Description

Burlington Northern (BNI-NYSE), a Dow Transport Index component, is undervalued at present prices ($26 on 7/25), as investors have priced in a dramatic economic slowdown and higher fuel prices. This thinking should prove to be erroneous, as railroads can take share (due to pricing and fuel efficiency) from truckers for less urgent deliveries. Bulk goods, such as coal and grains, are traditional rail markets that have shown firm prices, and the Fed’s actions should improve trade visibility for heavy manufactured goods such as cars and machinery. Investors have recently punished BNI for reporting a quarter that had been constrained due to spring floods and revenue compression due to legacy contracts, a reaction that seems excessive.

Background:

 BNI was formed by the merger of BN and Santa Fe Southern Pacific in 9/95.
 33,500 miles of track in 28 states and 2 provinces, vast majority west of Mississippi.
 BNI is the 2nd largest North American RR (after UNP) and employs 40,000.
 Intermodal (29%), coal (23%), and grains (14%) are BNI’s largest revenue producers.

Positives:

 Fed Play: heavy, basic materials should respond to strong fed stimulus. Machinery, Autos, Forest products, Construction materials, all ought increase in velocity.
 Energy: Coal will play a large role in Bush energy policy. Positive outlook here for the first time in many years.
 Grains: Chinese crop revisions not withstanding, major droughts in China and Brazil have firmed grain prices. Chinese entry into WTO expected to increase visibility for U.S. exports.
 Fuel: higher costs and slower economy have increased relative attractiveness of rail vs. the lower end of the trucking market.
 Share repurchases. Bought back 3.1 mm shrs. in Q201, has bought back 97 mm (or 20% of then outstanding) shares since program announced in 1997.
 Dividend recently raised to $0.13 per quarter. Yield of 2% as of 7/25/01. Has raised dividend 30% since 01/98.
 At $26, BNI is priced at just 1.33X book value and 5X operating cash flows.
 Strong dollar does allow for more imports of heavy goods like steel, cement, autos. Rail moves imports from ports to destinations.
 Rails have learned, albeit slowly, from the customer service initiatives pioneered by FedEx and UPS. Delivery guarantees, shipment tracking, on-line ordering, off-peak discounts on shipping rates, and payment among new customer options from BNSF.
 Of the 4 major U.S. RRs in last 5 yrs, BNI has consistently produced the best returns.
 Integration of Santa Fe complete, synergies now being realized.

Catalyst

Fed policy gains traction and manufacturing sector energizes.