Mr. Buffet, buying a real railroad is not like in the board game.

Hardly anyone can resist the temptation to by a railroad in the game of “Monopoly.” They are reasonably priced, have OK earnings potential, and if all four are owned, they have outsized rental rates and the payment rates with sites on all four sides of the board. In real life however, railroads are rarely cheap compared to their earnings and the STB will keep anyone from owning more than one. So why would such an astute investor as Warren Buffet purchase one?

With the criteria usually cited by Mr. Buffet for his acquisitions, any one of the “Big Four” U.S. railroads would qualify for purchase; all have limited competitive entry, all have pricing power and a strong brand recognition, and all will almost certainly grow in an expanding economy. Why choose BNSF over the others? Perhaps Berkshire is too focused on the past.

 

Prior to the current economic troubles, the BNSF had arguably the most profitable railroad franchise in the U.S. It had a commanding presence in the most coveted coal field in the country, it had the best land route between the main shipping port on the West Coast and the main distribution terminals in the Midwest, and it was not burdened with an abundance of single and small lot shippers whose traffic needed to be expensively gathered and delivered and sorted several times between the origin and destination points. Moreover, it did not require the same level of management talent to achieve profitable earnings as some of the other carriers did.

 

Since 2008, however, things have changed and the BNSF franchise looks a little thin. Its reliance on coal looks especially dangerous in view of the current political opinions on this commodity. While the country will need to burn coal for many years to supply power to fuel the economy, production may have already peaked as other sources of fuel are used to power the economy’s growth in the future. Electric production was down 4.5% in 2009 while coal fired electricity was off 14.5%.

 

The BNSF’s second most important traffic segment was intermodal, and this was driven by containerized Asian imports into the ports of Los Angeles and Long Beach. Imports are way down and there are good questions if Americans can afford to go back to their profligate spending on imported manufactured goods for the foreseeable future. It may be many years until the volumes that were recorded in 2006 are exceeded.

 

Lastly, the longevity of the pricing power of the railroad industry must be questioned for a number of reasons. First, they have provoked a reaction from a significant number of shippers without recourse to other means of transportation that may have the political momentum to counter the lobbying influence of the railroads in Washington DC. Second, some shippers have or will begin to change logistical operations to minimize the effect of the increase in railroad rates. And third, some shippers will see delivery costs by railroads making rail related products uncompetitive with other products delivered by other modes of transportation. Many coal burning electric utilities have the option to use natural gas, either now or in the future, instead of coal and its ever increasing transportation costs.

 

All of the railroads face some of these problems, but the BNSF is especially vulnerable. Maybe the pied piper is leading the investment community down the wrong path right now!

Toby Kolstad consults with leading institutions through GLG