Warren Buffett's Ride on the Rails Is Paying Off

A little more than a year ago, Berkshire Hathaway (BRK.A) Chairman Warren E. Buffett made his famous "all-in wager" on the economic future of the U.S. Berkshire spent $26.5 billion to buy the 77 percent of Burlington Northern Santa Fe railroad the company didn't already own, essentially taking it private. It seemed a daring bet at the time, considering that the U.S. had fallen into a deep recession that had crushed consumer spending and created the highest unemployment in a quarter century.

Yet in only 15 months the Burlington investment has played out better than even Buffett says he expected. The recovery from the recession, which ended in late 2009, continues to strengthen, unemployment has dipped, and even the unforeseen jump in oil prices has worked to railroads' advantage. All that's buoyed Buffett's financial return: In the first 13 months since the buyout, Burlington paid out $2.25 billion in dividends to its new parent, Berkshire, and will fork over another $1 billion this month. "It's worked out really well, and I'm surprised at how fast," says Bruce Allen, president of Bruce G. Allen Investments in Denver.

Burlington Chief Executive Officer Matthew K. Rose is determined to take advantage of the industry's improved climate and the flexibility he gets by having only one shareholder—Buffett. This year, Rose is boosting capital spending by 31 percent, triple the increase of other major rails. He's buying about 200 locomotives and building more huge transfer facilities where rail freight containers are switched to and from trucks before and after their transport by train. Rose's goal: to bolster the second-largest U.S. railroad's competitiveness relative to long-haul truckers.

Rose estimates companies spend $10 billion in the western U.S. to truck freight that could move less expensively by rail. That gap only widens with higher pump prices—up 31 percent in the past year—since locomotives are more fuel-efficient. "Maybe a big consumer goods company ships 25 percent intermodally [utilizing both rail and trucks on a single trip] today," Rose says. "Can we convince them to go 35 percent because of higher fuel prices or driver issues? Those opportunities are everywhere."

About $500 billion is spent each year to haul U.S. freight by rail or highway. More than half—$300 billion—is spent on shipments between cities. Rails today get only about 13 percent of that business, Rose says.

To expand rail's share, he pitches trains' greater fuel efficiency—railroads can carry a ton of freight two to four times as efficiently as trucks—and improved reliability, in part owing to heavy capital spending in recent years. A shortage of drivers and rising emissions standards are also eroding truckers' advantages, as is growing congestion on roads. "People need to know that the trains are going to run on time," says Chris Ferrell, a logistics consultant with Tompkins Associates. "They don't mind that you're a day and a half slower, they just want to make sure that you're a day and a half slower every time."

So far, Rose has received the hands-off management that Berkshire companies typically enjoy. Explains Buffett: "Every morning he can wake up and spend all day on Burlington and do whatever makes sense."

Lately, that's meant expanding the intermodal business, part of the consumer-products unit that generated 31 percent of Burlington's $16.9 billion in 2010 sales. Intermodal took off in the 1970s as manufacturers expanded the geographic breadth of their supply chains to lower costs. Burlington now has 32 intermodal freight hubs in places such as Haslet, Tex., and Memphis.

At the Haslet facility, three workers at computer terminals in a control tower coordinate the arrivals and departures of 17 trains in and out each day. A crane, guided by a worker on the ground and controlled by one in the cab, takes about 45 seconds to pluck a 6,500-pound container off the train and place it gently onto a truck. Workers can unload a 100-plus-car train in an hour and 45 minutes. From there, truckers haul the goods the final leg to a customer's store or distribution center.

Railroads still battle perceptions of delayed departures and cable-guy punctuality, explains RBC Capital Markets analyst Walter Spracklin. "Railroads are not known for service, trucking companies are," he says. "They're actually asking the customer to do a little bit of a leap of faith." That's why Rose in the past year doubled, to 12, Burlington's national sales team, which pitches the benefits of intermodal freight to customers such as Best Buy (BBY) and Home Depot (HD).

Rail's sweet spot is for hauls longer than 750 miles. It would be $1,002 cheaper to transport a freight container by rail the 2,020 miles from Los Angeles to Chicago, with half the carbon emissions, says Burlington. Landing a sale can take two years, says Chief Marketing Officer John P. Lanigan Jr. "In some cases, you're overcoming long-held beliefs that may have been grounded in fact two decades ago but are no longer," he says.

One recent win was FedEx (FDX), which, after years of being courted, in February started using Burlington for freight hauls of more than 500 miles in the western U.S., Lanigan says. "We were relentless over time," he says. "Finally, at some point, it just makes sense for them." FedEx declined to comment.

Ferrell says shippers don't make such changes quickly or lightly. "Once they're convinced service levels will not suffer, then it's Finance 101: Am I going to be decreasing my costs? If the answer is lower, you do it." Rose—and Buffett—certainly hope so.

The bottom line: During the recession, Warren Buffett bet more than $26 billion on a revival in railroads. A year later, business is gathering momentum.