Here is an article we wrote on Burlington Northern Santa Fe (BNI) in January 2009 (that was published on NoiseFreeInvesting.com and seeking alpha).

For decades the trucking industry has had significant advantage over the rail companies in shipping long-haul traffic. Rail offered a reasonable alternative for certain classes of business but failed to meaningfully challenge the trucking industry. Diesel powered trucks have a relatively efficient network to move from one end of the country to the other. To this day, for example, a two-person team driving a truck is the speediest way from Southern California to Chicago.

Perhaps even more frustrating for rail companies is that trucks have a ‘free ride’ on public roads while rail companies must maintain thousands of miles of track at significant expense using unionized labor.

For years railroads seem like the ultimate business to avoid. They are capital intensive, heavily unionized, and heavily regulated. After reinvestment in the business through capital expenditures that regularly exceed depreciation, profits available to shareholders have been anemic.

Berkshire Invests in Railroads

Charlie Munger, at the 2008 Wesco Annual Meeting, admitted the duo had changed their minds about railroads. Commenting on it, Munger stated:

“We did finally change our minds and invested. We threw out our old paradigms. We finally realized that railroads have a huge competitive advantage, with double-stacked railcars guided by computers, moving more and more goods. They have a big advantage over trucks in huge classes of business.”

Today, the cost advantages of shipping one container with rail over truck are noteworthy (with moderate gas prices). As the price of gas goes up, these advantages become significant.

The door-to-door delivery time of the rails is shrinking but still can’t compete with a two-person truck crew for speed. Presently rail is the same speed as a single driver truck.

Trucks used to have a large time advantage over rail. But, rail is (slowly) getting faster and trucks are slowing down because of increased congestion on the highways.

If you are trying to ship more than one container, it is enormously cheaper to use rail because trucks need about one vehicle per container. It makes no sense to ship more than one container by truck.

The barriers to entry are low in trucking. Anyone can start a company that drives trucks from one side of the country to another. You only need a truck. However, you won’t be able to create a national railway without massive amounts of capital (not to mention legal and other regulations). Considering the regulatory, environmental, and strong preferences for residents of suburbs to fight the noise, the odds of a new rail company in North America of any size are about as close to nil as you can get.

Environmentally there is no comparison between rail and trucks with rail taking the clear lead. As environmental concerns gain more and more social traction, there is likely to be government encouragement to curb carbon emissions. The government could, for example, offer financial incentives to companies using rail over truck for long-haul transportation. They could also increase fuel taxes and further the cost advantages of rail

Rail also has significant unused capacity and can relatively easily increase volumes.

A few years ago, in the Wesco letter to shareholders, Charlie Munger gave some clarity on how the Berkshire Hathaway 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). BNSF and CN, briefly attempted to merge in the late 1990’s and 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 decreased from 36% in 1993 to 21.5% in 2008. Over this same period, revenues 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, however, they 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 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, we 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 value. This way of thinking about BNI seems to explain the Berkshire logic in the timing and price paid for their shares. It speaks to why $80 was the magic number and not $90.

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 (pre-tax). 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 an initial 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.