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Bruce Greenwald: Buffett Has Lost His Mind


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Bruce Greenwald’s comments on the BNI deal (link: http://www.advisorperspectives.com/newsletters09/46-greenwald3.php):

 

I know you own Berkshire Hathaway, so I have to ask you what you think about Buffett’s purchase of Burlington Northern.

 

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.  So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too.  Their profitability is much lower than it looks.

 

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times.  Our calculation is he was paying 21-times.

 

Secondly, there are two kinds of assets.  There are the rights-of-way, which you can’t get rid of.  So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way.  If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value.  We didn’t see a lot franchise value or hidden asset value.

 

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up.  There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad.  If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.

 

There is nothing special about the railroads.  It’s entirely an energy play.

 

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that.  So you don’t have a good aggressive management over these five years producing outsized returns.

 

We looked back at when they did the merger with Santa Fe, because then they did increase margins.  But they got bored with it, and margins started to come down.  The same thing happened recently.  We don’t see a lot of hidden profitability in the culture of the company.

 

It looked to us like an oil play.  He has a history of making bad oil play decisions.  And that was at $75/share, we thought there were better oil plays.  At $100/share we think he has lost his mind.

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What Bruce identifies as the big negative in the BNI

purchase is actually the HUGE positive now that BNI

is wholly owned by BRK.  It's true that BNI has not

come close to exploiting its pricing power.  It's not

rocket science to come up with a plan to fix this.  

If this is too hard for anyone to grasp, go back in time

and see what WEB and Charlie did after they bought

Sees. :)

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Could the rail tracks BNI owns be a hidden asset not recorded on the balance sheet? They own 40,000 miles of track, which is enough to cross the U.S. multiple times. The replacement value of this asset is huge. Land and track structure was carried at $21 billion (before accumulated depreciation) on the balance sheet. This implies $0.5 mil per mile, low compared to recent project estimates.

 

I'm not a rail expert but one example I found was Canadian Pacific's Powder Basin expansion which covers 262 miles and is estimated to cost $6 billion.

 

http://www.coaltransinternational.com/htm/f20080220.994756.htm

 

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Could the rail tracks BNI owns be a hidden asset not recorded on the balance sheet? They own 40,000 miles of track, which is enough to cross the U.S. multiple times. The replacement value of this asset is huge. Land and track structure was carried at $21 billion (before accumulated depreciation) on the balance sheet. This implies $0.5 mil per mile, low compared to recent project estimates.

 

This brings back memories of this board's discussions of Sears Holdings from a few years back.  Some argued that the property Sear's owned (or controlled through long-term leases) was a valuable hidden asset on top of the cash flows from Sear's retail business.  Others argued, and I believe rightfully so, that valuing Sear's property in addition to the value provided by the cash flows of the retail business was double counting, as the property value couldn't be realized without discontinuing (or reducing the cash flows) of the retail business.

 

So, does the replacement value of the property a railroad owns really matter if the company doesn't plan to do anything other than to continue to hold and use the property for rail operations?

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So, does the replacement value of the property a railroad owns really matter if the company doesn't plan to do anything other than to continue to hold and use the property for rail operations?

 

I think you hit on the head Tooskinneejs.  No one is denying that BNI will be around a long-time, but the question that people have is if it's going to be a Netjets or MAE?  Those right of way assets, like the real estate Sears owns, have a tangible value.  The question is if the return on those assets is going to be great, middling, fair or poor.  Greenwald seems to think they will be fair to poor, which I disagree with.  But the jury is well out on those that believe it will necesarily be great.  Cheers!

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Another good point that Bruce makes about under

depreciation is actually a potential advantage for BRK.

Here's an analogy:  BRK buys an INS co and soon

discovers that they are under reserved.  BRK increases

reserves.  Result: GAAP earnings go down, but cash goes up

because there's no tax on the extra float

as there would be if they called the extra float: "earnings".

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Valid points on the drawbacks of valuing BNI on asset value alone. Although the high replacement cost acts as a moat. Buffett said in a recent Charlie Rose interview that it would take a competitor $100 billion or so to go up against BNI.

 

twacowcfa: There may be untapped pricing power but how does this fair with the fact that BNI's business is regulated?

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I think critics don't understand the constraints under which Berkshire operates.

 

The first principle is this: What's good for Berkshire is not necessarily good for others or individual investors. Berkshire is so big that it is seeking investments within a very narrow range of expected return. Seeking certainty and a modest return (more modest than most people would desire) is job #1 at Berkshire. Since it has low to no cost leverage, it can also seek investments yielding as little as 10% per year and it would still yield say 14-15% on shareholder equity. In this context, Burlington is within the Universe of stocks available and Very likely to meet the return expectations required.

 

For this reason, Berkshire can pay this price that others would not find very appealing. Even Buffet has stated it isn't a bargain, but Berkshire does not need a bargain to achieve its goals. We, or Greenwald, on the other hand do need that and so might choose to pass on the investment.

 

I can't believe intelligent investors like Greenwald (and even Niall Ferguson was critical of the deal on Charlie Rose) can't see something so obvious.

 

 

 

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The borrowing costs should go down with brk as the owner. If you look at the different in spread between Microsoft (AAA) and FFH(BB), it is about 4% points for long term debt. Since BNI has similar rating as FFH ( upgraded after the deal was announced ), the borrowing cost should decline. On 10 billion of debt, 1% difference is 100 million dollars.

 

I dont expect oil prices to go down significantly anytime soon or alternative technologies to disrupt BNI for the next 10-20 years. The real alternative that can kill BNI is a super jumbo cargo plane that uses alternative energy to fly reducing time and cost.

 

cheers!

shalab

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greenwald: "It looked to us like an oil play.  He has a history of making bad oil play decisions.  And that was at $75/share, we thought there were better oil plays.  At $100/share we think he has lost his mind."

 

How about Petrochina, was that fast 10 bagger a bad oil play decision? I think Greenwald is losing HIS mind, or maybe looking for a little publicity perhaps...

 

Anyway we are used to the periodic blasphem on Buffett; I would begin to wonder if there were none.

 

Also, this was not exactly an impulse buy; he'd been accumulating shares for a while, and this is center from his circle of competence book when he was analysing railroads for Ben.

 

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Rszutu604  I'm not expert on regulatory pricing issues

for railroads, but I think that rate control is now generally

left to the marketplace.  Does anyone have more detail

on this?  Regardless, their current ROA is rather low,

and appears to allow much room for higher returns.

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The history of railroads’ ROA has been , unfortunately, rather like airlines’: LOUSY! 

The first railroads often had extremely high, positive cash flows soon after

new  lines opened, but  most of this was soon needed for maintenance capex.

Penn Central went bankrupt in the 1970’s after it had been skimping on maintenance capex for decades.  Even the sainted Benjamin Graham with all his

experience looking at railroads’ balance sheets was blindsided by their descent

that was quicker than Enron’s. 

 

What Gates and Buffett have noticed in recent years is that the worm has turned

And that especially the western railroads don’t require nearly as much maintenance

Capex as they used to.  They don’t need nearly as much right of way to service their core routes as formerly and that frees real estate for potential , more profitable development in the years ahead,  without nasty ongoing costs.  This is a nice

Little bit of lagniappe  that comes with the main course of steadily increasing

profitability.

 

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how have the railroads economics changed since the 1990s ? What are the differentiation points between rail and road ? I see three points:

1) energy consumption

2) pollution

3) speed of delivery

 

1) I don't see any difference between the 1990s and today. If energy is expensive, it's more interesting to deliver your goods  by train for long distance; The competitive advantage of railroad is proportional to the price of oil. For me Greenwald has a point on this one.

 

2) pollution: I was puzzled by a recent graphic from Newsweek that shows that train is a big polluter. To release 1.25 tons of CO2 by person, it takes 2564 miles by airliner, 4359 miles by train, 11538 by bus and car, 21821 miles by hybrid car! (sources: Native Energy, American Airlines, Amtrak, Greyhound, US dept of Energy)

 

3) speed of delivery: maybe the investments made by railroads in the 2000s improved speed of delivery for trains. Has someone information about this?

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We know Gates/Buffett/Munger have said that the railroad economics have changed since then. Munger even said that Gate found the railroad opportunity before him/Buffett and should be running investing for BRK  ;D

.

 

Gates personally owns 7% of CN and another 2% through the Bill & Melinda Gates foundation.

 

Here's a little food for thought.  Locomotive maintenance drops through the floor on all-electric units used in Europe.  They also tend to last for about 50 years because they are simple machines.  Perhaps the coal car(s) of the future are giant boxcar batteries charged by wind or similar.  Carbon emissions to operate=0.  I know my train set wasn't diesel.

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Prevalou:

 

3) speed of delivery: maybe the investments made by railroads in the 2000s improved speed of delivery for trains. Has someone information about this?

 

WEB and Munger has mentioned about intermodal traffic increase in recent decade.

 

This article on wiki seems to confirm that:

"In the USA, starting in the 1960s the use of containers increased steadily. Rail intermodal traffic tripled between 1980 and 2002, according to the Association of American Railroads (AAR), from 3.1 million trailers and containers to 9.3 million. Large investments were made in intermodal freight projects."

 

http://en.wikipedia.org/wiki/Intermodal_freight_transport

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Shalab - very short comment you made, but a powerful statement.  I don't criticize the deal, because no one has put forward a better realistic deal that Berkshire Hathaway should have done.

 

To state differently, assuming capital was to be allocated to acquiring a business, no one has shown a better deal.  Let's be honest - if the banking rules were set up differently, he would have bought a bank.  But that was off the table.  He can't really buy any more beverage companies or consumer product companies, most likely b/c of Coke and P&G stakes.  He tried to invest a decent amount of cash in a utility, but that was rejected.  I don't love the BNI deal, but I don't hate it.  Overall, the general approach Buffett has taken is far superior to other conglemerates/financials.  I single out GE, Goldman Sachs, Morgan Stanly, AIG, etc....  Give me Buffett any day.

 

I do agree that a dividend may have been an option, but that has only happened once.  I believe Buffett is only focused on growing his empire.  A dividend, while maybe appropriate, does not fall in his mindset. 

 

Nevertheless, Berkshire Hathaway is set up nicely for the future.  Buffett isn't a value hedge fund investor (not anymore).  He runs a conglomerate.  At the right stock price, I am a buyer of that conglomerate.  The cash flow potential for Berkshire is huge, and will only get bigger.  I think in 3 years time (after BNI is digested), another big deal with follow. 

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Once a railroad locks in a shipper to an efficient,

long distance unitized train system, it's almost

impossible for a trucking co to compete and take

business away from a railroad, even if fuel costs

drop.  Think about It. Hundreds of truck drivers

on the road for two days and nights from the west

coast to the Midwest with operating maintenance

on hundreds of tractors vs a small crew for a nonstop train

trip with operating maintenance on perhaps four

very durable locamotives.

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It is better to buy a good company at a fair price than a fair company at a good price

 

I think critics don't understand the constraints under which Berkshire operates.

 

The first principle is this: What's good for Berkshire is not necessarily good for others or individual investors. Berkshire is so big that it is seeking investments within a very narrow range of expected return. Seeking certainty and a modest return (more modest than most people would desire) is job #1 at Berkshire. Since it has low to no cost leverage, it can also seek investments yielding as little as 10% per year and it would still yield say 14-15% on shareholder equity. In this context, Burlington is within the Universe of stocks available and Very likely to meet the return expectations required.

 

For this reason, Berkshire can pay this price that others would not find very appealing. Even Buffet has stated it isn't a bargain, but Berkshire does not need a bargain to achieve its goals. We, or Greenwald, on the other hand do need that and so might choose to pass on the investment.

 

I can't believe intelligent investors like Greenwald (and even Niall Ferguson was critical of the deal on Charlie Rose) can't see something so obvious.

 

 

 

 

 

 

I

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The borrowing costs should go down with brk as the owner. If you look at the different in spread between Microsoft (AAA) and FFH(BB), it is about 4% points for long term debt. Since BNI has similar rating as FFH ( upgraded after the deal was announced ), the borrowing cost should decline. On 10 billion of debt, 1% difference is 100 million dollars.

Completely agree about this, and that BRK will use the optimal accounting treatment to allow for long-term cash retention / tax-deferral to the extent allowed rather than to boost present-day reported earnings, potentially somewhat offsetting the advantage to present-day earnings that ensues from BRK's lower cost of borrowing (a minor synergy that effectively increases the FCF/earnings yield on the BNI purchase price once it's wholly-owned by BRK).

 

I dont expect oil prices to go down significantly anytime soon or alternative technologies to disrupt BNI for the next 10-20 years. The real alternative that can kill BNI is a super jumbo cargo plane that uses alternative energy to fly reducing time and cost.

 

Outside the short term, I can't imagine OPEC, the most important oil cartel, will seek to reduce oil prices by increasing production too much, though I doubt there's likely to be much of a carbon tax in the USA for a few years at least enough to really extend rail's advantage. I'd say that BNI fills a low-cost, non-time-critical niche principally for low-value-per-ton product where transportation costs (fuel, intrastructure and labour costs per ton-mile) could easily escalate to a large proportion of sale value. I'd imagine that alternative energy cargo planes are a long way off (though diesel conversions for turbo-props might continue to grow), and the same alt. energy technology is likely to be there sooner for rail, with options for track electrification if it happens to be more cost-efficient to transmit the alternative energy to the train than to carry it on board - not an option available on a plane.

 

If we're right about no significant long-run decline in oil prices (downside protection, moat protection, plus upside if oil costs rise) then stable to growing imports from eastern ports (i.e. Far East) should provide significant growth prospects. Exports (e.g. coal, minerals, chemicals) to the eastern ports (so the ships don't return empty) could also increase. Sure, it's not deep value or massively powerful intangible assets like a See's or Coke.

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