Following Buffett's Railroad Tracks

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Includes: BNI, BRK.A, NSC, TRN, UNP, WAB
by: Investment U

Warren Buffett is arguably the greatest value investor the world has ever seen. His investment holding company, Berkshire Hathaway (NYSE:BRK.A), has averaged a compounded return of 21% a year since 1965. That turned every dollar into $400,863. By contrast, the same investment in the S&P 500 would only be worth $6,840.

When Buffett starts buying, the markets take notice. And so do we…

A self-made billionaire, Buffett is famous for taking large positions in companies and holding them for a very long time. And "long hauls" are exactly what he's had on his mind recently.

Last year, Buffett started buying up railroads such as Norfolk Southern Corp (NYSE: NSC) and Union Pacific Corporation (NYSE: UNP). And now he's building his largest railroad position - Burlington Northern (NYSE: BNI). He owns 18.4% of the company - a massive $5.5 billion endorsement.

Why's he betting big on the railroad industry?

It seems to go against common thinking that the rail-freight shipping industry is doing well. After all, the economy is stumbling:

  • GDP is almost at a standstill at 0.6% growth.
  • Inflation increased 2.2%in the first quarter alone.
  • The volume among freight shippers decreasing from last year by 3.4%.
  • Fuel prices are steadily increasing and oil is hitting new records.

So what's missing here? Plenty.

The rail industry has seen its overall volumes decrease slightly over the last year. But railroads, considered to be behind the times, slow innovators, and in an industry that had little power to increase profit margins, are proving just the opposite.

Rail: The Economical Alternative to Trucking

There are more than 173,000 miles of track in North America, with 150,000 miles in the United States alone. As an industry, it's enormous, generating $42 billion in annual revenues. Some of that revenue is made by moving 30% of this country's grain harvest and more than 40% of all inter-city freight. That's more than any other mean of freight transportation.

As the agriculture industry brings more than 79 new ethanol plants online in the next two years, they expect much of the 12 billion gallons of ethanol to be shipped by railcar. (Ethanol cannot be transported in pipes like oil.)

Railroads also carry more than 65% of the nation's coal, which provides more than half of the nation's electricity. As our power demands increase, so will the coal companies' demand for shipping.

To be sure, trains are better than trucks. One standard railcar can hold up to 100 tons of densely packed freight. To ship that much by truck would take four standard tractor-trailers and four times as much fuel. This fuel efficiency allows a train to haul one ton of freight 423 miles on one gallon of diesel. As fuel prices go up, this efficiency will only make rail more competitive to alternative shipping options.

In fact, many trucking companies use rail freight for their cost savings. (UPS (NYSE:UPS) - a shipping company usually associated with trucking - is the railroad industry's biggest customer.)

Truckers, forced to raise their prices by rising fuel costs, are finding themselves undercut by rail freight costs. Railroads are in a unique position of being able to increase their pricing to press their cost advantage, and still remain a less expensive alternative to trucking.

But with many rail stocks trading at all-time highs, it's difficult to spot the bargains. Since we can't all have the foresight of "The Oracle from Omaha," let's take a look at how we can get on board the profit train without paying hyped-up prices.

Playing the Railroad Infrastructure Boom

Burlington Northern experienced declines in overall freight. But the company increased prices on its larger coal and agriculture shipments, which helped drive 2007 revenues to $15.4 billion. That's an $800 million increase from 2006.

Soaring demand for exports and commodities such as coal, agricultural products and ethanol have kept the rails active… even if they weren't at capacity. With competitive rates and advantages over trucking, the rail industry is well placed to weather all but a protracted slowdown in the economy.

The thing is, investors who rushed to copy Buffett's purchases pushed the prices much higher and will end up with an investment that will fail to return as well. It doesn't pay to follow the herd; those in the front have already made the biggest gains.

But the railroads aren't the only way to profit from this long-term trend.

The Department of Transportation predicts freight rail tonnage will rise 90% by 2035. In 2008, rail companies will lay new track and build new facilities, terminals and tunnels to prepare for the coming increases.

In all, U.S. railroads will spend close to $10 billion in capital improvements.

Here are a few of the companies they'll be hiring:

Westinghouse Air Brakes Technology Corporation, or Wabtec (NYSE: WAB) as it's known, produces locomotives, rail cars and transportation equipment.

Wabtec recently won a contract to build 26 trains for the Maryland transportation system, worth $95 million, and a $100 million contract in New York City. Wabtec has also received contracts from rail systems in California, New Mexico, Utah and Minnesota. And the numbers look good:

  • First-quarter earnings have risen 27% to $383 million,
  • Earnings have been increasing for the last four years and the past four quarters, and
  • It has increased its cash reserve to $234 million.

In its last earnings report, the company increased its guidance for 2008, now expecting earnings to be higher than originally expected. What's more, institutions love loading up on this stock. They hold 95% of all outstanding shares. The board of directors thinks the stock is cheap, too. It recently authorized the repurchase of $100 million worth of shares.

Trinity Industries, Inc (NYSE: TRN) is the largest North American freight rail manufacturer with 30% of the market. It produces freight cars, passenger railcars, boxcars and others. Trinity has a backlog of orders, roughly 31,800 railcars worth $2.7 billion. In the last quarter of 2007, Trinity shipped 6,740 railcars and received new orders for 7,310 more.

Interestingly enough, the company gets only 50% of its revenues from rail. Trinity has an Inland Barge group that increased 30% last year, and an energy division that has been doing even better.

The Energy Equipment group produces wind towers and construction materials for the exploding renewable energy industry. This division has been growing fast, increasing revenues by 46% to $141 million last year. The company expects revenue to grow even more this year, to $380 million.

Trinity also owns part of a joint venture that purchases railcars from Trinity and leases them to customers. Called TRIP, this venture increased its revenue by 70% to $80 million. It has agreements to purchase $1.4 billion in railcars from TRN.

Total company backlog across its multiple divisions totals over $4 billion, which will propel it well into 2009.

While TRN has four profitable groups, the thing to remember is that railcars are where it makes most of its revenue and its highest margins. Rail can be a cyclical industry and TRIP's continuous purchasing and leasing income will provide stability.

Uncle Sam Pitches in to Boost Rail as Well

We've all heard about the stimulus checks that the Fed is sending out to millions of Americans. But we haven't heard about the incentives for businesses.

There is a little known credit within this stimulus package that allows businesses to depreciate up to half a new asset's value in the first year. It gives companies an incentive to make large capital purchases before the end of the year.

So businesses buying rail cars can take a 50% credit for the new purchases. But the catch is that they must receive and use the property before the end of the year.

What's more, federal guidelines require railcars to receive regular maintenance for a service length of 50 years.

Right now, there are 1,563,000 rail cars across North America - 625,200 of them are older than 25 years. A conservative estimate would require that the industry produce 62,520 new cars a year for the next 25 years to maintain the current number, and that's not taking into account any of the increasing rail growth. 

That should certainly keep Wabtec and Trinity busy for the "long haul."

WAB vs. TRN 1-yr chart: