Warren Buffett writes about what he describes as "the prototype of a dream business" in the 2007 Berkshire Hathaway (BRKa) Shareholder Letter:
"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."
So, beyond See's, there just isn't much profitability to be had in the boxed-chocolates industry.
As far as volume growth goes:
- From 1972 to 2007, the growth rate of See's was roughly 2% in terms of volume.
- 16 million pounds of chocolate was being sold each year when Berkshire bought See's in 1972.
- At that 2% growth rate, volume had increased to roughly twice that amount when he wrote the 2007 letter.
So why exactly is this a "dream business?"
During this feature last year on See's, Charlie Munger highlighted the following about the reasons for their business success in an industry that actually hasn't done all that well overall.
Warren and Charlie and the Chocolate Factory
Charlie Munger said:
- They've made lots of correct decisions before and after Berkshire's purchase
- They've worked hard to avoid cannibalization of its stores
- They've got a cautious nature that led to long-term success
Their cautious nature, in part, means they didn't chase low return growth for its own sake. Munger also points out that "We haven't basically touched it at all" and highlighted the importance of See's as a gift:
"Who wants to give a gift that announces 'I'm a cheap ... ' You know."
In the same article, Warren Buffett said this:
"It was sort of the first non-insurance company we bought, or non-financial type company, and so I used to spend a lot of time. I used to be able to tell you which store numbers were which stores. But that's because we didn't have any other companies. Now we have 70-something companies."
Buffett later also said this about See's:
"We almost missed it. Charlie wouldn't have missed it. I would have missed it, and I would have never known what I missed."
Still, this doesn't really quite explain what makes See's such a great business.
Well, it's basically a great business because of durable competitive advantages that were built up over time.
Put simply, it's a great regional brand with "share of mind" developed over many years, primarily in California, that provides the pricing power. It's the fact that the business can at least maintain its competitive advantages with rather modest incremental capital requirements.
Back in 1998, Warren Buffett said the following about See's Candy at the University of Florida:
Buffett at Univerisity of Florida 1998
"We bought See's Candy in 1972, See's Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pre-tax or about 10x after-tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.
What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See's Candy and overwhelmingly it was favorable."
Buffett later added...
"I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas."
The fact is, most don't buy boxed chocolate for themselves, they buy them as gifts. Christmas is the biggest season of the year -- more than 90% of the earnings from the business back in 1998 comes from the three weeks prior to Christmas -- while Valentine's Day is the single biggest day:
"Guilt, guilt, guilt—guys are veering off the highway right and left. They won't dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine's Day is the biggest day.
Can you imagine going home on Valentine's Day—our See's Candy is now $11 a pound thanks to my brilliance. And let's say there is candy available at $6 a pound. Do you really want to walk in on Valentine's Day and hand—she has all these positive images of See's Candy over the years—and say, 'Honey, this year I took the low bid.' And hand her a box of candy. It just isn't going to work. So in a sense, there is untapped pricing power—it is not price dependent."
It takes some discipline to run a business where basically everything it earns happens around two holidays.
When Berkshire bought See's back in 1972, the capital required was around $ 8 million. The return on that invested capital was already very attractive (roughly 50-60% pre-tax) when they bought the business, but it has only become more so over time as they've raised prices. More from the 2007 Berkshire letter:
"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.)"
All that from a business that has grown volumes just 2% annually. The key thing to consider is that if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.*
In fact, the added unit volume might also require more capital to be employed.
Either way, it should mean less return on capital compared to just increasing the price of a powerful brand.
Of course, a good business might offer both opportunities to pursue high return increased pricing as well as high return incremental volume. It's just that sometimes an easier way to generate returns exists (via an increase to price), but the harder thing to do (increases to sales sometimes at reduced prices) is pursued with the justification being to grab market share or something similar.
I'm not saying it's not that it never makes sense to grab market share. I'm suggesting that, from an owner's point of view, it probably is at least worth being a little skeptical when you see this being pursued as a prolonged strategy.
(This, of course, necessarily comes down to the specifics of the competitive landscape, technology shifts, unique advantages and disadvantages of each individual business, etc.)
I'm also not saying that sometimes it makes sense to invest in a big opportunity now with a bigger payoff in mind much further down the road. It's worth mentioning that some of the best businesses can afford to forgo near-term profitability -- sometimes even for an extended period of time -- while they build out a great franchise (developing brand and distribution in a new region, for example) for the long-term.
Tom Russo: First Mover Advantage and the "Capacity to Suffer"
The best also have the financial wherewithal and competitive strength to invest in such things.
More on See's in a follow up.
Aesop's Investment Axiom - February 2013
Grantham: Investing in a Low-Growth World - February 2013
Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - February 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
Pricing Power - July 2009
The Growth Myth - June 2009
Buffett on Economic Goodwill - April 2009
Long position in BRKb established at much lower than recent prices
* Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
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