Stock certificate of Burlington Northern Santa Fe... Likely to be
an ancient artifact by next year
an ancient artifact by next year
Perhaps after playing way too many instances of the Monopoly board game—there is a version representing Berkshire Hathaway after all—Warren Buffett has succumbed to his desire for owning railroads and made a real-life offer, on behalf of Berkshire Hathaway shareholders, to purchase Burlington Northern Santa Fe in its entirety.
One pesky problem remains though: this isn't the 1930's. Owning Short Line, B&O, Reading and Pennsylvania railroads (the 4 R&R in Monopoly) won't generate immense wealth these days (of course, governments won't allow ownership of all four—rightly so—but that's another story.) Rails represent the past, no?
I don't usually look deeply at Berkshire Hathaway purchases because Buffett's target returns are lower than what I would like (mostly because of size.) However, the proposed buyout is very significant for reasons I will mention below so I thought I would take a deeper look than usual.
Proposed Buyout Details
One should refer to official filings for the full details but here is what the deal seems to entail:
- Cash (60%) + Share (40%) offer: Burlington Northern Santa Fe shareholders are being offered around $100 in a combination of cash and Berkshire Hathaway shares. The actual amount upon closure of deal will vary slightly since the offer includes Berkshire shares, which can fluctuate.
- Around 30% premium from last closing price: Pretty reasonable premium for a large-cap company but nothing spectacular. The price is somewhat close to the all-time peak from last year. It is essentially the price the stock was trading at before the stock market collapsed around October of last year.
- Government anti-trust acceptance required: Shouldn't be a problem
- BNSF Shareholder vote required: Likely early next year (I don't believe Berkshire Hathaway shareholders will be voting)
- BNSF management and board supports deal
- Berkshire Hathaway B shares will be split 50-to-1: An indirect effect is that this may enable inclusion of Berkshire Hathaway in major indexes such as S&P 500
Deal shouldn't run into too many problems and I think will be closed on time, early next year. As for risk arbitrageurs, there is little profit potential here (unless you leverage up.)
Quick Look at Valuation
Berkshire is not getting BNSF for cheap. But then again, elite companies can rarely be bought for cheap. Here are some valuation metrics I like looking at:
(Numbers below are from Yahoo! Finance and Morningstar @ $97.67 per share)
Burlington Northern Santa Fe (NYSE: BNI)
Market Cap: $33.3 billion
Enterprise Value: $34.9 billion
Trailing P/E: 18.6 (difficult to discern normalized P/E—depends on whether you think earnings peaked (i.e. cyclical) or not)
Forward P/E: 17.62
Price/Book Value: 2.11
Price/Cash Flow: 7.9
Operating Margin: 23.7% (normalized 10-year avg around 21%)
Profit Margin: 12.24% (10-year avg around 10% to 11%)
ROA: 5.89% (normalized around 4%)
ROE: 15.09% (ranges from 9% to 19% in the last decade)
BNSF is one of the largest railroads in North America and largely operats in the Western United States, west of the Mississippi river.
BNSF is probably one of the best railroads but the valuation is not low by any means. The trailing and forward P/Es are both over 17, and I would argue that is not trough earnings. BNSF is not cheap on a trailing basis and it even appears that Buffett is buying near peak earnings.
Railroads are really hard for someone like me, who relies on P/E ratios, to analyze because I can't tell if they are cyclical or not. Depending on the railroad in question, they are sensitive to the economy (all transportation industries are,) depend on commodity shipments, and world trade (imports/exports). So it's hard for me to tell if earnings will continuously increase. If you have bullish view of world trade, the economy, and/or commodities then it's easy to be bullish on the whole industry. Otherwise, it's hard to see why BNSF is worth buying at these valuations.
Some analysts are speculating that Berkshire Hathaway may reap some synergies but I doubt this is a big deal. Sure, Berkshire has a whole hoard of businesses that utilize shipping but I doubt it will amount to much.
This deal will be very profitable if oil prices skyrocket (trucking is not competitive if fuel costs are high) but Buffett doesn't make speculative macro bets. Even when he invested in PetroChina, he didn't do so on the expectation of oil prices skyrocketing. Instead, he did it based on the view that the assets are worth a lot more even if oil didn't go up much. However, he, like all investors, does try to capitalize on sustainable trends. For instance, he profitted immensely from the rising consumerism in America from the 1960's to the 2000's. One of his major insights was how advertising agencies in the 60's and 70's were riding the consumer goods/services companies and hence were good investments (I'm paraphrasing a bit.)
Is This A Bet On Coal?
Some say this is a bet on coal shipments—trucks can't handle coal—but I don't believe it is so. Although America still uses a lot of coal, I suspect it is a dwindling energy source, especially if carbon dioxide and various other emissions end up being considered harmful to humans (although the verdict is still out on so-called "clean coal.") Even if one looks at BNSF's revenue, it doesn't appear as if coal provides high profitability:
On top of all this, Warren Buffett himself, when interviewed on Fox Business today, suggested that coal is likely to decline in importance:
CLAMAN: BNI, of course, hauls about 10 percent of the nation's electricity-generating coal. Is this, Warren, a bet somehow on coal?
BUFFETT: Well, they haul a lot of coal and coal from the Powder River Basin in the West -- is more competitive, it's lower-sulfur coal than in the East. So, it will be around a long time. But coal, over the long run, coal will diminish in relative importance....
CLAMAN: Cheapest, best way. But then there's cap-and-trade, Warren. Some analysts are very skittish about coal and a possible backlash if cap-and-trade goes through. You mentioned now -- you said, we're going to see a diminishing of coal use. But what do you think cap-and-trade would do to the business if that went through?
BUFFETT: It won't change the composition of what utilities are doing tomorrow or next week or next year. The utilities over time are going to use less coal and probably more nuclear. Our own utility, for example, uses wind very substantially in Iowa.
So, over time, coal is going to diminish somewhat. Now, I think that will hit Eastern coal more than Western coal, but that's a fact of life over a considerable period of time. And that's true whether there's cap-and-trade or not, yes.
So, the question remains: what does Buffett see here if we assume that this is not a macro bet on very high oil prices?
I'm not really sure what Buffett sees here.
This looks very much like Buffett's Coca-Cola in that, he could have purchased it after the stock market crash at lower prices but ends up buying after the recovery (Coca-Cola in 1987 rather than 1988; BNSF in 2008 rather than 2009.) I'm not sure if Buffett approached BNSF management before and was rejected.
Just like the Coca-Cola deal, a lot of investors, including me, can't figure out what's so great about the company. Valuation for Coca-Cola did not appear low but it was a great buy.
Amateur investors who are trying to follow the 'Warren Buffett long-term buy & hold' model, like me, this deal will prove to be very important. This is a classic example of paying reasonable, as opposed to cheap, prices, for a good company. It is also a super-long-term investment, which means that one needs to analyze long-term prospects and invest as if you can't reverse the decision. It's a very good case study for Buffett-like 'buy & hold' investors and I will spend some time studying it over the next few years.
Paying With Shares? Shocking!
On top of the questionable valuation, Buffett is paying for the purchase with shares. This is an extremely rare move!
One of the most valuable things a business owner possesses is their equity ownership in their company. Paying for purchases by giving away their ownership is generally very expensive and not desirable. However, this depends on whether you are buying something that is much cheaper than your own company. If your company is overvalued (i.e. share prices high,) you can actually enrich yourself if you purchase other companies with shares (rather than cash.) Dot-coms in the late 90's, whose shares were wildly overvalued, were successful in utilizing their shares in this manner.
Most executives don't think like owners and could care less whether they purchase other companies with shares or cash. Warren Buffett, being an astute investor, is not such a person. He avoids paying with shares for anything.
The fact that Buffett is willing to pay with Berkshire shares means one of several things.
Firstly, it may mean that Buffett views the shares are overvalued. If so, paying with shares actually creates wealth for Berkshire Hathaway shareholders (it harms BNSF shareholders though.) I don't follow Berkshire Hathaway closely but my feeling is that it is not cheap. I have never considered investing in Berkshire Hathaway in the last 5 years—that's when I started investing—because it never looked cheap. But I don't believe it is wildly overvalued so I do think this reasoning (i.e. shares overvalued) was why Buffett was willing to pay with shares.
Another possibility is that Buffett recognizes potential for strong profit generation from BNSF and thinks that the buyout will be accretive to Berkshire Hathaway's profitability, without much loss in ownership. The quick look above indicates that BNSF is not cheap on a P/E basis or any type of earnings basis. But I haven't given much thought to the particulars of BNSF to form an opinion of its long-term profit potential. I took a somewhat deep look at railroads, particularly Canadian National (TSX: CNR; NYSE: CNI), about 4 years ago (before I had this blog) and didn't find anything special in them. I found rails, at least Canadian National, to be very sensitive to commodity prices (because they ship them) and world trade (because a lot of imports/exports goes through them.) I was turning bearish on commodities around that time so I gave up on the rails. Warren Buffett did not invest in them at that time but Cascades, Bill Gates' vehicle, did invest in CNI at that time. The situation may have changed so, without revisting the macroeconomic, business, and competitive environment, I can't say how the long-term future looks.
It is also possible that Buffett had to pay in shares to get approval of BNSF's shareholders. Paying in shares allows BNSF shareholders to defer tax payments and that may also play a role. Shareholders may have rejected the deal if shares weren't offered.
There are many Warren Buffett followers and Berkshire Hathaway followers who may have more insight into this matter. I'm waiting to see how they justify paying in shares.
Assuming the buyout of BNSF is completed successfully, it will be one of the lasting legacies of Warren Buffett. I'm not an expert on Buffett but from what I know, I think the BNSF buyout is as influential as the purchase of Berkshire Hathaway, Blue Chip Stamps, Geico, Washington Post, or Gen Re (a mistake IMO). The proposed deal is likely to be the last major investment in Warren Buffett's illustrious investment career.
The following articles contain information you may find useful:
Warren Buffett Fox Business Interview Transcript (GuruFocus)
Official Burlington Northern Santa Fe Presenation About the Buyout
Tags: Berkshire Hathaway (BRK.A), Warren Buffett