Portfolio manager’s Letter November 2009
“You know, when I was six, I wanted a railroad set and my dad didn’t get it”. Warren Buffett at the Columbia Business School Town Meeting.
Newly arrived in Omaha, 73 years late, but just in time for Christmas a shiny, but not exactly new Billion Dollar Train Set. There may be a bit of a problem placing this package under the Christmas tree because it comes complete with 6,500 locomotives 83,000 freight cars and approximately $2.1 billion in net income.
In some ways, this is a typical Berkshire Hathaway acquisition, but it some ways, it is different. Some analysts have considered it more expensive than Buffett’s usual purchase. At 16.7 times the 2008 earnings, it is not cheap. Still, from 2004 to 2008, the billion dollar train has increased its’ earnings from $805 million to $2,115 million, an annual rate of increase of 27.3%, so it may be that this more of a growth situation than is usual with a Berkshire Hathaway purchase.
Interesting aspects of this purchase are:
At $44 billion, this is a billion dollar train set. If you include the value of BNI’s debt, this is the biggest deal that Berkshire Hathaway has done. The next biggest was Gen Re for $16 billion in 1998.
Berkshire Hathaway expects to pay $16 billion in cash. They will borrow $8 billion and use $8 billion from pretty cash.
Buffett says this will leave with about $20 billion in cash. This is about the same level of cash as the company had at the end of the second quarter, before the billion dollar train, and would seem to indicate that cash is flowing into Omaha at a rate of about $4 billion quarter.
Doug Kass says that this will be Buffett’s last big deal, but I doubt it. Because Berkshire Hathaway’s cash flow will pay for the billion dollar train about a year and a half, and with further economic pain and suffering likely in a couple of years, Buffett’s next big deal may not be all that far into the future. Berkshire Hathaway’s current cash flow will increase with the addition of the billion dollar train and the improvement in the economy, and it is possible that instead of being Buffett’s last deal, this will be the first in a series of new, more significant acquisitions.
Berkshire Hathaway’s stock< split is another indication that the company has entered into a new era. For years, Buffett sought to limit membership to the club by keeping the entry fee high, but his gifts to the Gates Foundation have ended that era. It is now necessary to increase the liquidity of the stock to the point that the sales by the Foundation will not disrupt the market.
The stock split will increase the number of “B” shares from 14,500,000 to 725,000,000. The issuance of new stock to billion dollar train (Burlington Northern) shareholders, if they all take “B” shares (and they won’t), would add another 123,000,000 shares. I am not sure that this will relieve all pressure from the sales by the Gates Foundation, but it certainly will help to increase the stock’s trading volume. It also will make it more likely that Berkshire Hathaway will be added to the S&P 500, and that would definitely soak up all the stock sold by the Foundation.
Estimates by Standard and Poor’s are that 10% of stock of each member of the index is held by index funds. In Berkshire Hathaway’s case this would require that index funds purchase approximately $16 billion worth of Berkshire Hathaway’s stock. My estimate of sales by the Gates Foundation would be something like $2.5 billion per year.
Buffett is better than most at understanding macroeconomic trends, and this purchase of the billion dollar train has some exciting implications. It is a play on a weaker dollar, on rising energy costs and inflation in general. Buffett has said that the best hedge against inflation is a well run business with the ability to raise its’ prices. A monopoly transporter of basic commodities would seem to be in about as good a position to fit his criteria as any business.
The purchase is also, as Buffett said, a play on American business. A weak dollar will make American businesses more competitive both in their domestic market and in international markets. It may even put more money in the pockets of American workers and help to revive our consumer economy.
In a way, BNSF, the billion dollar train, reminds me of the purchase of Coke. There was a lot of skepticism at the time Buffett bought the stock. Why Coke? It was big, slow-growing, and unloved mainly on Wall Street. No one could figure out what Buffett saw in the company. Ten years later, in 1998, everyone agreed that it was a great purchase because now it was apparent what he saw in 1988. Large American brands could expand their sales in rapidly growing overseas markets.
I suspect that this too, is case were those of us without Buffett’s macro insight will have to wait a few years to understand what he sees now, and that it is likely that his judgment will look better and better as time passes.
Recent acquisitions have mostly happened after Buffett received an interesting phone call. This one for the billion train set is different because Buffett made the call. Buffett made the call, dropped a hint, and 15 minutes later (so he says), he had the deal he wanted. No, it probably was not that simple, but it is an interesting story. We are left with the impression that Buffett can have pretty much any deal he wants, all he has to do is pick up the phone.
Maybe Buffett is just bragging. But there is no one else on the planet with the reputation that would allow him to pull off anything like this kind of a deal he got for the billion dollar train. Berkshire is big and getting bigger, and it is going to take bigger and bigger deals to move the needle, but in this particular game it looks to me as though Buffett’s reputation for integrity leave him with little competition.
Berkshire Hathaway’s earnings in the third quarter came in at $3.2 billion, up 300% from the third quarter of 2008, largely as predicted, although the gain on their derivative contracts was about $400 million short of our guess.
Price action currently is being influenced by merger arbitrage. The hedges are buying the billion dollar train (Burlington Northern) and selling Berkshire Hathaway short to lock in the small premium that remains between the Market price of BNSF and the $100 per share that Berkshire Hathaway will pay when the merger is complete.
The current market price of Berkshire Hathaway is very cheap with the company selling at 1.2 times its market value plus float this is about the same level of value that existed in 2000 when Buffett offered to by the stock at $45,000 per share.
Bruce Berkowitz of Fairholme fund which has been repurchasing Berkshire Hathaway after selling it in early 2008, was quoted in a recent interview as saying the reason he is buying now is because of the credit meltdown and that because of this he feels the money Buffett has committed in the last year and a half may for the billion dollar train set and the other recent purchases, turn out to be the best investments of his career.