BNSF and MidAmerican

[jay21]

I feel as if I do not understand these businesses that well.  I understand that they are capital intensive businesses that are expected to earn good rates of returns on the capital deployed.  Does anyone know what exactly the return characteristics are?  Also, is there anything "special" about these companies that makes them different from their competitors?

[rmitz]

I feel as if I do not understand these businesses that well.  I understand that they are capital intensive businesses that are expected to earn good rates of returns on the capital deployed.  Does anyone know what exactly the return characteristics are?  Also, is there anything "special" about these companies that makes them different from their competitors?

They don't really have competitors.  Being heavily regulated, and in Midamerican's case, a utility, means you don't really have to compete in the same ways.  The railroads have parts of the country where they don't really operate as a matter of history.  Now this does not describe the entirety of their businesses but I believe it's a large enough chunk, and really was the core of the thesis.

[matjone]

I'm far from an expert on railroads but I've read security analysis and Graham had some stuff in there about them.

I think I remember reading that Buffett figured BNSF would benefit because they have more rails going out west than other railroads, and he believes there will be above average growth in freight traffic there due to population growth in the west and growth in trade with China.  I can't remember if it was Buffett that said this in a letter or if it was someone else in an article or blog.  Seems reasonable though.

Costs per ton-mile go down as the amount of freight on each trainload goes up.   So, if BNSF is already running a train from LA to new orleans today, and there is no one else with the same route, and 10 years from now there is 50% more freight that needs to be moved on the same route, you are getting 50% more revenue, before counting whatever price increases you are allowed. And maintenance on the track and fuel costs don't go up as fast as revenues do.

[twacowfca]

I feel as if I do not understand these businesses that well.  I understand that they are capital intensive businesses that are expected to earn good rates of returns on the capital deployed.  Does anyone know what exactly the return characteristics are?  Also, is there anything "special" about these companies that makes them different from their competitors?

They don't really have competitors.  Being heavily regulated, and in Midamerican's case, a utility, means you don't really have to compete in the same ways.  The railroads have parts of the country where they don't really operate as a matter of history.  Now this does not describe the entirety of their businesses but I believe it's a large enough chunk, and really was the core of the thesis.

BNSF is the easier of the two to understand.  The railroad industry has been very poor for returns on capital for most of its history.  However, about 10 years ago, Bill Gates and Cascade noticed that things had changed, especially for Railroads with long routes that were more economical for moving stuff over long distances than trucks.  Railroads like BNSF still have lots of potential capex for investment, but that capex now returns more than their cost of capital.  BNSF can borrow cheaply to finance a lot of their capex, especially under BRK 's wing.   They are also able to pay large dividends to the holding company in addition to their capex.

BNSF doesn't have a direct competitor, it would be way too costly for another railroad to encroach on their territory.  Trucks are not as economical an alternative over most of their routes.  BNSF connects the west coast to the Midwest.  The expansion of the Panama canal should not impact them as much as other railroads.

Mid American isn't such a good investment in my opinion, although they do relatively well in an industry that is tough.

[redskin]

"Mid American isn't such a good investment in my opinion, although they do relatively well in an industry that is tough."

Berkshire bought Midamerican for $34/share and now values it at $250/share.  Approximately 16% annual return.

I thought Buffett's comments regarding Midamerican at the annual meeting were interesting.  He believes they may have the opportunity to invest $100 billion over the next 10 years in Midamerican.

[mikazo]

BNSF doesn't have a direct competitor

I'd say Union Pacific is a pretty big competitor: http://pacificbiomassexport.com/wp-content/uploads/2011/06/USA_UP-BNSF.jpg

[jay21]

"Mid American isn't such a good investment in my opinion, although they do relatively well in an industry that is tough."

Berkshire bought Midamerican for $34/share and now values it at $250/share.  Approximately 16% annual return.

I thought Buffett's comments regarding Midamerican at the annual meeting were interesting.  He believes they may have the opportunity to invest $100 billion over the next 10 years in Midamerican.

How did he talk about the valuation?  Was it strictly FCF growth of 16%?

What will the $100b in investments earn though?  I guess my problem is I do not understand the return characteristics of a utility company.  If you are expecting a 10% return from these investments, I am not that enthused because then you will need a growth in float to get great returns.  If these companies earn a teens return, that's great.

Does anyone have a link to a good article describing the shift in capital returns that twacowfca was describing?

[twacowfca]

"Mid American isn't such a good investment in my opinion, although they do relatively well in an industry that is tough."

Berkshire bought Midamerican for $34/share and now values it at $250/share.  Approximately 16% annual return.

I thought Buffett's comments regarding Midamerican at the annual meeting were interesting.  He believes they may have the opportunity to invest $100 billion over the next 10 years in Midamerican.

How did he talk about the valuation?  Was it strictly FCF growth of 16%?

What will the $100b in investments earn though?  I guess my problem is I do not understand the return characteristics of a utility company.  If you are expecting a 10% return from these investments, I am not that enthused because then you will need a growth in float to get great returns.  If these companies earn a teens return, that's great.

Does anyone have a link to a good article describing the shift in capital returns that twacowfca was describing?

WEB's hurdle rate for BRK's subsidiaries has been 15%, and the Mid American investment has compounded at about that rate.  However,  the original investment in Mid Am was made at a bargain price, and the current rate environment for utilities is not good.  At some point in time, Mid Am may have the opportunity to pick up more assets at a bargain price.  Even so, it may be difficult to get a 15% return going forward or even a double digit return. 

Plus, everything in Mid Am is dead money for the Holdco to redeploy at extremely attractive rates of return opportunistically in the future in other ways that will certainly pop up.  Thus, Mid American's opportunities are limited to reinvesting in a subpar industry.  This is similar to Net Jets situation, but Net Jets capital and future earnings is much easier to redeploy.  There is an active market for business jets.

[thepupil]

Is it wrong to think of these two capital intensive regulated businesses as alternatives to fixed income? Berkshire still keeps its float in cash and fixed income but much of that can quickly be invested in a new acquisition. Do not these businesses provide dependable steady above fixed income returns and allow Berkshire to keep a shorter duration fixed income portfolio vs that of other insurance companies?

Yes I'd love all of Berkshire's investments to earn very high returns but when you compare the return on these businesses vs fixed income which comprises the vast majority of large insurance co's portfolios, their presence makes more sense.

[compoundinglife]

Not sure how or if this could play out regulation wise. But at the time of the BNSF purchase I was trying to think of non-obvious or off the wall reasons why BRK would want to buy them. Clearly there is the fixed income like nature of this company but what is the kicker? Only thing I could think was that in the future there might be some synergy between BRK's utility companies and BNSF. For example if there is a way to efficiently move power over long distances, maybe Mid Am. can utilize the rail roads tracks or land around the tracks to do so?