Saturday, 11 October 2014

Buffett: See's Candies - A Great, Not Just a Good, Business

Buffet never forgets that growth is good, but only at a reasonable cost.

In 2007, See's Candies sold 31 million pounds of chocolate, a growth rate of only 2 percent.  What does Buffett see that other misses?

1.  He paid a sensible price for the business.
2.  The company enjoys a durable competitive advantage:  Its quality chocolate is bought by legions of loyal customers.
3.  It is a business he understands.
4.  It has great managers.

But See's Candies possesses one more attraction.  It throws off cash and requires very little capital to grow. 

Here is Buffett explaining See's value proposition in his 2007 shareholder letter:

" We bought See's [in 1972] 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 totalled $1.35 billion.  all of that, except for the $32 million, has been sent to Berkshire."

Buffett uses See's cash 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.) .. There's no rule that you have to invest money where you've earned it.  Indeed, it's often a mistake to do so:  Truly great businesses, earning huge returns on tangible assets, can't for any extended period reinvest a large portion of their earnings internally at high rates of return."

But a company like slow-growing See's is rare in corporate America.  In order to grow earnings like See's, CEOs in other businesses typically would need "to invest $400 million, not the $32 million" that See's required.  Why is this true?  Because most growing businesses "have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments."  Not so at See's.

Buffett opines that the great business, like See's, is like a savings account that "pays an extraordinarily high interest rate that will rise as the years pass." 

See's is not just the candy.  To Buffett, the company is a chocolate-powered cash machine.

Additional notes:  Great, Good and Gruesome Businesses of Buffett

Capital Allocation and Savings Accounts

Buffett compares his three different types of great, good and gruesome businesses to "savings accounts." 

The great business is like an account that pays an extraordinarily high interest rate that will rise as the years pass.

A good one pays an attractive rate of interest that will be earned also on deposits that are added.

The gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

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