Warren Buffett's Railroad

Warren Buffett's Railroad

Warren Buffett's $5 Billion Railroad Stake…And How to Profit by Following in His "Tracks"

by Matthew Weinschenk, Investment U Research Team

Warren Buffett is arguably the greatest value investor the world has ever seen. His investment holding company, Berkshire Hathaway (NYSE: BRK.A), has averaged a compounded annual gain of 19.8% since 1964.

That easily turned every dollar into hundreds of thousands of dollars - approximately $400,863. By contrast, the same investment in the S&P 500 would be worth far less than $10,000.

When Buffett started buying, the markets took notice. And so did we…

A self-made billionaire, Buffett is famous for taking large positions in companies and holding them for a very long time. And “long hauls” are exactly what he’s had on his mind recently…

In February 2010, Buffett surprised the markets by buying Burlington Northern Santa Fe Railway, which used to trade under the symbol “BNI.”

Buffett had slowly and quietly been building his stock in Burlington since 2006, amassing 22.6% of the outstanding shares, until he finally bought up the remaining 77% in an all stock deal.

Buffett paid $100 per share for Burlington Northern, which had been trading around $77 before the announcement.

And why not? He still only paid $0.89 for every $1 of assets on Burlington’s books… a classic Warren Buffett deal. You know he’d have to get a good price to undertake the largest deal in Berkshire Hathaway’s history.

But why’s he betting so big on the railroad industry?

It seems to go against common thinking that the rail-freight shipping industry is doing well. After all, at the time…

  • Fuel prices were up 120% since the March 2009 lows.

  • Unemployment stubbornly hovered around 9% in most areas.

  • Shipping rates, as measured by the Baltic Dry Index, were 1/10th of their 2008 highs.

But then again, that’s exactly why Warren Buffet decided to buy.

Prior to his purchase, the rail industry had seen its overall volumes decrease. And most considered railroads behind the times, slow innovators, and in an industry that had little power to increase profit margins.

Now they are proving just the opposite.

It’s a simple fact that a healthy economy ships goods… lots of them.

Now that we’re in the early stages of a recovery, railways are set for a surge.

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Rail: The Economical Alternative to Trucking

There are more than 173,000 miles of track in North America, with 150,000 miles in the United States alone. As an industry, it’s enormous, generating around $40 billion in annual revenues.

Some of that revenue is made by moving large chunks of this country’s grain harvest and inter-city freight. That’s more than any other means of freight transportation.

Railroads also carry a significant majority of the nation’s coal, which provides more than half of the nation’s electricity. As our power demands increase, so will the coal companies’ demand for shipping.

To be sure, trains are better than trucks…

One standard railcar can hold up to 100 tons of densely packed freight. To ship that much by truck would take four standard tractor-trailers.

This fuel efficiency allows a train to haul one ton of freight 423 miles on one gallon of diesel. As fuel prices go up, this efficiency will only make rail more competitive to alternative shipping options.

In fact, many trucking companies use rail freight for their cost savings. (UPS – a shipping company usually associated with trucking – is the railroad industry’s biggest customer.)

Truckers, forced to raise their prices by rising fuel costs, are finding themselves undercut by rail freight costs. Railroads are in a unique position of being able to increase their pricing to press their cost advantage and still remain a less expensive alternative to trucking.

Knowing all of that, it's no shock that 2011 was an excellent year for U.S. railroads across the board when it came to revenue. Each of them, from Union Pacific to Kansas City Southern, reported double digit growth year-on-year in that department.

Playing the Railroad Infrastructure Boom

Soaring demand for exports and commodities such as coal, agricultural products and ethanol have kept the rails active… even if they weren’t at capacity.

With competitive rates and advantages over trucking, the rail industry is well placed to weather all but a protracted slowdown in the economy.

But the railroads aren’t the only way to profit from this long-term trend.

The Department of Transportation predicts freight rail tonnage will rise 90% by 2035. Rail companies are laying new track and building new facilities, terminals and tunnels to prepare for the coming increases. In all, U.S. railroads will spend close to $10 billion in capital improvements.

Here are a few of the companies they’ll be hiring…

Westinghouse Air Brakes Technology Corporation, or Wabtec (NYSE: WAB) as it’s known, produces locomotives, rail cars and transportation equipment.

In addition to its huge US business, the company formed a joint venture in the last few years to provide rail couplers to China.

Wabtec is constantly signing contracts from rail systems in California, New Mexico, Utah and Minnesota. And the numbers look good…

  • Total revenue rose from 1.5 billion to 1.96 billion year on year.

  • Total cash flow from operating activities rose from 176 million to to 248 million.

  • Net income rose from 123 million to 170 million.

But if you still want a more direct play, you can choose to compete directly with Mr. Buffett by buying shares of Union Pacific Corporation (NYSE: UNP).

Pre-merger, Union Pacific’s $14.1 billion in revenue actually bested Burlington Northern’s $14 billion to make it the largest rail company in the nation.

And more importantly, Union Pacific has revamped its operations following the recession, which has paid off.  Union Pacific invested $10 billion in four years in capital spending.  Since then, they’ve improved services and timeliness of shipments.

The HUB Group, a $1.6-billion-a-year shipper, shifted all its west coast business away from Burlington Northern to Union Pacific. And Union Pacific’s CEO plans to get the company’s return on capital up into the double digits from its current 7.3%.

No matter how you look at it, rail shipping in the new economy is the future.

“In business,” Buffett has said, “I look for economic castles protected by unbreakable ‘moats.’”

The economic moats around railroads are the billions of dollars it costs to build them and the fact that the rights of way they need are all but impossible to obtain today.

Fact is, you’ll never see a new railroad built in America again.

That’s the kind of economic moat that should certainly keep Buffett happy – and wealthy – with his investment… and keep Burlington Northern and Union Pacific busy for the “long haul.”

Good Investing,

Matthew Weinschenk, Investment U Research Team

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