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BNSF: "I'd rather be in the West"

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By ToddFinances1
January 5, 2010

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Warren recently made these comments regarding BNSF:

"I'd rather be in the West than the East"
"I think the West is going to do well"
"I think I know how the country is going to develop"

While Wall Street is fixated on BNSF's "tepid" short-term outlook Warren is looking at a "renaissance" in the making, not just for rails but for the West in particular. There are several variables working together that will propel BNSF's business for decades to come, including a geographic advantage, demographic advantage and an energy advantage.

Geographic Advantage

There are several geographic advantages, one is the proximity to the Pacific Ocean and the other is the distance between the cities in the West.

A) Pacific Ocean:

*The Pacific ports are the doorways to and from China. CSX and NSC operate in the East and pull from Europe and Latin America via the Atlantic but BNSF and UNP have China.

*Not only do we like to buy goods made from China because of the low price but China and other Asian countries like to buy our grain to satisfy their growing demand. Approximately 50 percent of the agricultural commodities traffic BNSF hauls is transported to export points in the Pacific Northwest, Gulf of Mexico, Mexico and the Great Lakes.

*BNSF's international inter-modal business has grown at a compound annual growth rate of 11% between 1998 and 2007

*China may increase exports by 20% in the 1st quarter of 2010 as the economy recovers, according to Macquarie Securities Ltd. and Royal Bank of Scotland Group Plc.

B) Distance

The benefit of rails over trucks is naturally MAGNIFIED with distance. In the East, you have large cities that are closer together while in the West you have, well, lots of land.

*Rail is 2-5x more fuel efficient than trucks.

*In 1980, U.S. railroads moved a ton of freight an average of 235 miles per gallon of fuel. In 2007, the comparable figure was 436 miles, an 85% percent increase.

*One BNI train replaces more than 280 long-haul trucks from the road.

*Rail is more environmentally friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.

*Ever since the Staggers Act in 1980 it cost 54% less in inflation-adjusted terms to move freight by rail in 2007 than it did in 1981, thanks to efficiencies like double car stacking and technology.

*Inter-modal traffic is the fastest growing segment and has more than tripled in 20 years. For the first time ever, inter-modal surpassed coal in terms of revenue in 2003.

*Burlington is the largest inter-modal carrier with a 33% share and delivered 47% more units (BNSF slide #30) than the second highest inter-modal RR.

*Railroads have lower employee injury rates than other modes of transportation and most other major industry groups, including agriculture, construction, and manufacturing (in fact, since the Staggers Act, train accidents are down 71% and rail employee injuries are down 80%).

*Railroads are the safest way to transport hazardous materials. Railroads and trucks carry roughly equal hazmat ton-mileage, but trucks have nearly 16 times more hazmat releases than railroads.

II. Demographic Advantage

In the BNSF slideshow there is an interesting graph (slide #19). Population growth from 2005-2030 is displayed and in 3 markets there is estimated to be greater than a 60% jump in the number of people, two of which are in BNI's territory, areas of Arizona and Texas; 8 markets show population growth of between 40-60% and 6 (75%) of those markets are in the central/west region. It's simple, the greater the number of people, the greater the volume of goods for BNI.

III. Energy Advantage

BNI has one of the largest coal reserves in the world located in it's own backyard, the Powder River Basin.

*In 2008, around 40% of American coal production came from here, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years. There is much more coal available at PRB but it would take higher prices to get it out.

*PRB coal has extremely low sulfur content and many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. In fact, PRB coal is 60 percent lower in sulfur than most other U.S. coal sources.

*PRB costs are consistently the lowest at $1.45/MM btu as of August of this year which is significantly cheaper than the Illinois basin, central Appalachian, or natural gas (BNSF slide #6). Natural gas is 132% more expensive (even now after the big drop in nat gas prices) and inherently more volatile, thus less reliable, spiking greatly in price during Katrina and in 2008.

*Total electricity generation has been down year-over-year only 3 times since 1949, this is projected to be the FIRST 2 year dip (slide #11). When demand comes back it may snap back rather quickly to get back to trend which means more coal over BNSF's rails.

When you add it all up you get a system that favors rails for decades to come, specifically for those located in the West like BNSF. Like Mungofitch, I noticed the projection that BNSF had for 2014 and the range averaged about $10/share, which is an alarming double in just about 5 years. I guess this isn't all that alarming since BNSF grew earnings about 11% over the past 5 years which includes this year (a down year) as the END point. The average multiple for UNP, NSC and CSX are currently about 17x earnings. If BNSF were to earn $10/share then that would equate to share price of $170 (had Warren not agreed to buy them). So at a price of $100/share that would still mean a theoretical average annual return of 11% a year as the premium gets spread over those 5 years. The longer the time horizon, the more the premium gets spread out so your average, annual return goes up.

As Charlie Munger points out:

"Over the long-term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

The Return on total capital has been growing with BNSF. According to ValueLine it was 9.6% in 1999 and reached 12.2% in 2008. With the economic dislocation, it's temporarily down as it's estimated to be around 9% for 2009. As time goes by I expect the return on capital to continue to increase for BNSF and may be closer to 15% in 10 years or so as new technology continues to increase efficiencies, and rail volumes increase. Also, new coal contracts need to be signed. It is estimated that 60% of BNI's coal contracts will be renegotiated in the next 5 years which will benefit BNSF. On top of that, electricity usage will likely snap back to trend as we haven't had a 2 year drop since 1949. Couple this with a more normalized economy and one can see why $10/share for 2014 is feasible.

But as John Lennon said:

"Life is what happens to you while you're busy making other plans".

Only time will tell how BNSF works out. In the mean time, I do look forward to Warren Buffett discussing it in more detail at the annual meeting, specifically as it relates to using BRK shares as part of the transaction.



(BNSF slideshow: I recommend it)