April 1, 2009

Value Idea: Valuation Analysis: BNI -part III

Valuation Analysis:
The business franchise of BNI is worth the investment as a core holding for the long run. Its earning power is solid if averaged over the economic cycle. You simply can't reproduce BNI franchise. It is one of those businesses than no amount of resources will enable any entity to reproduce it. P&G, J&J, Coke, Pepsi..etc with enough resources can be reproduced but I can argue that BNI and other rail roads have high barriers to entry, or rather impossible to entry.

The economic assets of BNI are significantly understated by historical accounting. For example, land is under valued on the BNI balance sheet. BNI land value is booked at $1.7 Billion only, while land prices have inflated tremendously over the life of BNI operating history. 

If you want to understand how significantly understated just use recent M&A data in the rail industry and apply the multiples. One way to do it is to calculate the market value for each mile of track BNI owns. Canadian natural Railway just purchased 300 mile track in the city of Chicago. Also, in 2003 BNI sold 18 miles of track for $260 million or $14.4 million per mile. If you apply purchase price for each mile of track to BNI the figure will be astronomical. 

I will not delve into the asset valuation approach because the figures, however you value them, will be off the charts. Instead I will focus on the earning power value of the company. For valuation i will need to adjust BNI's TTM EBIT and figure an appropriate discount rate. 

Discount Rate
To determine the appropriate discount rate to calculate BNI's future free cash flows I will start with their average cost of debt. Then I will add expected equity premium and company specific risks as identified in the previous post.

Equity premium5.75Shiller observed equity premium based on data from 1871-1999
Adjustments for Risk:

I will add basis point based on the specific risks i identified in post 2
Risk of price gouging litigation 1.25As economic situation deteriorates, government will be sympathetic to industries about high shipping prices and will likely intervene on their behalf in forms of legislation and such.
Risk of government policies on coal shipments.5I will keep this low as I really do not see any alternative for coal over the horizon. Coal will still make up 50%, and will grow, as a source of electricity generation
Trade shift non BNI coverage.25This is normal cost of doing business.
Other1I will make a catch all for risks that I did not capture
Equity required rate of return8.75I avoided the CAPM model and Beta because risk as defined in Beta is meaningless. 
Avg. cost of debt6.5 Based on BNI debt interest rates
WACC (weighted based on BNI capital structure) Discount rate7.8The discount rate looks low due to almost zero risk free rate. 

EBIT Margins
BNI business is cyclical and tied to the economy as evident by its EBIT margins, see chart. Margins have compressed as a result of the 2001-2003 rescission and expanded since then. in order to estimate its earning power it is better to average its EBIT margins across 10 year period to normalize cyclical variations. The 10 year EBIT average is 20.8%. 

If you compare EBIT margins with industry peers you will conclude that BNI transport much less economic sensitive business as discussed in part 2. BNI's margins are less volatile during the economic business cycle compared to industry peers due to its business mix. 

Below I will attempt to arrive to Economic Power Value based on no growth scenario. I will adjust EBIT for some elements that I feel should impact earnings going forward. 

Item$ in MillionsNotes
Revenue (TTM)18,018
EBIT3,747I apply the normalized 10 year EBIT margins of 20.8% to arrive at a vague estimate of the perpetual EBIT assuming no growth.

Pension Plan Costs(23)BNI have a pension plan deficit so we need to adjust for further hits to its earnings as its contribution must increase. 
Adjusting for reserves (environmental, injury)(37)BNI does a good job in reserving for contingent outcome like personal injuries and environmental cleanups. However I feel the two items below is under reserved based on recent payments by the company:
  1. 19 for personal injuries 
  2. 18 employee separation costs
Adjusted EBIT3,687
Less: Taxes(1,290)Based on 35% marginal tax rate
Add: Depreciation1,397Historical depreciation do not represent a meaningful economic concept.
Less: maintenance Capex(1,631)Maintenance Capex is higher than depreciation and makes the bulk of BNI Capex figures. the average maint. Capex is about 75% of total capes spending over the last 4 years.
Adjusted Earning2,163
Earning Power Value27,730BNI's worth assuming no growth in revenues: a present value of a perpetual stream of earnings (Adjusted Earnings from previous step / discount rate)
Less: LTD Debt9,099
Add: cash452Adding cash above 1% of sales as most companies do not require that to operate.
EPV 19,083
BNI Mkt cap20,000

As we can see BNI is fairly valued currently based on very conservative assumptions. However, The company does offer more than adequate margin of safety through its balance sheet, prospect for growth and competitive advantage. Therefore I do not have any problem owning it at these prices.  


MG (moneygardener) said...

I'd be interested in your thoughts on CP Rail. I really like the potential for this stock long term.

Sami said...


I did not examine CP operations in a lot of details but what is good for BNI and CNR is good for CP as well. They have a competitive advantage and pricing power. however there are some differences:

1. CP I think has the more operational improvement/ earnings growth between BNI and CNR. This is becuase management can improve margins by being more effecient. CNR and BNI are effecient and there is not much room to go.

2. CP is more commodity oriented so its freight volumes will go up and down with the price of commodities and will be more economically sensitive.

3. The reason I selected BNI over a Canadian rail is weather disruption during winter that can lead to lower utilization and lower revenue. not a big factor in the grand scheme of things.

but overall I like rail as a good solid long term investment. the risks are very low of being wrong in rail.