(The following story by Scott Deveau appeared on the Financial Post website on September 10.)
OTTAWA — With the U.S. economy slowing down and rail volumes shrinking, it seems an odd time for investors to ride the rails, but try telling that to Warren Buffett.
The Sage of Omaha’s Berkshire Hathaway Inc. not only revealed last week it had increased its stake in Burlington Northern Santa Fe Corp. to 15%, but said it may eventually increase the investment to 25% of the railway. Berkshire’s Burlington buy comes on top of smaller investments earlier this year in two other top tier railways –Union Pacific and Norfolk Southern.
On the surface, it seems like a bad time to go full steam into such investments with U.S. freight shipments down 3.5% in the first eight months of the year, and intermodal traffic down 1.9%. Fewer housing starts have shrunk lumber shipments, and shipments of most commodities, motor vehicles and equipment are down.
The remainder of the year doesn’t look much better with the U.S. economy slumping. Canada is faring a little better, but total carloads are down by nearly 1% on the year.
So why is one of the world’s most savvy investor betting on an industry in a downturn? The answer is simple: He’s in it for the long haul.
“Warren Buffett’s history, Berkshire Hathaway’s history is definitely a buy-and-hold type of investor,” said Edward Jones analyst Tom Kersting. “Typically when he takes big stakes in a company like this, he owns them for a very long period.”
Mr. Buffett has held similar sized stakes in Coca-Cola, American Express, and Wells Fargo for 20 years or more, Mr. Kerting said. The Nebraska businessman has modestly increased his stake in those companies along the way, he added.
“He sees something in the rail industry that, over the next decade or longer, will make this an attractive investment,” Mr. Kersting said.
Berkshire is not the only company looking at the long-term potential for the railways. Canadian Pacific Railway Ltd. suspended its 10% share buyback program last week, opting instead to buy Dakota, Minnesota & Eastern for at least US$1.48-billion. While Fred Green, CP chief executive, said that synergies with the regional railway and its access to the lucrative ethanol trade in the U.S. Midwest would add to CP’s bottom line, it was clear the gem in the deal was DM&E’s rights to develop in the coal deposits of Wyoming’s Powder River Basin.
The country’s second-largest railway agreed to pay an additional US$1.05-billion should it go ahead with the Powder River project. Mr. Green said the investment provided an “opportunity for future growth,” but it would take at least five years before it was hauling coal out of the basin. The project is expected to cost an additional US$4-billion to develop.
While analysts griped about the price CP paid and argued that shareholders would have been better served by the share buyback program, most saw the long-term potential of the investment and few changed their rating or earnings forecast on the stock.
“In the past, when railroads have been faced with economic downturns, one of the first things they have done is slash capital improvements,” said Tom White, a spokesman for the Association of American Railroads. “That isn’t happing now.”
This year North America’s top-tier railways plan to invest a record $9.4-billion on capital expenditures, up from $8.4-billion last year, he said.
The improvements range from double-tracking lines — such as Burlington has done on its transcontinental line from Chicago to Los Angeles — to putting in signaling and other capacity-generating investments.
“The reason they are maintaining that level [of investment] is they recognize the economic downturn is temporary,” Mr. White said.
While 2007 is certainly set to be softer than 2006, he said, last year was a record for volumes, intermodal traffic, and profit, with U.S. railways making a combined US$6.5-billion.
The industry has benefited in the past 25 years with increased pricing power and less regulation, according to UBS analyst Fadi Chamoun.
“Our view is, notwithstanding there are some risks associated with the economic outlook, these assets are still undervalued in terms of their competitive advantage when compared with other modes of transportation,” he said in an interview.
The railways continue to take market share from the trucking industry, due in part to the 3-to-1 fuel efficiency advantage and driver shortages in the trucking industry.
The railroads are also running leaner, more efficiently, and faster than ever before.
CN is leading the pack with an operating ratio — a closely watched indicator of a railroad’s expenses as a proportion of revenue — of roughly 60%, something that was unheard of a decade ago.
Increased global trade has also buffered the rails against downturns in the North American economy, with bulk commodities increasingly shipped overseas and cheaply made manufactured goods brought in from Asia.
Still, Mr. Chamoun cautions that some railways are better quality investment than others, like Canadian National Railway Co., Norfolk, and Union Pacific.
Investors have taken notice with Standard & Poor’s Railroads 500 Index, which includes all four Class 1 U.S. railways, gaining 28% in the past year. Shares in CP and CN are trading 30% and 20% higher than a year ago respectively, even with the takeout premium knocked off CP after its DM&E purchase eliminated leveraged buyout speculation.
National Bank Financial analyst David Newman said the downturn in the U.S. economy may present a buying opportunity for investors.
Mr. Newman noted that if the U.S. government slashes interest rates on Sept. 18, as is widely expected, the rails will be one of the first industries to recover.
“I just generally believe that the rails are far better than they ever have been and they are not going to be as impacted by the cycle,” he said.
Typically, Class 1 rails trade between 12 and 16 times projected earnings, he said. As of Friday, they were trading at roughly 13 times projected 2008 earnings. When it bottoms out at 12 times, it often only takes six months. “If it drops to 12, I’d be buying,” he said.