Like many others, I printed out Warren Buffett's annual letter and read every word over the weekend. And I wasn't disappointed. His conglomerate, Berkshire Hathaway (BRK.a), continues to deliver strong returns, which came to 20% last year. Buffett also admitted some mistakes, such as the NetJets investment and had funny one-liners (especially about Wall Street bankers).

But a critically important topic was Buffett's $44 billion acquisition of Burlington Northern Santa Fe (BNSF), which is his biggest deal ever. He called it an "all-in wager on the economic future of the United States." And yes, it's a big bet for the future of Berkshire Hathaway and also shows how Buffett is starting to change his approach to mergers and acquisitions.

On Oct. 23, 2009, Buffett had a 10-minute meeting with the CEO of BNSF, Matthew Rose, and wondered if the company would be receptive to a buyout. If so, Buffett said he would be prepared to pay $100 per share. Interestingly enough, he thought a fair value for the company was in the mid-$90s and that his offer was the highest he could go.

Given Buffett's track record and reputation, such an offer is solid. While he has a folksy demeanor, he takes dealmaking absolutely seriously.

Ongoing Due Diligence

So Rose said he was interested and from there, the deal went into high gear. BNSF engaged two financial advisers: Evercore (EVR) and Goldman Sachs (GS), in which Buffett has a large equity stake. Cravath, Swaine & Moore helped draw up the legal papers, and Mayer Brown reviewed the complex regulatory issues.

Buffett didn't use an investment banker, but he did hire the law firm of Munger, Tolles & Olson. There was also little due diligence. Then again, since 2006 Buffett had been purchasing shares in BNSF.

The railroad wanted to seek out other bidders. However, this seemed fruitless. Because of the credit crunch, a private equity buyer couldn't muster the financing, and a rival railroad would probably have a hard time because of antitrust concerns. Still, BNSF tried to get a higher price. But of course, Buffett said no.

By Nov. 3, the deal was announced.

Why Buffett Bought

The Burlington deal fits some of the main M&A requirements for Buffett:
  • He believes that railroads will be around for at least another 100 years and should have long-term growth, as the American population continues to grow.
  • It would take $100 billion to buy another major railroad and many years of construction (BNSF has 30,000 miles of roadway). Besides, this is something that obviously cannot be moved to lower cost countries, like China or India.
  • BNSF has developed a highly efficient operation, which has made strides in being environmentally friendly. Last year, the company moved a ton of freight for 470 miles on only one gallon of diesel.
Yet, the BNSF deal highlights an evolution in Buffett's dealmaking strategy. First of all, he agreed to use stock for 40% of the transaction. The reasons included improved tax benefits as well as preserving liquidity (which can be vital in today's volatile world). But in his letter, Buffett admits that this increased the deal's costs because he believes Berkshire's shares are undervalued.

BNSF is also heavily capital-intensive and regulated. As a result, Buffett says returns will be reasonable and stable, not high.

Because of Berkshire's size, Buffett notes, it's really impossible to get the kinds of results that were possible decades ago. No doubt, it's nice to have $8 billion to $10 billion to invest every year. But it also means that returns will normalize. And if Buffett wants to stick to companies with long-term futures -- which seems to be the case -- it means he'll probably be looking at industries like railroads and utilities, which require large amounts of capital and are subject to the heavy hand of government regulation.

Chances are slim, however, that he'll do another deal along the lines of BNSF.


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