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January 2010



Rail News: BNSF Railway

Buffett's buy-in buoys BNSF's growth prospects — and the rail industry's spirits



by Jeff Stagl, managing editor

Several days before Berkshire Hathaway Inc. and BNSF Railway Co. shocked the rail world by announcing the $44 billion buyout on Nov. 3, Matt Rose approached Warren Buffett. BNSF's chairman, president and chief executive officer wanted the billionaire to provide a statement for their joint press release that explained why Berkshire wanted to buy the railroad. Buffett came up with one that the media ultimately ran with: "It's an all-in wager on the economic future of the United States."

"We barely changed a word," says Rose, recalling his mild surprise while discussing the buyout Nov. 17 in his Fort Worth, Texas, office. "He nailed it."

Rose also believes Buffett hit the nail on the head for his investment company — which owns GEICO Auto Insurance and Marmon Holdings Inc. among more than four dozen holdings, as well as a large stake in Goldman Sachs — by tapping into BNSF's, as well as the rail industry's, long-term growth potential.

"This is a realization of the value of railroads to the U.S. economy," says Rose. "It's like the Good Housekeeping seal of approval that says railroads are here for the future."

If Berkshire's largest-ever transaction, which calls for buying the remaining 77.4 percent of BNSF shares it doesn't own for $100 per share in cash, closes as expected in the first quarter, many rail industry constituents and observers agree that the world's preeminent dealmaker will have made a shrewd, forward-looking investment.

The main reason: Buffett would acquire North America's second-largest railroad whose three main traffic segments — coal, grain and intermodal — are projected to increase in volume both domestically and internationally during the next decade, a new coal- impacting energy bill notwithstanding.

"The three core businesses are all potentially secular growers: intermodal, because of its inherent fuel efficiency and relative environmental friendliness; grain, because the industrialization of the Pacific Rim has turned Asia into a grain importer; and coal, because it's key to America's energy self-sufficiency," says John Larkin, a Stifel Nicolaus & Co. Inc. analyst.

Buffet also would own a Class I that's well-positioned to recover quickly from the economic downturn and well-run by young and dynamic senior managers — a perfect match for Berkshire's hands-off management style, deal bystanders believe.

Meanwhile, BNSF no longer would have to answer to Wall Street, or cover the costs of various filings and travel associated with a public company, and could focus more on long-term capital investments and growth vs. short-term earning gains, they say.

"This frees up the management team, which can be more productive," says Arthur Hatfield, a Morgan Keegan & Co. analyst.

However, the buyout's positive or negative ramifications on the rail industry — from additional Class I buyouts to railroad mergers to rail rates to regulation to increased investor interest in the rail sector — are more difficult to interpret. The effects of Buffett's entrance into a capital-intensive, regulated and unionized industry, aren't clear, either.

And whether Berkshire is under- or over-paying for the Class I or offering a fair price will always be open to debate. BNSF shareholders will say yea or nay at a Feb. 11 meeting while a class-action suit filed last month by stockholders who believe the selling price is too low moves through the federal court system.

A matter of opinion

More than one dozen Class I CEOs, analysts, rail shipper and short-line officials, and industry observers who Progressive Railroading contacted in the weeks following the deal's announcement provided varying opinions on the buyout's terms and implications, which wasn't entirely unexpected since no Class I has been privately owned for more than two decades and Buffett has never owned a railroad.

That said, a majority of observers view the buyout as a positive development for the rail sector, one that will boost BNSF's growth prospects and be a boon to the industry's regulatory pursuits — namely, attempts to thwart legislation aimed at eliminating railroads' antitrust exemption — given Buffett's ties to the Obama Administration.

Others plan to continue watching Berkshire/BNSF closely in the months ahead to see if any ripples — or waves — cascade out into industry waters, such as another large equity firm acquiring a Class I or large regional.

Under analysis

Count a half-dozen analysts among those who'll be keeping close watch. They were eager last month to render opinions and attempt to size up the buyout, which more than piqued their interest because of the dollars and parties involved.

Regarding the deal's terms, the $100-per-share price is right in line with a report BMO Capital Markets released Sept. 3 that stated BNSF's target price should be increased to $100 to reflect improving industry conditions and 2010 earnings expectations, says Randy Cousins, an analyst with the firm.

"Buffett isn't over-paying. BNSF's stock was at $110 per share in May 2008," he says. "Buffett's seen the railroad's ability to adjust to a drop in volumes by managing its costs and capacity."

Buffett already owned more than 20 percent of the Class I's shares and less than 10 percent of Union Pacific Corp.'s and Norfolk Southern Corp.'s stock, which Berkshire sold. So, he was more vested in BNSF, says Cousins.

"Why pay a premium to 90 percent or more of shareholders?" he asks.

Frost & Sullivan analyst Matthew Scruggs agrees the deal is a good one for both Buffett and BNSF shareholders.

"The stock was trading at $75 per share before the deal and now shareholders would get $100 — that's a 25 percent increase," he says.

History will show that Buffett arranged a solid deal, Deutsche Bank AG analyst Justin Yagerman believes.

"It's a fair price for where we are in the economy," he says. "Now, railroads are under-valued."

Although the price might "seem rich" based on the near-term economy, the forward (2010 consensus) multiple compares well with past deals, including recent short-line offerings, said independent rail industry analyst and Progressive Railroading columnist Tony Hatch in a column that was published in the December issue.

However, compared with other Class I transactions of the past, the selling price is on the low side, says R.W. Baird & Co. Inc. analyst Jon Lagenfeld.

"The calamity of the economy has passed us by — why not be a buyer when things are on sale?" he asks. "I think the price shows the opportunistic fashion of the deal."

Not buying another buyout

Over time, Berkshire might under-perform the rail industry, and it could prove out that BNSF was better off as an independent company, Morgan Keegan's Hatfield says. Nonetheless, the Class I's stock price was attractive to Buffett and the deal appears to be a fair, albeit somewhat surprising, one, he says.

"I didn't think anyone had the patience or wherewithal to do this," says Hatfield. "There really isn't anyone else that can do something like this as a cash offer, they'd have to finance the deal."

But other investment firms likely won't even try to pull off a similar deal, given the capital required, Deutsche Bank AG's Yagerman believes.

"This doesn't signal a period of more Class I buyouts — this is a one-off deal," he says.

Large equity firms such as Apollo Global Management L.L.C. or KKR & Co. can't be ruled out from acquiring a Class I, Stifel Nicolaus' Larkin believes. Yet, a buyout similar to Berkshire's would be difficult to pull off because a railroad's capital intensity makes it hard to lever a deal that would boost returns high enough to meet return targets, he says.

"Of course, an end-to-end railroad merger also is unlikely just by the virtue of the onerous STB approval process," says Larkin. "Most railroads are discovering that many of the synergies one gets in a merger can be realized through cooperative operating and marketing agreements, as well as through co-investment in infrastructure upgrades."

Whether Buffett's buyout will prompt more investors to discover the rail industry's growth potential is subject to debate, as well.

Three weeks after the deal was announced, rail stocks gained 22 percent in value, but by early December, the sector had become "overheated," as one analyst put it. The stocks rallied slightly by year's end.

"I don't think this will bring new blood to rail," says R.W. Baird's Lagenfeld. "Plus, you're taking a large capital player out, and $20 billion in capital gets deployed over other stocks, and only some of those will be in transportation."

Frost & Sullivan's Scruggs disagrees.

"I think more investors will turn an eye towards rail," he says. "The deal shows confidence in the industry and brings attention to it. We could see more private investment in the industry."

Adds Deutsche Bank AG's Yagerman: "This is a show-me story that sheds light on the rail group."

Regulatory ally

However, several analysts and railroaders do concur that bringing Buffett into the rail industry mix likely will draw his Obama Administration pull to key regulatory matters, specifically the Surface Transportation Board Reauthorization Act of 2009 (S. 2889) introduced by Sen. John Rockefeller

(D-W.Va.) last month (see "Rail and shipper interests begin to weigh in on STB reauthorization bill").

"Buffett is well-connected to the Administration and regulatory issues are likely to get a more business-sensitive hearing in Washington," says Stifel Nicolaus' Larkin. "Legislators are more likely to pass legislation that encourages railroads to invest in incremental capacity."

If more rail regulation is enacted, Buffett and BNSF will need to assess the long-term implications, says R.W. Baird's Lagenfeld. But Buffett knew the industry's regulatory risks well before he made his pitch for the Class I and "he's not about to step on a land mine," he says.

CSX Corp. Chairman, President and CEO Michael Ward also believes the potential for more industry regulation decreases because of Buffett.

"Such a wise man making a $44 billion investment says the regulatory risks in the industry are not that high," he says. "This says from Buffett, 'I like the industry long term.'"

John Hellmann, president and CEO of short-line holding company Genesee & Wyoming Inc., pegs Buffett as an asset in D.C., too.

"Having someone of Buffett's stature as a voice on issues related to national rail policy can only help the U.S. rail industry, particularly a thoughtful voice that is close to the current Administration," he said via email.

American Short Line and Regional Railroad Association President Richard Timmons not only views Buffett's participation in the industry as a big boost in D.C., but a "positive sign railroads have a promising future."

"Buffett sees the vitality of railroads," says Timmons, adding that the deal would have no effect on BNSF's short-line relationships because the same management team would remain in place. "In a broad sense, this is good for the rail industry — the tide raises and lowers all boats."

Ditto, says NS Chairman, President and CEO Wick Moorman.

"I find the deal the same way others and Buffett have portrayed it: good for the industry and good for business," he says. "It shows railroads are valuable and validates what we've been saying all along about the strength of our business and opportunities going forward."

Rating rates

However, a couple of rail shipper groups don't believe the deal is good for their members' business. BNSF's rates might go up to compensate for the expensive buyout or to exercise market power, they say.

The Class I could "become less transparent in its activities" because it will not be required to file reports with the Securities and Exchange Commission (SEC), said Robert Szabo, executive director of freight-rail shipper coalition Consumers United for Rail Equity (CURE), in a prepared statement.

"The risk in a transaction like this is that consumers end up paying the premium paid for BN through excessive rates that the railroad can charge because of monopoly pricing protections," he said. "Hopefully, Mr. Buffett will put BNSF on a more pro-competitive and consumer-friendly path."

The deal's book value premium, and how that premium might be tabulated in regulatory proceedings, is a concern, says Bruce Carlton, president of the National Industrial Transportation League, which counts rail shippers among its members.

"We don't want to see this deal become some variable in rate negotiations. I think this should be behind the curtains," he says. "If something happened with rates, shippers would contest the fairness of a rate built from the bottom up, and it would be a long and drawn-out affair. We'll wait and see."

However, the National Association of Wheat Growers (NAWG) doesn't anticipate any BNSF rate or service changes.

"From what we have heard, we don't expect the Buffett/BNSF deal to affect service and we expect things to be business as usual as the deal works its way through the regulatory process," says NAWG Director of Communications Melissa George Kessler. "We continue to work on rail issues in a variety of ways, including a grower-BNSF advisory council."

Several analysts also believe BNSF's rates won't be driven by the deal, but by what the market will bear.

"Buffett has done his due diligence around pricing," says Deutsche Bank AG's Yagerman, adding that he anticipates a disciplined pricing approach.

In addition, Berkshire subsidiary MidAmerican Energy Holdings Co. owns 11 coal-fired power plants. So, in a sense, Buffett himself is a BNSF customer and wouldn't want to raise his own rates, analysts say.

Trust in team Berkshire/BNSF

While discussing the deal in his Fort Worth office, Rose mentioned another thing Buffett doesn't want to do: manage BNSF. Rose isn't expecting a tight rein from the billionaire or to be micro-managed.

"Warren doesn't want to run a railroad," says Rose. "If this was See's Candies, he wouldn't change the candy recipes."

Berkshire has 20 employees at its Omaha, Neb., headquarters, "and there isn't one of them that knows how to run a railroad," said Buffett — who declined an interview request — during a chat with Rose that was recorded by BNSF in late December for employees, posted on its Intranet and included in a SEC filing.

"You'll be running the railroad, and you'll run it in an efficient way," he said to Rose. "And when times are good, you're going to have more people employed than when times are bad."

Buffett has only asked BNSF's CEO to do two things: come to Omaha once a year to go over the Class I's business plan, "which takes about an hour," and attend Berkshire's annual meeting, says Rose.

"Warren becomes an advice sounding board more than anything," he says. "We have to deal with our board today to make investment decisions, so there's already a decision-making process."

Making capitalization decisions on a long-term vs. quarter-by-quarter basis will provide more stability to BNSF's long-term investment strategy, says Rose.

"We can look at a one- to three-year timeframe now," he says. "Warren looks at the entire cycle."

Berkshire is borrowing $8 billion to finance the deal, but won't sell the railroad's assets to pay down debt, said Buffett during the BNSF interview. The firm plans to continue investing in the railroad's infrastructure.

"We're not going to buy a business and starve it," said Buffett.

The billionaire believes BNSF is interwoven with the U.S. economy and is poised to benefit from an increase in imported goods from the nation's Asian trading partners, including China.

"I'd rather be in the West than the East. I think the West is going to do well," he said during the interview.

Buffett also expects BNSF to survive the economy's ebbs and flows for the next century and beyond.

"We're going to have more people in this country and they're going to be using more goods over time. And there's a bad year from time to time," he said during an interview conducted Nov. 13 on PBS' The Charlie Rose Show. "In the next 100 years, there will probably be 15 bad years, and I don't know what order they'll appear, but the railroads will be essential to the country."

It's certainly a good thing that someone of Buffett's stature is "interested in our business and what we do," says Rose. The upside for long-term growth more than offsets any potential near-term downside to going private, he believes.

"Buffett is the business icon of modern-day history. We get the halo effect," says Rose. "The deal creates tremendous value for our shareholders and proves what rail assets bring to the table."

'Best Way' paves way for better on-time performance

Although the Berkshire buyout is drawing plenty of BNSF execs' attention, they continue to focus on the task at hand: finding ways to make BNSF a better railroad.

"It's a big deal, but we still have a job to do," says Chairman, President and CEO Matt Rose.

That job entails improving operational performance so the railroad can boost efficiency and reduce costs. Lately, the Class I has been hitting on both counts through the Best Way initiative.

Launched two years ago at Argentine Yard in Kansas City, Kan. — the Class I's largest classification yard — Best Way calls for developing and implementing standardized processes at terminals, yards and shops. The facilities then will operate more efficiently, reduce "waste" — such as rework — and increase operational flexibility and velocity, BNSF execs say.

"We're attacking how terminals operate to gain consistency and sustainability in processes," says Executive Vice President and Chief Operations Officer Carl Ice.

Everyone on same page

Each terminal is unique according to traffic, weather and geography, so tasks aren't executed the same way, he says. That variability means there are "opportunities for dropped passes," adds Vice President of Transportation Greg Fox.

"It's about getting everyone on the same scorecard and preventing miscommunication," says Fox. "Expectations are clear, and everyone knows how to respond and what they're accountable for."

For example, terminal workers previously received numerous phone calls or hundreds of text messages daily on individual tasks. Now, all workers use a computerized system to "follow a train's journey through a terminal," says Fox.

"It's all done electronically," he says.

The first 10 terminals to adopt Best Way improved on-time train performance from 48 percent in 2008 to 91 percent through mid-November 2009. Non-Best Way terminals only improved year over year from 59 percent to 71 percent, says Fox.

Two Best Way implementation teams are working to roll out the initiative at more facilities. At 2009's end, BNSF expected to implement Best Way at 12 terminals that handle about 40 percent of all merchandise traffic, says Fox.

"We'll get to 80 percent [this] year," he says.

BNSF also has rolled out Best Way to other areas, including dispatching, hub centers, mechanical facilities and engineering. The railroad expects to finish rolling out the initiative in the transportation department and at hub centers this year, and complete implementation in other areas during the next several years.

"For now, we have the waterfront covered, but there are other potential areas, like accounting or government relations," says Fox.

Although BNSF is only about halfway through the initiative's roll out, service and velocity are noticeably improving, he says.

"Best Way has helped us to build the ship as we sail it — one that can handle a lot more volume," says Fox.

— Jeff Stagl



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