It’s no longer a secret that Warren Buffett has been buying Burlington Northern Santa Fe (BNI) with some degree of enthusiasm. In total, Berkshire Hathaway (NYSE:BRK.A) owns about 22% of the entire company.
A few years ago, in the Wesco letter to shareholders, Charlie Munger gave us some clarity on how the company thinks about entering common stock positions after they ‘lowered the bar’.
Unless, however, we see a very high probability of at least 10% pre-tax returns (which translates to 61/2-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun.
Before we get into how Buffett likely came up with his $80 price let’s look at BNSF the business.
Without getting into too much detail, BNSF is one of the best rail companies. It has an advantage of being on the West Coast, is one of the more predictable and stable companies, and lacks the debt that competitors like CSX have. Perhaps the only better managed rail company in North American is CN (Bill Gates holds a large position in CN). In my research, BNSF and CN, briefly attempted to merge in the late 1990’s. Regulators asked for a 15 month review period. The two companies felt this created too much uncertainty for their shareholders and called the merger off.
Recent history suggests that BNSF can do financially well when oil prices go up. Railroads, despite common belief, are still profitable with cheap oil (fuel) prices. In the past 18 years, BNSF has failed to turn a profit in only one (1993). As mentioned in a prior post, trucks are slowly losing any advantage they had to railroads as companies in a competitive environment for transport. Rails are become becoming faster, cheaper, and more reliable, which is important for organizations which operate under ‘lean’ or ‘just in time’ inventory. Throw in locomotives that are more fuel efficient and computerized scheduling, and you quickly realize that paradigms have shifted.
Two huge operating expenses for the company are compensation (unionized) and fuel. Although we didn’t graph it, compensation as a percent of revenue has gone from 36% in 1993 to 21.5% in 2008. Over this same period, revenues have increased from 4.5B to 18B. In part this is because the company can pass along rising fuel prices to customers (who have little alternative but to pay).
Now the company earns a lot of money, but they constantly spend more on capital expenditures than on depreciation. Some of this difference is because of “growth” capital-expenditures, but the majority of the difference is just because of cost inflation. It costs more to resurface track today than it did 6 years ago. Locomotives cost more today than they used to (they are also about 15% more efficient). Because the company spends more on maintenance cap-ex than depreciation, this means that owners’ earnings — the earnings that can be taken out of the business without harming its long term competitive position — are less than stated earnings.
The equity bond
Over the last 15 years, BNSF has been a model of consistency. Buffett and Munger also acknowledge that the company — despite the unions and high capital requirements — has a competitive advantage. This is perfect for how Buffett thinks about about an ‘equity bond’. In order to have a bond that pays a growing coupon you need something predictable with moderate growth opportunities for retained earnings (or, in equity bond terms, the retained portion of the coupon).
Since 1994 BNSF has been consistently profitable and we know the company is fairly predictable as to what it will look like in 10, 20, or even 30 years. Technology is likely to change slowly and benefit the industry as a whole over alternative modes of transport. As the cost advantages of Rail become even more apparent, there is a long runway for the future to earn average returns on capital.
Knowing the business is a model of consistency, Buffett can attempt to value it like a bond. Generally speaking, a bond is pre-tax, so we can add back the income taxes paid to net income to get pre-tax earnings. Now we divide by 10% to get the price one would pay for a 10% bond with this coupon. If we divide that by the number of shares we get the approximation of intrinsic value (see the chart below). This way of valuing BNSF seems to follow the Berkshire logic in the timing and price paid for their shares. It speaks to why $80 was the magic number and not $90.
NFI Note: For a more accurate picture you have to take earnings less the difference between (maintenance cap-ex) and depreciation. This gives you an accurate picture of owners’ earnings. For 2008 the company spent 1,862 on replacement capital and had 1,397 in depreciation. To approximate owners’ earnings we do the following: (2,115 - earnings) plus (taxes - 1,253) less (maintenance cap-ex, which is maintenance cap-ex less depreciation 1862-1397) = 2,903. The new maintenance cap-ex is used because historical depreciation is too low. We’re not including growth cap-ex. Thus we can look at BNSF as a bond that paid a coupon of about $2,900 (in millions, pre-tax) last year. Part of this coupon gets paid to shareholders regularly through dividends and another part of it gets reinvested in the business at about 11%.
What would someone be willing to pay for a bond paying a coupon of 2.9 billion a year that desires a 10% pre-tax return? (2900/.10) = 29B. If we divide that by the number of shares outstanding as of 31-Dec-2008 (339.2 million) we come up with the approximate price of $85.58.
Disclosure: Long BNI.