Study: Operating Efficiencies of BNSF and UNP
Though BNSF carries more freight and spends more on capital expenditures than any of the five other major North American railroads, its profit margins have slipped relative to all five since our purchase. I believe that our vast service territory is second to none and that therefore our margin comparisons can and should improve.
Warren Buffet, 2023 shareholders letter
Buffett has built his reputation as a patient owner focused on long-term results. He has no desire to “dress up” a business in the short run only to have it falter later. BRK stays away from trendy approaches to management and sticks with what has worked for decades. Managers are not asked to implement quick fixes to “make the numbers” this quarter or this year.
But Buffett’s patience is not unlimited, and when it comes to numbers, he is not likely to have missed the sub-par performance of BNSF, the railroad that BRK acquired in 2010.
BNSF’s operating ratio has been on the high side over the past decade and, over the past two years, has exceeded the operating ratio of all other Class 1 railroads. When we compare between BNSF and Union Pacific (UNP), its closest competitor, BNSF’s operating ratio has been higher every year.
Why BNSF underperformed?
This is a subject of much debate, but many point to the adoption of Precision Scheduled Railroading (PSR) by competing railroads. PSR is an approach created by Hunter Harrison who had a long and very successful career in the railroad industry. He died in 2017 but continues to influence the industry through his numerous protégés, including Jim Vena, the current CEO of Union Pacific.
Buffett notes that rail is essential for the economy and will always require very large capital investments. He alludes to political risks for railroads, including the possibility that union wages could continue to grow faster than reported inflation. While he is obviously proud of the railroad’s role in the American economy, he clearly wants BNSF to at least perform in line with its peers.
BNSF is one of BRK most important subsidiaries. Many shareholders seem to be under the impression that BNSF is a place where BRK can invest its free cashflow from its other business operations. Actually, the opposite has been true. BRK receives cash distributions from BNSF and must find a place to reinvest that cash elsewhere.
Since the acquisition in 2010, BNSF has sent a total of $53.7b to BRK to allocate elsewhere (as of 2023). In the early years, BNSF distributions to BRK exceeded free cash flow, funded by the addition of debt. In recent years, distributions have approximated free cashflow.
There is no reason to believe that the approach will change in the future. BNSF does have massive CAPEX requirements, but those are met with cashflow from operations. After deducting CAPEX, cash is sent to BRK which reinvests it elsewhere.
If BNSF underperforms relative to its peers, even by a significant margin, it will still be able to fund the maintenance of its railways, but dividends to BRK will be reduced, giving BRK less cash to redeploy.
BNSF 2023 vs 2022 results
BRK reports information for BNSF, but the railroad files its own more detailed financial reports because it is an issuer of debt that is not guaranteed by BRK.
BNSF reported net income of $5,087m, a decline of 14.4% from $5,946m in 2022. Freight revenues declined by 6.3% due to 5.7% drop in car/units transported and 0.6% drop in average revenues per car/unit.
Operating expenses were only cut by 4.7%. The failure to cut expenses while revenues fell resulted in the operating ratio rising from 66% to 68%.
Results from 2014 to 2023
Volumes measured by car/units have actually declined over the past decade, from 10.3 million to 9 million.
Average revenue per car/unit has increased from $2,180 to $2,549.
The net result is that freight revenues have been flat, rising from $22.4b to $22.9b. Note that these are nominal figures. In real terms, BNSF has experienced a significant revenue decline over the past decade.
For the first several years, management was able to reduce expenses to more than offset the revenue decline, resulting in the operating ratio improving from 70% in 2014 to a low of 61% in 2021. However, over the past two years, expense controls have deteriorated, causing a 68% operating ratio in 2023.
Comparing with UNP results
UNP reported net income of $6,379m in 2023, a drop of 8.8% from $6,998m in 2022. Freight revenues fell by 2.5%, due to 0.7% drop in car/units transported and 1.9% drop in average revenues per car/unit. Expenses increased by 0.5%, causing operating ratio to rise to 62% from 60% in 2022.
Results from 2014 – 2023
Over the same decade, UNP revenues was flat at $24b, which mirrors BNSF’s experience. However, UNP has consistently delivered a lower operating ratio.
From 2014 to 2021, both railroads operated efficiently, reaching operating ratios of 61% (BNSF) and 57% (UNP) in 2021. After that, the gap has widened over the past two years, ending 2023 with 68% (BNSF) and 62% (UNP)
Expense Efficiencies Add Up Over Time
We see the cumulative impact of expense control from 2014 to 2023:
1. BNSF: $228b of operating revenues and $77b of operating income.
2. UNP: $222b of operating revenues and $85b of operating income.
Operating efficiency is always important, but is even more critical in an industry experiencing very little revenue growth. When compared with UNP, it is clear why Buffett is not happy with recent results.
Results since Acquisition
To better context, we measure the cunulative results against the transaction price paid.
BRK paid $22.5b in cash plus $10.6b in BRK shares for full ownership of BNSF. Here are some cumulative statistics for BNSF from the year of the acquisition from 2010 to 2023:
1. Operating revenues: $305b
2. Operating income: $99b
3. Net income: $68b
4. Cash flows from operations: $95b
5. Depreciation: $30.6b
6. CAPEX: $51.5b
7. Free cashflow: $43.4b
8. Dividends to BRK: $53.7b
Railroads require high CAPEX to maintain infrastructure. Since existing property and equipment is recorded at historical cost, depreciation charges fall short of maintenance CAPEX.
The result is that net income overstates economic earnings for railroads. We should focus on free cashflow, not net income, when thinking about BNSF’s true level of cash profitability.
BRK has now received cash distributions of $53.7b compared to the $33b purchase price. However, remember that BRK did not pay all cash for BNSF. 80,931 Class A shares and 20,976,621 Class B shares were issued to BNSF’s owners, and this was valued at $10.6b on transaction date.
The value of those shares as of year-end 2023 would be $57.8b. In effect, existing shareholders of BRK “sold” part of their interest in the business in exchange for BNSF.
Was it a Good Deal?
Would BRK have been better off not acquiring BNSF in 2010?
We think that the railroad is an important asset that provides a stream of cashflow that is independent of insurance results. In combination with the broadly diversified manufacturing, service, and retailing (MSR) group, these cashflows allow BRK to assume risks in the insurance business.
Conclusion
Warren Buffett is known as a patient owner but he did not get to his current position in business by accepting inferior long-term results.
If BNSF had matched UNP’s 62% operating ratio in 2023, operating income would have been $9b rather than $7.4b. This would have brought an additional ~$1.2b to the bottom line, obviously a meaningful number, even for a company as large as BRK.
In labor negotiations, BNSF does have a potential disadvantage because it is owned by BRK, a parent company that has “deep pockets.” This type of political pressure is not likely to ease.