Wednesday, April 28, 2010

Short lines in the Buffett era

Written by  Roy Blanchard, Contributing Editor

Now that BNSF is no longer a public company and is a wholly owned subsidiary of Berkshire Hathaway, what can BNSF’s short lines expect? There are two indicators, both of which are in Warren Buffett’s 2009 Shareholder Letter (available at www.berkshirehathaway.com).

First are the basic rules under “What We Don’t Do.” Not only do they speak volumes about how BNSF wound up in the Berkshire fold but they also flag what short lines can do to fit the Berkshire mold. Here are some excerpts, rephrased as admonitions for short line owners and operators:

• Avoid businesses you can’t evaluate no matter how exciting their products may be. For short line owners, that includes the sometime-shippers who talk a great game but whose business premises are shaky. For example, the plight of the Montreal Maine & Atlantic is in part due to the paper-making plants in northern Maine that are having trouble maintaining market share. No market share, no carloads. No carloads, no trains.

• Never become dependent on the kindness of strangers. Arrange your affairs so that any requirements for cash are dwarfed by your own liquidity. Too many short lines fall woefully short here. I would argue that any railroad that cannot stay afloat by merit of its own cash flow may be more of a drag on the fraternity than a contributor to the good of the order. And, sad to say, they must be allowed to go out of business if they must become wards of the state to survive.

• Be sure decision-making occurs at the operating level; avoid becoming a monolith that is overrun by committees. As a Buffett-watcher for more than 20 years, I can safely say he expects the same of the companies he owns. This creates a great opportunity for short line owners to go to BNSF with sound recommendations where the homework has been done and to expect prompt and fair action.

• Keep communications with stakeholders as direct and unabridged as possible. Buffett expects that his own personal values—openness, integrity, extreme honesty—be reflected at his companies. Need proof? There is a scathing account of what happens when somebody reporting to Buffett is less than forthright in Chapter 49 of Alice Schroeder’s “Snowball” biography of him.

Then there are the financial and commercial aspects of the short line relationship. “Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities,” Buffett’s letter says. “In both cases, we provide fundamental services that are essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come.”

The railroad is a wasting asset, and what wears out must be replaced. Having the cash to repair and replace means having a healthy balance sheet. One place Buffett looks first is at the Retained Earnings line under shareholder’s equity. And he prefers to look at it in terms of market capitalization or enterprise value. The relationship between Retained Earnings in the balance sheet sense and market cap or enterprise value comes into play in the 1996 “Owner’s Manual.” There are 13 “Owner Business Principles,” of which Retained Earnings is no. 9: “On a rolling five-year basis, each dollar of Retained Earnings delivers shareholders at least one dollar of market value for very dollar retained.”

Though it has been argued since that the rule doesn’t work in market bubbles, I’ve found that dividing a year-end retained earnings figure into the market cap at the end of the year gives a fair indication of whether shareholder value is created or destroyed.

Short lines may not have market caps, but they do have book values or enterprise values and they have retained earnings. Looking at the year-over-year rate of change of each will at least give you an indication of whether you’re heading in the right direction. It’s the direction Buffett expects in the companies he owns. Following his lead—whether you’re a BNSF connection or not—will do wonders for your customers, your stakeholders, and you.