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Bruce Greenwald on Positioning First Eagle?s Funds

November 17, 2009

by Robert Huebscher

There must be some risks in these stocks.

The thing that makes us most nervous is that these incredible franchise stocks are available at prices that seem to be very attractive based on conservative assumptions.  I think it’s because there is this phenomenon that when people want absolute certainty, a little bit of risk scares them and they won’t look at it. 

How do you get people to accept bizarre choices?  You say here you can get “x” for free, or you can have “x” plus “n” with one chance in a thousand of an outcome of minus a hundred.  People will choose “x” for free all the time.  I believe that’s what’s going on, and why we worry about these franchise businesses.

American Express has a huge ability to manage costs, which is the cost cutting I mentioned earlier.  They’ve done a lot of it, and have basically gotten rid of $2 billion of costs, but they may spend about $800 million of that back, which is a crime. You’ve got tremendous cost control on the downside and perfect inflation protection, because they just collect a fraction of the billings.  Yet it was selling at a ridiculous price and is still selling at a slightly ridiculous price. 

I know you own Berkshire Hathaway, so I have to ask you what you think about Buffett’s purchase of Burlington Northern.

It’s a crazy deal.  It’s an insane deal.  We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did.  You don’t have a high earnings return.  They are paying 18 times earnings, but it’s really much worse than that.  They report maintenance cap-ex very carefully.  They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex.  So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too.  Their profitability is much lower than it looks. 

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times.  Our calculation is he was paying 21-times. 

Secondly, there are two kinds of assets.  There are the rights-of-way, which you can’t get rid of.  So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way.  If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value.  We didn’t see a lot franchise value or hidden asset value. 

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up.  There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad.  If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive. 

There is nothing special about the railroads.  It’s entirely an energy play. 

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that.  So you don’t have a good aggressive management over these five years producing outsized returns. 

We looked back at when they did the merger with Santa Fe, because then they did increase margins.  But they got bored with it, and margins started to come down.  The same thing happened recently.  We don’t see a lot of hidden profitability in the culture of the company. 

It looked to us like an oil play.  He has a history of making bad oil play decisions.  And that was at $75/share, we thought there were better oil plays.  At $100/share we think he has lost his mind. 

You’ve co-authored a book on the media industry [see link at the beginning of this article], which challenges a lot of conventional wisdom about some of the problems that have plagued that industry.  Have your views on this industry led to any investments?

When you look at the media business, there are three parts to it.  There are the content providers (who never made any money), which are the production houses in the movies and the imprints in the record houses.  There are no barriers to entry there.  If you look at the last 20 years, everything went right for the movies.  First they got VCRs, then cable, then DVDs, then good foreign distribution.  Revenues grew by about 8.5%.  Costs per movie grew by about 9.8% and the number of movies grew by 1.2% annually.  There are going to be good years and bad years.  So, when everyone says content is king, remember that content production is not king.

The second part of the business is the aggregators.  The movie companies and the record companies used to do the aggregating.  For example, the record companies pressed the records and shipped them to the stores in bulk.  What kept their advantage, and why there were four majors, was because it’s expensive to do that.  It’s hard for an entrant to do that.  That went away with electronic distribution.  

Once you can do that electronically, that advantage is gone, and they got killed.  If you think about the aggregation of newspapers, the same thing happened.  They had to put the news together, print it, and so on.   Electronic news distribution destroyed their business model.

The aggregation profits now are in the cable networks.  To do a cable network, you need a full slate of programming.  If you dominate a specialty niche, like Discovery does, it’s hard for others to pay for that programming.  If you have the best distribution for that kind of programming, you get the best prices and all the advantages of economies of scale. 

But if that model evolves to where you have all the content on a web site, such as the Discovery Channel web site, everyone just picks and chooses, and all of a sudden that barrier to entry is way down   We’re very leery of these businesses.  We want high returns – much higher than the NBC-Universal deal – on the aggregators, because the history has been that the aggregators can go away, just as continuous content has gone away.  It used to be that nightly news or the soaps were a big thing that you had to do every day, and they were hard to produce.  Now people can make one-off soaps.