Buffett and Burlington: Betting on Growth

So I thought I’d do a little number crunching on Buffett’s Burlington Northern Santa Fe (BNI) deal. What does that tell us? That Buffett is paying a full price for a business with mediocre returns on capital. That he’s betting on growth, not value.

Valuation (based on share prices of $100 for Burlington, $59 for Union Pacific (UNP), and $48 for Norfolk Southern (NSC)):

Enterprise Value to 2010 unlevered free cash flow (think of this as a better version of P/E):

• BNI = 29x
• UNP = 24x
• NSC = 18x
  

Return on capital employed (based on 2010 operating income and year-end ‘10 balance sheet estimates.

• BNI = 11%
• UNP = 10%
• NSC = 10%

(I’m using Stifel Nicolaus estimates for 2010)

The cash flow characteristics of the business don’t seem fantastic. BNI poured 68% of operating cash flow back into capital expenditures from 1999-2009. That’s cash flow that doesn’t go to shareholders.

Nor are the returns fantastic. Because operating a railroad requires so much CapEx, the return on capital employed is only mediocre.

As an asset, railroads do seem very well-positioned. And Burlington Northern particulary so. Increasing fuel costs hit truckers harder than railroads, so that works in their favor.

And as my Reuters colleague John Kemp points out: “Burlington’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with ‘carbon capture and store’ technology to curb the carbon-dioxide emissions.”

Burlington has track carrying clean coal out of the Powder-River Basin in Wyoming and Montana. PRB coal has lower sulfur content than Appalachian coal. To the extent we increase coal-fired power generation in the U.S., we’re likely to do it on a “clean” basis, giving PRB coal (and those who ship it) a competitive advantage.

But again, given the high price he’s paying, Buffett needs a lot of things to go right for this deal to generate meaningful returns for shareholders.

Comments

[djackson:]

It definitely is a bet on coal

Nov 03 03:26 PM

[mrxg4:]

You're downsizing the importance of all the land BNI possesses. You'd have to know the exact value of said land in order to affirm this is exclusively a bet on growth and not value...

I'm guessing Buffett is way more capable than the author of figuring this out, and indeed, it appears that he has.

Nov 03 03:53 PM

[Stonebridge:]

There are a lot of factors your analysis doesn't take into consideration. Firstly, he IS betting on growth (as you pointed out) but the future earnings growth is multi-faceted. It is not just generated from increased coal shipments, but also from the increased transport revenues as MANY companies will have to switch to rail transport instead of trucking due to much higher future oil prices.

Also, as the global economy recovers, all commodities will be in high demand. Most commodities are large and heavy and non-perishable, so rail will be the most cost-effective and efficient transporter. Rail volume and prices will increase. Thus, BNI's margins and ROIC should increase dramatically.

As for price, he paid about 17x p/e. (or 30x unlevered FCF) But the FCF and accounting earnings should grow dramatically over the next few years. So his actual price might be 13x forward p/e (or 20X FCF). But there are other benefits you aren't aware of that lower his cost basis further. For starters, Obama announced special incentives to railways to improve their infrastructure (as an environmentally friendlier alternative) that will result in BILLIONS of dollars of govt. subsidies to BNI. As an owner, this reduces Buffet's purchase cost. So maybe his real cost is 10 or 11 x p/e. Also, there are synergies that exist with BNI and his holding company, Midamerican Energy, where the railroad can supply his utility holdings with "cleaner coal" far cheaper than competitors. His railway and utility companies will benefit; a form of vertical integration. They also have a deal with CN Rail (in Canada) that increases both networks efficiencies. And there more things I can't go into right now...

Suffice to say, when you add all these factors in, he paid maybe 10x p/e (or 15X unlevered FCF) for BNI, and the company will likely have future ROIC in excess of 15% or 20%. So its not really a bad deal. Buffett needs sompelace to invest his billions and position the company well for the future. This strategy counteracts a deflating greenback and rising oil, commodity, and energy prices.

Its not my favorite deal, but it suits Buffett's long-range strategic needs.

Nov 03 04:01 PM