Monday, May 30, 2011

Buffett: What See's Taught Us - Berkshire Shareholder Letter Highlights

In his 1991 shareholder letter, Warren Buffett noted that Berkshire Hathaway (BRKa) had just passed a milestone.

The milestone?

Twenty years earlier, on January 3, 1972, they had purchased control of See's Candy. Why is that a milestone worth noting?

Well, because that business happens to have played a role in the evolution of their thinking on what actually makes a quality business franchise.

How did the experience of owning what seems to be a simple candy business influence the thinking of two great investors?

From the 1991 letter:

Appreciating the Economic Value of a Franchise
"The nominal price that the sellers were asking [for See's] - calculated on the 100% ownership we ultimately attained - was $40 million. But the company had $10 million of excess cash, and therefore the true offering price was $30 million. Charlie [Munger] and I, not yet fully appreciative of the value of an economic franchise, looked at the company's mere $7 million of tangible net worth and said $25 million was as high as we would go (and we meant it). Fortunately, the sellers accepted our offer."

Profits Grew Substantially from 1972-91 (volume did not)
"...See's candy sales...increased from $29 million to $196 million. Moreover, profits at See's grew even faster than sales, from $4.2 million pre-tax in 1972 to $42.4 million last year."

Minimal Incremental Capital Required
"For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce it. On this score, See's has been astounding: The company now operates comfortably with only $25 million of net worth, which means that our beginning base of $7 million has had to be supplemented by only $18 million of reinvested earnings. Meanwhile, See's remaining pre-tax profits of $410 million were distributed to Blue Chip/Berkshire during the 20 years for these companies to deploy (after payment of taxes) in whatever way made most sense."

Untapped Pricing Power
"In our See's purchase, Charlie and I had one important insight: We saw that the business had untapped pricing power. Otherwise, we were lucky twice over. First, the transaction was not derailed by our dumb insistence on a $25 million price. Second, we found Chuck Huggins, then See's executive vice-president, whom we instantly put in charge."

Weak Volume Does Not Translate into Weak Profits
"In 1991, See's sales volume, measured in dollars, matched that of 1990. In pounds, however, volume was down 4%. All of that slippage took place in the last two months of the year, a period that normally produces more than 80% of annual profits. Despite the weakness in sales, profits last year grew 7%, and our pre-tax profit margin was a record 21.6%."

Record Profits Despite Recession & New Sales Tax
"Almost 80% of See's sales come from California and our business clearly was hurt by the recession, which hit the state with particular force late in the year. Another negative, however, was the mid-year initiation in California of a sales tax of 7%-8% (depending on the county involved) on 'snack food' that was deemed applicable to our candy.

Shareholders who are students of epistemological shadings will enjoy California's classifications of 'snack' and 'non-snack' foods:

Taxable 'Snack' Foods
Ritz Crackers
Popped Popcorn
Granola Bars
Slice of Pie (Wrapped)
Milky Way Candy Bar

Non-Taxable 'Non-Snack' Foods
Soda Crackers
Unpopped Popcorn
Granola Cereal
Whole Pie
Milky Way Ice Cream Bar

What - you are sure to ask - is the tax status of a melted Milky Way ice cream bar? In that androgynous form, does it more resemble an ice cream bar or a candy bar that has been left in the sun? It's no wonder that Brad Sherman, Chairman of California's State Board of Equalization, who opposed the snack food bill but must now administer it, has said: 'I came to this job as a specialist in tax law. Now I find my constituents should have elected Julia Child.'"

Lessons Learned from See's
"Charlie and I have many reasons to be thankful for our association with Chuck and See's. The obvious ones are that we've earned exceptional returns and had a good time in the process. Equally important, ownership of See's has taught us much about the evaluation of franchises. We've made significant money in certain common stocks because of the lessons we learned at See's."

Buffett added this at the 2003 Berkshire meeting:

"Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News."

More recently, in Buffett's 2007 Berkshire letter, he mentioned that sales volume growth since 1972 at See's has been relatively modest. In fact, it grew volumes only 2% annually over that time frame. Despite this meager growth See's earned nearly $82 million in 2007 compared to less than $ 5 million back in 1972.

Nearly all of those earnings were available to invest in high return opportunities of Buffett's choosing since See's has little need for incremental capital. From the 2007 letter:

"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."

So a business with pricing power that doesn't need much capital to maintain competitiveness makes for a terrific franchise even if it has relatively modest physical growth prospects.

Adam

Long BRKb

Related previous posts:
Buffett on Coca-Cola, See's & Railroads
Buffett on "The Prototype Of A Dream Business"
Buffett on Economic Goodwill
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