Over the past week, Warren Buffett has commented on the valuation of Berkshire Hathaway shares and the logic behind issuing shares as currency to pay for part of the Burlington Northern acquisition. Mr. Buffett’s statements have helped to answer many of the questions we raised in December. The question now is whether the price tag will be justified when we look back at this deal in five to ten years.
“Crazy Deal” or “Heck of an Investment”?
Bruce Greenwald, Professor of Finance at Columbia University and Director of Research at First Eagle Funds, is one of the most successful and respected value investors operating today. Given Mr. Greenwald’s reputation, his comments in an interview published on November 17 attracted a great deal of attention because of his negative assessment of the Burlington Northern transaction.
At the same time, other value investors such as Bruce Berkowitz have been very positive on the acquisition due to Berkshire’s ability to deploy low to zero cost float to fund the transaction. Clearly there is controversy within the value investing community regarding the wisdom of the acquisition.
A Different Type of Acquisition for Berkshire
Those who are familiar with Warren Buffett’s annual shareholder letters know about his enthusiasm for businesses that generate large amounts of free cash flow but require low levels of ongoing capital investment to maintain the business. See’s Candies is the perfect example of such a business. (See the appendix to the 1983 letter for a good discussion on See’s.) If such a company can deploy free cash flow within the business at high returns on incremental equity, the business is home run.
Unfortunately, many businesses cannot deploy incremental cash flow profitably. In many cases, the cash flow is wasted. One of the main drivers of value at Berkshire is that Mr. Buffett has consistently harvested free cash flow from operating businesses that cannot reinvest at high rates on incremental capital. These cash flows were then invested in other businesses with better prospects.
Other than the fact that railroads are obviously different from making candy, Burlington Northern’s business is very much the opposite of See’s because the company has a large amount of fixed assets that require constant maintenance. This consumes a significant chunk of the company’s annual cash flows.
A capital intensive business is not one that is likely to be sending large amounts of cash back to Omaha for Mr. Buffett to invest elsewhere. Instead, the value proposition is exactly the opposite: The hope is that Burlington Northern may be a good destination for free cash flow coming into Berkshire from other operating subsidiaries or from the float generated from the insurance companies.
Burlington Northern: Free Cash Flow and Capex History
If the justification for purchasing Burlington Northern is that it will serve as a good destination for Berkshire’s cash going forward, we must first examine the company’s track record over the past several years. To what extent is Burlington Northern generating free cash flow? What level of maintenance capital expenditures have been made versus expansion expenditures?
The following table presents some relevant data for Burlington Northern over the past five year period:
We can see that Burlington Northern has devoted a significant portion of operating cash flow toward capital expenditures over the past five years. Of the amount spent on capex over the five year period, nearly 80 percent has been identified by the company as “maintenance” capex. Although the figure for depreciation is below the maintenance capex amount, this difference can be accounted for by the fact that depreciation is based on the historical cost of the assets while maintenance capex is purchased at today’s prices.
The company has not pursued any significant expansion capex over the past five years. Instead, the majority of free cash flow has been returned to shareholders either via dividends or share repurchases:
The apparent lack of significant expansion capex can be verified by small growth in the overall size of the company’s fleet of locomotives and freight cars, along with a steady average age for rolling stock. Additionally, the majority of railway investments have gone toward existing tracks rather than expansion activities:
Rapid Expansion Ahead?
Assuming that Bruce Berkowitz and others are correct regarding the opportunities for Berkshire to deploy low to no cost funds into the railroad business, one must then come to the conclusion that Mr. Buffett is planning on a rapid expansion of Burlington Northern in the coming years.
If Burlington Northern continues on its current course of capital expenditures, the company will still be generating significant free cash flow each year. Virtually all of the free cash flow was returned to shareholders over the past five years and, going forward, these cash flows could instead be reinvested in Burlington Northern for expansion purposes. Another way of looking at this is that prior to requiring any cash inflows from Berkshire, Burlington Northern already has around $1.5 billion of cash each year to invest in expansion.
Beyond deploying the internally generated cash, Burlington Northern may be a good place to invest additional funds that Berkshire Hathaway has generated from other operating subsidiaries or through insurance float.
A reasonable conclusion to come to after looking at the data as well as the rationale for the acquisition is that Mr. Buffett must be planning a major expansion of Burlington Northern’s operations. If the railroad does not expand, it will continue to generate enough cash flow to maintain operations, fund modest expansion, and return some funds to Berkshire Hathaway in the form of dividends.
That may not seem like a bad result. However, if this is all Mr. Buffett has planned for Burlington Northern, the deal is subject to Prof. Greenwald’s criticism. The main way in which this transaction generates value for Berkshire Hathaway shareholders is if profitable expansion is possible and can not only consume Burlington Northern’s internally generated cash but also a significant amount of cash flow from Berkshire’s other operating companies.
The spreadsheet provided below contains the data for the tables presented above along with links to the source SEC filings.
The author owns shares of Berkshire Hathaway.
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