Description

Summary

Burlington Northern Santa Fe is the second largest Class I railroad servicing the Western half of the United States.  The Company operates a railway system of approximately 32,000 miles of track over which it transports coal, consumer products, agricultural products and industrial products.  At the current price, you are paying $1.35 million per mile of track that costs $2 million in materials and labor to build but excluding the real estate which is inestimable.  While the shares appear reasonably priced today, there are some significant hidden assets and, over time, the pricing power the company enjoys should allow it to generate above average returns on capital. 

Brief History of Industry

In 1980, the Staggers Act was signed that largely deregulated the railroad industry since the passage of the 1887 Interstate Commerce Act.  Not surprisingly, the industry underwent significant consolidation over the next 20 years bringing the number of class I railroads (a railroad company with over $320 million revenues) from 30 businesses to seven today.  In the United States, Burlington and Union Pacific effectively hold a duopoly over the western half of the country, while CSX and Norfolk Southern hold a duopoly over the eastern half of the United States.

Since 1980, the number of rail employees has been cut by over 50%, the miles of track by 40%, the number of freight cars in service by 25% and at the same time, the number of revenue ton miles operated by the rails has doubled.  In 2004, demand started to outweigh the reduced supply of the railroad industry and the Rail companies finally gained pricing power of their customers. 

Business Description

A railroad company generates cash by charging customers such as utilities or trucking companies a fee per ton of load carried and uses cash to pay expenses of labor (mostly unionized), fuel, equipment rents, depreciation/replacement of railcars and track, and transportation services such as ramping and drayage.

Burlington generates about 36.5% of revenue from transporting intermodal containers both domestically and internationally.  “Intermodal” is better thought of as multimodal.  Burlington enters into 1-5 year contracts with shippers or truckers to transport containers primarily from ports to centralized trucking distribution centers where the containers are then moved to the end customer by a company such as JB Hunt or Schneider.  About 8% of  the 36.5% of consumer products is related to automotive, and that 8% primarily relates to imports, not the Big Three, leaving Burlington the least leveraged to the U.S. auto industry. 

Burlington also transports a significant amount of coal.  BNI generates approximately 20% of revenue moving coal from coal mines to utilities, who are the customers of this business.  Coal contracts are typically 10 years in length and the utility owns the cars which transport the coal.  Burlington operates primarily in the Powder River Basin of Wyoming and Montana.  For those not familiar, Powder River Basin (PRB) coal is the lowest sulfur coal.  Coal-fired plants currently generate approximately 50% of the electricity in the United States.  Because of the government enacted caps on sulfur emissions from coal-fired plants, PRB coal has become the cheapest to burn per mmbtu of energy created given its sulfur (and heat content) vis a vis Central and Northern Appalachia coal and others.  Burlington currently competes with UNP in the southern PRB region and does not appear to compete with anyone in the northern half of the PRB.

The agricultural products segment generates approximately 17% of revenue for Burlington and consists of the transportation of corn, wheat, fertilizer and soy beans.  BNI benefits from 1) a rail network concentrated in the regions where most crops are harvested 2) exposure to the western ports for grain export and 3) the often written about growth in ethanol which is produced primarily in the western region of the United States.

Finally, BNI generates about 24% of revenue from the transport of industrial products.  Of this 24%, revenue is comprised of building products (33%), construction products (32%), petroleum and chemical products (27%) and food and beverage (8%).

Valuation

Though Burlington currently trades at 16.0x GAAP earnings, GAAP needs to be adjusted to get a true picture of owners’ earnings.  First, maintenance capital expenditures runs at about 140% of stated deprecation and amortization.  Second, Burlington enjoys a tax rate that is significantly lower than the 35% Federal + state tax because of the accelerated depreciation on the rail stock.  As long as BNI remains in the rail industry, this deferred tax liability is in effect deferred to infinity and so the tax rate averages about 25% versus 38%.  Adjusting for these items, BNI trades at approximately 16.5x tax-adjusted free cash flow.  A 6% free cash flow yield doesn’t seem worthy of the $5,000 prize, but it is what’s beneath the track surface that makes this a very interesting investment.

First, is the “hidden asset” in the form of below market contracts.  Coal contracts are typically 10 years in length and since we are 3 years post the time during which they enjoyed pricing power, there are 6-7 years worth of coal contracts signed at a time when 1) supply exceeded demand and 2) UNP and BNI were engaged in price wars.  Management estimates that these contracts are about 30% below market if re-signed today.  Applying decently conservative estimates to the coal revenue streams, a full repricing will add approximately 20% of fully-taxed free cash flow to the current earnings streams.  While this is relatively well known in the industry, another “hidden asset” lays in the fuel provisions in the contracts.  Prior to 2004, many of the contracts did not contain the fuel pass thru that are included today.  Diesel averaged around 65 cents per gallon versus the LTM $2.03 per gallon paid.  Assuming simply a ‘mark to market’ of gas prices in historical contracts, BNI will add another 17.5% of fully-taxed (38%) free cash flow to current earnings.  Over a 6 year time frame, repricings should add approximately 6% per year to a holder’s total return bringing us to 12% prior to any growth in GDP+inflation plus the earnings growth resulting from owning a non-replaceable asset that acts as a tax on commerce.

In addition the coal contracts, I think there lays significant hidden value in the intermodal business.  Because I cannot find segment level numbers, consider simply that rails is a $50 billion per year industry.  Trucking is a $600 billion per year industry.  Now rails will never move things from Wal-mart’s distribution center to their stores, however there is significant upside as gas prices have increased for rails to take market share from the trucks in the medium hauls.  Currently, the rule of thumb is less than 500 mile per haul goes to truck.  However, implicit in that rule is a gas price which has tripled over the past years as we saw in the coal contracts.  As gas prices increase, the “market” for intermodal actually increases exponentially.  And so we are up to 6% cash yield + 6% from repricing plus GDP + inflation + outsized growth in intermodal business given its cost advantage over trucks.

And finally, to get a sense of the true upside in earnings power, I think a look at the replacement cost of this asset is far more useful.  At the current price, you are effectively paying $1.35 million per mile of track.  There are three costs to recreating a railroad: 1) cost of labor, 2) cost of material, 3) the “right of way” or real estate underneath the track.  The cost of #1 and #2 today are approximately $2 million per mile or approximately 48% higher than you are paying for BNI.  The cost of #3 is inestimable.  Buffett often talks about a moat by illustrating the money it would cost to recreate Coca-Cola.  This is better.  You actually can recreate Coca-cola, you would just earn a miserable return on your capital that was required to do so.  You can NOT recreate Burlington with any amount of money.  Right of way was given away to railroads during the 1800’s to incent construction to develop the western half of the United States and to increase commerce.  That will never happen again as long as we live (and beyond).  You can absolutely buy the “right of way” in the middle of Nevada for probably a few thousand dollars per mile, but your track will never connect to the Port of Los Angeles and so it’s useless.

A useful comp to consider is the situation with D,M&E who tried to build a new 262 mile track to haul coal in the Powder River Basin in Wyoming.  The project was slated to cost $6 billion which equates to $22.9 million per mile.  The Company was seeking a federally-subsidized loan for $2.3 billion, so assuming that was actually zero cost, at $3.7 billion, that cost to build is approximately $14.1 million per mile versus the $1.35 million you are buying BNI for today.

Final Word 

Everyone knows Buffett has been buying; the other important buyer is the Company itself.  In 2004, the Company generated $782 million from cash flow from operations less investing.  Of this, it spent $376 million repurchasing stock and $231 million in dividends.  In 2005, the numbers were $586 of cash generated, $789 million spent buying back stock and $267 million on dividends.  In 2006, BNI generated $1.022 billion in cash flow from operations less investing, and spent $1.040 returning cash to shareholders.  Since 1997, the Company has repurchased over 160 million shares compared with 358 million fully diluted outstanding today.  Even with these repurchases, the Company remains significantly underlevered today, particularly when you consider that the deferred tax liability on the balance sheet ($8.4 billion of $22.7 billion of total liabilities) will never have to be repaid. 

When the recession fully rears its ugly head and the world realizes that Burlington’s volumes don’t drop off considerably given the high percentages associated with grains and coal, the multiple expansion will be nicely amplified by the repurchases. 

Catalyst