Buffett's Big Buyout Bets on Buoyancy

Tuesday brought big news on Berkshire Hathaway's (BRK.A) proposed buyout of Burlington Northern Santa Fe (BNI) railroad at $100/share, cash and stock. This transaction is a textbook window into Warren Buffett's equity valuation model.

Uncle Warren has dropped hints over the years on how he values a stock. Buffettology books (particularly those by Mary Buffett) have done an excellent job outlining his calculation of "owner earnings" (net income plus depreciation minus average capital spending), his use of the 10-year Treasury yield as a discount rate, and his preference for companies that consistently grow retained earnings per share over long periods.

I built an equity valuation model using these principles and got an interesting result. Discounting $BNI owner earnings for the past four quarters at a discount rate of 3.5% (approximately the prevailing 10-year Treasury yield in recent weeks) results in a share price of slightly more than $150. Warren Buffett doesn't buy anything unless he can get a severe bargain, so paying $100 for a stock he believes is worth around $150 represents a 33% discount.

I believe Uncle Warren's key insight is his tweaking of the growth factor used in traditional DCF models. In place of the "b" retention rate for net earnings not spent on dividends, he substitutes the average long-term growth rate of retained earnings on the balance sheet. Multiplying this modified "b" by his version of ROE (owner earnings divided by shareholder equity) gives us the annualized growth factor "g" that he uses to estimate those future owner earnings.

I'm intrigued that Uncle Warren chose to assume $BNI's relatively high long term debt load onto Berkshire's balance sheet. Apparently he thinks the cash flow from Berkshire's finance and insurance lines will be sufficient to pay that off. If this gamble works, it gives Burlington the operational freedom needed to continue investing in technological innovation.

It's almost a done deal pending regulatory hurdles. Anti-trust scrutiny will probably force Berkshire to divest its other rail holdings, namely Union Pacific (UNP) and Norfolk Southern (NSC). Forced selling of those large stakes might make them attractive plays for other value-oriented transportation sector investors. It would also give Berkshire additional cash if they need to sweeten this deal.

My play? I immediately sold a few short puts under $BNI at 95 on the premise that Buffett's bid establishes a firm floor for the stock and will be approved without any glitches early in 2010. The worst-case scenario for this special situation would be a market dislocation that tanks Berkshire's own share price, forcing it to further dilute its own shareholders to maintain the agreed mix of cash and equity for this buyout. If my puts are exercised against me, my own worst-case scenario is that I end up owning a long-term position in either $BNI (if the deal collapses) or Berkshire, two companies that the greatest investor of all time thinks are terrific to have.

Full disclosure: Anthony J. Alfidi is short Jan 2011 puts on $BNI at 95 (covered with cash) and holds no position in any other stock mentioned in this post.

Comments

[Mad Hedge F...:]

xho You’ve got to hand it to Warren Buffett, who never does anything half heartedly. The stunning news that his Berkshire Hathaway (BRK/A) is paying $44 billion for the 73.4% of Burlington Northern Sante Fe (BNI) he doesn’t already own, a 30% premium, had punch drunk traders picking themselves off of the floor. The other rails rocketed, like Union Pacific (UNP), CSX (CSX), and Kansas City Southern (KCSR). The deal is the Oracle of Omaha’s largest in his career, and took the BNI board all of 15 minutes to approve. For me this deal speaks volumes about the long term trends in the US economy as seen by its greatest investor. It screams Commodities! Commodities! Commodities! Rails can only prosper moving bulk freight from the heartland to ports on the three coasts, which foreigners are buying in ever larger quantities at ever higher prices. It also says the coal industry isn’t going anywhere soon, as it accounts for 70% of all rail traffic, so you can kiss Cap & Trade goodbye. Buffet let loose of some fascinating statistics about the enormous productivity increases the industry has accomplished. In the last 25 years, it cut employment from 500,000 to 175,000, while increasing freight by 60% and reducing track by 40%, and now accounts for 40% of the total goods moved in the country. Railroads are the greenest transportation out there, a ton of freight requiring only a gallon of fuel to move 470 miles. When I was growing up, my big goal in life was to become a train engineer. Maybe it’s time for me to revisit that aspiration. And I promise not to text while driving!

Nov 04 06:44 AM

[bindlepete:]

Buoyancy ? I would say stagflation and a return to commodity exports ( coal and topsoil), a collapse in high value manufactured items, and dependence on the politically pwerful utility industry and their paper /bong holders the insurance industry.

Sorry to have lost BNI from my portfolio but I retain the best route structure of CNI . Lets wait until Canadian commodity exports swell to contain wheat, petroleum and their abundant coal resources.

It will take time but Kitimat, North America's closest port to Asia, belongs to CNI.

Nov 04 11:14 AM