Legalectric

Author:  Daniel Sinclair

Reasons commentators ascribe to Buffett’s offer to acquire one of North America’s largestrail networks, Burlington Northern Santa Fe (BNSF) are now familiar. Growing global trade, continued reliance on (especially low sulphur) coal, a resurgent and growing US economy (without needing to pick product ‘winners’ and ‘losers’), a low risk way to gain exposure to any rising process for commodities, a hedge against inflation given rail’s pricing power, a competitive advantage in rail’s oligopoly and high barriers to entry, more productive rail with more efficient and technologically advanced operations and a rise double-decker railway carriages, a way to play higher oil prices and cap and trade or carbon tax laws given that rail is 3 to 4 times more fuel efficient than trucks.

Those reasons are all good, and they have been part of the core investment thesis for rail. But, it is submitted, there may be something extra that offers compelling upside to rail that has Buffett excited. Think about all the land that rail owns. BNSF, for example, operates one of the largest railroad networks in North America with about 32,000 route miles of track plus an additional 23,000 miles for other rail related infrastructure and property. Much of this land is of relatively little value beyond the use of rail. No one is going to build condos or hotels or new subdivisions along side railways.

Fanciful? Not really. The US Department of Energy projects that 20% of the U.S.’s electricity could be produced by wind turbines placed along a narrow ‘wind corridor’ stretching from Texas to North Dakota, thus giving the potential to be the US “Saudi Arabia of wind power”. While, one may note that, when looking at a wind map of the U.S. there is also strong wind to be found in certain other portions of the U.S. Guess which railway looks like it has a network stretching from the Dakotas to Texas? BNSF.

Other railways pass through high wind areas – as well as areas with high levels of year around sunshine for solar. An exercise you might undertake to see this visually is to do what I did last year. Take a rail network map (for example, see http://cnebusiness.geomapguide.ca/) and overlay that on a wind map of the United States (for example, see http://rredc.nrel.gov/wind/pubs/atlas/maps/chap2/2-01m.html) and you’ll get the picture of the potential.

Energy generated by wind and solar farms (partly built, perhaps, with government subsidies or tax credits) would provide cheap and stable sources of energy for trains, particularly as electric locomotives become the norm. Carbon credits will become additional sources of revenue. Excess energy would be sold to utilities as cheaper sources of energy or provide a cheaper source of green energy to Berkshire’s large electricity utility business, MidAmerican, in the case of BNSF.

Given BNSF’s network expanse, the potential for electricity generation is colossal. And why will such enormous amounts of electricity need to be generated? This is not just about merely switching sources of energy generation but increased demand of electricity itself. Last year, President Obama has called for 1 million plug-in electric cars by 2015. Obama launched a $2.4 billion program to advance development of plug-in electric vehicles in the U.S., including grants for the production of auto batteries.

What was one of Berksire’s major investments in 2008, in the middle of the financial crisis? BYD, the Chinese electric car company in which Buffett bought a 10% stake in 2008. And who did Buffett trust to travel with to China when looking into BYD? David Sokol, chairman of MidAmerican Energy who also happens to be the putative CEO-in-waiting at Berkshire to take it into the future.

Buffett’s 2008 ‘bail out’ investment in General Electric fits in all of this as well. GE’s Ecomagination strategy is poised to win in a big way should large scale wind farms are developed and should electrification of rail become a reality as its products cover wind mills, smart grids, electric batteries and all-new electric locomotives. Last year, BNSF purchased 200 fuel-efficient locomotives from GE.

Buffett’s purchase of BNSF has a further advantage for Berkshire. There is so much opportunity now for capital investment in alternative energy and energy efficiency with the prospect of attractive returns, this plays in the hands of the expertise of existing management stars within Berkshire’s portfolio, like Sokol. In other words, this transaction game changes Berkshire and neutralizes the loss of Buffett at the helm when he retires. In other words, it allows for capital allocation opportunities within Berkshire for decades without needing to look for external investments, and to rely as much on the next CIO filling in Buffett’s shoes, as much.

This might have been obscurely hinted at in a CNBC interview with Buffett this week (http://www.cnbc.com/id/15840232?video=1391031740&play=1). In that interview he said that while he, i.e. Berkshire Hathaway, is paying a high price now for his rail investment in BNSF he sees terrific opportunities for capital allocation over the next “100 years”. Now, for Buffett, capital allocation can mean taking free cash flow from one company and reallocating it elsewhere in other companies he owns or in investments. That’s how he built Berkshire Hathaway, sucking out the free caash from the original textile manufacturing company and reallocating it to other investments.

But that does not seem to be what he has planned for BNSF. At the end of that same interview he finishes off with this: “We’ll invest billions and billions and billions to have our facilities prepared for the society of tomorrow”. What’s interesting is not just the “billions and billions” because capex is rail’s lot. The interesting words, as one might parse them, is “the society of tomorrow”. What does he mean by that? He and Munger have been increasingly clear about what they see in the society of tomorrow including in relation to energy.

Here is a hint of what Buffett and his partner, Charlie Munger, were thinking as there vision of the “society of tomorrow” in Berkshire’s annual shareholders’ meeting weekend in 2009. Listen to this from Munger “As I move close to the edge of death, I find myself getting more cheerful about the economic future. I see a final breakthrough that solves the main technical problem of man. By harnessing the power of the sun, electrical power will become more available around the world. That will help humans turn sea water into fresh water and eliminate environmental problems. If you have enough energy you can solve a lot of other problems.”

And while all this might seem fanciful, groundwork is already beginning. For example, North Eastern U.S. rail, Norfolk Southern has begun to install wind turbines. And Railway Age, has reported that U.S. rail companies, including BNSF, are studying “electrifying rail networks” including by using electric locomotives.

BNSF is looking at allowing electric transmission line companies us its rights-of-way “to send electricity from massive wind farms to major population centres” while giving BNSF access to “low-cost power for electric locomotives”. So rail might also be integral to Obama’s smart grid initiative by using railway cables and rights of way for electrical transmission. Norfolk Southern, has apparently joined BNSF in exploring electrification. Meanwhile, Union Pacific, the U.S.’s other mega freight rail company is apparently speaking to transmission line companies about providing its rights-of-way, that may include electrifying corridors.

Two additional points are also worth weighing when thinking about rail’s future in America. Firstly, the Obama Administration outlined in its April 2009 “Vision For High-Speed Rail in America” plans to invest in “an efficient, high speed passenger rail network”. As “first steps” they referred to the $8 billion funding in the American Recovery and Reinvestment Act (ARRA) and a high-speed rail grant program of $1 billion per year proposed for the 2010 budget). While that funding is not directly targeted at freight rail companies, who provides the infrastructure, such as tracks, for a lot of U.S.’ passenger rail network? The large freight rail companies like BNSF.

Secondly, remember when Buffett justified the proposed BNSF acquisition saying, “It’s an all-in wager on the economic future of the United States. I love these bets.” But listen to what he apparently said when he spoke to Canadian business students in 2008: “The 19th century belonged to England, the 20th century belonged to the U.S., and the 21st century belongs to China. Invest accordingly.”

Now read this: in April 2006, BNSF announced it “will become the first U.S. railroad to open an office in China when its representative Shanghai office”. The announcement points out that BNSF’s international intermodal business has been growing double digits since 2000 and most of that business originates in China.

Another interesting part is the reference to a five-year Memorandum of Understanding BNSF signed with the China Ministry of Railways and that BNSF has been providing “best practices in areas such as railway management, operations, logistics and technology”. Guess who is committed to spending big on its rail infrastructure? China. And BNSF has further announced that it is expanding its relationships with other China Ministries. To what lucrative end, one can only surmise.

Unlocked asset value and earnings through a revaluation of BNSF’s land holdings and cheap green energy for BNSF (and for on-sale through MidAmerican). Fastest form of land transport. Electric cars. Clean tech. Smart grid. China. Buffett’s investment in rail has the potential to make more money than he ever has before. This could be the crowning glory of Buffett’s masterpiece and with the potential to be more lucrative than the wildest dreams of Berkshire Hathaway’s shareholders.

And by helping America achieve energy independence, and thus lowering its trade deficits and debt that funds it, improving health and its costs by reducing pollution and dramatically improving the environment while facilitating a more efficient industrial United States with and enhanced infrastructure for trade, one can understand why Buffett keeps on saying, throughout this crisis, “America’s best years lie ahead”.

The question for Burlington Northern shareholders is: are you sure that you should be saying yes to Berkshire’s proposed acquisition at $100 or do you think you should think about the value that you might be giving away?

Meanwhile, the share component of the transaction becomes less attractive as Berkshire’s shares continue their climb out of discount territory.

The arm is raised. The rail industry is going to be very interesting.

Daniel Sinclair BA (Phil.) LLB MBA (A.K.M Medal) is based in Toronto, Canada with holdings including Norfolk Southern and General Electric.