Berkshire acquired BNSF a decade ago. Time flies.
This deal changed Berkshire. Suddenly wholly-owned operating businesses were REALLY important.
Back in 2009, some said Buffett had lost it. The old guy had gone crazy. We are used to that at this point, as it has been a common theme for the last few years. Apple’s stock decline and Berkshire’s massive position is bringing a ton of these comments back to stage. Well, Buffett is probably laughing at these guys back in Omaha.
In November 2009, many were looking for answers. BNSF was not the typical Buffett business.
Not to pick on Bruce Greenwald, but he was one of the critics at the time. Here are his thoughts:
“It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex.”
These are perfectly rational comments from a respected professor. It is interesting to look at what attracted Buffett to BNSF. Also, with the benefit of hindsight, why Buffett was right and his detractors wrong.
One very important fact of this transaction, was his level of conviction. In November 2009, there were a ton of cheap opportunities. Buffett picked BNSF, and paid a 30% premium to gain full ownership. Also, 40% of the total consideration was paid with arguably deeply undervalued BRK shares. So, safe to say he really wanted BNSF.
The $34bn paid for BNSF, represented almost 25% of Berkshire’s equity! It was a huge bet, with significant repercussions.
At the time, Buffett said it was an all-in wager on the economic future of the US. That is fine, but we know he was looking at other details that made BNSF a great value. Even at prices considered high by many experts.
Ok, so 10 years (a bit less actually) have passed. It might be time to look at the results so far…
Since the acquisition, BNSF has paid Berkshire more than $30bn in dividends. That is almost the complete purchase price in less than 10 years! Very similar to a bond with a 10% coupon, but with likely rising coupons and PAR value. Great. That is impressive for a capital intensive business, also given the optically “high” purchase price.
Earnings have jumped from $1.8bn in 2009 to +$5.0bn. I know earnings were at a cyclical trough in 2009 and might be reaching a cyclical peak now, but those are still impressive numbers. It is more impressive if we take into account how much capital Berkshire has taken out of the company in the form of dividends.
Something that is quite useful for our exercise is that UNP is a public company. And it is a very similar railroad, operating a similar network. They generate basically the same amount in revenue at ~$23bn. UNP is slightly more profitable as they have a bit higher margins, arguably for structural differences (business mix).
An interesting fact is that UNP headquarters are in…you guessed it…Omaha, Nebraska. Buffett picked the other railroad. Well, that is not relevant but it is a funny fact.
What is relevant is that we know what the market thinks about UNP and how its stock has performed in the past 10 years. Also, in this period BNSF and UNP results have been very similar with revenues up 50% and cash flow doubling.
Since November 2009, UNP has offered its investors an IRR of 22%. That is impressive.
During this period, the S&P 500 generated an 11.8% return, which is very good, but almost half the return offered by the railroad.
UNP currently has an enterprise value of $130bn and a market cap of $110bn. This represents 12.5x EV/EBITDA and 19x P/E. Those are some helpful figures that we can use to get to an approximation of market value for BNSF.
Applying similar numbers, we get to an Enterprise Value of $125bn and an equity value of $105bn for Berkshire´s railroad. Once again, Buffett paid $34bn, took out $31bn in dividends and is left with +$100bn in value…Good job Warren.
So we know returns for this massive investment have been impressive, but let´s get to a number. And the number is…~18%. That is massive for an investment many thought at the time would produce mediocre returns. Remember many experts thought he was overpaying for a capital-intensive, regulated and cyclical business.
18% is 1.5x the return of the S&P 500 during a bull market. But it gets better…At the time of the acquisition, Berkshire already owned ~20% of BNSF stock…so he didn´t have to pay the takeout premium on 100% of the shares outstanding. In reality, he had to pay ~$26bn for the shares he didn´t own. Also, Berkshire employed a bit of leverage to fund the acquisition. The company issued $8bn in bonds, so we get, leveraged returns. If we take into account the leverage and the shares of BNSF Berkshire already owned, then the return on the equity would go…way up. But I think we get the point.
There is also a negative aspect to the deal. Berkshire issued $10.6bn in undervalued BRK shares to complete the acquisition. It is fair to assume that this dilution was not optimal. But looking at the numbers, I think it is safe to say that we are better off now with BNSF. Even if it required issuing some shares.
Something interesting about this acquisition is that Berkshire had a lot of cash on hand. $20bn to be more precise. So why did he issue shares? Well, Buffett has mentioned in recent years that he won´t go below the $20bn in cash line. There was a lot of temptation at that time to go below that mark, and he didn´t. That is discipline.
So, what has changed in BNSF since the acquisition…
On the balance sheet, the company has put on $12bn of additional debt. Most of it has gone to Berkshire in the form of dividends. I guess this makes sense since the cost of debt is so low for this high quality issuer.
Revenues have also increased 50%. In 2009, during the middle of the crisis, revenues were $14bn. Since then, with economic tailwinds and some help from the US oil boom, revenues increased 50% to $23bn. Important to note that coal was 25% of sales, and that has been a significant headwind throughout this recovery.
50% revenue growth over a decade is decent, but that is not the main cause of the success. I believe the key for this investment has been pricing power. BNSF has repriced most contracts with its customers as these came up for renegotiation. Industry consolidation, an underpriced service and a competitive advantage over trucking have helped railroads push pricing over the last decade and more.
This combination of volume and pricing growth plus management keeping expenses tight, has boosted margins. EBITDA margins have increased from 35% at the time of the acquisition to current levels of 45%. Also, the additional financial leverage has amplified the returns.
Well, Buffett has been right so far. He has made a ton of money out of businesses that have untapped pricing power (See´s, Coca-Cola, Moody´s, etc). This formula of volume and pricing growth over long periods of time has been very productive.
Going forward, this looks like an asset that should continue sending dividends to Omaha for many years to come. Hopefully.
And a final thought…
BNSF´s carrying value is $43bn, and we are saying it is worth $105bn. Here we found a reason why real business value might exceed book value in the case of Berkshire. We can leave that for another post.