2009 3rd Quarter Report

(Download printable .pdf version here.)

We are pleased to bring you our third quarter report for 2009. We do apologize for the delay. Value Architects has been fighting off some cold and flu bugs over the last several weeks. For this quarterly, you will find our discussion divides into two parts, first, a macro overview focused on banking reform, and secondly, a review of the Berkshire Hathaway purchase of Burlington Northern.

The third quarter provided ample evidence that capital markets were no longer concerned about the possibility of a second coming of the depression. Against this backdrop, the nation’s third-quarter return to growth was a great relief. Real gross domestic product increased at a solid annual rate of 3.5 percent. The recession hasn’t officially been declared over, but a wide array of data suggests that the corner has been turned. In the third quarter, residential investment—which was the epicenter of the downturn—rose at nearly a 25 percent annual rate, albeit from a very low level. Home sales, prices, and housing starts are once again climbing. Meanwhile, manufacturing is also beginning to show signs of strength. This was helped by a rebound in motor vehicle production, boosted by the government’s temporary cash-for-clunkers. The stimulus packages implemented by central banks and treasuries around the world have helped to restore confidence. According to Piergiorgio Alessandri and Andrew Haldane, two economists at the Bank of England, the total interventions on behalf of banks worldwide have totaled $14 trillion, about one quarter of world GDP. It dwarfs any previous state support of the banking system. These interventions have been as imaginative as they have large, including liquidity and capital injections, debt guarantees, deposit insurance and asset purchases. For those who worry about creeping socialism coming into the US, we suggest that state socialism is even more alive and well outside these borders. Happily, governments and central banks have learned the lessons of the 1930’s and decided, correctly, to prevent collapses of either the financial system or the economy.

A bit of history of banking and its relationship with the sovereign government. The link between the state and the banking system has been almost umbilical. Starting with the first Italian banking houses in the 13th century, banks were financiers of the sovereign. Sovereign need was often greatest following war, revolution, or other major crisis. The Bank of England was established at the end of the 17th century for just this purpose, financing the war debts of William III. Government debt, largely because of the risk of war, was viewed as highly risky by the financiers. As awareness of sovereign risk grew, banks began to charge higher loan rates to the sovereign than to commercial entities. In the 15th century, Charles VIII of France paid up to 100% on war loans to Italian banks, which were at the same time charging Italian merchants 5- 10%.The Bank of England’s first loan to government carried an interest rate of 8% – double the rate at which the Bank discounted trade bills.

Following a few centuries, the tables turned. The state has instead become the last-resort financier of the banks. As with the state, banks’ needs have typically been greatest at times of financial crisis. And like the state, last-resort financing has not always been repaid in full and on time. The Great Depression marked a regime-shift in state support to the banking system. The credit crisis of the past two years may well mark another. There is one key difference between the situation today and that in the Middle Ages. Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks. The mathematical geniuses who trade creditdefault swaps deal in default insurance and in fact, seem to have figured this out. They currently charge a higher insurance premium for some G-7 countries than they do for some corporate credits like McDonalds or Campbell Soup.

Most investors believe that reform is needed in banking regulation to lower the probability of poor banking decisions contributing to failure of the entire system. In a recent academic paper, two researchers for the European Corporate Governance institute examined bank performance of 100 global banks (19 US) with assets over $50 billion before and through the crisis. They made some fascinating observations:

1. One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of - 87.44% during the crisis but an average return of 33.07% in 2006. This evidence is most consistent with the Tsunami explanation for the crisis: the attributes that the market valued in 2006, prior to the 2007-2009 crisis, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit.
2. Strikingly, banks with more pro-shareholder boards performed worse during the crisis! Such a result does not mean that good governance is bad. Rather, it is consistent with the view that banks that were pushed by their boards to maximize shareholder wealth before the crisis took risks that were understood to create shareholder wealth, but were costly ex post because of outcomes that were not expected when the risks were taken.
3. Banks with more Tier I capital, more deposits, and more loans performed better. In other words, traditional banks doing conventional deposit taking and lending and avoiding exotic capital market transactions outperformed.
4. Banks from countries that had stronger regulators actually underperformed. The powerful regulation came at the expense of shareholders since powerful regulators raised more capital for a given amount of write-downs ensuring a stronger banking system for that country.

The repercussions of the crisis will continue to influence many of our beliefs. First, the supremacy of western, particularly US models of finance is no longer evident. The pendulum is definitely swinging towards regulation. While governments are gradually withdrawing their direct ownership of banks, they cannot afford another crisis. Supervision will become tighter and regulatory structures will be reformed. There are serious questions about the globalization of finance. Governments have discovered an unpleasant task to rescue home banks that have lent abroad or purchased bad assets abroad. We suspect this will result in a re-domestication of banking. Deliberate efforts to attract financial services business globally by attempting to attract business through looser standards has also come to an end. Regulation will become more universal and global. The overall banking system will become safer, more oligopolistic and less innovative.

The modern case for the free market economy has been set back years by the disarray in financial markets. In short, we are learning the hard way that old-time virtues like prudence, temperance, thrift, promise-keeping and honesty (not to mention a willingness not to do to others what we would not want them to do to us) cannot be optional extras in societies that value economic freedom. If markets are going to work and appropriate limits on government power are to be maintained, then societies require substantial reserves of moral capital.

Banking is a peculiar industry because of the asymmetric nature of its payoffs. Gains to shareholders are potentially unlimited. But the same is not true when markets head south. The reason is limited liability. That constrains the losses of shareholders to around zero. Losses beyond that point are borne by other parts of banks’ capital structure - wholesale and retail depositors. Therein lies the problem. If protection of depositors is felt to be a public good, these losses instead risk being borne by the state, either in the form of equity injections from the government (capital insurance), payouts to retail depositors (deposit insurance) or liquidity support to wholesale funders (liquidity insurance). The gains risk being privatized and the losses socialized. The fact that government has repetitively come back to support the system unfortunately only encourages risk-taking by the participants in order to maximize expected profits.

In decision theory, the “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak.

Reforms will ensure that banks avoid excessive leverage, hold sufficient capital, and ensure their liquidity; regulation will further reward only genuine longterm value creation not short-term risk-taking. Government will be through bailing out misadventure.

In practical investment terms, we think the near term will be difficult for banks in general. A protracted period of consumer deleveraging will result in lower bank earnings, a dramatic reduction in the number of US consumers who qualify for credit, and a period of dramatic regulatory change which will contribute to broad based re-pricing and disrupted bank returns. We continue to be very particular and discriminating in our bank stock selections.

Is Burlington Northern the New Coke?

Much of the investing world’s focus recently has been on the extraordinarily large and significant purchase of Burlington Northern Railroad by Warren Buffett for Berkshire Hathaway.

Certainly, this investment has created a huge amount of controversy, not only because of its size, but also because many people view this as having some implications as far as commodity prices or even the future of the US economy.

As Buffett said in a CNBC interview: "Berkshire's $34 billion investment in BNSF is a huge bet on that company, the CEO Matt Rose and his team, and the railroad industry," "Most important of all, however, it's an all-in wager on the economic future of the United States. I love these bets," he said.

Few of us remember that a similar controversy arose in 1988 when Buffett, then hardly known to the public, had made a disproportionately large investment in Coca-Cola. In the 1988 Berkshire letter to shareholders, the Coca-Cola purchase was noted as a one-liner: “In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time.” At the time, the Coke purchase of some $600 million represented the single largest purchase Buffett had made to date, and at market value, was the third largest marketable securities position in Berkshire’s portfolio, slightly smaller than Capital Cities Broadcasting/ABC and GEICO. By 1989, the Coke position was augmented with another $400 million, and became the single largest holding for Berkshire.

At the time Buffett had joked about his decision-making:

"This Coca-Cola investment provides yet another example of the incredible speed with which your Chairman responds to investment opportunities, no matter how obscure or well-disguised they may be. I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each.

In this excursion into high-margin retailing, I duly observed the extraordinaryconsumer attractiveness and commercial possibilities of the product.

I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes…. Of course, we should have started buying Coke much earlier, soon after Roberto and Don began running things. In fact, if I had been thinking straight I would have persuaded my grandfather to sell the grocery store back in 1936 and put all of the proceeds into Coca-Cola stock. I've learned my lesson: My response time to the next glaringly attractive idea will be slashed to well under 50 years."

I can recall that at that time, many investors questioned the wisdom of paying what looked like a fairly substantial premium to the existing market for this company. After all, Coke was hardly a depressed stock with a stock price that had grown by about 18% a year, well ahead of the overall market since 1980.Free cash flow had grown every year, a concept that few analysts discussed at the time. In fact, in the decade preceding Buffett’s purchase, Coke’s free cash flow had compounded at a 21% CAGR (compound annual growth rate). Though the P/E multiple seemed high at about 14 times, most analysts focused on earnings rather than the underlying value of the brand. The value of that investment in Coke, needless to say, has grown spectacularly.........about 24 times including dividends.

How should we be thinking about Buffett’s latest big "bet?"

There are two camps forming. In simple terms… those that think it is a great purchase given long-term transportation and pricing dynamics, and those that remain skeptical of the price paid, the free cash flow generated, and return on invested capital of this business.

Let’s describe BNI’s business. Burlington Northern (known to most of us oldtimers as Beanie) operates one of the largest North American rail networks with about 32,000 miles in 28 states and 2 Canadian provinces.

The operational positives: BNI operates the premier US intermodal franchise with a very large West Coast presence and what is regarded as a decent service proposition. The company moves more intermodal shipments than any other railroad through its international, domestic, truckload/intermodal marketing company, and expedited/LTL (less than truck load-relatively small freight) offerings. Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes. The method reduces cargo handling, and so improves security, reduces damages and losses, and allows freight to be transported faster. Reduced costs versus over road trucking is the key benefit for intra-continental use. BNI stands to improve its intermodal results and growth as import volumes increase. The long term picture here is quite positive in that volumes of intermodal should grow faster than GDP over the long run. Intermodal pricing should strengthen as the economy recovers and the Truckload (TL) market tightens from its current over-capacity and give-away pricing.

There has been considerable comment on the energy benefits of using rail. TCI, a UK based activist investment manager made a presentation to a Congressional committee on rail transportation to discuss their involvement with CSX, another large rail carrier and their views on the railroad industry in general. Here is a copy of that transcript:

To quote from their study:

"We are excited about the prospects for the US railroad industry. Railroads can, and must continue to, play a critical part in meeting America’s growing freight transportation needs. Railroads are the cheapest, most efficient and most environmentally friendly form of land-based freight transportation, and they don’t require taxpayer dollars, a public-policy panacea if ever there was one.

As valuable as railroads are to America today, their potential is even greater, and that is what we should all find truly exciting. Over the last 100 years, the industry has transformed itself from one operating under heavy regulation to one that competes in the free market. This transformation has taken decades, and while rail market share has nearly halved as they have lost share to trucks, it has brought enormous benefits to shippers – since Staggers rates are down while volumes, service, and investment are up.

However, as the railroads were trying to adapt to the dynamic competitive market, many opportunities were left unexplored. As we look into the coming decades, we see the potential for US railroads to capture these opportunities."

In my view, railroads win the ecological battle based on their fuel consumption advantages in moving many tons, many miles, with relatively little fuel and a modest carbon footprint. But there are many battles ahead and the war will drone on for quite some time. There is a strong rivalry that exists within the transportation sector as intermodal involves railroads and trucking companies and of course political lobbying. The scalability of the rail industry leaves a lot to be desired in my opinion. Class 1 railroads currently have 95,000 miles of track, and it would be virtually impossible to expand the system without major population disruptions. Additionally, the existing rail network has very little extra capacity. As far as water transportation, the champ as far as economic movement of tonnage, the United States has just 26,000 miles of navigable waterway channels.

In contrast, the United States has built 4 million miles of highways, including the interstate highway system. A tremendous amount of freight moves over those highways, and that is unlikely to change significantly. There is an inherent flexibility and on-time deliverability that is part of trucking. Some 70% of all freight in this country is carried by truck.

In a recent discussion with another Buffett devotee, he noted:

"I own two truckers, HTLD and KNX, and obviously ask them about the competitive threat from railroads. I have also been watching the volumes at the intermodal carriers like JB Hunt and CH Robinson for years. My conclusion has always been that a) trains only go certain places, and b) they are subject to significant quality problems whenever volumes surge. The truckers all tell me that “yes trains are very competitive on certain long haul routes (like 1000 miles), but that trains go to very few warehouses or stores and that somebody has to move the intermodal container the last leg on the road”. I have also noticed that whenever freight volumes pick up the service quality suffers, and then a lot of long haul business gets pushed back on to trucks. Most lean operators cannot deal with late shipments, even if they are cheaper. At the end of the day, trains are sequential – you cannot accelerate a late shipment around other cars in the system.

Railroads have two other factors most of us value investors have long avoided – aggressive unions and customers with a lot of bargaining power. The unions have long resisted changes that would improve costs. These changes come, but usually only after a very acrimonious process. Finally, the federal government’s role is to set an acceptable return on capital (this is where the historical vs. replacement cost comes in). This function was basically set up to protect the coal power companies from price gouging by the railroads, which was a real problem back in the robber-baron days. So every time the railroads talk about raising rates the utilities scream bloody murder. It is amazing how responsive a politician is to a utility claiming every voter’s bill is going up if a railroad raises prices."

Another potential problem that I see in the rivalry with truckers is their lobbying power. The trucking industry employs some 3.5 million drivers. It is estimated that there are over 500,000 trucking companies in the U.S. Of that figure 96% operate 28 or fewer while 82% operate 6 or fewer trucks. The transportation industry paid $37.4 billion in federal and state highway-user taxes. Commercial trucks make up 12.5 percent of all registered vehicles, but paid 36.5 percent of total highway-user taxes in 2006, the last available figure. By way of contrast, there are only 7 Class I railroads in the US employing all of 164,000 employees.

Like so many industries, the railroad industry has enjoyed a period of relatively benign regulation, an environment that may be changing. As one industry analyst observed:

"While we expect Washington to act prudently and protect the nation’s longterm transportation interests by encouraging railroad expansion project investment, stranger things have happened than Washington taking a shortsighted view or acting irrationally."

Shippers have generally been happy with improved rail service since deregulation of this industry transpired in the early 1980s, but a significant minority is getting the attention of Washington, complaining of predatory pricing. In fact, Senator Jay Rockefeller of West Virginia has been drafting legislation to alter the regulation of railroads as he believes, "captive shippers suffered unfairly as federal regulators weighed in on the side of railroads in the deregulation era."

As I said, the trucking lobby is quite powerful, not to mention coal dependent utilities. As a result of a very weak TL market, shippers have moved more economically sensitive freight to TL providers due to very low TL rates and in many cases cheaper fuel surcharges due to aggressive carrier pricing. So the long term picture for growth for railroads may be impressive, the near term has resulted in some freight diversion of intermodal traffic to the trucks. Shippers are rebidding business to take advantage of the capacity underutilization on both sides.

Despite the ongoing competitive rivalry, rails exhibit additional competitive strengths, especially Burlington Northern. On the utility and the coal side, BNI has access to the Powder River Basin, a competitive advantage that provides it a fairly reliable recurring revenue stream. It is the single largest source of coal mined in the United States, and contains one of the largest deposits of coal in the world. According to the government’s energy information administration, the EIA, the nation’s coal supply should increase at about a 1% CAGR (compound annual growth rate) until 2030 with Western coal taking share from Appalachian coal. Between 2000 and 2007, BNI doubled its Powder River basin transport of coal to over 100 million tons. The Company is not only growing the volumes of coal shipped but demand is also increasing. There are over 17,000 megawatts of coal plants under construction for utilities in 19 states which represent an incremental demand of about 70 million tons of annual demand. In addition, BNI is starting to price upwards some of its older legacy coal contracts.

Earnings and profitability of Burlington Northern and all Class I railroads has improved significantly in the last decade. The boom years of 2003-05 created a renaissance in thinking as the industry focus shifted from just moving volume to actually improving profitability. The industry has improved revenue per carload by some 10% compounded over the last five years with its renewed focus on pricing discipline and shifting to a fuel surcharge scheme to maintain margins and pass through costs. Here is a look at yearly changes in revenues per carload in the last few years for BNI and its largest competitor, Union Pacific:

	2004	2005	2006	2007	2008	2009
BNI	+2.9%	+11.4%	+6.5%	+11.3%	+17.7%	-9.0%
UNP	+3.4%	+9.0%	+11.4%	+6.0%	+16.2%	-4.5%

This sort of pricing power seems to resemble “branding power” more so than what most of us regard as a quasi-government regulated service. In some ways, pricing power at the rails for many of these years has been better than that of Pepsi or Coke!

Combine this with some decent cost controls: parking of locomotives, layoffs of employees, reduced dwell times, and improving fuel efficiency and suddenly, railroads look a lot more interesting.

Capital expenditures remain an issue in this industry. Though the track and the rail bed itself may have existed since the nineteenth century, the railroad industry has fairly heavy ongoing spending requirements. For BNI, historically some 13-19% of revenues are spent on capital expenditures. Though some believe that BNI has accelerated its capital expenditure program and may be able to reduce its spending in some future years, heavy utilization of railbeds with heavy loads at high speeds takes its toll. Maintenance capex will remain significant in my opinion.

Despite this characteristic and not unlike the Coca-Cola example, there has been free cash flow generation every year of the last decade for BNI. In fact, free cash flow generation has compounded over the last decade in excess of 12%. Coke’s free cash flow generation, ahem, only 8% compounded…Pepsi’s only 10%! In terms of the stock market performance, BNI wins again (even before Berkshire’s bid) with a compound return for the decade of over 13%, ahead of Pepsi’s 8% and Coke’s less than 1%.

Of note, BNI management (along with most other rails’ managements) has provided good return of capital to shareholders. For BNI, return of capital through dividends and net share buybacks has amounted to 40-50% of cash flow from operations in recent years. This is a decent trait for management to have developed…this will now upstream directly to Berkshire’s Omaha HQ.

Returns on invested capital for BNI have actually been fairly impressive and superior to all other US based Class I rails. Though not in the category of a Pepsi or a Coke since this clearly is a capital intensive business, ROIC has been between 8 and 14%, not the 20’s of Coke or Pepsi, but reasonably better than what most investors envision when thinking about this industry.

The greatest risks relate to assumptions of pricing power continuing at the same pace. When competing against a much larger, more politically savvy group of truckers, rails are subject to potential freight diversion. Competition will likely remain fierce. Politically, the climate to upset de-regulation of many industries needs to be considered. Again, Buffett is hardly a political neophyte and certainly has many friends in Washington, particularly given his pronouncements re executive compensation or estate taxes.

The rare use of Berkshire stock as currency in this deal suggests to some people that Buffett sees special value or upside to BNI. I think it was the only way to accommodate small BNI shareholders to provide a tax-free exchange and hence, the 50-1 split on the Berkshire B stock, as an accommodation rather than as a special endorsement of upside value.

We remain faithful and loyal Berkshire shareholders. This is truly a transformative deal where Berkshire is becoming an ever increasing spinner of free cash flow from its wholly-owned operating businesses, primarily insurance, utilities, and now the rail. As Buffett and Munger prepare for succession, it appears that the company that will remain has gotten simpler to operate. The cash flows will be massive and will likely continue to be deployed in fill-in acquisitions of related businesses. Anti-trust law may preclude too much exposure in some businesses, for example, in carpeting, Berkshire already owns some 50% of the market, in rails, it is very unlikely that anything else in this country could be purchased. My suspicion is that the massive cash flows may fund a dividend, once the master capital allocator is gone.

Bottom-line, the Burlington Northern should provide an acceptable return on the capital employed and ample free cash flow to upstream. Maybe not a Coke 24 bagger - but still a rewarding acquisition.

As to overall investment posture, despite the extent of this rally, on average, US equities are fairly valued, not significantly over-valued. We have taken advantage of this run up to sell some securities as they reach our estimates of intrinsic value to replace with cheaper alternatives. While the compelling valuations of early March 2009 are long gone, we continue to find some securities that offer superior risk/reward characteristics. Given the “spike” in prices, we expect that the market will at least consolidate its gains and mark time for awhile.

As always, we appreciate your confidence and trust.

Rick Konrad