Buffett's Long-Term Bet On Rails

By Sham Gad | November 03, 2009 AAA

Warren Buffet's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has just made the biggest acquisition in the company's history by agreeing to buy the remaining 77% of railroad company Burlington Northern Santa Fe (NYSE:BNI) for $100 a share. Including debt, the deal is valued at $44 billion.

The Elephant Deal
For years, Buffett has been vocal that Berkshire had the cash and willingness to make a large acquisition if the company and price were right. Well that day has come, and the company was a railroad. Investors can glean some meaningful insight from Buffett's bet, although we can only guess at all the benefits and reasons for making such a big bet. What Buffett did say in the announcement is that "Our country's future prosperity depends on its having an efficient and well-maintained rail system ... Conversely, America must grow and prosper for railroads to do well." (For related reading about the importance of the rail industry in America, check out The Giants Of Finance.)

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The Deal
In typical Buffett fashion, this deal was agreed to very quickly. Berkshire will pay $100 a share in cash or stock. The stock component is designed to minimize tax consequences for those investors who do not want to take the cash. Berkshire has agreed to split the B shares 50:1. Considering Buffett's permanent aversion to stock splits, his willingness to do this is a sign of his high degree of conviction in this deal. The fact that he is willing to exchange stock also suggests his belief that Burlington's shares offer a more compelling value over the long run than Berkshire without Burlington. It may also suggests that many of Berkshire's smaller business that are directly tied to the U.S. consumer and housing markets may be in a funk for many years to come, despite an economic recovery. So betting big on Burlington is certainly a strong way to move the needle at Berkshire.

The market seems to agree, as both companies' shares prices rose upon news of the deal.

The Implications
Rail transport is the most cost-effective way to move goods across land. The industry has become more efficient over the years as tons per mile of goods shipped has increased while costs have decreased. However, I think Buffett also sees a future where rail shipping becomes the de-facto choice for companies that want to save money. If you believe that the future economy will recover but not to the extent of the boom of a couple of years ago, then you can see why railroads will do exceedingly well. In addition, railroads are likely to be first in line to benefit from a sustained economic recovery.

Not surprisingly, CSX (NYSE:CSX), Union Pacific (NYSE:UNP) and other railroads are enjoying this news too. I wouldn't get too excited right away. Buffett is buying Burlington to benefit from it for many years to come. However, the rails as an industry have improved economically and over the long-run, it often pays to bet with Buffett. (For more, check out Think Like Warren Buffett and Build A Baby Berkshire.)

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