In an amended filing of the proxy for Berkshire Hathaway’s (NYSE:BRK.A) proposed acquisition of Burlington Northern Santa Fe (BNI), new details have been provided regarding Burlington Northern’s management forecasts of future results based on a number of different macroeconomic assumptions. The restrained nature of the forecasts and the fact that management projections for 2010 net income are lower than Wall Street consensus forecasts, even under the most optimistic scenario, was the subject of an article in Barron’s over the weekend.
In addition, Warren Buffett’s comment during negotiations that Burlington Northern is worth approximately mid-$90s per share has attracted attention particularly given Berkshire’s use of stock to fund part of the transaction. Let’s take a brief look at some of the more interesting information in the latest proxy filing.
Excess Conservatism or Better Insights?
As the Barron’s article points out, Burlington Northern forecasts earnings per share of $5.04 in 2010 under its most optimistic scenario. This falls short of the Wall Street consensus of $5.50 for 2010 earnings per share. Furthermore, since Burlington Northern management indicates that they believe a 2011 recovery is more likely, earnings per share might be even lower. For full details regarding the four scenarios presented by Burlington Northern, please refer to pages 42 to 44 of the proxy document.
The Barron’s article implies that Burlington Northern’s management prepared the scenarios and estimates after the merger was proposed in November. However, the proxy statement indicates that the management cases were prepared in September prior to an annual board meeting devoted to a discussion of long term plans. These management cases were provided to Goldman Sachs and Evercore Group in late October as inputs into the independent valuation analysis these firms performed for Burlington Northern during the board’s deliberations on Berkshire’s proposed acquisition.
Management came up with four scenarios: 2010 Recovery, 2011 Recovery, No Recovery, and Deeper Recession. The Board instructed Goldman Sachs and Evercore to regard the 2011 Recovery case as the most probable. This scenario calls for earnings per share to increase from $4.41 in 2010 to $9.35 in 2014. The more optimistic 2010 Recovery case projects earnings per share to increase from $5.04 in 2010 to $10.96 in 2014. The No Recovery case calls for essentially flat earnings on average over the five year period while the Deeper Recession case obviously projects even worse results.
Does this imply that Burlington Northern’s management is being much more conservative than Wall Street analysts? It seems that the answer is yes given that the “most likely” scenario is the 2011 Recovery case rather than the 2010 Recovery case. As we have discussed in the past, railroads are a “derived demand” industry meaning that business trends can provide great insight into overall economic conditions. Since rail indicators continue to show relatively weak results, it seems prudent for management to exercise caution when making long term plans.
“Fair Value” for Burlington Northern: Mid-$90s Per Share?
On pages 36 to 39 of the proxy, a detailed account of the merger discussions is provided. One portion of the discussion is particularly interesting for Berkshire Hathaway shareholders:
Mr. Buffett expressed his belief that fair value for BNSF’s common stock was in the mid−$90s per share, and that therefore the $100 per share price he was contemplating was, in Mr. Buffett’s view, as high as Berkshire could pay.
If fair value for Burlington Northern was in the mid 90s per share, then why did Mr. Buffett agree to offer $100 per share? As he stated at the time, the transaction is obviously a major bet on the United States economy. This does not mean that a recovery is imminent in 2010 or even in 2011, but obviously Mr. Buffett believes that rail traffic will be substantially higher five to ten years from now.
One aspect of the transaction that troubles many Berkshire shareholders is the fact that stock is being used to fund 40% of the purchase price. As we discussed in coverage of the transaction at the time of the announcement, Mr. Buffett does not believe in issuing Berkshire stock unless Berkshire is receiving as much or more intrinsic value in return. If Burlington Northern shares are “fully valued” in the mid-$90s per share range and Berkshire is using stock to fund part of the $100 per share acquisition, then are Berkshire shares fairly valued or overvalued?
While it is certainly possible that Mr. Buffett regards Berkshire shares as fairly valued, two points must be made that could lead to a different conclusion: First, in any merger transaction, the acquirer is obviously not going to brag about obtaining terms that undervalue the acquisition target. While Mr. Buffett may regard Burlington Northern as worth no more than $100 share today as a stand alone publicly traded company, he apparently has a positive view of the United States economy that can support a much higher valuation for Burlington Northern five to ten years from now. Second, it is possible that Mr. Buffett believes that Burlington Northern is worth more as a Berkshire subsidiary than as a stand alone public company. The fact that Berkshire has significant cash flow from operations to invest each year along with the ability to borrow at very low cost is a great match for a business that requires steady capital investment.
The definitive answer to the question of whether Berkshire is overpaying for Burlington Northern will not be known for several years. However, use of Berkshire Hathaway stock as a funding source at a time when Berkshire’s share price is clearly “on sale” based on a number of measures we have discussed in the past is cause for legitimate concern. The stakes are high and macroeconomic factors, rather than the execution of Burlington Northern’s management, will play the predominant role in determining the outcome.
Disclosure: The author owns shares of Berkshire Hathaway.