On Berkshire and Burlington Northern

Includes: BNI, BRK.A, BRK.B
by: Dan Braem
During the past year, I wrote a book titled “Building the Next Berkshire Hathaway.” On page 12, I note that it will be interesting to see the direction that Berkshire Hathaway is headed. My prediction was that it will increase its holdings in both railroads and utilities. Check one of those off the list.
I believe it is clear that Berkshire, if excess capital is available, will try to expand its utility operations. Please note the failed attempt to take over Constellation Energy (NYSE:CEG). These stable cash generators (railroads, natural gas pipelines, utilities) are the future of Berkshire Hathaway. However, it may take some time before another big deal is made.
As it stands now, Berkshire Hathaway is a cash flow machine. Note the following income streams:
1) Approximately $1.5 billion from preferred dividends and similar investments (Wrigley (WWY), GE (NYSE:GE), DOW Chemical (NYSE:DOW), and Goldman Sachs(NYSE:GS))
2) $300 million from Coca-Cola (NYSE:KO) dividends
3) $1 billion (approximately) from future Burlington Northern Santa Fe (BNI) acquisition
4) Cash from other fixed investments (see investment float from insurance operations)
5) Approximately $1 billion from utility operations
Berkshire Hathaway is a huge conglomerate, and the above is just to provide a general idea of cash flow sources. There are many.
The point I want to make is that it is entirely possible that Berkshire Hathaway will generate $10 billion in free cash flow per year for the indefinite future. All of that capital will eventually need to be allocated. This is truly an amazing company.
Burlington Northern Santa Fe
Many people were shocked by this acquisition. As I mentioned above, I am not surprised that Berkshire bought BNI. However, I was surprised at both the price and the use of Berkshire Hathaway shares used to finance the deal.
However, please keep in mind own two of the owner related principles of Berkshire Hathaway (which have been around for a long time):
  • A managerial "wish list" will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
  • We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance, not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company and that is what the issuance of shares amounts to on a basis inconsistent with the value of the entire enterprise.

Obviously, the deal is not cheap by any financial metrics, but Buffett must believe that it will be beneficial to shareholders. Time will tell.

One item that has not been mentioned in the press is how the BNI deal fits into the Berkshire Hathaway model. As we all now by now, Buffett prefers owning entire companies as opposed to owning smaller positions. There are at least two major benefits from owning entire companies:

1) Buffett can allocate the excess capital (as opposed to the previous management handling excess capital not used for future business purposes).

2) There is a tax advantage on the repatriation of dividends for wholly owned companies.

Let’s look closer at the BNI deal:

1) The annual dividend for BNI is $1.60 a share, or about 2% when the stock price was in the $75 range.

2) By paying $33 - $34 billion for the company, Berkshire will get all of the $1 billion in free cash flow. That equates to a 3.3% cash flow stream (as opposed to the 2% cash flow from 20+% ownership)

In addition, dividends from 20% or more owned companies are taxed on 20% of the dividend, multiplied by a 35% tax rate. As an example, if Berkshire were to receive $1,000 from BNI, $200 would be taxable at a rate of 35%, or $70. In short, 7% of every dividend Berkshire Hathaway would receive from BNI (before the deal) would go to the U.S. government.

Now, 100% of the distribution (assuming the BNI deal closes) will go to Berkshire Hathaway tax free. Over time, the 7% haircut is not immaterial.

It is certainly difficult for Berkshire Hathaway to make deals that “move the needle.” The BNI deal certainly is a significant transaction. I would expect that in three years time, there will be another large transaction. Keep an eye on the utility sector.

Positions: None