119: BNSF-As-A-Bond?
Parsing Buffett's comments about Berkshire's railroad. What about the time-value-of-money?
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Disclosure: Long BRKB.
The Big Question
How relevant is Berkshire Hathaway’s 2010 purchase price of the BNSF railroad today?
That’s the question I found myself asking after reading Buffett’s annual letter and hearing him at the 2024 annual meeting.
From the letter:
Berkshire is receiving an acceptable return on its purchase price, though less than it might appear, and also a pittance on the replacement value of the property.
From the annual meeting1:
What it earns in relation to its replacement value is a pittance. But we’ll do fine in terms of what we paid for it, and we’ll distribute substantial amounts in relation to what we paid in a very tax-efficient way.
Bolded emphasis is mine.
What about TVM?
My first thought was: What about the time value of money? Surely that’s a relevant consideration, is it not? Buffett referenced a purchase price of $35 billion at the annual meeting. My analysis (taken from my book2) has a cost of $33.5 billion, a stated deal value for equity of $34.2 billion, and an enterprise value of $44.5 billion. I’ll use Buffett’s $35 billion for simplicity.
Inflation between 2010 and 2023 was a cumulative 40%, so at the very least shouldn’t the real, present-value outlay of $49 billion ($35 billion x 1.40) be considered? What if we used a 10% discount rate to account for the time value of money? That would put the 2023 bogey at 3.45x or a whopping $120.75 billion.3
BNSF earned $5.1 billion in 2023. That’s a 10% return on the inflation-adjusted value but a mere 4.2% on the larger TVM figure.
Bond Logic: “Writing in the equity ‘coupons’”
Two things helped me unravel this puzzle. One is Berkshire’s holding period of “forever”. Buying all of a company removes its stock price from the ticker tape and leaves the investor (rightly) looking to the business to assess its performance. There is one decision, one outlay of capital, and no market quotation or “exit price”. You earn a return from the business based on what it can earn and distribute to you.
In this way, an equity investment looks very much like the purchase of a perpetual bond, my second insight. The only difference is that bonds have a known coupon payment. Buffett has touched on this before saying that the equity analyst’s job is to write in the coupons.
Replace “$35 billion equity investment” with “$35 billion bond investment” and write in the following series of “coupon payments” (dividends).
You end up with a series of coupon payments that look fairly attractive. Just three have rates of return lower than 10%, and nine are higher, sometimes significantly so, like the 15.6% return in 2018.
Viewed in this way, BNSF looks more like a bond. Such a characterization is not much of a stretch considering the utility-like characteristics of railroads.
Two Items of Note
BNSF has two other characteristics that make it very much unlike a bond. One is that the rail must incur capital expenditures above its depreciation to hold steady. A huge base of long-lived assets and inflation will see to that. The implications are that reported net earnings are higher than true economic earnings.
The other item, which is a positive, is deferred taxes. Accelerated depreciation on capex means BNSF’s cash outlays for taxes are slightly lower than its reported tax figure.
A Few Final Words
BNSF is a good asset for Berkshire and would be impossible to replicate. But it’s still just a good business, not a great one. A few observations from the table below:
Carloads are basically flat over the past decade and a half at around 9 million.
That said, its capacity to move more freight has increased. From 2010 to 2023 its locomotive fleet increased from 6,700 to 7,500. It also spent considerable sums to strengthen bridges and raise tunnels to handle double-decker cars.
Related, capex spending above depreciation totaled $22.7 billion over the last 14 years. Some of that was true growth capex but a good portion was simply inflation-related.
Stay rational! —Adam
I’m using 10% over 13 years. 1.10^13 = 3.45.