Monday, March 3, 2008
The passage below from Mr. Buffett's 2007 Letter to Berkshire Hathaway shareholders is particularly interesting:
Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.
At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)
Re: "2% growth rate in volumes"
- Yet, the growth in revenues is materially above 2% per annum:
- Sales growth comes from raising prices every Valentine's Day with minimal increase in invested capital, suggesting extraordinarily high return on incremental capital - that are (a) sustainable, and (b) scalable to even greater levels.
- Roughly 60% pretax return on capital, circa 1972
- Roughly 200% pretax return on capital, circa 2007
- Incremental revenues are largely free cash flows.
How did Mr. Buffett manage to turn a $25 million investment in 1972 into a machine that's generated $1.35 billion of free cash flows?
California Joe just won't tell California Jane on February 14:
- Honey, I love you so much this year that, for the first time, I bought the cheaper chocolate bar, and the dollar I saved shows my true love for you. Happy Valentine's Day!
A far better approach is:
- Honey, I hope you don't mind that I spent an extra dollar this year; this is a reminder of our first date and your love is priceless. Happy Valentine's Day!
See's Candy is effectively a (rising) royalty on love men pay, annually, in the state of California.
Ultimately, per Mr. Buffett:
There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
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Recommended Amazon Reading
See's Famous Old Time Candies: A Sweet Story by Margaret Moos Pick
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Kindle 2: Amazon's New Wireless Reading Device (Latest Generation)