If you think the man has lost his touch, think again.
Warren Buffett’s ‘elephant-gun’ purchase of the Burlington Northern Santa Fe, LLC (NYSE:BNI) railroad for $34 billion in 2010 was impeccably timed (coming as it did a year off the 2008-2009 financial crisis) and a huge bet on the revival of the US economy.
However, just four years later, this investment is worth at least $65 billion, according to analysts.
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“Based on 8x forward EV/EBITDA and a P/E multiple of 14x our 2015 earnings outlook, this would imply a current equity value for BN of around $65bn,” say Barclays analysts Jay Gelb, Sarah DeWitt, Jessica Idiculla, John O’Brien and Adam Frank in their April 28, 2014 research note on Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), the conglomerate and ultimate owner of Burlington Northern Santa Fe, LLC (NYSE:BNI).
“Notably, this gain in intrinsic value since the acquisition is not captured in Berkshire Hathaway’s financial statements,” they add.
The magic touch
The chart below shows how earnings at BNSF have expanded following its acquisition by Buffett.
The analysts also brush off the recent adverse publicity surrounding the railroad’s drag on Berkshire Hathaway Inc.(NYSE:BRK.A) (NYSE:BRK.B)’s Q1 results as a weather-related quirk.
BNSF and Berkshire’s first quarter
Net income was down to $4.71 billion ($2,862 a share) from $4.89 billion ($2,977 a share) in the year ago period. Operating profit during the quarter declined 7% to $ 3.53 billion ($ 2149 per share) from $ 3.78 billion ($ 2302 per share) a year ago. The consensus estimate was for profit of $ 2172 per share.
However, book value per share was higher by 2.6% at $ 138,426 compared to $ 134,973 as at the end of the year. This is Buffett’s preferred metric.
At BNSF, pre-tax profit for the first quarter fell nearly 9.3% compared to the same period last year as per Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s quarterly filing.
“In the first quarter of 2014, Burlington Northern Santa Fe, LLC (NYSE:BNI)’s revenues and earnings were negatively affected by severe weather conditions and service-related challenges, particularly in the Northern U.S service territory,” reveals Berkshire’s quarterly filing. “Together, these factors reduced operating efficiencies and gave rise to higher costs for service recovery.”
“Nevertheless, we expect that revenues and earnings over the remainder of 2014 will exceed 2013. In addition, our planned capital investments and new employee hiring in 2014 will expand capacity and allow us to maintain high service levels in the future,” assures Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) in its filing.
According to the Barclays analysts, the severe weather conditions during the winter made operating conditions very difficult for transportation companies across the country and BNSF, as well as main competitor Union Pacific Corporation (NYSE:UNP), were no exceptions.
The following graphic shows the impact of the weather on network fluidity as measured by train velocities.
According to Barclays, fluidity is reverting slowly to BNSF’s network. “While some challenges in BNSF’s system could persist well beyond the first few months in 2014, especially in the carrier’s northern operations, broadly we expect network recovery to track the pace of the broader industry,” they say.
At Berkshire’s annual shareholders’ meeting in Omaha, held over the weekend, questions were raised of Buffett regarding BNSF’s disappointing quarterly performance.
Buffett reassured shareholders that the company would be spending many, many billions of dollars to boost the railroad’s performance. “We are making significant investments,” said BNSF executive chairman, Matt Rose.
“At BNSF we will spend a lot of money to have the best railroad possible but we’re not going to be buying other businesses,” Buffett, 83, said, however.
“This business requires substantial capital expenditures (currently $5bn annually), although BN’s cash flows are more than adequate to cover these requirements” say the Barclays analysts. “Solid volume growth, marginal pricing gains, and the potential for unit cost improvement create a favourable backdrop for BN.”
This capital spending, as well as Burlington Northern Santa Fe, LLC (NYSE:BNI)’s locomotive capacity suggests that the weather disruptions during the winter could be mostly short lived, suggest the analysts. “Recent network disruptions are seasonal not structural… After taking a deep dive, we found these structural concerns to be a bit overdone.”
Burlington Northern Santa Fe, LLC (NYSE:BNI) is one of the largest railroad operators in the United States, running a network across 32,500 miles, as shown below. According to Buffett, BNSF transports about 15% of all inter-city freight, “whether it is transported by truck, rail, water, air, or pipeline.”
The railroad will benefit in 2014 from freight demand due to 3 factors:
- a record North American grain harvest
- growth in crude oil transportation markets
- and the shift from trucking to rail-intermodal service
In particular, Barclays note that BNSF is strategically positioned to take advantage of the US crude oil boom because of its direct access to the Bakken shale formation which is delivering significant growth for the railroad.
BNSF has already demonstrated a sustained rise in net margins from 12.4% in 2008 to 17.2% in 2013 as shown below:
“In 2014, we expect solid volume growth and continued focus on cost containment to deliver another year of solid earnings improvement for BN,” says the Barclays research note.
Competition is robust
According to Barclays, competition in railroads remains robust, and arch rival Union Pacific is slightly ahead. “Union Pacific has generated notable improvement in profitability and cash flow conversion over the past several years,” note the analysts. Post the Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) acquisition, BNSF has kept pace, though “Union Pacific comes out slightly ahead in terms of free cash flow conversion, margin expansion and capital returns.”
Nevertheless, market analysts, such as Josh Brown of Ritholtz Wealth Management do raise the question of the impact of the 1700 mile long Keystone XL pipeline project on the business of BNSF, were it to obtain the necessary approvals.
“We expect solid volume growth, marginal pricing gains and the potential for unit cost improvement should create a positive setup for BN earnings in 2014,” says the Barclays research note, however. “Importantly, we expect the company will maintain an adequate ability to pay a consistent and large distribution to Berkshire Hathaway.”
This should be highly beneficial for Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) given that Burlington Northern Santa Fe, LLC (NYSE:BNI) accounts for nearly 26% of Berkshire’s pre-tax operating earnings. More power to the elephant gun!