Street Capitalist: Event Driven Value Investments

Why Warren Buffett is Betting on Railroads

If you looked back at the S&L crisis, sharp investors like Gerald Ford managed to make huge returns by acquiring the carcasses of failed banks, infusing them with capital, and picking off credits from weaker banks in their geography. Ford himself made over $1B personally with his Golden State bank deal.

Now, it appears as if other investors (including J.C. Flowers, Paulson & Co, MSD Capital, and Soros) are seeing the attractiveness in acquiring failed banks:

Of the 140 banks closed by the government this year, private investors have acquired only two outright—IndyMac and Florida’s BankUnited. Private equity investors argue that they should play a bigger role, as their funds’ billions in unspent capital could bolster the banking system.

Part of the test will be how well OneWest works with financially troubled homeowners, especially under the Obama administration’s loan-modification programs.

OneWest is already generating hefty profits. For the six months ended Sept. 30th, it posted net operating income of about $700 million, according to filings with the FDIC. In 2007 IndyMac, saddled by troubled mortgages, posted a $614 million loss.

During the FDIC’s roughly eight-month control of IndyMac before selling it, the agency cleansed the bank of some of its bad loans through asset sales and write-downs, shrinking it by about 27%, according to filings. It also reduced the bank’s headcount by about 45%.

The FDIC also agreed to share in losses with the ownership group in both the IndyMac and First Federal deals.

OneWest’s improved performance allowed it to bid aggressively for First Federal. The owners didn’t invest additional money to acquire the bank’s assets; rather, the money came from cash on OneWest’s balance sheet.

OneWest paid $401 million, or a 6.6% premium, for First Federal’s assets, according to FDIC documents. That makes it among the first FDIC-arranged deals in which a premium was paid for a failed bank’s assets—many are sold at a discount to their assets.

Investors Reshape IndyMac (WSJ)

It is difficult to throw a dart at the board and scoop up good banks, especially smaller, more regional banks. Many of these banks have not properly written down the value of CRE loans on their books. Still, some banks are poised to do well. The ones that are now overcapitalized and acquiring the assets of failed banks should offer opportunity for investors. A lot of this depends on good stock picking, you need to look at the quality of their loans, what they are acquiring (and the deal terms), and also the quality of their management teams. You need to seek out bankers who are disciplined but enterprising enough to enter the fray and take market share. This requires more effort than simply picking up an ETF, but it should be rewarding.

Bruce Berkowitz:

These are big scale businesses that will let Berkshire put more money to work over time. Berkshire has a tremendous amount of float from premiums received from long term insurance policies. That float must be invested in very secure, sound, financial instruments such as electric utility where you are cost plus or a railroad which has stability unlike many businesses. So here he’s taking float with a zero cost and investing it, not at an egregious yield, but at a reasonable investment yield. But when the cost is zero the returns are phenomenal. So he’s brilliant, Warren Buffett is being Warren Buffett in that he’s married another great big business to Berkshire Hathaway that’s going to make a sizeable difference over time.

Full video:

via: Letter to the Editor – Buffett and Burlington Northern (Advisor Perspectives)

To the Editor:

I read with some amusement professor Greenwald’s discussion of Berkshire Hathaway’s purchase of Burlington Northern (BNI), I could not disagree with his analysis more. One of my Native American friends says that one must be careful not to view things with “old eyes” and I fear that is what is happening to the professor’s view of Burlington Northern.

When I first began to look at railroads in the 1980’s, they were the very epitome of capital-intensive, labor-intensive companies consistently earning less than their cost of capital and that was during a period when they all had millions of acres low cost land holdings with attached mineral rights. At that time, the one true measure of a railroad’s operating success, its operating ratio, was rarely below 90%. Union work rules were killing them.

Since that time, a reduction in government regulation, mergers and disposals of surplus lines, changing crew consist rules, technology and improved motive power efficiency have combined to make railroads productive and highly profitable companies. They have created huge cash flows which have funded debt reduction and capital spending, making them much more profitable. Today, any railroad with a operating ratio in excess of 75% is considered to be poorly managed. They have not accomplished this by diversifying their business; their resource land grants are long gone they are almost pure rails now. They have not done it with increased leverage as they carry less debt and preferred than they did 10 years ago. They have done it by sticking to their knitting, serving the customer, driving down costs, capital discipline, technology investments and just hardnosed business practice.

An example of increased efficiency: changes in engine design have reduced the number of motive units needed per train, reducing costs in terms of both fuel and crew. Recently, GE introduced a new line of motive units with 16 cylinder higher horsepower diesel engines that, at sustained speeds, turn off four cylinders and maintain their speed on the remaining 12. The fuel savings are in the area of 30% for comparable runs.

The other issue unique to BNI is that the nature of its traffic has allowed it to replace many of its previously fixed costs with variable costs, giving it greater financial flexibility and the ability to change in an instant to accommodate business conditions. This in turn allows greater capital discipline and better returns.

While Buffett’s purchase of BNI does not seem to satisfy Berkshire’s traditional pattern of purchasing irreplaceable franchises, it does meet a more basic precept of being a toll-taker by offering a product an economy cannot do without. Most of the traffic on today’s railroads cannot be moved by any other modality. If we are going to continue to import goods from lower cost developing world countries, then the BNI route structure from the west coast ports to the mid west will be one of the few (two actually) to move that traffic.

Did he overpay? Maybe. Does it revalue all the rails? No. Will it work out for Buffett and his shareholders? Probably and better than most viewing it with “old eyes” can see at this point.

Dennis Gibb
President
Sweetwater Investments
Redmond, WA