BHRG, led by Mr. Buffett’s favored manager, Ajit Jain (to whom shareholders have been urged to “bow deeply”), has been a spectacular success for Berkshire and is unique among the major businesses as the only significant home-grown operation. Unlike a typical reinsurer, BHRG is focused on one-off or special situation transactions. A BHRG contract is usually costly, but as the head of Lloyd’s once quipped after buying a major cover, “Our owners wanted to sleep at night, so we bought the world’s best mattress,” referring to BHRG’s financial strength and reputation. When an insurer wants regulators and investors to not worry about an issue, they call Mr. Ajit, as American International Group Inc (NYSE:AIG) did when it purchased asbestos protection. In addition to attractive underwriting terms, BHRG has significantly added to Berkshire’s “float.”
With revenues that are large and often lumpy—BHRG could report several billions of dollars of premiums written one quarter and zero the next—forecasting results is a challenge: 2013 likely will be weighed down by the expiration of the Swiss Re quota share contract, but we know the company was active during the April renewals in Japan and has made recent headlines with its entry into Lloyd’s with a major quota share written through Aon.
Float
When discussing the underwriting operations, the concept of “float” is important to understanding Berkshire. Most insurers and reinsurers attempt to position their investment portfolios conservatively, largely in fixed income investments with durations that match liabilities. Experience (stemming from an industry crisis in the 1970s) and regulatory pressure force this discipline. Berkshire, however, views its claims liabilities as assets to be invested to earn an attractive return before needing to be paid out. For this reason, the company has a special taste for long-duration liabilities such as asbestos. Mr. Buffett has described his views on float at length in his annual reports.
As critical as float may have been over the first several decades under Mr. Buffett’s leadership, we view that its importance has declined as the company has grown. As we later discuss, with the company buying 100% of large companies such as Lubrizol, Berkshire is becoming less and less of a quasi-investment vehicle and more of an operating company.
Make Way for Railways: BNSF Railway—the Former Burlington Northern Santa Fe
While railroads may have the reputation of being a business of yesteryear, the railway industry currently is experiencing a boom. Growth in U.S. energy demand has been one major driver, but the technological advances of things like fleets of “hot trains” that deliver consumer products for FedEx Corporation (NYSE:FDX) or Amazon.com, Inc. (NASDAQ:AMZN) have also contributed to the growth. Capital spending by the freight railway companies is at new highs (see chart below), as the industry expects increasingly long-term demand.
While the ups and downs of BNSF’s business are affected by the demand levels for its major products shipped, such as coal, agricultural products and industrial products, there has been relatively consistent growth in recent years despite the fluctuations of the U.S. economy. (Revenue and EBT CAGRs have been around 13-15% and we expect that to continue through 2014.) This has been driven by the rise in price of gasoline, making rail more efficient versus trucking, as well as the large amounts of capital improvements in the rail lines themselves. To illustrate efficiency, we note that in 2012 the rail industry could move 1 ton of freight 476 miles on one gallon of fuel on average, with the economies of scale favoring the largest players; this is a 100% improvement over 1980.
Of the major class 1 railroad companies, BNSF is really only challenged by Union Pacific (UNP) in terms of scale and performance. BSNF and Union Pacific Corporation (NYSE:UNP) rank first or second in just about every comparable operating metric, including total cars on line, average speed, tonnage moved, etc., as well as financial metrics including total revenues and margins.
The scale advantages are obvious, and with bigger meaning better, the large amounts of capex being deployed will likely only further the gap between BNSF and Union Pacific Corporation (NYSE:UNP) versus the other competitors, translating into even better revenues and margins. BNSF was estimated to be worth approximately $34bn when it was taken out. Given that UNP trades at approximately ~17x earnings currently, we have used our similar multiple for BNSF, equating
