Berkshire + Burlington = Hypocrisy, Expediency and Full Dose of Ego?

I've gotten tons of calls and emails since the Berkshire (BRK.A)/Burlington (BNI) deal was announced. I'm flattered that so many people care about my thoughts (or are just kind enough to humor me). Having followed Buffett since before he was widely known and cool, I know what a Buffett acquisition looks like. Burlington is out of character.

Whether it's motivation, price, method of payment, etc, Burlington is unlike any Berkshire deal I am aware of. While most people focus on the massive size of the deal, it is the least surprising aspect of the transaction. After all, Warren Buffett has often talked about hunting for elephants.

Many articles have already been written about this merger and I don't want to belabor it. Suffice it to say that some people have worshiped at the Oracle's altar for so long that they have lost all objectivity. I saw one article today saying that Warren's childhood love of trains led (in part) to this deal!

Lionel train sets are (slightly) cheaper?!?! And isn't Buffett the unemotional Sage of Omaha? Where is the cold calculating bridge player?

Sadly, there is a grain of truth in the train love story. Buffett usually gets 10 to 15 percent cash on cash returns on Day 1, so clearly something else is at work here. Why pay 20+ times earnings?

There are elements of hypocrisy and expediency (as evidenced by the stock split), empire-building, and a full dose of ego in this Burlington deal.

Here are 3 articles that encapsulate my thinking:

• Buffett's Pricey Rail Trip - Berkshire uses its cheap stock to buy fully priced Burlington by Andrew Bary in Barron's
  
  
• Buffett Revisits Hunting Ground for Survivors by Alice Schroeder @ Bloomberg.com
  
  
• Burlington Bet Could Derail Berkshire by Doug Kass @ TheStreet.com
  

All three make excellent points and do it more eloquently than I can manage. The Doug Kass article is my favorite. He addresses Buffett's departure from the norm on price, the issuance of Berkshire shares, the stock split, and the increasing risk due to lower cash levels.

Bary addresses the fact that Buffett is selling Berkshire equity at cheap prices and paying up for Burlington. Schroeder knows Buffett well and has some interesting insights into the possible motivations.

Hint: it's more about legacy than value.

Buffett is famous for avoiding these kinds of quasi-auction transactions. They destroy value for the acquirer.

Buffett is the guy who underpays... or he used to. I remember minority Dairy Queen shareholders suing Buffett over the price he paid for their company in 1998. He stole it, but they lost the lawsuit anyway. Berkshire shareholders have been rewarded ever since.

Burlington shareholders won't be suing Buffett this time. And the Capitalist Woodstock is certain to be even more crowded.

I won't be there. For the first time in years, I don't own Berkshire shares. The Burlington deal is assuaging my guilt.

Disclosure: The author does NOT own shares in any of the companies mentioned.

Comments

[Carlos Lam:]

Perhaps he has great insights into investing, but because Warren Buffett is a hypocrite of the greatest magnitude I simply would not trust him with my money. Behold:

* Buffett criticized Pres. Bush's tax cuts and said that Americans should pay more taxes yet had BH bid for Fannie and Freddie's $3 billion in tax credits. If we Americans should pay more taxes, Warren, doesn't that mean BH shareholders as well?

* Buffett begged the US Senate in '03 to NOT eliminate the estate tax. What went unsaid was that BH has an insurance business that BENEFITS from the estate tax by selling a kind of insurance policy that makes sure that heirs have enough money available to pay the estate tax without having to liquidate assets.

* Buffett famously called derivatives "financial weapons of mass destruction" yet BH sold $2.5 billion in credit-default swaps in '08.

Such a duplicitous person may, of course, make money for those who he invests for. It's the agency risk--trusting a person who is two-faced--that would keep me up at night.

Nov 05 06:13 AM

[ain't no fo...:]

My question was and is:

The entire discussion on the web has been about Buffett and Berkshire's motivations, and this isn't the first time he's come to the aid of the markets with his "patriotic" dealmaking. He did the same last year after Bear. BUT, the real mystery may be why did BNI spend all of about 30 seconds deciding to go for the deal? What did THEY know?

Nov 05 08:29 AM

[Steve Mc:]

This crowd here seems familiar, who are they? Oh, I know who they are. They are the same folks who ridiculed Buffett and wrote articles like "Buffett's Lost His Touch" last March when Buffett received millions of stock warrants from Goldman Sachs with a $115 strike price and 10% yield, when GS shares were trading at $70.

I also believe Buffett made his aquisition of Coke shares back in the late eighties when the company was trading at approximately 4X its tangible book value; hardly a deep value investment in my opinion.

Nov 05 08:46 AM

[Roger Knights:]

First, Buffett may have a justification in mind, like high inflation or currency collapse, that he doesn't want to mention. (I suspect that was behind his selling of long-term puts on the market.) And he could have made a worse buy. But here's what I commented yesterday on this deal:

Why pay a premium and put all your eggs in one basket? Why not buy a basket of RRs at market prices?

There's a considerable long-term risk in BNI: The port in Mexico's west coast that is being built, in conjunction with improvements to a railroad line from it to Kansas, that is intended to be a low-cost alternative to high-wage US west coast ports. This could divert a good deal of traffic.

This bet leaves less discretion for Buffett's successor to mess things up. Or affect things at all. Apparently he hasn't found anyone to fill his shoes. This may be a large part of his motivation.

Nov 05 08:51 AM

[UncleLongHair:]

I agree that the deal is out of character. Buffett broke his 3 cardinal rules: don't issue stock, don't issue debt, and don't split the stock. He broke all 3 rules in the same deal.

He obviously stretched into the acquisition, and paid a pretty price as well. This is a big departure from his previous deals in almost every way.

However, I don't think this is simply hubris or some unfulfilled childish infatuation with trains. Berkshire has for a long time needed major operating businesses to go with the insurance and investments, for numerous reasons. One is simply to maximize the earnings potential of the company, but I think this deal goes beyond that.

I think that succession and hence Berkshire's long-term health factored into this deal in a few ways. I have long been of the opinion that it would be a big mistake for Buffett to leave Berkshire to his successor with billions of cash requiring investment. A single bad investment made by his successor could undo decades of careful building. He also does not want to give his successor a bunch of hard problems to address such as betting the company on whether or not to provide hurricane reinsurance. Finally, he probably has quite a short list of possible successors, and knows their skill sets.

I think the Burlington deal addresses all of these questions. It transforms Berkshire into a huge operating company full of businesses that are generally easy to run. It provides an enormous sponge to absorb Berkshire's cash -- Burlington requires billions of cap ex every year for maintenance and growth. Burlington is also related to Bekrshire's energy businesses, and I suspect that Buffett's successor will come from there (i.e. David Sokol).

So with a single deal, Buffett has transformed Berkshire into a more secure, easier to run company, with indefatigable earnings power. The opportunity to do this during a market trough, I believe, explains Buffett's willingness to stretch into it.

Nov 05 09:04 AM

[William Taylor:]

Just a few short months ago Buffet was all doom and gloom saying our economy was in financial chaos and we were on the road to ruin.

He seems to have changed his stripes rather quickly.

Nov 05 09:28 AM

[The Geoffster:]

Buffet will be dead long before his reasons for the BNI deal become apparent. He's looking out 10-20 years.

Nov 05 09:29 AM

[The Lonely ...:]

Uncle Long Hair: your points are well made. They are exactly the ones made by Alice Schroeder at Bloomberg. But the railroad business is cyclical and the idea that Berkshire is somehow safer after this deal is absurd.

Nov 05 10:39 AM

[UncleLongHair:]

> Just a few short months ago Buffet was all doom and gloom
> saying our economy was in financial chaos and we were on the
> road to ruin.

He wrote an op-ed piece in October 2008 telling everyone to buy American stocks, and he put his money where his mouth was. This turned out to be a mistake as he bought just before the worst of the disaster.

There are no quotes from Buffett about "doom and gloom and financial chaos". You are making that up.

Nov 05 11:03 AM

[SamiC:]

BNI makes six bucks per share in owner earnings at a minimum, right now in the middle of the worst recession in seventy years, (closer to eight the last two years.)
these earnings are growing at roughly 10-11% annually over time. It is a near monopoly with priceless and not replaceable land use right of ways. Rails are the cheapest way to move freight with any weight. BNI debt is about twice their operating earnings, and the returns on equity are the best of any of the rails.
If commodity prices increase due to inflation, they can raise prices accordingly.

why has Buffett been paying sixty five to seventy five dollars for BNI for years?
because it's worth $100 easy, (at about 13x normalized owner earnings) and that value will grow.

I'm pissed he stole it and I have to decide if I want to own more berkshire or pay the tax man.

This is a classic Buffett deal, simple, easy to understand business with high barriers to entry and run by the best managers in the industry at a fair price.

Nov 05 12:12 PM

[SamiC:]

Carlos, you make some questionable points: see below.

> Perhaps he has great insights into investing, but because Warren
> Buffett is a hypocrite of the greatest magnitude I simply would not
> trust him with my money.

Compared to who? Stanford? Madoff? a mutual fund or hedge fund manager with few assets of his/her own under management and no downside risk?


Behold:
>
> * Buffett criticized Pres. Bush's tax cuts and said that Americans
> should pay more taxes yet had BH bid for Fannie and Freddie's $3
> billion in tax credits. If we Americans should pay more taxes, Warren,
> doesn't that mean BH shareholders as well?

No, as a steward of other people's capital (and his own) Buffett should maximize BH's after tax return within the law, never mind if he believes the law is fair. Beneficiaries who agree with him can give money away if they have more than they need. He doesn't like paying taxes more than anyone else, but unlike most billionaires, he is not blind to the inequality in the world and the moronic overspending by the government since Reagan.


>
> * Buffett begged the US Senate in '03 to NOT eliminate the estate
> tax. What went unsaid was that BH has an insurance business that
> BENEFITS from the estate tax by selling a kind of insurance policy
> that makes sure that heirs have enough money available to pay the
> estate tax without having to liquidate assets.
>

how much of Berkshire's income is in this business? less than a percent maybe? He simply believes that the government should prevent dynastic wealth from being tax-free. not right or wrong, just an opinion.


> * Buffett famously called derivatives "financial weapons of mass
> destruction" yet BH sold $2.5 billion in credit-default swaps in
> '08.
>

Financial weapons of mass destruction for the idiots at AIG, Bear, Lehman, not for people like him who are good at calculating odds and spotting underpricing, and never take positions with unlimited downside risk. That's the part that leads to mass destruction, not taking calculated risks with limited downside risk.


> Such a duplicitous person may, of course, make money for those who
> he invests for. It's the agency risk--trusting a person who is two-faced--that
> would keep me up at night.


I disagree that he is Two-faced, if you actually read enough of his writing to understand what he means, he has pretty high integrity- and a good sense of humor.

I am most worried about the market's inability to price Berkshire properly, though that does make it easier to pick it up for a discount and sell for a premium as long as you don't need your money at a specific time. If I really can't handle market risk, I should have my money in CDs or a mattress.

Nov 05 12:33 PM

[David White:]

This play by Buffet is completely in line with his long term strategy thesis. You can virtually no longer build railways in the US. It is too expensive. The only real way to build new railways is to build them next to the current ones. Apparently there are some plans for this.

Oil will become more expensive. China and India will use a lot more soon, driving up the price. They currently use only a small fraction of what the US uses per person (less than a tenth). We will shift to solar, etc. to power our homes, but the problem of transport will still exist. Trains will be the cheapest way to accomplish this for long hauls. Long term BNI will be a great acquisition.

As for making BH share price cheaper through the split, I think that was a great idea. It makes BH more available to the masses. It makes it easier for BH to raise cash by issuing more stock. A huge buy like BNI probably put BH in a worse cash position than Buffet would like. He may be old, but the guy still has it. He's got guts too!

Nov 05 01:29 PM

[User 509562:]

You are entitled to your opinion and WB is entitled to his, but a honest CEO has to create value for all its shareholders regardless of personal opinion.


On Nov 05 06:13 AM Carlos Lam wrote:

> Such a duplicitous person may, of course, make money for those who
> he invests for. It's the agency risk--trusting a person who is two-faced--that
> would keep me up at night.

Nov 05 02:34 PM

[long_on_oil:]

If you don't like the TV show turn the channel. If you don't like Buffets decision then sell your shares. The way I see it he is giving 15% of Berkshire to increase earnings 40%. He not only gets rid of cheap dollars, he buys a great company with a greater future. BNI earnings based on 1.55 million outstanding BRK shares = $1200 per share. BRK's last 4 quarters earnings=$2935 per share based on yahoo earnings info.
Probably way to simplistic.

Nov 05 04:01 PM

[Carlos Lam:]

On Nov 05 12:33 PM SamiC wrote:

"Financial weapons of mass destruction for the idiots at AIG, Bear, Lehman, not for people like him who are good at calculating odds and spotting underpricing, and never take positions with unlimited downside risk."

Buffett didn't qualify that derivatives were WMDs of financial mass destruction only for "idiots." He made a general statement. Then, he proceeded to engage in derivative trades. Again, I do not want to invest in a company whose chairman blatantly says one thing and does the opposite. Perhaps you are correct that Buffett isn't as two-faced as I perceive him, perhaps not. Either way, I view the principle-agent risk to be too great.

Nov 05 08:07 PM

[Graham and ...:]

Not the best deal that Buffett can make.

But a better deal than a likely successor can make.

Clearest indication yet that Buffett is looking at stepping down (or being carried out), and that he wishes to tie the next person's hands.


On Nov 05 09:29 AM The Geoffster wrote:

> Buffet will be dead long before his reasons for the BNI deal become
> apparent. He's looking out 10-20 years.

Nov 07 03:27 PM

[lower98th:]

Dollar, will be "worth less," American resources will be for sale, and BH will help us send it all away. If you can't beat 'em, join 'em.

Nov 07 05:50 PM