(The following column by Paul Sullivan appeared on the Globe and Mail website on December 1, 2009.)
TORONTO — Early in November, the world’s second-richest man made a deal to buy America’s largest railway, swallow it whole and take it off the market.
At a total value of $34-billion (U.S.) it is Warren Buffett’s biggest deal ever. If shareholders finalize the deal as expected early in 2010, it can be argued that his purchase of Burlington Northern Santa Fe (BNI-N98.460.160.16%) (BNSF), based in Fort Worth, Texas, will do good things for the U.S. economy and cement Mr. Buffett’s legacy as the Sage of Omaha. When you’re pushing 80, that’s a good thing.
But what does it mean to ordinary investors? There are those who are argue that the deal isn’t very good for shareholders of Mr. Buffett’s company, Berkshire Hathaway (BRK.B-N3,352.30-0.70-0.02%) , or those of BNSF, even though Mr. Buffett has offered the equivalent of $100 a share in cash and stock.
Hard on the heels of the deal’s Nov. 3 announcement, three lawsuits were filed alleging that BNSF management shortchanged shareholders, rushing into a deal for their own benefit and failing to get the highest price for the railroad’s shares.
You could argue that the litigants are all wet, as the deal for the 77 per cent of the stock Berkshire Hathaway does not already own represents a 32-per-cent premium over BNSF’s closing price on Nov. 2, the day before the deal was announced. At one point last March, the stock had dipped to $51.20. Too bad for his own shareholders, Mr. Buffett wasn’t able to make the deal then. Still BNSF stock had climbed to $113 on its own in May, 2008, before the recession took the steam out of its locomotives, so maybe Mr. Buffett hasn’t lost all is marbles.
Even Mr. Buffett concedes that BNSF doesn’t come cheap, unlike some of his other legendary deals. And he’s doing some things in this deal that he doesn’t normally do – like issuing stock. He’s offering a 50-to-one split on Berkshire Hathaway’s B shares, which means that Berkshire’s B shares, which are currently trading at about $3,354 will trade around $67 after the deal is approved.
At least you won’t have to mortgage your house to buy one, which will still be the case with Berkshire’s A shares, currently trading at about $100,600 – the most expensive stock on the market.
You could dismiss the litigants as greedy, as did BNSF spokesman John Ambler, who told the Fort Worth Star-Telegram, “Unfortunately, it has become almost a universal occurrence for certain law firms to file lawsuits of this type around any corporate M&A activity.”
Yet a Scotia Capital Markets report indicates that Mr. Buffett paid too much for his railroad. A report issued at the end of November indicates that profit estimates for the Big Six North American railroads are inflated and may have to be adjusted downward. Since the deal was announced shares of the other five railways are up 12 per cent on average, and that includes Canadian National Railway Co. (CNR-T56.301.001.81%) , up five per cent, and Canadian Pacific Railway Ltd. (CP-T51.900.931.82%) , up more than eight per cent.
“In the short term, we would not be surprised to see the group retrace the gains made post the announcement of the bid,” writes Scotia analyst Cherilyn Radbourne.
Not a ringing endorsement of railroads.
Even Alice Schroeder, former Wall Street analyst, Bloomberg columnist and Buffett biographer, thinks Mr. Buffett paid too much for BNSF. “I’m not surprised he bought it,” she told Bloomberg on the Economy. “I was certainly surprised at the price … he’s getting a five-per-cent return on his initial investment which is considerably less than half of what he likes, and he’s issuing stock.”
So when that stock becomes available to trade, will it indeed be overpriced at one-fiftieth of its current price?
Despite what Ms. Schroeder thinks, UBS analysts point out that while Mr. Buffett paid within the acceptable range of earnings multiples of 8 to 9, the multiple was based on recession-depressed earnings. If his offer was based on that May, 2008, price of $113, for example, it would fall below 8 times earnings, which is why some shareholders are going to court.
Still, when your railroad is coming out a deep hole, $100 a share sounds pretty good, and it’s likely the deal will go through as scheduled early in the new year.
Which leaves a lot of people still asking the fundamental question: A railroad? There was, a time, not so long ago, when Buffett and Co. were leery of investing in railroads because they were capital-intensive, mired in union strife and make-work rules, but the Sage has changed his tune in recent years.
Rail is more environmentally sound than trucking. One freight train can move a ton of cargo 436 miles on a single gallon of diesel and can carry the load of 280 trucks.
According to Sharon Dunn, the executive director of the Georgia Railroad Association, if one per cent of freight currently moved by trucks went on rail instead, the reduction in greenhouse gases would be 1.2 million tons and the fuel savings would be 110 million gallons.
As the price of fuel increases, rail becomes an increasingly attractive alternative – and that capital intensive disadvantage becomes an advantage: no one is going to start a railroad. In defending the deal, Mr. Buffett told CNBC: “I basically believe this country will prosper and you’ll have more people moving more goods 10 and 20 and 30 years from now and the rails should benefit.”
Mr. Buffett has famously called the deal “an all-in wager on the economic future of the United States.” And, he added: “I love those bets.”
Ok, it’s not high-tech or bio-tech or Google. But it’s certainly one of the most intriguing deals of the 21st century, and it puts the spotlight on railroads. Many analysts believe that Canadian Pacific, which has none of the foreign ownership restrictions of the larger Canadian National, could be the next railroad on the block. So you may not have to buy into BNSF at a premium – CP is up in the wake of the BNSF deal, but nowhere near the 30-per-cent range – to get in on the next big thing. All aboard!