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.

Investing heavily in your best ideas

While this may be a scary choice to make – concentrating your investments in a few stocks – that is what the young Buffett was doing in 1960s.

Sanborn, for instance, formed about 35% of Buffett’s portfolio in 1960. Plus it was a small company with an illiquid stock (just 105,000 shares outstanding).

Despite these attributes that can scare any investor, Buffett saw a great opportunity and invested heavily in Sanborn. He later did the same thing with See’s Candy in the 1970s.

Let’s me be clear here. I am not suggesting that you put 30-40% of your money in any one stock or investment. However, if you really believe in an idea, you may be willing to take it to around 10-15% of your portfolio.

Too many people over-diversify – allocating the same amount of money to their best ideas as to their worst ones. But then, as they say, “Concentrate to grow your wealth and diversify to preserve it.

So while you may buy a number of stocks for your portfolio, it pays in the long run to put most of your money in your best ideas.

http://www.safalniveshak.com/wit-wisdom-warren-part4/

Buffett’s Watershed Investment - From Graham to Fisher: See’s Candies:

• Buffett was initially "not sold" on purchasing See's Candies when presented with the opportunity in 1971.
• See's Candies was offered for $30 million and it was hardly a Graham style investment. See's had only $5 million in tangible asset value at the time.
• Berkshire shareholders can probably credit Charlie Munger, Berkshire's Vice Chairman, for convincing Buffett to make this investment.
• Buffett eventually agreed to a $25 million purchase of See's and based the logic of the purchase on See's earnings power and brand equity.
• The valuation paid was approximately 11.4 times trailing earnings.
• Buffett believed that See's had significant additional pricing power that was not being leveraged and could sell for premium prices compared to other candies.

This was what Buffett had to say about See’s Candies in his 2007 annual letter to shareholders:

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.

Lessons learned:

1.  Clearly See’s Candies is a business that is today worth many times the amount paid to acquire the company in 1971.
2.  It is not a business that requires a high level of invested capital.  
3.  The value of See’s is the earnings power of the business.
4.  That earnings power of See does not come from tangible equity.  It comes from intangible assets, and specifically from the brand equity of the business.



Comparing Benjamin Graham and Philip Fisher's Techniques

Practical Application of Fisher’s Techniques
What can value investors take away from Philip Fisher’s book and from Warren Buffett’s application of these concepts?  

The evidence is overwhelming that buying a business like See’s is far more attractive than buying “cigar butt” investments that are quantitatively cheap but either dying or offering average prospects for the future.  

However, the big caveat is that any investor seeking the higher payoffs accruing to intangible assets like brand power must be very sure in his analysis to avoid buying into the sort of promotional stocks that Fisher warned us to avoid. 

In short, knowing your “circle of competence” is critical to avoid paying up for illusory growth and taking the risk of permanent loss of capital. 

Losing capital permanently is much less likely with Graham’s quantitative approach, but that approach also entails higher turnover and lower potential returns compared to a successful application of Fisher’s techniques.


Read:
Roger Lowenstein’s excellent 1995 biography of Warren Buffett, The Making of an American Capitalist, the purchase of See’s in 1971.
Alice Schroeder’s recent Buffett biography, The Snowball,

See's Candies for sale

One day, Buffett got a call from Bill Ramsey, Blue Chip's president, saying that a local Los Angeles company, See's Candies, was for sale.

"See's has a name that nobody can get near in California," Munger told Buffett. "We can get it at a reasonable price. It's impossible to compete with that brand without spending all kinds of money." Ed Anderson thought it was expensive, but Munger was overflowing with enthusiasm. He and Buffett went through the plant, and Munger said, "What a fantastic business. And the manager, Chuck Huggins - boy, is he smart, and we can keep him on!"

See's had a tentative deal on the table already and wanted $30 million for assets worth $5 million. The difference was See's brand, reputation, and trademarks - and most of all, its customer goodwill.

Buffett and Charlie Munger decided that See's was like a bond - worth paying $25 million for. If the company had paid out its earnings as "interest," the interest would average about 9%. That was not enough - owning a business was riskier than owning a bond, and the "interest rate" was not guaranteed. But the earnings were growing, on average 12% a year. So See's was like a bond whose interest payments grew. Furthermore:

"We thought it had uncapped pricing power. See's was selling candy for about the price of Russell Stover at the time, and the big question in my mind was, if you got another 15c a pound, that was 2.5 million dollars on top of 4 million dollars of earnings. So you really were buying something that perhaps would earn 6.5 or 7 million dollars at the time, if just priced a little more aggressively."

At the price offered, $25 million, the $4 million it was earnings pretax would give Buffett and Munger payback of 9% after-tax on their investment from the first day they bought it - not factoring in future growth. Adding in the $2 to $3 million of price increases they thought See's could institute, the return on their capital would rise to 14%: a decent level of profitability on an investment, although it wasn't a sure thing. The key was whether the earnings would continue to grow. Buffett and Munger came close to walking. The pickings had been so easy until now, and they had such an ingrained habit of underbidding, that it was like swallowing live guppies for them to pay the asking price.

"You guys are crazy." Munger's employee Ira Marshall said, "There are some things you should pay up for - human quality, business quality, and so forth. You're underestimating quality."

"Warren and I listened to the criticism," says Munger. "We changed our mind. In the end, they came to the exact dollar limit of what we were willing to pay."



Price paid: $25 million
Earnings: $4 million pre-tax
Initial return: 9% after tax
Earnings growth rate: 12% per year

If earnings increased to: $6 - $7 million
Return on their capital: 14%


Ref: Page 345 The Snowball, Warren Buffett and the Business of Life, by Alice Schroeder