By ANDREW BARY | MORE ARTICLES BY AUTHOR
A PESSIMISTIC BUSINESS FORECAST BY THE management of Burlington Northern Santa Fe as the railroad considered Berkshire Hathaway's merger proposal in late October may mean U.S. industrial activity will be less robust in 2010 than many on Wall Street anticipate.
Railroads, which transport more than 40% of the country's freight, are an excellent gauge of economic activity. If Burlington's (ticker: BNI) outlook proves accurate, the nation's other major railroads -- CSX (CSX), Norfolk Southern (NSC) and Union Pacific (UNP) -- also could see subpar results. Shares of all three have rallied since Burlington's Nov. 3 announcement of its acceptance of Berkshire's (BRKA) $34 billion proposal.
After Berkshire CEO Warren Buffett made what proved to be a successful $100-a-share bid to Burlington CEO Matthew Rose, Burlington management sent the railroad's board four potential financial scenarios to consider as it weighed Buffett's proposal. The most optimistic -- that Burlington could earn $5.06 a share if the economy and the company's business recover in 2010 -- was at odds with Wall Street's far more upbeat 2010 consensus earnings estimate of $5.50 a share, according to the preliminary proxy for the merger.Management thought it more likely the economy wouldn't start to recover until 2011 and that the railroad would earn a depressed $4.40 a share in 2010. The other two scenarios were even more bearish: Either there would be no recovery and unit growth would be flat for five years, or the economy would enter a "deeper recession."
These forecasts suggest Berkshire overpaid for Burlington. Wall Street thinks Buffett paid a full but not excessive price, especially as 40% of the deal price will be paid in Berkshire shares.
At 99,000 each, Berkshire's Class A shares are little changed since the merger was announced Oct. 23. The stock is up 2% this year and trades for 1.2 times our estimate of year-end 2009 book value of $84,000 a share, below an average multiple of 1.6 times book in the past decade.
Berkshire looks attractive, given its low valuation and the company's enhanced earnings power, which stems from several well-timed investments Buffett made during the financial crisis, including stakes in preferred stock and warrants of Goldman Sachs and General Electric.
IF BERKSHIRE IS UNDERVALUED, Burlington holders are getting a particularly good deal. The Burlington board's quick approval of the transaction suggests it believed Buffett is paying a full price. Besides, the board determined it had few other options; a merger with another big railroad would have raised antitrust issues. It was told private-equity buyers were unlikely to bid because of the difficulty of financing such as a large purchase.
Burlington is an atypical Berkshire acquisition because it doesn't generate a lot of free cash flow, owing to the costs associated with maintaining its large rail network. The company spent $3 billion last year on locomotives and other capital equipment, more than double its depreciation expense. Burlington shares now trade at 98.40, a slight discount to Berkshire's purchase price. The acquisition is expected to close in the first quarter of 2010.
Buffett takes a long view and he called the Burlington deal an "all-in wager on the economic future of the United States." It also bespeaks his confidence in the American West. Burlington and Union Pacific are the dominant rail carriers west of the Mississippi, with Burlington a major hauler of coal from the Powder River basin of Wyoming and Montana. It's also a big carrier of agricultural commodities.
WALL STREET IS PLAYING DOWN the importance of Burlington management's bearish 2010 forecast.
"We believe the Burlington board is probably conservative in its approach and economic outlook, which would encourage management to provide scenarios that are also somewhat muted," wrote JPMorgan railroad analyst Thomas Wadewitz in a report titled "Thoughts on BNI's proxy: Were 2010 Scenarios Conservative or Cause for Concern?" Wadewitz thinks Burlington's forecasts "may not provide a good read for other railroads."
Burlington and other major railroads report weekly car loadings, and Burlington's performance has been the worst of the bunch in recent months. Its shipment volume is down 14% in the fourth quarter, against a 7% drop for Union Pacific. Coal traffic, which accounts for about a quarter of Burlington's revenue, has been weak because utilities, the major coal consumers, recently were sitting with 77 days of supply, compared with a normal level of 45 days at this time of year.
The Bottom Line
Warren Buffett's Berkshire Hathaway is paying $100 a share in cash and stock for Burlington Northern. Because Berkshire looks cheap, Burlington holders ay do well.
"There is no V-shaped recovery at this point. The recovery is shallow," Dan Keen, the assistant vice president of policy analysis with the Association of American Railroads, said in our D.C. Current column last week.
At a time when major market indexes are at or near 2009 highs and valuations on many industrial stocks are signaling a significant recovery, the cautious view of Burlington's management is worth heeding. It could mean 2010 will be tougher for the markets and the economy than Wall Street expects.Share Investor Links
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