3…2…1… Liftoff! Alright so this is going to be my first blog post, going to start it off with just some random musings since I didn’t have anything planned (and our presentation is taking up chunks of free time). So, here goes.
Everyone was buzzing about Buffett’s deal for Burlington Northern yesterday. Every financial newspaper rolled out the obligatory article with some variation of “is Burlington Northern worth this valuation?” or analyzing the cash/stock ratio of the deal. With all due respect, they’re missing the point. I don’t doubt that Buffett has a very good valuation of the company, and I’ve been bullish on transportation myself (obligatory tooting of my own horn). My question is why did Buffett choose Burlington Northern? It’s not the only railroad with a large rail system in the Midwest-West. In fact, of the 4 largest railroads (CSX, Union Pacific, BNI, NSC) you have an even split of CSX/NSC in the East and BNI/UNP in the West.
So I’m going to try to follow Buffett’s perspective here. First off, the Western two railroads have an inherent advantage of terrain. Why? The sheer amount of land they cover is much, much larger as well as touches the Gulf and Pacific. I’ll get into why that’s advantageous in a moment. If you’re not sure that it actually is larger, hark back to 3rd grade Social Studies when you learned about the Louisiana Purchase and subsequent land grabs. Alternatively, here’s a handy picture ripped straight from Union Pacific’s Annual Report.
Now you’re probably wondering why size of the territory matters. After all, isn’t it volume of freight that truly determines profitability and if there’s more activity going on in the East size can be a poor measure of strength. Indeed, it may even be a sign of weakness because more miles of track equals higher maintenance costs and higher expansion costs if they decide to lay down more track. True! However, I’m going on the hypothesis that Buffett, in his long-term perspective, is seeing deeper than that. What matters here isn’t volume or freight rates, but overall efficiency.
Right now we have a substantial volume of cargo shipped daily by long-haul trucks criss-crossing the United States burning gas and running people over when their drivers fall asleep. A quick look at freight’s energy efficiency, speed of delivery and cost of transport and it’s fairly clear that the nation’s long-distance cargo future is freight’s to lose. Trucking companies are already cutting rates to the bone to keep afloat, mainly because they’re overcrowded and exposed to oil fluctuations whereas freight isn’t exposed to much of anything. The chances of a new railroad laying down thousands of miles of track or a smaller one somehow raising the capital is minimal, but starting a trucking fleet is so easy ex-NFL players can do it (and have). But freight has a major disadvantage – lack of precision.
I mean, this guy could probably do it:
If you’re trying to ship something from St. Louis to NYC you’re not going to be able to do so only through rails. However, what you can do is ship it across rail to the nearest junction and offload it onto trucks for the remaining distance. Transportation companies refer to this as “Intermodal” delivery. Specifically, this refers to transportation that doesn’t require actual handling of the cargo between modes (meaning it can be offloaded from the train directly onto the truck). Why is this significant? Because Intermodal transportation is much, much more energy efficient and lower cost than pure trucking, plus is generally faster.
So now you’re probably wondering why all this is even relevant. What does it mean? Consider the advantage rail has over trucking. Mile for mile, rail is more efficient. That means over long distances rail has a distinct advantage. This is made more significant by the much vaster tract of land in the Western 2/3rds of the U.S. So here we can see that longer distances/larger area to cover = beneficial for rail. Again, rail does not have significant fluctuations in cost (unlike trucking) and can offer competitive rates without slashing to the bone. And the proverbial cherry on the top – because of rail’s greater energy efficiency it’s likely to benefit from any environmentally conscious legislation.
To add this all up now for Burlington Northern. Operating in the Western 2/3rds is definitely an advantage for BNI. Another reason which was very briefly touched on but is also a huge factor is International Intermodal provides a hefty chunk of revenue (ferrying from the Gulf to the Pacific and the reverse). That cuts out CSX and NSC, the Eastern freighters, unless Florida somehow increases 1000x in size. Between BNI and UNP, they’re very similar. They both ship roughly the same products (although there are slight differences) – however remember that Intermodal is currently the most efficient and cost-effective method of transporting bulk freight. And unsurprisingly, Burlington is significantly more invested in Intermodal transport (~28%-20%) than UNP which positions itself very well to take advantage of any surge in both International and Intra-Continental transportation (if you’re wondering what BNI ships significantly less of compared to UNP, it’s automobiles). Is this definitely his rationale? Who knows, but I certainly think it’s a strong argument for BNI and freight in general.
There you have it! The much-longer-than-I-meant-to-write post at 838 words, although technically 1838 if you count the picture as a thousand words and much more if you also tally up each frame of the video. Up next (week) will probably be an outlook on the Droid and how it will impact Motorola/Verizon. If you’re actually curious about how it matches up against the iPhone (fairly well), here’s a decently unbiased review although it barely scratches the surface of the Droid’s capabilities:
I’m sure Buffett realizes that trade with China and Asia in general is going to continue to increase over the next 20-50 years. This is very important for BNI because UNP and them are the only two railroads with rail access to the Port of LA, and it is highly unlikely that enough capital would ever be available to build another railway into LA.
Ken I think you need to add 1 big topic to your analysis. COAL. Buffet realizes that coal is a major energy source in the United States and will become more widely used in the years to come not only in the United States but also abroad. Consider the fact that power plants are trying to utilize clean coal technology to fire up its turbines. In addition I know for a fact that India is currently constructing at minimum 50 new coal power plants. Burlington Northern has direct access to the largest coal mine in the United States. Furthermore as you said since it is well connected to the ports in the west. What this means is that Burlington Northern is positioned to benefit from the huge coal trade that is undoubtedly coming and is currently developing. I believe Buffet bought Burlington Northern because it gives him great exposure to commodities especially coal.
Ken – I’m not sure if China factors too much into it, because they’re trying to transition to a service-based economy just like us, meaning fewer manufactured “solid” goods. It won’t be a radical change as of yet but it is happening. I do agree that there never will be more or less than 4 major railroads, because it’s highly unlikely they’ll ever approve a merger between any 2 oft hem.
Avi – Hm, that’s a good point. I didn’t know that it had exclusive access to the mine over UNP. There are a few advantages to UNP though, namely that they’re growing their miles of track very quickly which may lead to an advantage if volume increases significantly.
An interesting thing he pointed out was that rail was one of the few industries that could never be outsourced, or have to compete with outsourced prices. Which is interesting because there aren’t a whole lot of industries like that at all.
Don’t forget the boost in trade activity from expansion of panama canal
http://www.economist.com/businessfinance/displaystory.cfm?story_id=14807131