Burlington Northern
The following is my response to an article by James Stewart in SmartMoney encouraging an investestment in Burlington Northern. The article can be found at: SmartMoney
Your analysis of Burlington Northern is lacking. While I would hate to be on the other side of trade as Buffett, I believe he has found a good company selling at a good price. This is not a great company selling at a good price or a good company selling at a great price.
More importantly, throwing out a P/E, ROE, and growth rate is only the start of the analysis. The problem is that these figures are misleading when it comes to many companies, including Burlington Northern.
Earnings are unimportant if they do not reflect the underlying cash flows. Just ask any investor in Enron. While Burlington’s earnings are real (unlike Enron) they have significant capital expenditures that offset their earnings and make the underlying valuation much more expensive. The earnings of $1.9B should be offset by the difference between maintenance capital expenditures and D&A ($1.5B - $1.1B) or $400M. The free cash flow generated by the business was therefore approximately $1.5B in 2006. The company’s Price/Cash Flow is equal to 31.6/1.5 = 21.
In addition, your use of ROE is misleading because it is an accounting construction rather than a real financial measurement. What matters is the return on the capital the company invests. By the company’s own admission, they have increased this number from the single digits to a record 11.4%. Not an impressive return on capital and much lower than the accounting construct you quote.
While I believe that Buffet has found a good company with good management, the valuation is not compelling. An investor is paying 21 times cash flow for a company that returns 11% in a banner year. Unless the future is unusually bright for the company — a company with high fixed costs and a unionized workforce — there are more compelling investments to be found.
