An In-Depth Look At Berkshire Hathaway, Part 3: Burlington Northern Santa Fe

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This is the third article in a series describing Berkshire Hathaway's business units. Part 1 described its insurance subsidiaries. Part 2 described its energy and utility companies. Part 3 describes Burlington Northern Santa Fe.

Berkshire Hathaway (BRK.A, BRK.B) has a remarkable collection of businesses in addition to its well-known investment portfolio and insurance operations. Berkshire is better regarded as a large conglomerate. Rather than performing a simple calculation based on book value, each business unit can be evaluated separately. Part 1 of this series estimated the value of its insurance businesses at $92 billion, or $37 per B share. Part 2 of this series estimated its energy and utility companies, principally organized under MidAmerican Energy, at $15 billion or $6 per B share. This article will compare Burlington Northern Santa Fe to competitors to derive a reasonable valuation.

Burlington Northern Santa Fe (or BNSF) operates one of the largest railroad systems in the United States. According to Berkshire's annual report, BNSF "[serves] the Midwest, Pacific Northwest and the Western, Southwestern, and Southeastern regions and ports of the U.S." This includes 32,000 route miles of track over 28 states and two Candian provinces. BNSF ships products and commodities from manufacturing, agricultural, and natural resource industries.

About 42% of inter-city freight in the United States is carried by rail, and BNSF carries 28% of this, the largest share of any carrier. BNSF shipped 9.2 million carloads in 2010, including over 1 million each of agricultural products, industrial products, and consumer products (with more than 1 billion cans of canned goods). Coal accounts for roughly one-third of all cargo carried on BNSF, more than 90 percent of which comes from the Powder River Basin in Montana and Wyoming. Between coal, industrial products, and agricultural products including fertilizer, BNSF is significantly exposed to the overall economic health of the United States. Indeed, Warren Buffet made this point in his reasoning behind the purchase of BNSF: in the 2010 annual report, Buffet posits that "over time, the movement of goods in the United States will increase, and BNSF should get its full share of the gain."

BNSF had 2010 revenue of $16.85 billion and after-tax profit of $2.46 billion. The numbers reported in Berkshire's annual report are slightly different because the acquisition closed on February 12, 2010. I'm using the full-year numbers because those more accurately reflect the strength of the business in current and future years.

The railroad industry in the United States has only a few major national players. Since a railroad renaissance increased shipping efficiency in a gradual process over the last 20 years for all railroads, they trade at similar P/E multiples. Norfolk Southern (NSX), Union Pacific (NYSE:UNP), and CSX (NYSE:CSX), and Canadian National (NYSE:CNI) are Burlington Northern Santa Fe's closest competitors. They trade at P/Es based on 2010 earnings of 13.2 - 16.4, with an average P/E of 15.2. Applying this P/E multiple to BNSF's 2010 after-tax earnings yields a value of $37 billion, or $15 per B share.

BNSF has strong historical growth, and continues to grow its revenues and earnings at a good pace. In the third quarter 2011 report just released, BNSF increased third quarter revenues by 13%, and after-tax profits by 8.5% over the year ago quarter. In the first 9 months of 2011, BNSF increased revenues by 15.7% and after-tax profits by 13.7% over the first 9 months of 2010. These gains are significantly above the estimated 5% average increase for the 4 comparison railroads listed above.

So what is a reasonable range of valuations?

1. If BNSF were priced according to the valuations given to its competitors, it would be valued at $37 billion in total, or about $15 per B share.

2. However, $37 billion is just 9% higher than the purchase price of $34 billion while earnings are more than 60% higher than they were at the time of purchase. That suggests that Berkshire would value BNSF at $55 billion today, or about $22 per B share. Even if you believe Berkshire paid too high a price of BNSF, $22 is a reasonable upside valuation.

3. Applying the pre-merger market multiple of BNSF to current earnings would give a valuation of about $41 billion, or $16.60 per B share. A combination of superior management, lower finance costs, and faster growth suggests that BNSF should be more valuable than its competitors.

In summary, an appropriate range for the value of BNSF is $37 - 55 billion, which corresponds to $15 - $22 per B share.

Disclosure: I am long BRK.B.