Burlington Northern Santa Fe (BNI)

Industry and environmental watchdog estimates peg rails as 2x-4x more efficient than trucks in fuel usage and 3x cleaner as measured by NOx emissions on a ton-mile basis. A high oil price environment favors railroads over truckers as it is a smaller operating expense in terms of delivered cost. Burlington specifically stands to benefit more than the other major rails in that western railroads typically entered into longer legacy contracts in an era before fuel surcharges. As the contracts roll over, BNI’s renewed pricing power picks up noticeably and the fuel exposure is largely mitigated via the added surcharge.

Industry and environmental watchdog estimates peg rails as 2x-4x more efficient than trucks in fuel usage and 3x cleaner as measured by NOx emissions on a ton-mile basis. A high oil price environment favors railroads over truckers as it is a smaller operating expense in terms of delivered cost. Burlington specifically stands to benefit more than the other major rails in that western railroads typically entered into longer legacy contracts in an era before fuel surcharges. As the contracts roll over, BNI’s renewed pricing power picks up noticeably and the fuel exposure is largely mitigated via the added surcharge.

Importantly, the amount of profitability is improving relative to the capital deployed. This has allowed debt/operating income to move to new lows as less debt is needed to provide acceptable returns to equity investors. Free cash flow, after being abysmal for many years, is improving, though it is still too low a percentage of annual net income for a slow growth business. BNI’s annual share count reduction is finding a productive use for excess cash and improving earnings per share.

The tremendous amount of railroad consolidation and the monopolistic/duopolistic nature of most BNI freight routes virtually ensures annual profitability.

The tremendous amount of railroad consolidation and the monopolistic/duopolistic nature of most BNI freight routes virtually ensures annual profitability.

Importantly, the amount of profitability is improving relative to the capital deployed. This has allowed debt/operating income to move to new lows as less debt is needed to provide acceptable returns to equity investors. Free cash flow, after being abysmal for many years, is improving, though it is still too low a percentage of annual net income for a slow growth business. BNI’s annual share count reduction is finding a productive use for excess cash and improving earnings per share.

BNI’s diversified exposure, including nearly 40% to commodities and their widening cost advantage over truckers, should help cushion the blow if the economy weakens.

Buffett and Munger have made investments in three different railroads – Burlington Northern, Union Pacific (UNP), and Norfolk Souther (NSC). Buffett has targeted Burlington Northern Santa Fe (NYSE: BNI) as his largest railroad position. He currently owns about 15% of the company worth some $4.3 billion and recently filed and received regulatory approval to buy up to 25%. Likewise, just this last week it was revealed that Buffett now owns BNI options that (when exercised) will bring his Burlington stake to 17.2%.

Update: Berkshire Hathaway exercised options mentioned above in October, 2007. As of Feb. 8, 2008, Berkshire owns about 63.7 million shares or roughly 18.2% of the BNSF, worth around $5.6 billion.