(The following story by Joe Ruff appeared on the Omaha World-Herald website on January 31, 2010.)
OMAHA, Neb. — Warren Buffett, known for his masterful investments as CEO of Berkshire Hathaway, skipped the company about 20 blocks east of his midtown Omaha office when he decided to buy a railroad.
Instead of Union Pacific Corp., Buffett bought Burlington Northern Santa Fe Corp., based in Fort Worth, Texas. BNSF shareholders are expected to approve the deal at a special meeting Feb. 11.
Union Pacific and BNSF share similarities.
Both operate in the West. Each hauls coal, consumer goods, automobiles, grain and industrial products on about 32,000 miles of track.
They have alternated as No. 1 among the nation’s big four railroads in revenue, with Union Pacific winning by a nose in 2009 at $14.1 billion versus Burlington Northern’s $14 billion.
Buffett has said that Union Pacific shouldn’t feel slighted. His $26 billion cash-and-stock purchase is a big bet on the importance of all railroads to the country’s economic future, and both BNSF and U.P. will do well, Buffett said.
Jim Young, Union Pacific chairman, president and CEO, said Buffett sees value in the railroads and in the West in particular, where the greatest opportunity for growth exists.
“It’s what we have been talking about for a long time,” Young said.
Trying to answer the question of why Buffett picked Burlington Northern instead of U.P., analysts point to differences that might have prompted Buffett’s choice. They include track records, complexity of rail networks and the ability to generate cash.
Hinting at any differences, Buffett has said, “The economics of this particular railroad are of some importance, obviously.”
Rick Paterson, an analyst with UBS Investment Research, said, “It is strange that Buffett bought the guys in Texas, not the guys across the street. I thought at first he picked the wrong one.”
Paterson said he likes Union Pacific’s progress since 2004, when Young became president and chief operating officer. “In fact, they’re currently at record operating margins.”
U.P. struggled to provide service during its 1996 merger with Southern Pacific, and in 2004 it was caught with worker and equipment shortages when demand surged unexpectedly, Paterson said. Slowed service and congestion resulted.
Dick Davidson, Young’s predecessor, said in an interview before the 2005 annual meeting that 2004 “was a disappointment for all of us.”
With a bigger upside for improvement than BNSF, Union Pacific might be seen as more enticing for someone like Buffett, Paterson said.
On the other hand, Burlington Northern historically has been more stable and a better manager of its finances, qualities highly valued by Buffett, Paterson said.
For example, he said, the company has generated more than $1 billion in cash after capital spending but before paying dividends each year since 2006. In that time, Union Pacific has generated more than $1 billion in free cash flow only once, in 2008.
Free cash flow for Burlington Northern in 2009 was $1 billion; for Union Pacific it was $850 million.
“Obviously, whichever one Buffett buys won’t be paying dividends. Rather, it will be contributing cash to Buffett’s coffers,” Paterson said.
Young said his company in the last 15 years has underperformed Burlington Northern in operations and finances.
“With Buffett, it’s all about cash flow,” Young said. “But I’m focused on running my business, and we’ve done well over the last four to five years. We are No. 1 in service today in the rail industry, and we were last if you look back four or five years ago.”
Writing in Railway Age magazine, former Association of American Railroads spokesman Lawrence Kaufman said Buffett’s bid in the middle of a recession was a bullish vote on the economy and the future of all railroads.
“Railroads have not been considered a true growth industry for more than a century,” Kaufman wrote. “Thanks in large part to Warren Buffett, they may be again.”
In buying Burlington instead of Union Pacific, Kaufman wrote, its capital spending might have been the principal factor.
Burlington Northern embarked on a massive capital spending program in 1995 that included double-tracking a key 2,300-mile line between Chicago and Southern California, Kaufman said.
Robert D. Krebs, who headed BNSF at the time, was criticized for spending billions of dollars in hopes the railroad could “build it and they will come,” but the strategy paid off, Kaufman said.
“With BNSF ready for the resumption of traffic growth, it may fit the Buffett investment criteria better than other railroads,” Kaufman said.
Meanwhile, much of Union Pacific’s capital spending has been on the old Southern Pacific lines, Kaufman.
“U.P. has owned S.P. for 13 years, a measure of how much upgrading was required.”
But Union Pacific is a strong competitor in the West, Kaufman said.
Paterson at UBS said a management team would find Burlington Northern easier to run because the bulk of its revenue comes from fewer lines of track and fewer sectors of goods.
Paterson said BNSF operates primarily on lines from Chicago to California and from Chicago to the Pacific Northwest, while Union Pacific’s traffic is more widely dispersed.
Burlington Northern gets about 70 percent of its revenue from grain, coal and consumer and other goods carried by intermodal containers easily transferred from ships to railcars to trucks. Union Pacific’s mix includes higher volumes of automobiles and chemicals, Paterson said.
Young discounted conclusions about U.P.’s complexity versus Burlington Northern’s simplicity.
“There has been some discussion about business models: Is ours more complex, is their bulk rate more? That is not a competitive advantage,” Young said.
He said Union Pacific’s strategy is simple: providing service to customers, safety for workers and investing in the rail network.
Financially, Union Pacific finished 2009 with an improved balance sheet and $1.8 billion in cash on the books, the highest amount ever, Young said.
“Those are things long-term investors look for in strength and ability to return cash to shareholders,” he said.
Nor will Buffett’s ownership of BNSF Railway change what Union Pacific does, Young said.
“It changes nothing,” he said. “I think it’s just a good vote in the potential for this industry.”