and Japan combined, is scheduled to build 500 additional coal-fired powerplants over the next decade. After first becoming a net importer of coal in 2007, the country’s appetite for coal will undoubtedly force it to increase its reliance on imports. Given BNSF’s plentiful access to Pacific ports, it sits in a prime position to benefit should coal producers look to direct their coal shipments across the Pacific.
Mr. Buffett has never shied away from admitting his bullishness with regards to the US’s long term prospects. In fact, following the deal’s announcement, Buffett told CNBC, “America’s best years lie ahead, there’s no question about that.” If one assumes that Mr. Buffett’s remarks are correct, this deal should put Berkshire Hathaway in an enviable position to ride that wave of prosperity over the next 50-100 years. BNSF gives Berkshire a brawny, strapping infrastructural presence, transporting carload-after carload of goods and resources cross-country. The relative cost-effectiveness of rail transport (it takes only one gallon of diesel fuel to move one ton of goods 470 miles) gives it an obvious edge over the automobile. In fact, should gas prices rise considerably, demand for rail freight will undoubtedly increase.
Berkshire Hathaway prefers to identify companies which hold a competitive advantage within their industries. BNSF’s competitive advantage lies in its strong infrastructure base, some 32,000 miles of tracks. Furthermore, its geographic footprint-primarily located between the population centers of the Great Plains and the West Coast-ensures that it holds a distinct advantage for moving not only processed goods and products, but more importantly, coal. As US, and for that matter, global demand for goods and resources accelerates over the coming decades, Berkshire Hathaway and its shareholders could be rewarded handsomely.