Berkshire Continues To Increase Stake in BNI

[Guest ericopoly]

a great reading on this subject is "the intelligent investor" from Benjamin Graham (chapter 2 the investor and inflation)

 

Studying the 1950/1970 period, he found that with inflation, earnings on capital actually decreased (instead of increasing). Culprits: 1) a rise in wage rates exceeding the rate of productivity, and 2) the need for huge amounts of new capital, thus holding down the ratio of sales to capital employed.

 

In an inflationary context, BNI would be sensitive to these two points, Coca Cola certainly a lot less.

 

You mention that BNI is "sensitive" to these two points, by this I presume you mean they will be squeezed.

 

1)

Wage increases:   I don't see why you assume BNI can't raise freight costs at the same speed as the wages they pay their people.  Keep in mind that a purchase of BNI today is from a favorable terminal point (a recession so bad that people endlessly debate Depression), but aside from that why are rail freight prices in the category of costs that don't keep up with wages?  Graham didn't make a point specific to freight, so you are taking a generalized observation of Graham's and putting it to a specific application (BNI).

 

2)  

Cap ex:  Buying more rail cars at higher prices doesn't matter as long as your cash flows are proportionally higher.  Inflation doesn't make your rail cars wear out faster.  You are focusing on the nominal replacement cost of the rail car without regard for the nominal cash from operations.

 

Yes, nominal cap ex will increase, but it's completely meaningless if cash from operations goes up in step.

 

To some degree I think of BNI like a taxi service that owns the cars that it operates -- you are claiming it is bad to be a cab driver because the replacement cost of the car will go up with inflation.   I say, so does the cab fare so a rational person has no fear of that.

 

 

There is an ongoing maintenance expense of Coca-Cola's intangible asset, but you either don't think it exists or don't concede it will increase with inflation (you only focus on their tangible assets).  

 

The aggregate amount of funds provided by our Company to bottlers, resellers or other customers

of our Company’s products, principally for participation in promotional and marketing programs, was

approximately $4.4 billion in 2008.

 

http://www.thecoca-colacompany.com/investors/pdfs/form_10K_2008.pdf

 

 

 

 

[Guest ericopoly]

and last try:

BNI Roa is about 13%

KO Roa is about 100%

 

when there is inflation, businesses are reactive and there is generally a lag between the increases in expenses and the repercussion on prices.

So, it is better to have a margin of safety. With a 100% ROA, the margin of safety is from my point of view better than with a 13% ROA.

 

 

That's their return on tangible assets. 

 

You aren't buying KO at book value, I tried to get you to consider what your return on assets would be if you purchased the entire thing -- it would give you a huge intangible asset to think about.  Your return as an investor would therefore not be the 100% you are tossing around.

[Guest ericopoly]

You are focusing on the nominal replacement cost of the rail car without regard for the nominal cash from operations.

 

 

Instead I think we could focus on the nominal cost of corn syrup without regard for the nominal cash from operations.

 

[Guest ericopoly]

I think that with every unit of freight shipped, a little bit of that rail car is used up.

 

Likewise, with every can of coke, a little bit of corn syrup is used up.

[pohick]

if you have a toll bridge, you only have to maintain it to maintain your pricing power, (not replace it)

 

replacement is a fiction of depreciation accounting, some long lived assets can last a long time, not the convention

[Guest ericopoly]

if you have a toll bridge, you only have to maintain it to maintain your pricing power, (not replace it)

 

replacement is a fiction of depreciation accounting, some long lived assets can last a long time, not the convention

 

 

Here is my stupid reasoning (I didn't go to business school):

 

1)  Cash from operations less capital expenditures leaves us with free cash flow.

2)  Free cash flow is readily distributable to the owners

3)  Intrinsic value is a function of earnings distributable to the owners

4)  Free cash flow at BNI is not hurt by inflation provided that they raise the price of freight in line with inflation, and their cap ex rises with inflation.

 

I don't care how much money it cost to buy all of their land and such.  I heavily doubt that the land on the books has anything to do with present market value anyhow.  As a going concern, it doesn't matter what their property is worth -- intrinsic value is based on that free cash flow. 

 

[pohick]

i agree, (don't need b school)

 

the key point:

 

1)  Cash from operations less capital expenditures leaves us with free cash flow.

 

the estimate of cap ex can be tricky (not necessarily what 's in the report)

at what point would defered maintenance affect cash flow?

 

when you have a moat (pricing power) the cash flow improves with inflation,

but if you have a Berkshire Fine Spinning, then your cap. ex. merely postpones the going out of business sale

 

the problem with ROA and ratios is it don't tell you about the quality of the assets (are they "good until reached for") and cash flow

[Guest ericopoly]

and last try:

BNI Roa is about 13%

KO Roa is about 100%

 

when there is inflation, businesses are reactive and there is generally a lag between the increases in expenses and the repercussion on prices.

So, it is better to have a margin of safety. With a 100% ROA, the margin of safety is from my point of view better than with a 13% ROA.

 

 

That's their return on tangible assets. 

 

You aren't buying KO at book value, I tried to get you to consider what your return on assets would be if you purchased the entire thing -- it would give you a huge intangible asset to think about.  Your return as an investor would therefore not be the 100% you are tossing around.

 

 

I think, a better way of stating my point, is that if you believe your ROA is nearly 100% at KO... then it's only because you believe their return on intangible assets is ZERO.

 

Most of what you're buying per KO share is the intangible -- there's the rub.  But it sure makes ROA look good to assign all the returns to the tangibles, doesn't it.

[Guest JackRiver]

Not that it matters, but I think Eric is spot on.

 

Yours

 

Jack River

[prevalou]

thank you for your thoughful posts. I appreciate your rationality.

Actually I realize we are in a "dialogue de sourds".

 

First forget about the respective merits, brands, price of Coca Cola and BNI, I don't want to defend one or the other, I took the Coca Cola exemple as an illustration of a light business.

 

You rightfully explain that if a good business can increase its price at the same level than its expenses (or capex), in line with inflation, free cash flow will not be affected in real terms.

My point was and is about respective inflation risks for a light business and an heavy business. Maybe, it doesn't apply to BNI, but Graham stated that in an inflationary context, investors were surprised, because they thought businesses could compensate for their cost increase during the 1950/1970 period; they could not and worse, their ROA decreased.

 

So, I prefer to be cautious, and i don't take as a given that BNI can raise its price as the same level than inflation.

 

All things equal, a light business has an advantage. If you have a 7% free cash flow on revenues, and can increase your prices 10%, when your costs increase 20%, your free cash flow yield becomes negative. If you have a 20% free cash flow on revenue and the same apply, your free cash flow yield will be 12.7%. Not good but more protective.

 

Now we can argue that with its stong brand, land, etc., BNI is protected and that 7% free cash flow yield on revenue is enough, but I prefer to look at the risks, before they happen. The Graham story is a reminder that logical accuracy can be denied by the facts.

 

 

[ValueBuff]

Great conversation here...

 

But with BNI's debt..how much of an impact would the increase in cashflow due to inflation have on it current debt?  If cashflow and enetprise values are expanding via inflation and debt stay the same...then would it not be another positive for the company?

 

Or is this a near sighted thought.

 

thanks

[prevalou]

I think it would be  a positive if interest rates increase and their debt is fixed rate (the value of debt would decrease) . The deferred tax liability would be a positive too, because it's a zero rate financing.

[Guest ericopoly]

i don't take as a given that BNI can raise its price as the same level than inflation.

 

Nor do I take it as a given that Coke can raise prices at the same speed that it's production costs rise.  I think they can (as I do with BNI), but it's not a given.  They only make a tiny profit per drink -- forget exactly, but isn't it something like only a penny a drink?  So, if CapEx is an insignificant cost at Coke, then I suggest one focuses on their costs of significance.  Do those costs of significance not rise with inflation?  If they do, why are you not discussing them instead of capex?

 

I care as much about the expenses subtracted out before arriving at operating income as I do about the ones subtracted out afterwards (capex).

 

All things equal, a light business has an advantage. If you have a 7% free cash flow on revenues, and can increase your prices 10%, when your costs increase 20%, your free cash flow yield becomes negative. If you have a 20% free cash flow on revenue and the same apply, your free cash flow yield will be 12.7%. Not good but more protective.

 

I wonder about BNI's cap ex.  How much was simply expanding their fleet to grow their capacity versus replacing worn out cars?  The idea I am driving at is this:  growing the fleet is discretionary.

 

[prevalou]

first point: already answered in my precedent post. . Anyway free cash flow takes into account capex and operational expenses.

second point: from BNI 10 K:

 

Capital Commitment  Outlook for 2009

•

 

The Company’s planned capital commitment program for 2009 is approximately $2.7 billion, or about $150 million lower than 2008.

 

 

•

 

BNSF expects to spend $1.9 billion to refresh track, signal systems, structures and freight cars and to upgrade technologies.

 

 

•

 

The Company anticipates acquiring approximately 350 locomotives at a cost of about $675 million.

 

 

•

 

Because of the significant volume declines associated with the economy, the expansion portion of the 2009 capital program is minimal and consists of ongoing work on projects already started.

 

 

[Guest ericopoly]

first point: already answered in my precedent post. . Anyway free cash flow takes into account capex and operational expenses.

second point: from BNI 10 K:

 

Capital Commitment   Outlook for 2009

•

 

The Company’s planned capital commitment program for 2009 is approximately $2.7 billion, or about $150 million lower than 2008.

 

 

•

 

BNSF expects to spend $1.9 billion to refresh track, signal systems, structures and freight cars and to upgrade technologies.

 

 

•

 

The Company anticipates acquiring approximately 350 locomotives at a cost of about $675 million.

 

 

•

 

Because of the significant volume declines associated with the economy, the expansion portion of the 2009 capital program is minimal and consists of ongoing work on projects already started.

 

 

 

Apologies for misunderstanding you (you say you already addressed the "first point").  I never could tell if you understood my points about Coke's "Cap Ex" to polish their brand image and their operational costs.  One post you were saying the intangibles would never depreciate and that 100% ROA beats 13%, I refuted it, and I never heard back from you about that.  Then in your last post you brought up the words "heavy" and "light" and figured you still hadn't moved on from that stance.  I guess you did.

 

Anyhow, I agree more free cash flow as a percentage of sales is better, all things considered.  Who wouldn't want more?

 

 

 

 

[prevalou]

high net income/revenues (or earning power/revenue or free cash flow/revenue) is a better protection against the risk of inflation. We agree on that.

high revenues/assets is a better protection against the risk of inflation. Same reasoning than before: no margin of safety when you have heavy assets to produce revenue.

When you have a high ROA, you have pretty good chance to have high free cash flow/revenues and high revenues/assets. It was the case with Coke. I recognize you can have high ROA companies with low free cash flows/revenues and very high velocity, where you can wonder if they are well protected against inflation. It would be another debate...

[calonego]

Very detailed explanation (http://www.berkshirehathaway.com/letters/1983.html):

 

"Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.

 

That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

 

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

 

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

 

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

 

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

 

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

 

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

 

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

 

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

 

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.

 

But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled "No-Will". Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an "asset" just as if the acquisition had been a sensible one.

 

* * * * *

 

If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder.

 

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%.

 

With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business.

 

Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true" earnings of $3 per share cause him to rethink his purchase price?

 

* * * * *"

 

[prevalou]

thanks. It is better explained by Buffett himself.

[SharperDingaan]

 

Couple of very simple things being missed:

 

For BNI to go bankrupt they have to borrow & loose a massive amount of cash, run an operating cash deficit every year, exhaust all their capital market access, sell/lease back all their rolling stock, & sell/lease back all their rights of way. Total cash raise of maybe 2-3x the current BV, & all of it invested to earn a minus 100% return ? Not very likely.

 

Trains are green (vs trucking), & capital intensive. Operating cash cost/paid mile is minimal, capacity is easily scaleable (except at choke points), & a 10% increase in paying rail traffic reduces fixed cost/paid mail by at least 12-18%. ie: The more traffic on your rails the less you can charge per mile, encouraging still more traffic at an accelerating rate. A rise in gasoline prices just further accelerates the process.

 

Buy today & you buy when rail traffic is minimal. But in 'normal' times .... wouldn't the average traffic be at least 25-30% higher ? & because of the fixed cost structure .. wouldn't almost all of that incremental revenue flow straight to the bottom line ? A nice bump to owner earnings.

 

Nice business

 

SD

 

 

 

[prevalou]

what I don't like is declining volume with increases in prices. It masks the problems. Material companies like Martin Marietta do the same: increasing their rates with a declining volume. How long can it last  ? What is the true earning power of these companies ?

Often, companies that underprice their service are better investments, because their true earning power is better than it seems.