Monday, May 9, 2011

Buffett on Coca-Cola, See's, Railroads, & Utilities: Berkshire Shareholder Letter Highlights

"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." - Warren Buffett in the 2007 Berkshire Hathaway (BRKa) Shareholder Letter

Warren Buffett explains why a business like Coca-Cola (KO) or See's can offer effective protection against inflation in these excellent 2011 Berkshire meeting notes (by Ben Claremon).

Buffett also says that, while their capital intensive railroad and utility businesses should produce good returns over time, Coca-Cola and See's are the better businesses.

From the notes:

Question 8: Crowd - Aside from not needing to put huge amounts of capital to work, are Coke and See's still great business to own in an inflationary situation? Are they better than companies with irreplaceable hard assets and pricing power (like the railroad) in protecting against inflation?

Buffett: The first businesses are superior. If you have a great consumer product that requires very little capital to grow and support that growth--and you do more volume as inflation grows — that is a wonderful asset to protect against inflation. The ultimate example of that is your own earning ability. People who have made investments in themselves — outstanding teachers and doctors — see their wages increase with inflation. They also don't have to make an additional investment in themselves. People should think about a long term real estate asset like a farm where additional capital is not required to finance inflationary growth.

The worst businesses are the ones with huge receivables and inventories. Their volume stays flat and they have to come up with more money to finance that volume. Normally BRK does not like businesses that require a lot of capital — railroads and utilities. But, he and Charlie believe that they should be able to generate a good return in the railroad because of the value it provides to the economy. The ideal business is one like See's. See's Candy was doing $25M-$30M in revenue when they bought it and they were selling 16M* pounds of candy. Now they are doing over $300M in revenue. It took $9M of capital then and the business only needs $40M in tangible capital now. If the price of candy doubles they don't have any receivables or inventory. Fixed assets don't have to increase either.

It may not be obvious why a slow growth business like See's produces terrific returns. Just about everyday on business news and analyst reports you'll see, more often than not, the focus on future growth prospects.

Makes sense intuitively, right?

Not necessarily. That focus on growth is often misplaced.

The growth focus would make sense in a world where durable competitive advantage, pricing power, and the minimal need for incremental capital could be taken for granted in a business. For most businesses, that world doesn't exist.

Many businesses have grown much faster than See's for decades but end up lacking in some of the above qualities (or all the above qualities in the case of airlines) so investor returns ended up sub-par.

See's volumes have grown barely 2% per year since Berkshire bought it back in 1972 yet returns have been fantastic.

So if See's can achieve great returns with modest growth then the business with even higher growth and See's great characteristics must be even better, right?

In theory, if you can find a business like that...yes. In theory.

While there may be rare exceptions, in the real world, a business with See's-like economics that happens to also be growing very fast will eventually attract more competition. Having a well-executed first mover advantage matters but it's intense competition (there are some very good businesses that provoke little competition, in part, because of unexciting or modest growth characteristics) that might make what look like great economics today into not so great economics down the road.

So yes there are exceptions but they reside within the more unpredictable competitive environments (a place where more mistakes are likely to be made).

In both the 2007 Berkshire Hathaway shareholder letter and 1983 Berkshire Hathaway shareholder letter, Buffett provides an explanation of the characteristics that make See's a superior business.

For convenience, here are some previous posts (and excerpts) on See's that cover this ground.

From the 2007 Berkshire letter:

Buffett on "The Prototype Of A Dream Business"

"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."

Later Buffett continues....

"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.)"

From the 1983 Berkshire letter:

Buffett on Economic Goodwill

"...businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See's – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill."

I think See's is one of the more useful business case studies because it reveals that a business with: 1) durable competitive advantage, pricing power, and the minimal need for capital trumps growth, and 2) while the value of economic goodwill will not be found on a balance sheet it is extremely important and very real.

See's is a superior business because it is durable and, despite little in the way of growth prospects, it produces a high return on capital for the investor. The source of that high return on capital is its unique combination of qualities (durable competitive advantages, pricing power, modest needs incremental capital etc.).

Other businesses may not necessarily be the equal of See's but possess many of these same qualities (A hint: look in the cupboard).

See's as a case study seems simple and in many ways it is. I'm guessing the deceptive simplicity may make some say to themselves:

"There's got to be more to it than this."

Well, there really isn't.

The ideas just need to be internalized and applied with discipline. The bottom line: understanding See's more fully makes sense because the lessons from it are potentially lucrative for long-term investors.

Adam

Long BRKb and KO

Related previous posts:
Buffett on "The Prototype Of A Dream Business"
Buffett on Economic Goodwill

* The notes had 60M pounds as the number but the actual is 16M. More than understandable when typing that fast with no recording device. All in all, these are the best Berkshire notes I've seen.

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