Warren Buffett Didn't Buy All of the Railroads

 |  Includes: CSX, UNP
by: YCharts

The fabulous opportunity represented by the first-quarter 2009 bottom for these two railroad stocks is long gone, of course, and even Warren Buffett didn’t buy at the very bottom. His Berkshire Hathaway (NYSE:BRK.A) waited until November of 2009 to cut its deal to acquire the 77.4% of Burlington Northern Santa Fe (BNI) it didn’t already own, for $26.4 billion in cash and stock.

UNP, CSX Chart (click to enlarge)

For investors, Burlington Northern has largely disappeared into the well-managed maw that is Buffett’s conglomerate. But Union Pacific (NYSE:UNP), CSX (NYSE:CSX) and other large railroads remain, and the early stages of the economic recovery are very encouraging for them. Freight volume is rising sharply. The railroads are unashamedly raising prices. And they are only slowly calling back workers laid off during the falloff in business. The result is leverage – profits rising faster than revenue. And revenue has been snapping back quickly.

UNP, CSX Chart (click to enlarge)

Union Pacific’s net income rose 48% for the first six months of the year, to $1.23 billion, or $2.42 a diluted share, on a 21% rise in revenue. Operating expenses crept up only 11%. During that period, the railroad actually managed to employ fewer workers, on average, than a year earlier. “We demonstrated great volume leverage,” CEO Jim Young crowed about the results.

CSX likewise managed a 31% increase in profit, to $719 million, or $1.84 a diluted share, on a 16% hike in revenue during the first six months. CSX managed to charge coal shippers 16% more per carload. Automotive shippers paid 10% more. Chemical makers paid 8% more.

UNP, CSX Chart (click to enlarge)

What was most impressive was how both companies cut costs rapidly enough in 2009, so that each had a respectable year, even with revenue falling about 20%. They also caught a break from lower fuel prices, though diesel, like gasoline charted below (click to enlarge), has since headed back up.

Gas Price Chart

Buffett, of course, likes businesses with “moats” dug around them, barriers to entry that reduce competition and give a company pricing power. Railroads have that in abundance. The rights of way needed to build a new railroad would be nearly impossible to gather up today. CSX, a combination of many rail mergers, dates back to 1830. Its 21,000 miles of rail routes cover 23 states east of the Mississippi River. Union Pacific’s 32,000 route miles cover 23 Western states.

So, when the economy is really smoking, and railroads are capacity constrained, they raise prices more aggressively; note the revenue peak below (click to enlarge).

UNP, CSX Chart

There are two major problems, however. One, railroads are incredibly capital intensive. Union Pacific sinks about $2.5 billion a year into its rail system and rolling stock. It installs more than 4 million railroad ties a year. And the busier the railroad is, the tougher some of that maintenance is to complete.

UNP, CSX Chart (click to enlarge)

The other problem is the very scarcity that railroads enjoy. The tracks and yards get so crowded that shipping slows, customers become irate, and some eventually call a trucking company. The railroads claim that, this time around, they didn’t cut too deeply, that they’ll be able to handle the rising loads of freight. If they’re right – and so far, very early in the recovery, they’re doing well – following Warren Buffett into railroad shares wouldn’t be a bad idea.