It is well known that Warren Buffett is bullish on the railroad industry. But among the top four American railroad companies, Burlington Santa Fe (BNI), Union Pacific (NYSE:UNP), CSX (NASDAQ:CSX) and Norfolk Southern (NYSE:NSC), he has clear preferences. BNI is no doubt on the top, UP comes as the second, and NSC and CSX are much less favored. Through this article, I will try to provide my understanding of his logic behind his preferences. I will attempt to answer three questions, 1) Why does he pick the railroad industry? 2) Why are CSX and NSC less favored? And 3) Why is BNI more favored than UP?
To Question 1: Railroad has to be the future of American freight transportation
When we talk about moving freight around without incurring hefty costs, normally there are two options, trucks and locomotives. In the old days, thanks to the low energy cost, the advanced highway infrastructure and their point-to-point flexibility, the trucks dominated the shipping market. But now the picture is changing. I believe in the long run, the railroad will become the backbone of the American freight transportation network, while the truck companies will be confined to short distance shipping, operating between railroad stations and the customer locations as a support to the national railroad network.
The above statement is based on the following facts and beliefs.
First, railroad is simply a more efficient way to move freight. According to BNI, one intermodal train removes more than 280 long-haul trucks from the nation’s highways.
Second, based on the type of freight (industrial material, agriculture product, coal, etc) , the rail is 2-8 times more fuel efficient than trucks.
Third, Rail is more environmentally friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.
Fourth, the progress of information technology helped the railroad companies build more sophisticated train control systems, resulting in increased accuracy, efficiency and flexibility, continuously narrowing the advantage of trucks over railroad.
Fifth, I believe the coming era will be featured by high energy price, which will continue to consolidate rail's cost advantage over the trucks.
Sixth, intensified environment concerns will drive stringent regulations, which will drive up the operation cost for both rail and trucks, but the impact will be a lot more punishing for trucks than for rail, thus the cost advantage of the latter will be further consolidated.
Seventh, under the recession, the cost awareness of the customers makes rail an even more attractive alternative to trucks. This will help rail companies gain market share against trucks, better position themselves to take advantage of opportunities created by the economic upturn, thus further build its dominance over trucks.
To Question 2: For BNI and UNP, the geographic layout of their railway network gives them insurmountable competitive advantage over NSC and CSX
The competitive advantage of BNI and UNP is of a unique type. It has nothing to do with branding, technology superiority or management excellence, but originates from the simple fact that BNI and UNP happen to be the ones that operate the railroad network in Midwest and West America. To be more specific, the advantage lies in the following aspects:
1) Intermodal. For all four companies, intermodal is a significant portion of their revenue. CSX and NSC operate in East America. They connect with ships from the Atlantic Ocean, transport shipments originating from or destined for Europe and Latin America. Whereas BNI and UNP connects to the Pacific ports, eventually with Asia and Australia. Now the picture is clear. Across the Pacific ocean, BNI and UNP has China. On one hand, China is the world factory, manufacturing virtually everything required in American daily life, on the other hand, an emerging economic giant, thirsty for all sorts of goods produced from the American land, especially energy and agriculture products. This type of import and export is projected to grow strong for the coming dozens of years, thus offering BNI and UNP vast growth potential.
2) Agriculture. In the past several years, externally, Asian countries need to import grain from the US to feed their people, and internally, America needs corn to make ethanol. The soaring demand for these types of goods created the agricultural boom. The recession slowed things down, but will it change the domestic and international demand pattern of American agricultural products? My answer is No. Again, BNI and UNP happen to own the railroads that run through the enormous American farmlands, and there is no means that is more cost effective than trains to move grain, corn or beans. The farmlands now give BNI and UNP another growth opportunity that their two brothers in the east can only dream of.
3) Geography and industrialization. In East America, the territory controlled by CSX and NSC, we see higher industrialization, dense population, numerous big cities, a slew of ports along the Atlantic Ocean, in other words, a well developed environment for all means of transportation to prosper, including trucks, ships and rail. Therefore, for CSX and NSC, in addition to competing with each other, they have to compete with other shipping means, which normally are already mature and well managed. While in the west, the Rocky mountains and the desert somewhat confined the industrialization to the strip along the Pacific Ocean. It is the vast plain running deep into the heart of the continent. Here we see small population, sparse cities, tiny towns and infinite farmland. It is never the preferred means to move the common goods, such as coal or grain, around with trucks, because the volume would be small, the cost would be high, and normally you have to move long distances. In summary, this is an environment where only the rail can manage to survive and prosper. For BNI and UNP, except competing with each other in certain regions, they don't face any other serious challenges.
To Question 3: The black gold gives BNI the edge over UNP
In western America lies one of the largest coal reserves in the world - Power River Basin (PRB). Once it was estimated to have 200 billion short tons. The newly published study revised the number in a shocking manner, claiming 190 billion tons of reserve, about 95% of the original assessment, as economically unrecoverable. So there is only 10 billion tons left, let's accept it for now. In 2008, around 40% of American coal production came from this area, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years.
And for the next 10 years, I believe the amount of coal that the railroad ships out of this area will grow year after year.
First, the growing demand of power generation requires greater coal output.
Second, currently the fuel types for power generation include petroleum, renewables, nuclear, natural gas and coal. For renewables, there is still a long way to go before they become reliable and significant sources for power generation. For nuclear, there is always the key concern about safety. For petroleum and natural gas, they are turning too expensive, and there is no chance for the trend to reverse considering the worldwide demand will only intensify. So coal somewhat becomes the only option. I see power generations will rely more and more on coal, which adds further demand for the output from this area.
Third, coal from this area has extremely low sulfur content. Thus, many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. We foresee the environmental regulation will become stricter, which may become another contributor to the higher demand of PRB coal.
Now comes the last and the key question. Who has the privilege to move the PRB coal? Checking the railroad network map, you will find BNI has almost exclusive coverage in the area. In 2008, 22% of BNI's revenue was from coal, and now it seems this big chunk of revenue is not only guaranteed, but also guaranteed to grow. Therefore, right here, lies the ultimate advantage of BNI over UNP.
Disclosure: Long BNI, No Positions in UNP, NSC and CSX