BNSF and MidAmerican

[mcliu]

Isn't the idea of WEB buying capital intensive businesses that they earn a return on capital on the marginal dollar of capital invested that's higher than the cost of capital.

 

Hence, each dollar invested will be worth more in the future than it is today.

 

 

 

Could you explain this point? Not saying you're wrong, but I'm not clear what you're getting at. Wouldn't a capital light business also do the same?

 

I think the problem with a capital light business that generates significant cash flows is that you need to consistently find places to reinvest the cash. Given the amount of cash flowing into BRK, it's impractical for WEB to consistently find capital light businesses to invest in.

 

With high capital intensity, a significant portion of the cash flow is automatically reinvested, and it's accretive to the value of the business as long as it earns more than the cost of capital.

[Palantir]

So do you think WEB is simply trying to get a "decent" return over the cost of capital, rather than a "great" one, with the decent return leveraged up via the float?

[xo 1]

I appreciate the discussion.  I've been asking these questions of myself for over a past decade and haven't yet cracked the nut.  I suspect our depth of understanding the strategy will deepen over the decades until, in retrospect, the genius seems obvious.  The thoughts above have helped me further that process.  With that as caveat, here are some reflections:

 

Float may play a role in the initial acquisition, but if I am thinking about this right, not in the subsequent capital investment, which appears to be funded from funds from operations.  However, a similar (albeit not quite as cheap) approach for both MidAmerican and BNSF is to add non-recourse leverage to the mix to boost their ROE.  With energy, the periodic tax incentives for certain types of energy also add a layer of complexity and enhance returns. 

 

With railroads, the long-lived nature of the assets must be attractive.  The depreciation rate doesn't fully cover the necessary replacement capex true, but the depreciation rate also doesn't track the true life of the asset.  And I agree that railroad transport looks to be becoming ever more competitive with trucks and planes, which competitive advantage seems likely to grow annually.

 

Finally, a component of the attractiveness of both BNSF and MidAmerican is the predictably of returns.  Those can be goosed, opportunistically, with tuck-in acquisitions.  The Constellation venture is a good example.  But fundamentally, BRK can predict a range of cash flow with a solid low-end estimate.  The unknown part of the range is to the upside.

 

Positive thoughts aside, I do hope that Buffett will be asked to explain in greater detail than he has the nearly flat performance of MidAmerican since the 2006 acquisition (excluding the one-time gain on Constellation), despite heavy capex.  It may well be building value, but  the results aren't showing up in enhanced earnings so far as I can tell.

[mcliu]

I'm not sure if my thinking is right, but these capital intensive businesses serve as great compliments to the insurance businesses in that, you're invested with long-term asset/liability matching with highly predictable returns.

 

It enhances your capital intensive business' competitive advantage by providing them with the lowest cost of capital (compared to accessing debt/equity markets) in the industry and it enhances your insurance firms' competitive advantage by providing consistent returns (compared to most investment programs at insurance companies) on your float which increases your pricing abilities in underwriting..

[LC]

I'm not sure if my thinking is right, but these capital intensive businesses serve as great compliments to the insurance businesses in that, you're invested with long-term asset/liability matching with highly predictable returns.

 

It enhances your capital intensive business' competitive advantage by providing them with the lowest cost of capital (compared to accessing debt/equity markets) in the industry and it enhances your insurance firms' competitive advantage by providing consistent returns (compared to most investment programs at insurance companies) on your float which increases your pricing abilities in underwriting..

Yes! And from a more practical perspective, it is brilliant:

Take health/life insurance: you receive constant premiums over the course of the insured person's life, and then a payout occurs when a major health issue (or death) happens.

 

Now, you match those cash inflows by reinvesting in that person: namely, by selling them the power/heat/water during the course of their life!

[Kiltacular]

This guy: http://seekingalpha.com/article/1058551-omaha-hold-em-going-all-in-on-berkshire-hathaway

 

...makes the point I was making earlier in this thread w/r/t BNSF's deferred taxes and how they do, in effect, produce much better than "apparent at first glance" returns.

 

In addition, this is a generally excellent analysis of Berkshire.

 

EDIT: I see Jeff linked to this article in a new thread.  Well, I'm going to leave it here too since I like that he made the point I was making in this thread.  ;)

[jeffmori7]

Kiltacular, I thought about posting it here first, but I decided to got Parsad way and start a new thread about the article only :)

[Palantir]

You guys make sense when you treat BRK as a "strategic investor" in BNSF with its ability to use its float to leverage the railroad, treating it like a bond etc etc. That's fine, and makes sense, but that doesn't explain why others have gone into railroads, before and after Buffett, in addition, railroads have done really well since before WEB made his buy and have continued to be strong. Cascade Investments' purchase of CN Rail is an example of that.

 

So, I think there is more to the story than simply its fit into Berk's collection of businesses.

[Kiltacular]

You guys make sense when you treat BRK as a "strategic investor" in BNSF with its ability to use its float to leverage the railroad, treating it like a bond etc etc. That's fine, and makes sense, but that doesn't explain why others have gone into railroads, before and after Buffett, in addition, railroads have done really well since before WEB made his buy and have continued to be strong. Cascade Investments' purchase of CN Rail is an example of that.

 

So, I think there is more to the story than simply its fit into Berk's collection of businesses.

 

Palantir,

 

I'd answer you as follows:

 

1)  As for "more to the story", I alluded to the notion that Buffett stepped in -- "late" as it were -- once this industry had fully consolidated.  The railroad industry was far more fragmented 25 years ago.  So, there are two major competitors in the West and two in the East.  Since there won't be any more competitors, the value of consolidation accrues fully to the owner.  As Munger says, some businesses "cascade towards scale".  This is one of them.

 

2)  This industry used to be much more unionized, much less efficient with labor.  Also, it used to be much less efficient before it was consolidated.  Once consolidated, it made sense that owners invested large amounts into optimizing -- with double stacking and adding addt'l lines in highly congested areas, etc.  You can find all kinds of articles using some google-fu if you're so inclined.

 

3)  Buffett made it clear about 3 or 4 years ago that he believed that oil (and therefore diesel / gasoline) demand had caught up with supply.  This meant / means that diesel / gas cost was unlikely to drop way back down.  If one believed / believes that, the rails have an enormous energy advantage against their main alternative competitor -- trucking.  Buffett has commented over and over again about how far BNSF can move 1 ton of freight on 1 gallon of fuel.  When one adds in the fact that this energy efficiency also has an environmental advantage (and therefore, possibly, a regulatory / societal benefit), it is just gravy to the energy advantage idea.

 

4)  With regard to the specific point I was making earlier in the thread and the point that was made in the excellent seeking alpha article, one can see -- if both I and the other writer are correct -- BNSF (and likely the other rails) are much, much more profitable than they appear because of the huge tax advantage.  Read the whole thread carefully -- again -- including the the write-up that was included from value investor's club earlier in the thread.  This write-up, which is years old, is what orginally pushed me to look into possible tax advantages for BNSF.

 

All the info. you could want is here, in my opinion.  Now I've put it on a platter.  I like doing that once in a while just as others have done it for me on other ideas discussed on this board.  This is helpful for all of us.

 

Best of luck

[Palantir]

Fair enough, I appreciate the response.

[Palantir]

Does anyone know why BNSF's financials are still published? I thought once it was taken out, they would be consolidated into BRK.

 

http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000015511&owner=exclude&count=40&hidefilings=0

[gfp]

large amount of outstanding bonds

[jay21]

I want to take a quick look at this year's results:

 

BNSF pre-tax income: 5,377

Mid American pre-tax income: 1,644

Combined: 7,021

 

EOY 2011 Regulated Business Equity: 71,781

EOY 2012 Regulated Business Equity: 74,639

 

Equity excludes any deferred tax allocation.  These are from BRKs filings.  I'll probably look into BNSF's filings later.

[Kiltacular]

I want to take a quick look at this year's results:

 

BNSF pre-tax income: 5,377

Mid American pre-tax income: 1,644

Combined: 7,021

 

EOY 2011 Regulated Business Equity: 71,781

EOY 2012 Regulated Business Equity: 74,639

 

Equity excludes any deferred tax allocation.  These are from BRKs filings.  I'll probably look into BNSF's filings later.

 

BNSF pays out a bunch to Berkshire proper as well which reduces equity at the subs.

[racemize]

I want to take a quick look at this year's results:

 

BNSF pre-tax income: 5,377

Mid American pre-tax income: 1,644

Combined: 7,021

 

EOY 2011 Regulated Business Equity: 71,781

EOY 2012 Regulated Business Equity: 74,639

 

Equity excludes any deferred tax allocation.  These are from BRKs filings.  I'll probably look into BNSF's filings later.

 

BNSF pays out a bunch to Berkshire proper as well which reduces equity at the subs.

 

I thought they were putting in ~10 billion a year in both of these, which is greater than the pre-tax income, which would mean money flows into these two rather than out--are there other payments to berkshire outside of earnings?

[fareastwarriors]

Does anyone know why BNSF's financials are still published? I thought once it was taken out, they would be consolidated into BRK.

 

http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000015511&owner=exclude&count=40&hidefilings=0

 

Is it not because they issue bonds which are not guaranteed by BRK?

[Kiltacular]

Is it not because they issue bonds which are not guaranteed by BRK?

 

fareast,

 

I think that is the reason.  MidAmerican also still files and they too issue bonds not guaranteed by Berkshire.

 

It makes sense that this would be the law / requirement.

[fareastwarriors]

http://www.bloomberg.com/news/2013-03-13/oil-riding-rails-creates-jobs-as-buffett-puffs-chest-freight.html

[jay21]

I want to take a quick look at this year's results:

 

BNSF pre-tax income: 5,377

Mid American pre-tax income: 1,644

Combined: 7,021

 

EOY 2011 Regulated Business Equity: 71,781

EOY 2012 Regulated Business Equity: 74,639

 

Equity excludes any deferred tax allocation.  These are from BRKs filings.  I'll probably look into BNSF's filings later.

 

BNSF pays out a bunch to Berkshire proper as well which reduces equity at the subs.

 

One of the points that I am making here is that these businesses earned 9.78% on beginning of the year equity.  That seems very low.  But it also makes me think about how high the ROE the other businesses had.

 

Now let's try to estimate the returns on capital/equity going forward.  Let's deduct the 20,056 in goodwill to come up with a tangible equity number: 51,725.  The return on tangible equity is 13.57%.

[twacowfca]

I want to take a quick look at this year's results:

 

BNSF pre-tax income: 5,377

Mid American pre-tax income: 1,644

Combined: 7,021

 

EOY 2011 Regulated Business Equity: 71,781

EOY 2012 Regulated Business Equity: 74,639

 

Equity excludes any deferred tax allocation.  These are from BRKs filings.  I'll probably look into BNSF's filings later.

 

BNSF pays out a bunch to Berkshire proper as well which reduces equity at the subs.

 

One of the points that I am making here is that these businesses earned 9.78% on beginning of the year equity.  That seems very low.  But it also makes me think about how high the ROE the other businesses had.

 

Now let's try to estimate the returns on capital/equity going forward.  Let's deduct the 20,056 in goodwill to come up with a tangible equity number: 51,725.  The return on tangible equity is 13.57%.

 

That's helpful information.  Is it possible to infer Mid American's return on tangible equity separate from BNSF?

[jay21]

 

That's helpful information.  Is it possible to infer Mid American's return on tangible equity separate from BNSF?

 

Sure, here's BNSF.  $5,377 pre-tax over tangible equity (34,329-14,836) is a whopping 27.5%

 

http://www.bnsf.com/about-bnsf/financial-information/form-10-k-filings/pdf/10k-llc-2012.pdf

 

That means Mid-American is 40,310 in equity minus (20,056-14,386) 5,670 in goodwill for tangible equity of 34,640 and a return of 4.74%.  Wow, did i do something wrong?

 

 

[Kiltacular]

One of the points that I am making here is that these businesses earned 9.78% on beginning of the year equity.  That seems very low.  But it also makes me think about how high the ROE the other businesses had.

 

Now let's try to estimate the returns on capital/equity going forward.  Let's deduct the 20,056 in goodwill to come up with a tangible equity number: 51,725.  The return on tangible equity is 13.57%.

 

Oh, I see.  Yeah, the ROE's aren't that bad.  Plus, they're somewhat muddled for BNSF because there's now a lot of goodwill and there are enormous deferred taxes each year.  (I feel strongly that these deferred taxes will be indefinitely deferred and therefore act as real cash.  Unless Berkshire shrinks the PPE&E or there's a tax law change, it amounts to a lot of money.)

 

*_*_

 

That's helpful information.  Is it possible to infer Mid American's return on tangible equity separate from BNSF?

 

I mentioned previously that MidAmerican files.  You can find info. on the MidAmerican holding company online:  "MidAmerican Energy Holdings Co / New"

 

They filed their 10k March 1.  Equity at the holding company (excluding $9MM of non-controling interests) was $15.742 billion on 12/31/12.

 

MidAmerican doesn't have, as I read it, the same kind of tax deferrals indefinitely as BNSF but they have currently been getting all kinds of tax benefits from wind (and soon solar) that don't appear if one just takes reported earnings and divides by equity to get the ROE.

 

My 2 cents on these subjects.

 

 

 

 

 

[jay21]

My initial analysis did not include a breakout of the deferred taxes (BRK reports one deferred tax line item as opposed to by operating segment).

 

When looking at MidAmerican's filing: http://www.midamerican.com/include/pdf/sec/20121231_99_mehc_annual.pdf

 

We get a much better understanding of the ROE:  15,910 equity and 5,120 of goodwill. Much better than the ROE I was showing before.

 

The deferred taxes of BNSF equals 16,319 and Mid-American is 7,903 so that should help us better understand the capital that we should allocate to the Regulated Business segment of BRK.

[racemize]

My initial analysis did not include a breakout of the deferred taxes (BRK reports one deferred tax line item as opposed to by operating segment).

 

When looking at MidAmerican's filing: http://www.midamerican.com/include/pdf/sec/20121231_99_mehc_annual.pdf

 

We get a much better understanding of the ROE:  15,910 equity and 5,120 of goodwill. Much better than the ROE I was showing before.

 

The deferred taxes of BNSF equals 16,319 and Mid-American is 7,903 so that should help us better understand the capital that we should allocate to the Regulated Business segment of BRK.

 

Thanks for doing this, I've been very curious.  As I'm being lazy today, what did the return on newly invested capital (or return on tangible equity) get to on MidAmerican with the adjustments you just mention?

[Kiltacular]

My initial analysis did not include a breakout of the deferred taxes (BRK reports one deferred tax line item as opposed to by operating segment).

 

You can find the growth / change in deferred taxes for BNSF using their filings. 

 

I've found that many people quickly grasp how Berkshire's deferred taxes on its stock holdings represent an interest free loan from the gov't.  They see that the present value of this deferral is unknowable because we don't know when the underlying stock holdings will be sold.  Still, they see that this deferral has significant value at Berkshire because many of the stock holdings which represent the bulk of the unrealized gains have been held for a very long time -- especially Coke and AXP and to a lesser extent Wells Fargo.

 

However, when it comes to discussing the deferred taxes for BNSF, they don't seem to see the value.  These deferred taxes -- as I read it -- are even MORE valuable than those generated by the stock holdings because they are likely to be permanent.

 

I mean, Buffett has made it clear that they plan to hold BNSF "for 100 years", etc.  Second, it is clear to me that because of inflation, the total amount invested in PP&E at BNSF is likely to grow and, as well, Buffett has made it clear that BNSF is spending well above depreciation in any case.  So, therefore, as long as the total invested in PP&E doesn't shrink AND the rules regarding BNSF's benefit from accelerated depreciation don't change, this deferral is effectively permanent and the cash it currently provides BNSF in excess of reported earnings is a substantial number.

 

Because of the regulated return on capital nature of BNSF, I don't think Buffett will go to pain to highlight this situation if it is correct.

 

The filings for BNSF can be confusing.  They keep two current with the SEC: "BNSF Railway Co" and "Burlington Northern Santa Fe, LLC"

 

I believe the second one, the "LLC", is the one you want to use.  It shows, for example, the distributions to Berkshire while the former one doesn't.

 

Using the second filing, we can see that in 2012, deferred income taxes went from $15,637 to $16,319 for an increase of $682 million in 2012 alone.

 

The cash represented by this increase is not reported in earnings but, I'm arguing, it is real cash flow for BNSF (as long as the requirements I described above are met -- I think they are and they will be indefinitely, and that's key).

 

If you talk to an accountant, he will tell you simply that deferred taxes represent differences between GAAP taxes and those calculated to determine tax payments to the IRS.  He'll tell you that "they eventually converge".

 

The issue here is that, in some cases, "eventually" can be a really, really, really long time.

 

I think these kinds of insights are a big reason Buffett is so rich.

 

I mean, if every year you tell yourself that you owe taxes to your government of $50,000 and therefore your gross income of $200,000 is reduced by $50,000 and so your net is $150,000 (your "reported" earnings).  But, in fact, you only pay your government $40,000 but you make an entry on a ledger that notes you "eventually" will owe the other $10,000. And, crucially, that "eventually" is at least 100 years away, then, effectively, you've made more than $150,000.  You've made something much closer to $160,000 because the present value of the deferral is a much smaller number than what you've recorded on your ledger.

 

This is a very similar concept as to what Buffett highlighted again this year regarding Berkshire's "liability" on its balance sheet for "float".  (With float, though, you have a different set of circumstances that make it true.  I feel confident that Buffett understands all these things -- he's the one that taught me the concepts  :) )