Buffett's Burlington Deal
Buffett's Burlington Deal
On Melbourne Cup day, Berkshire Hathaway produced a shock of its own. Warren Buffett's company announced it had made an 'all-in wager on the economic future of the US'. Berkshire has agreed to buy the 77.4% of Burlington Santa Fe railway group that it didn't already own for US$100 per share in cash and stock - a 31% premium to the 2 November closing price.
The price - equating to an equity valuation of $US34bn and a price-to-earnings multiple of about 18 times - could hardly be considered cheap. Particularly when judged against Buffett's historical standards. But you can draw one of three conclusions from the deal.
Firstly, in a world of rising inflation and rising energy prices, Buffett believes rail is going to be the big winner: 'Burlington Northern Santa Fe last year moved, on average, a ton of goods 470 miles on a single gallon (3.8 litres) of diesel, and society has an enormous interest in using less oil to transport goods'. He went on to say that 'Each train displaces 280 trucks on the road. When it comes to spewing pollutants there is nothing more efficient than trains.'
The second conclusion you could draw is that he thinks Berkshire's own stock is overvalued. A significant portion, 40%, of the purchase price will be paid for with Berkshire shares. The last time Buffett made such a large scrip acquisition was the US$16bn, 1998 purchase of General Reinsurance. At the time, much of Berkshire's $US60,000 share price comprised of overpriced (by Buffett's own admission) equity investments. Many of his long-term holdings, such as Coca Cola and American Express, are still trading below their 1998 levels more than 10 years later. Berkshire itself looks more reasonably priced today, but perhaps Buffett knows something we don't.
Finally, while I don't want to upset the Buffett world again by suggesting the Oracle may have lost his marbles, he may simply be preparing Berkshire for a post-Buffett world. Burlington mightn't be the cheapest investment he's ever made but there's every chance it will still be around and profitable in 50 years' time. Perhaps that gives him a lot more confidence in the future of his estate than leaving behind a large pile of cash for someone else to manage.
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According to T. Boone Pickens, there are 6.5 million 18 wheeler trucks in the US, what a phenomenal number! There must be huge scope to transfer some of this (the long-haul trucking) over to rail. Buffett probably sees the rail network as grossly underutilised compared with where it should be in a high oil price environment.
BTW, Berkshire is a bargain at US$100,000 a pop, I'm pretty confident you're barking up the wrong tree on that one. The Burlington board insisted on part scrip for tax reasons, and Buffett obviously thinks he's getting more value than he's giving up. But Berkshire is very unlikely to prove overpriced at $100,000 per A share.
So how much should I add to the purchase price for the fact that he's paying with cheap scrip?
Anyone's guess is as good as mine. But my point is that if Buffett thinks he can significantly increase capacity (by increasing the number of trains, length of trains, and capacity of each car) at a time when trains have a significant and perhaps permanent pricing advantage over long-haul trucking, then today's PER isn't really relevant to judging the overall attractiveness of the deal (obviously, I know that you know this).
Anyone can see that if Buffett thinks Burlington is selling at 60% of fair value and Berkshire at 80% of fair value, the deal is a great one, especially considering it's more than half paid for with cash.
That's not to detract at all from your last paragraph, but I don't think that paragraph is any revelation. Buffett has warned for years that shareholders will need to settle for lower returns, and this deal should adequately beat cash in the bank.
Wazza likes trains and the only difference betweeen billionaires and men is the size of their toys.
There are probably two important reasons for this: 1- the Berkshire Hathaway portfolio is too skewed towards financial companies [which is part of the reason he is selling Moody's every chance he gets, besides the GFC rating debacle's damage to its reputation, moat, and future cash flow] and ; 2- He believes the FED will keep interest rates low and the US dollar weak and therefore export traffic and income should improve. Note that for the last few years he has been trying to buy foreign [non US] companies to profit from their earnings as the US dollar declines.
The Burlington deal is exactly what Buffett has always spoken about.
1. It is an opportunity to allocate a lot of capital in one go on something he already knows a lot about.
2. It has limited financial downside.
3. It has mouth watering economics. Margin expansion is almost guaranteed as Burlington increases its transport prices along side road transport while its costs don’t mimic those of road transport as much. Burlington is a smart oil play.
4. Through time the business will attract more customers without having to cut prices (it will actually increase them) or deploy a lot more capital. ROE is going to rise through time.
5. It probably will have the capacity to allocate new large amounts of capital to new opportunities e.g. to service the 6 or 7 new coal generating plants planned to be built in the USA.
To consider this deal in the context of its current PER is to miss pretty much everything Buffett has ever said about value. It has nothing to do with the FED or GFC or any legacy issue but all to do with business economics and buying big good ideas with a low risk factor. This is the kind of deal he has always spoken about so it should really be a no brainer to understand it. I can't wait till he talks about it come May.
It would appear Buffett is so keen to do this major deal he would pretty much agree to any minor demands to get it across the line. He will pay a 30% premium so alarm bells should be ringing on this one for the seller.
And I thought that other 80 something year old Bart Cummings was having a good couple of weeks! Those two have a lot in common.
This comment: "Anyone’s guess is as good as mine. But my point is that if Buffett thinks he can significantly increase capacity (by increasing the number of trains, length of trains, and capacity of each car) at a time when trains have a significant and perhaps permanent pricing advantage over long-haul trucking,"
Shows a fundamental misunderstanding of how rail freight works; indeed of how the interaction between road and rail (and in the US coastal shipping works).
Some points
Railroads in the US are regulated (if lightly), cetainly much more heavily than road. Rail cannot carry many freight tasks (ie where the pick up and or delivery point require a truck which can be shown to more cost effective or faster over the total freight task). Trains often cannot be made 'longer'. One cannot often run 'more' trains either due to capacity constraints. This could lead to price increases but as has been shown in the US, Australia and overseas even when rail is cheaper it only garners a small portion of the freight task; once the price-point reaches a level where it is uncompetitive (particularly in the trade-off with total time elapsed - rail is always slower than road end-to-end) then the freight stays on the road.
The 'capacity of each car' is a good example of not understanding an industry - the capacity of a car is generally already maximised everywhere in rail - of course its a combination of factors but there are very few rail cars running anywhere that are not maximised and dont forget that most rail freight is either containerised travelling on a flat bed car OR is carrying such bulk material as coal or wheat.
Its not for me to question Buffett but I for one wouldnt be placing a large slice of my fortune in an industry as difficult as rail. The energy price spike is unlikely to create massive gains for this industry unless carbon taxes and the like do the job for the owners.
Again I have to query these two claims:
"It has mouth watering economics. Margin expansion is almost guaranteed as Burlington increases its transport prices along side road transport while its costs don’t mimic those of road transport as much. Burlington is a smart oil play."
The very economics mentioend here have been in play ratio-wise for decades. They havent resulted in some sort of mouth-watering monopoly type returns (indeed there are a number of listed railroad stocks in the US, so Burlington wont have the rail game to itself). The trade-off between road, rail and shipping (domestic coastal and river in the US are both much larger than here) will partly drive results. But for all those who want trucks off the road let them explain how a farmer gets his goods from farm to market; or a supermarket distributor to the Coles in Prahran by using rail. Rail is good for long-haul point-to-point where speed is not an issue and the cost mix is right. One other factor to consider - rail is generally much less reliable than road and I dont think even Buffett can fix that - neither can Burlington which does not control all the levers in the supply chain, including total track access.
4. Through time the business will attract more customers without having to cut prices (it will actually increase them) or deploy a lot more capital. ROE is going to rise through time.
Really. How do you justify that comment? Blind faith perhaps? To increase capacity one must invest in both rolling stock and locomotives - these are VERY expensive items, although they do have a long-life. The users of the rail network (ie, BUrlington) are also required to pay significant fees to maintain the network - its not provided for free.
I suggest you go back and have a look at the financials of Burlington – the last 20 years worth, and compare the last 10 years with the previous 10 years and the last 5 years to the 5 years before that. The numbers speak for themselves about the changing dynamics in this business. With over $36 billion of assets every 1% incremental increase on return on those assets adds up over time and the long term trend is up. This is a better business than you think.
published view on the deal from Alice Schroeder
http://bloomberg.com/apps/news?pid=20601039&sid=aL9x8sp3.Nwk
Steve, you're not the only one who thinks Buffett has lost it, check out these quite incredible comments from Bruce Greenwald, professor of finance at Columbia and an esteemed value investor. I quote, 'we think he has lost his mind' http://www.gurufocus.com/news.php?id=76392
sorry for the late comments on this, but I thought it was worth considering this
Buffet paid 100 per share for the remaining 77.4 % of BNI he did not own. This cost his 26.3 bn. Net profit for the previous year was 2.11 bn. 77.4 % of this would be 1.638 bn. This equates to an initial rate of return of 1.638/26.3, or 6.2 %. This is itself is not too shabby, but better when one considers that BNI has increased its EPS on a compound annual growth rate of 12.56 last decade. This gives Buffet an initial coupon of 6.2, with an annual growth of 12.56.
Not too shabby me thinks !
Es
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