Ranking BNSF Vs Peers: Why Berkshire’s Bet On Railroads Continues To Pay Off (NYSE:BRK.A)

Introduction

“Rail is essential to America’s economic future”. This is what Warren Buffett wrote to Berkshire’s shareholders in his last shareholder letter. And here we are, ready to understand why he thinks so.

Since all North American Class 1 railroads have released their FY 2023 annual reports, we are in the best position to go over the largest Class 1 railroad: Burlington Northern Santa Fe, and compare it to its peers. And, in case you have never heard of it, you have probably heard about its owner: Warren Buffett through his Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B). This is why, in Berkshire’s reports, BNSF always finds a spot.

In this article, I want to go over BNSF’s results and use this review to rank all six railroads according to some lesser-used yet greatly helpful assessing metrics.

How Warren Buffett Assesses Railroads

As some SA readers may know, I began covering the railroad industry after I had carried out a thorough study on Buffett’s investment in BNSF. This case study helped me understand how Mr. Buffett’s reasoning behind this acquisition found its cornerstone in a few ideas and metrics that I had not generally seen in other analyses on Class 1 railroads.

In particular, I concluded he had a true hierarchy of these metrics, moving from the most important to the least relevant.

First and foremost, he had to overcome a major issue: railroads are capital-intensive businesses. As such, they have high capex. To face their needs, they borrow money and, therefore, raise debt.

As Buffett wrote in his last shareholder letter:

BNSF must annually spend more than its depreciation charge to simply maintain its present level of business. This reality is bad for owners, whatever the industry they have invested in, but it is particularly disadvantageous in capital-intensive industries. At BNSF, the outlays in excess of GAAP depreciation charges since our purchase 14 years ago have totaled a staggering $22 billion or more than $1.5 billion annually. Ouch! That sort of gap means BNSF dividends paid to Berkshire, its owner, will regularly fall considerably short of BNSF’s reported earnings unless we regularly increase the railroad’s debt. And that we do not intend to do.

So, to overcome this disadvantage, these businesses must be profitable, that is, they have to earn as a return on their capex more than they pay for interest. In his early years, Buffett used to keep away from these businesses. But then he came to understand that as long as a business earns a decent rate of return, there is no reason to ignore it just because it is capital intensive. But, clearly, part of how Berkshire received good returns is the low purchase price:

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. That’s no surprise to me or Berkshire’s board of directors. It explains why we could buy BNSF in 2010 at a small fraction of its replacement value.

This issue has made Buffett acknowledge a railroad’s earning power as the most important metric to assess whether a railroad’s financials are insulated and protected from any major economic downfall. In fact, earning power is calculated as pre-tax earnings/interest expense. In other words, it shows how many times a company’s earnings cover its interest expense. The minimum threshold for railroads is usually 6.0. But there are railroads able to score a 10 or above, especially during the strongest part of the cycle.

Of course, since railroads are regulated, it is important to be confident the regulator will allow decent returns for railroad operators. So far, North America has proven to be a good environment under this perspective.

After a company’s earning power, the second most important metric is the return on invested capital. A good result is in the mid-teens.

Third, we need to assess a company’s operating efficiency. Here, we will align with a traditional metric of the industry: operating ratio. But a close look will always be given to fuel efficiency. In fact, it is somewhat of a proxy to understand if the fleet is aging and if operations are running smoothly (velocity, terminal dwell, and similar).

Finally, we can look at how a railroad uses its excess cash. In particular, dividends and buybacks are to be funded mainly by free cash flow generation, rather than by debt issuance.

With these metrics, I keep track of the whole industry.

But I also shared some in-depth articles to show how each one of the six class 1 railroads has performed over the last decade. By doing so, we had the chance to calculate the huge profits Berkshire has already earned thanks to its ownership of BSNF.

In particular, I shared this graph showing that in the first five years of Berkshire’s ownership of BNSF, the railroad distributed to its parent company way more than its FCF. This was done by taking LT debt to have additional cash available for distributions.

What was done is easy to understand: Berkshire moved part of the debt it took to buy BNSF out of its balance sheet into BNSF’s. In this way, BNSF uses its balance sheet to repay Berkshire immediately. This is a smart move because Berkshire has a higher return on capital than BNSF itself. As a result, the cash that was borrowed by BNSF and then distributed to Berkshire has probably compounded at a good rate of return.

Buffett spent $33 billion for the acquisition and from what we see in the graph above, at the end of 2022 he had already been paid back in dividends more than what he spent. In addition, he owns an asset whose worth could be around $100 billion, which is almost a 3x on the investment.

At the end of the first nine months of 2023, we went over the main railroads and compared them according to three metrics.

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The outcome was clear: Canadian National (CNI) was the best one, with an earning power close to 9.0, the lowest operating ratio, and the highest ROIC. This is why I keep considering it the best pick among class 1 railroads.

BNSF, on the other hand, beats its closest peer Union Pacific (UNP) in earning power and ROIC while severely underperforming in operating ratio. After all, BNSF is the only railroad that still has to implement PSR.

Now that we have the new annual reports, we can assess more correctly the whole fiscal year of each one of these companies, to see how their economics and financials are doing.

BNSF’s 2023 Results

BNSF still releases its 10-K filings, enabling us to keep assessing its operations and comparing it to the industry.

As we can see, BNSF’s operating revenues declined by almost 7% to $23.5 billion, both because of lower fuel surcharges and decreasing rail traffic.

After-tax earnings (one of the items Buffett considers of utmost importance) of BNSF declined 14.4% in 2023 vs. 2022, coming a little above 2021.

The biggest decline was in consumer products, which were down 8.4%. This was also understandable, since 2023 has been a destocking year for many companies, whose inventories needed to be cleared.

On the other hand, industrial products held up well thanks to the automotive industry.

Ranking North American Class 1 Railroads

We will look at each one of the metrics I talked about, starting from the most important.

Earning power

At the end of FY 2023, here is the ranking of the earning power each railroad achieved:

1. Canadian National – 9.00
2. BNSF – 6.31
3. Union Pacific – 6.14
4. CSX Corporation – 6.05
5. Canadian Pacific – 3.96
6. Norfolk Southern – 3.21

Let’s make a few comments. First of all, both Canadian Pacific and Norfolk Southern have a poor score. We will talk about this at the end because we need to put their metrics in the right context. Secondly, since earning power is a ratio between pre-tax earnings and interest expense, it can go up or down depending on whether the numerator and the denominator increase or decrease. In an economic environment where pre-tax earnings have come down due to slower traffic and decreasing volumes, coupled with lower fuel surcharges, the numerator (pre-tax earnings) is decreasing, making the ratio lower. But this has been true for the whole industry. The difference in the six outcomes we have seen above comes from interest expense, which depends on the amount of debt each railroad carries on its balance sheet.

Canadian National wins thanks to its conservative balance sheet management, which makes it the railroad with the least amount of debt in the industry. BNSF’s data are not available on YCharts, but from its financial report, we know the railroad’s LT debt and finance leases amount to $22.2 billion, positioning it in second place in the graph above.

ROIC

Some railroads, such as the Canadian ones, disclose this metric, while others don’t. To make things even and fair, I calculate the ROIC myself using the formula NOPAT/invested capital. For those who are not familiar with NOPAT, it stands for the net operating profit after tax.

The outcome is the following:

1. Canadian National – 17.7%
2. Union Pacific – 10.8%
3. CSX Corporation – 10.3%
4. BNSF – 6.2%
5. Norfolk Southern – 5.5%
6. Canadian Pacific – 4.4%

Once again, the winner and the two laggards are the same, with Canadian National outperforming the industry by a wide margin, while Norfolk and Canadian Pacific at the moment report a return on invested capital more or less equal to the current cost of capital. BNSF here is not in second place anymore but has slid back into fourth position. Part of this has something to do with lower operating profits because it is the only company in the industry not implementing PSR.

Operating ratio

What we have seen above could make us already know where BNSF will be in the operating ratio ranking.

1. Canadian National – 60.8%
2. CSX Corporation – 62.1%
3. Union Pacific – 62.3%
4. Canadian Pacific – 65%
5. BNSF – 69%
6. Norfolk Southern – 76.5%

Surprisingly, BNSF, although it reports opex of $16.48 billion, which is 69% of the yearly revenues in 2023, is not the worst performing railroad in 2023 because of Norfolk’s 76.5% operating ratio.

Part of the difficult task railroads have to face nowadays to bring their OR below 60% has to do with what Buffett describes as “an evolving problem”. That is, fewer Americans are willing to work in rail operations. This has led to huge wage increases, whose negotiations “can end up in the hands of the President and Congress”.

In fact, Buffett explained BNSF’s poor performance with the following words:

Last year BNSF’s earnings declined more than I expected, as revenues fell. Though fuel costs also fell, wage increases, promulgated in Washington, were far beyond the country’s inflation goals. This differential may recur in future negotiations. Though BNSF carries more freight and spends more on capital expenditures than any of the five other major North American railroads, its profit margins have slipped relative to all five since our purchase. I believe that our vast service territory is second to none and that therefore our margin comparisons can and should improve.

Fuel efficiency

Fuel consumption per 1,000 GTMs doesn’t always paint the whole picture, but it is a good proxy to feel the pulse of how efficiently a railroad runs its operations. Moreover, fuel consumption is a direct function of locomotive and fleet age: the older, the poorer the efficiency is.

Here is the ranking at the end of FY2023 (gallons of fuel per 1,000 GTMs):

1. Canadian National – 0.87
2. CSX Corporation – 1.02
3. Canadian Pacific – 1.04
4. Union Pacific – 1.09
5. Norfolk Southern – 1.13
6. BNSF – N.A.

Unfortunately, I haven’t been able to find a place where BNSF discloses its fuel efficiency. However, my understanding is that it is more or less aligned with Union Pacific’s.

Shareholder Returns

Let’s look at free cash flow, calculated as operating profits minus capex. Keep in mind that for the two Canadian railroads, the currency is the Canadian dollar.

To rank the railroads’ FCF, we will look at the conversion rate, determined as the ratio of FCF to operating profits.

First of all, let’s calculate the railroads’ free cash flow and their conversion rate:

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Here BNSF is the best-performing company in the industry, with the highest conversion rate.

But let’s look at the relationship between FCF and shareholder distributions.

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As we can see, while BNSF, UNP, and CP have distributed less than their FCF, the other three railroads distributed more than their yearly FCF. Where does the extra money come from? Mainly from new LT debt.

Conclusion

Burlington Northern Santa Fe is not the best-performing railroad in the industry. This is clear from what we have seen so far. However, it has become more conservative in shareholder distributions and has the best FCF conversion rate. This means it currently is the best cash cow, even though it can greatly improve its operations. Overall, within the other five publicly traded railroads, Canadian National stands out as the clear winner.

Has BNSF been a good investment for Buffett? Considering BNSF achieved $23 billion in revenues and that we could easily value the company at a 4x multiple to its sales, we have an overall valuation of around $100 billion. Berkshire currently has a market cap of $880 billion. This means BNSF alone makes up 11.3% of Berkshire’s market cap. However, I think it is questionable to believe such a valuable asset as BNSF to be worth that much of Berkshire. In fact, I don’t think Berkshire’s market cap fully reflects and prices-in the real value of many assets, among which BNSF surely stands out. In other words, Berkshire is not trading at its true book value. This is why, even though the stock is near its highs, I still consider it a good opportunity in today’s market.