Rail sector may be on track for higher returns
(The following story by David Milstead appeared on the Globe and Mail website on November 5, 2009.)
TORONTO — Racing around buying all the railroads may be great strategy for the Monopoly board game, but investors should be cautious about employing the technique in the wake of Warren Buffett's big buy.
The famed investor sent share prices rising throughout the rail sector Tuesday when he announced his Berkshire Hathaway Inc. (BRK.B-N3,381.0055.651.67%) investment vehicle would plunk down about $26-billion (U.S.) to buy the 77 per cent of Burlington Northern Santa Fe Corp. (BNI-N97.100.100.10%) it didn't already own. At $100 per share, the deal represented a 31.5-per-cent premium to the prior day's closing price, and Burlington shares rocketed to $97, giving it the richest multiples in the industry.
The other U.S. and Canadian rail companies also rose Tuesday, albeit with gains that paled in comparison. Union Pacific Corp., Norfolk Southern Corp., CSX Corp. all saw bumps of 5 to 8 per cent, while Canadian Pacific Railway Ltd. and Canadian National Railway Co. rose 4.2 per cent and 2.7 per cent, respectively. Most of the five companies built on those gains in yesterday's trading.
The end result, as it always seems to be, is that if you want to follow Mr. Buffett's investment strategy, the price for these companies is now higher. More importantly, investors who hope to see the competitors' valuations soon rise to Buffett-boosted Burlington levels should temper their expectations.
By buying Burlington in its entirety, Berkshire gets complete access to the company's cash flow as sole owner of the venture. That's something that investors in any of the other publicly traded railways cannot obtain. They must wait for the companies' boards of directors to declare dividends.
This control premium means Burlington should trade at levels above competitors until the Berkshire deal is finalized. It can already be seen in a couple of commonly used metrics.
Walter Spracklin at RBC Dominion Securities Inc. says that at current levels, Burlington has a 15.4 price-to-earnings ratio based on 2008 earnings while its major U.S. competitors trade between 10.7 and 13.1 times trailing earnings. CN and CP trade at 14.5 and 12.0, respectively. (Mr. Spracklin uses net operating income excluding special items as the ‘E' in his P/E models.)
The gap is maintained in his 2009 earnings forecast: Burlington trades at 20.5, while the other major American and Canadian railways trade from 16.0 to 18.2. And the pattern repeats when Mr. Spracklin's 2010 and 2011 estimates are used.
Turn the knob to a slightly more complicated calculation – enterprise value (market cap plus debt) to EBITDA (earnings before interest, taxes and depreciation), and the higher valuation remains.
At this point, no one seems able to name a logical buyer for the other railways. Regulatory concerns seem to be an obstacle for mergers, while lack of credit would stymie potential financial buyers.
All that being said, Mr. Spracklin and others who follow the sector see plenty of room for returns. He's got a “sector perform” rating on Union Pacific, but his 12-month target price implies a 24-per-cent return. Implied returns for CP, Norfolk Southern and CSX – his three railways with an “outperform” – range from 25 per cent to 40 per cent. CN is the laggard at 15 per cent.
Mr. Spracklin says the railway group as a whole is trading below historical multiples and should have upside leverage in an improving economy. Potential increases in fuel could shift business from trucks to railways. Edward Jones analyst Dan Ortwerth says that while rail has historically spent 10 per cent of sales on diesel fuel to run its trains, a typical trucking company spends 15 per cent, “a sizable cost difference.”
Rail sector pessimists, however, see an industry that continues to have heavy capital expenditures that eat up cash flow. “For 20 years, it's been an industry that's never earned its capex and never had high return on capital,” said Christopher Bloomstran, a St. Louis-based money manager who's heavily invested in Berkshire Hathaway. Mr. Bloomstran and other Buffett-oriented value investors may continue to see a red light at trackside.
Thursday, November 05, 2009
