Guest Columns

See’s Candies was a fantastic business. Buffett and Munger couldn’t have asked for much better. With Chuck Huggins, the See’s brand name, and the superior economics of the candy industry, they got the whole package for $25 million. But ultimately, the success of any investment comes down to the price paid relative to the value received. Was paying 12.5 times after-tax earnings justifiable?

In hindsight, the investment turned out to be more than acceptable. Assuming See’s Candy could have been sold in 1999 for the same 12.5x multiple, and factoring in the approximate cash that it distributed over the years, Berkshire Hathaway’s internal rate of return would be just under 35% (pre-tax). This is for a period of 28 years during which the S&P 500 returned 14% annually including dividends.

One can learn only so much by assessing investments through the rearview mirror. Nassim Nicholas Taleb, author of “The Black Swan,” says it best: “History seems clearer and more organized in history books than in empirical reality.” To attempt to avoid this retrospective distortion, I find it best to examine investments within the context of when they were purchased. In this situation, the evolution of Buffett and Munger’s investment methods played a key role in their decision to purchase See’s Candies.

The Goodwill

When Warren Buffett began his investing career, he paid little attention to qualitative factors in investment decisions. Buying tangible assets for much less than they were worth was his bread and butter. Benjamin Graham, Buffett’s mentor, played a large role in these views. Graham taught that investments should be made only when the business can be purchased at a large discount to its tangible value (hard assets like cash, inventory and property).

Toward the later years of the Buffett Partnership, Buffett began to move away from buying companies solely on a quantitative basis. In 1968, he wrote to his partners, “When I am dealing with people I like, in businesses I find stimulating (what business isn’t?), and achieving worthwhile overall returns on capital employed (say, 10-12%), it seems foolish to rush from situation to situation to earn a few more percentage points.” This transition was brought about by a combination of Buffett’s experience in dealing with struggling businesses, and the growth in his base of capital to invest. Other influences on this change of style were Philip Fisher, author of “Common Stocks and Uncommon Profits,” and Buffett’s partner, Charlie Munger. Munger has cited See’s role in the evolution of Buffett's investment thinking:

See’s Candy was acquired at a premium over book [value] and it worked. Hochschild, Kohn, the department store chain, was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses.

Munger’s point was that it’s much easier to buy a good business and watch it grow, than to buy a deeply discounted but struggling business and spend time, energy, and more money setting it straight. When estimating the intrinsic value of a business, there are two categories of assets that must be valued: physical/tangible assets, and intangibles like economic Goodwill. Valuing the latter is the tricky part, and isn’t just a matter of checking the balance of “Goodwill” on the balance sheet. Buffett discussed the nature of economic Goodwill, using the See’s purchase as an example, in the 1983 Berkshire Hathaway Annual Report:

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.

When a company earns a market rate of return (or “cost of capital” in finance textbooks) on its invested capital, it should be worth the market value of its net tangible assets—no more, no less. But when a business like See’s Candy can sustain high returns on capital, it should be valued much higher than its tangible net-worth (depending on the extent of the excess returns). The difference between this tangible book value and true intrinsic value is what Buffett calls economic Goodwill. If it were recorded as an asset on the balance sheet, it would represent intangibles like See’s brand name, its “mind share” among customers, and other aspects of See’s competitive advantages (detailed in Part I). Unlike property and equipment, this asset requires little in the way of maintenance expenditures—as long as See’s keeps doing what they’re doing, economic Goodwill won’t degrade with time. With minimal reinvestment, this Goodwill should continue to produce excess profits well into the future.

Although never putting this concept fully into practice, Benjamin Graham was no stranger to economic Goodwill. In his book “Security Analysis,” Graham writes:

It may be pointed out that under modern conditions the so-called “intangibles,” e.g. goodwill or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore grow more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales. [My emphasis]

The Growth

At the time of purchase in 1972, See’s Candy had $8 million in net tangible assets and after-tax earnings of $2 million, giving it a return on invested capital of 25%. To justify the $25 million price tag, See’s would have to not only sustain their excellent performance, but grow the business and generate sufficient free cash flows to fund future growth. Regarding the second criteria, See’s passed with flying colors. Growth in earnings was another issue, but let’s first examine the benefits of a high return on capital business.

Compared to a company that has a low or average return on its assets, See’s has the ability to grow sales with little need for additional capital. Even without growth, physical assets of any business will need to be replaced over time whether motivated by competition or continuous inflation. Sales growth through any method will eventually require a subsequent increase in working capital. And when this time comes, See’s will have to put only a small portion of its earnings back into the business—which yields greater free cash flow and hence more value to owners. At this point, the astute reader may ask: why not reinvest all the profits, and grow at a much faster rate than those with lower returns? Depending on the business, this is usually the preferable option. But at See’s, growth is more difficult (more below) and would come at the cost of sacrificing profit.

Buffett has commented that they’ve tried many times to put more money into See’s—but to no avail. Return on invested capital may continue to improve, but return on incremental capital invested is what matters most for a growing business. And with Warren Buffett allocating capital, current profitability won’t be sacrificed for diminishing rates of return. In the 1991 Berkshire Annual Report, Buffett talked about See’s and the allocation of its free cash flow:

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.

As mentioned in Part I, over a period of 27 years after the acquisition, See’s had an average of three net store openings a year (since then almost a fifth of total stores have been closed). This may sound like sufficient enough growth, but compare this to modern-day examples like Starbucks—which last year alone opened 2,199 stores. One cause of this discrepancy is the growth rate of each industry—unlike See’s, Starbucks practically created the market for their product and they continue to grow into it. (The market for premium chocolates is expected to reach $1.8 billion in 2008) The slow growth rate frustrated Buffett at times as he remarked that they “…regard the most important measure of retail trends to be units sold per store rather than dollar volume.” Despite this volume problem, See’s was able to grow earnings in other ways: the most important of them being the ability for the “dollar volume” to rise whilst the unit volume remained steady.

The most basic determinates of revenue are price and volume. To grow sales and consequently earnings, you’ll have to either raise prices, or sell more products. Early on Buffett realized that See’s was well suited to grow through the former method. “In our See’s purchase,” he commented in the 1991 Annual Report, “Charlie and I had one important insight: We saw that the business had untapped pricing power.” Customers aren’t shopping at See’s because of its low prices. As long as quality is uncompromised, paying a dollar more than you did last Valentine’s Day isn’t a problem. If costs of ingredients go up, prices go up. Inflation? Not a problem at See’s. This ability to continually raise prices without interruption in unit sales is a tremendous advantage over products in other industries. Over the years, these price increases have supplied a majority of the close to 9% compounded growth in earnings—despite the second-rate growth in store base and unit volume.

Advertising is another way to maintain and grow a business’s Goodwill. One advantage that See’s and other candy companies have is they can distribute marketing costs over a shorter amount of time. Instead of selling ads throughout the year, the holiday season is all that’s necessary. Over half of annual chocolate sales are made between Thanksgiving and New Year’s Eve. The month of December alone accounts for about 90% of annual profits. During Christmas and Easter, the See’s factory in San Francisco gets several tanker trucks full of melted chocolate on a daily basis (See’s was the first candy company to come up with this method of delivery).

See’s Candy was the ultimate example of paying a fair price for a quality business (it’s when people are willing to pay any price for a quality business that they get into trouble). The qualitative factors are many, but the combination of high returns on capital and steady growth through price increases played a key role in the success of the investment. So the next time you’re given the opportunity to invest in a business of similar quality to See’s—at a price of only twelve-and-a-half times earnings—don’t hesitate to back up the truck.

(Part I of this article was posted yesterday)

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Resources

Buffett: The Making of an American Capitalist

Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

The Warren Buffett CEO: Secrets From the Berkshire Hathaway Managers

See's Famous Old Time Candies: A Sweet Story

Good to Great: Why Some Companies Make the Leap... and Others Don't

The Essays of Warren Buffett : Lessons for Corporate America

Related Reading

Warren Buffett and the Washington Post

Posted by Geoff Gannon at 01:17 PM | Permalink | Comments (0) | TrackBacks (0)

By Max Olson

(This article is Part I of Max Olson's two-part series on Warren Buffett and his investment in See's Candy. Part II will appear tomorrow; it will further explore the quantitative aspects of Buffett's investment in See's Candy.)

William Ramsey, an executive at Blue Chip Stamps, stood in the office of Robert Flaherty as they both awaited a call. Moments earlier, Flaherty had attempted to persuade Warren Buffett, majority owner of Blue Chip Stamps, to consider purchasing See’s Candy, a popular West Coast candy maker. Buffett turned them down—up until then, he was used to buying boring businesses on the cheap: banks, textile mills and insurance companies. Ramsey however, thought See’s was a great buy, and desperately tried to get Buffett back on the phone. Their secretary finally got hold of Buffett at his home in Omaha. He had reviewed the numbers, and liked what he saw.

After consulting with his friend and business partner, Charlie Munger, Buffett was ready to make an offer. This would be Buffet’s biggest investment to date, and he wasn’t one to overpay for anything—the deal almost fell through during negotiations, but the sellers finally accepted Buffett's offer.

The final price was $35 per share. With one million shares outstanding and $10 million in cash on the books, the net purchase price was $25 million. Blue Chip Stamps now owned 67.3% of See’s Candy Shops, with the remainder purchased from about 2,200 public holders in the months after.

But one thing remained unfinished: who would run the company? Buffett made it clear upfront that he wouldn’t be calling the shots at See’s. At the suggestion of the previous owner, Buffett, Munger, and a friend named Rick Guerin met with Charlie Huggins—executive vice president and twenty-year veteran of See’s. After three hours of discussion, Buffett knew that Huggins was the man for the job.

The History

The first See’s Candy shop was opened in Pasadena, California in 1921 by Charles See and his mother, Mary See. Each made their own contributions: Mrs. See used the recipes she had created over the past 50 years of candy making; Charles had studied the methods of a successful chain of candy shops in their native Canada.

Many customers remember the stores for their signature black and white motif that started at this first store and was designed to resemble Mary See’s home kitchen. Under the leadership of Charles See, the company steadily grew throughout California. They successfully navigated the business through the Great Depression and World War II, when sugar was severely rationed and customers lined up around the block to buy See’s limited supply of chocolates. By the time Charles died in 1949, the company had 78 stores and two manufacturing plants: the original plant in Los Angeles and a second one in San Francisco.

Over the next two decades, See’s Candy was run by Charles’ two sons, Laurance and Harry See. The brothers See expanded the shops into neighboring states and grew the number of locations to over 150 by the end of the 60’s. Two years after the death of Laurance See, his younger brother Harry no longer wanted to run the business and decided to pursue other interests (he owned a vineyard in Napa Valley). After more than a half century of family ownership, See’s was put up for sale. One of the several interested parties was Robert Flaherty, investment advisor to Blue Chip Stamps.

The sale was finalized in 1972, and See’s Candy was now a subsidiary of Blue Chip Stamps. Not long after, Blue Chip would be folded into Berkshire Hathaway (BRK.B) and See’s would become one of the earliest members of Warren Buffett’s cash generating conglomerate.

At first, employees and customers were worried that the new owners would change See’s for the worst. When the purchase was publicized in the local papers, everyone knew who the buyer was, and people didn’t have a lot of respect for them (Blue Chip had recently been through an antitrust case). Charlie Huggins was in charge of the transition, and recalled that he spent a lot of time “… dealing with customers who were concerned, mad that the family had sold and now [they were] in the hands of a company that would ruin See’s.” Angry patrons would send hate mail—claiming the candy was bad, and See’s had somehow changed it. It took Huggins almost two years to convince loyal customers and employees that nothing had changed, and that product quality and customer service would be better than ever.

In the first year of operation under new ownership, See’s sold about seventeen million pounds of candy for just over $31 million. This number continued to grow steadily under the shrewd management of Charlie Huggins. Fourteen years after his promotion, Huggins remained modest. “Our candy is a third of the price of say, Godiva chocolates,” he told a local paper. “They do a wonderful packaging job, though. Consumers seem to think that if the box is beautiful, the candy inside must be just as good. But quality wise, we feel that we’re at least their equal.”

At the close of the twentieth century, See's Candies had expanded to over 250 black-and-white shops across the United States, a majority of which were located in California. Since the acquisition, this growth represented an average of over three successful store openings a year. Customers purchased 33 million pounds of candy annually, giving See's earnings of $73 million on $306 million in sales (to put those numbers in perspective consider that, at the time, 33 million pounds of candy equated to almost one-pound of candy per California resident).

The Manager

Charles N. Huggins regularly made inspections of See’s factories—calling workers by their first names and taste testing chocolates, carefully “measuring” their quality and consistency. Naturally, See’s encourages all employees to eat as much candy as they like. It is Huggins’ belief that any employee who loves a certain variety of candy will express that love in their work and ultimately to the customers.

Chuck was born in Vancouver, Canada and first began working at See’s in 1951, when he was 26 years old. His first supervisor was Ed Peck, the general manager in San Francisco. As the company expanded, Huggins continued to work his way up the ranks, earning the trust of the See family. By the time Huggins was handed the role of Chief Executive Officer in 1971, he had worked in various positions at the company for over two decades. Almost immediately, Warren Buffett knew that Huggins was the right man for the job: “It took me 15 seconds to decide to make Chuck CEO and President, and to this day I wonder why it took so long.” There is no doubt that without Charlie at the helm, See’s wouldn’t be where it is today.

Over the years Huggins led by the following management tenets: 1) Concentrate the efforts of all employees to attain ever-increasing excellence in customer service and product quality; and 2) Never compromise quality ingredients or service over profits. Commenting on his style of management, Huggins listed a number of traits that were essential to his success: the ability to solve problems, the desire to learn, curiosity, discipline, creativity, and patience.

Huggins was a “Level 5” leader, as characterized by Jim Collins in his book Good to Great. He was an insider who knew the business well and was fanatically driven toward results. He channeled ambition into the company, not himself, and blended personal humility with strong professional will. Asked to explain See’s business, Huggins said, “It’s about the customers. It’s about making sure the customer is pleased, whatever it may take, no matter how outrageous. … There are certain things we do inadvertently… where we dissatisfy the customer. And when that happens, we always admit that we blew it, and ask what we can do to make it right. And then we stand on our heads until we get that done.”

The Moat

Quality is one of the most important aspects of See’s advantage over competitors and a key element in the marketing of their products. See’s chocolates are all preservative-free, and each box has the date it was filled and location in which it was filled so that the customer can see that they are getting the freshest product. Ingredients from suppliers are carefully examined by quality assurance teams at the factories for microbiologic compliance and purity.

The See’s Candy brand is the moat that ensures See’s will continue to be the dominant chocolate producer on the West Coast for years to come. Commenting on these advantages, Charlie Munger says that “…in some businesses, the very nature of things is a sort of cascade toward the overwhelming dominance of one firm. It tends to cascade into a winner-take-all result.” Product quality is just one of the many contributors (albeit a very important one) to the brand—along with customer service, store image and the public’s mental perception of the product.

A few non-candy examples illustrate this point: Most people would much rather be seen drinking their latte from a cup brandishing the green Starbucks (SBUX) logo than from some other generic brand. A loving husband could probably find a diamond necklace for his wife a lot cheaper off the internet—but if he handed her a similar necklace encased in a robin’s egg blue box from Tiffany & Co. (TIF), she’d know that he loved her. And likewise, come February 14, your significant other won’t think twice about where that heart-shaped box of chocolates will come from—after noticing the See’s “Famous Old Time” Candies logo on the front, the box doesn’t even need to be opened.

Marketing plays a huge role in this perception. Customers know that the three-word motto “Quality Without Compromise” is not taken lightly at See’s. Buffett constantly reminded Charlie Huggins about what they were really selling—“Maybe the grapes from a little eight-acre vineyard in France are really the best in the whole world, but I have always had a suspicion that about 99% of it is in the telling and about 1% is in the drinking.”

In 1989, after an 8% year-over-year increase in pounds sold (a very high number for same-store growth); Buffett explained that shrewd advertising was the cause. That year, advertising expenditures had been increased from $4 million to $5 million. “When business sags,” says Buffett, “we spread the rumor that our candy acts as an aphrodisiac. Very effective. The rumor, that is; not the candy.”

Another reason that See’s was able to grow so successfully throughout the years was their astute real estate planning. During the 1950s, population growth in California resulted in an even larger increase in suburban development.

It was during this period of suburban expansion that the modern day shopping mall was born. Laurance See recognized the potential of malls and expanded See’s into new developments locally, and for the first time, outside of California. For stand-alone stores, the See brothers would attempt to place them on the shady side of downtown roads, assuming that people are more likely to walk on that side of the street when it’s hot outside.

Throughout the years, See’s has been very careful not to expand too quickly and only open a location when it makes sense. “The ordinary company puts in too many stores,” says Charlie Munger. “You have this huge overhead you’re carrying through July and August, and you just can’t get well at Christmas. But See’s has always had the discipline of knowing their own business.”

In hindsight, See’s would become one of Warren Buffett's most important investments. The company had all the traits that he would later look for when making a purchase: a family owned, well managed business with strong competitive ad¬vantages and little need for additional capital.

(Part II of this article will follow tomorrow)

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Resources

Buffett: The Making of an American Capitalist

Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

The Warren Buffett CEO: Secrets From the Berkshire Hathaway Managers

See's Famous Old Time Candies: A Sweet Story

Good to Great: Why Some Companies Make the Leap... and Others Don't

The Essays of Warren Buffett : Lessons for Corporate America

Related Reading

Warren Buffett and the Washington Post

Posted by Geoff Gannon at 11:22 AM | Permalink | Comments (0) | TrackBacks (0)

By Max Olson

Much of the information in this article is now out of date as the situation regarding the company has changed rapidly. The author, Max Olson, submitted this update to precede the original text. It is the policy of this site not to delete any article simply because of subsequent events; this policy can lead a careless reader to assume the current situation regarding a stock or company is similar to the situation as described in the article. Please do not make this mistake. Thank you.

- Geoff Gannon, Editor "Gannon On Investing" (Dated: June 12, 2007)

Added Comment From the Author:

"On June 11, Tweeter Home Entertainment announced they would be filing for Chapter 11 bankruptcy. With the amount of money they were already losing, and the most recent financial burden of the store closings (getting out of leases, etc.), it was inevitable that something had to be done. Whether that came in the form of new financing arrangements, Chapter 11, or a complete restructuring, was unclear at first. Hopefully while in bankruptcy, and with the new $60 million credit facility from GE Capital, Tweeter will be able to turn itself around and emerge as a much leaner, money making operation. I also hope that management gets their act together and finds a successful strategy without having to compete head-to-head with the bigger home electronics retailers. If not, I would love for a distressed investor to come along and do what Eddie Lampert did to Kmart when it was in bankruptcy."

(Dated: June 11, 2007)

Original Article:

Tweeter Home Entertainment (TWTR) recently announced it will sell one third of its 153 retail stores and lay off over 650 workers. Although such cuts are never good news, these actions may constitute a necessary step for Tweeter to take to further its turnaround effort. With a 2006 net loss of $0.66 per share, Tweeter needs to be as lean and competitive as possible. The company hasn't turned a profit since 2001; clearly something needed to be done.

Management still has a lot more to do to turn things around, and I blame them for Tweeter’s poor performance in recent years. They are not as bad as some others I've seen. They just seem stuck on the idea that people will keep coming to their stores for all their home entertainment needs, regardless of price. A sign in their store reads: “Price should never be a reason to not do business with us.”

Carving a Niche

When you have places like Costco (COST), Best Buy (BBY), and Circuit City (CC) undercutting them on TV prices, it's hard to convince customers to buy from Tweeter. The company can’t compete with the category killers and discount retailers on price. A quick online example: A Panasonic 50” Plasma HDTV is on sale at Tweeter, Best Buy, and Circuit City where it sells for $2,498, $1,999.99, and $1,999.99 respectively.

Just because you can’t win on price doesn’t mean you’re dead in the water. Many customers would be willing to pay more for the same products at Tweeter, if Tweeter provided much better service and helped customers solve their problems. This is how Tweeter differentiates itself: by offering consumers an enriched experience, expert information, in-home installation, and an assurance they will be taken care of in the future.

Walgreens (WAG) can price consumer durables at much higher prices than their equivalents at Wal-Mart (WMT) and Costco because they give customers something the discounters don't: convenience and speed. Someone who needs a prescription in the middle of the night or a tube of toothpaste isn’t going to make the trip to a discount superstore when there's a Walgreens right around the corner. But, this kind of “service” differentiation only goes so far.

Paying an extra dollar for toothpaste isn’t bad. But, when you’re shelling out a couple grand on a flat-screen TV, saving $500 means a lot. Some home entertainment buyers would like the extra service and knowledge that comes from buying at Tweeter. But, apparently the cost of providing this service is more than the premium charged for that service.

In an article announcing the store closings, the Associated Press wrote:

"[CEO Joe] McGuire said Tweeter wants to focus on its strengths, which include seven new ‘playground stores’ featuring simulated home room setups displaying high-end equipment in various installation possibilities."

Read "Tweeter Opens New CE Playground"

For Costco or Home Depot (HD), opening a few "concept" stores to test some new retail ideas is fine. But, I don't think Tweeter can afford to take that kind of risk right now.

Having seen pictures of the store, I'll be the first to admit I would love to go in one just to take a look around. But, can Tweeter generate enough profit per square foot from these "showcases" to justify the investment? I have a hard time believing it can.

The Numbers

Tweeter's combined opportunity cost for the real estate (about $13 per square foot) and working capital for the stores (about $2 per square foot) comes to $15 per square foot. So, Tweeter needs to generate over $15 per square foot of retail space in operating income (before rent expense) to justify the investment. For 2006, that threshold was about $11 per square foot, including excess depreciation.

That's not too bad. $11 per square foot is slightly higher than Sears/Kmart at the moment – however, Sears Holdings (SHLD) has a much lower real estate cost. Compare this to Best Buy who has sales of $930 per square foot (vs. Tweeter's $457) and operating income before rent expense of $72 per square foot – which is over six times Tweeter’s profit per square foot.

With the right management team (or a completely different view from the current team) Tweeter could be very successful – both with its stores and with its shareholders. Right now, the stock is trading at approximately 53% of tangible book value. By my calculations, if the company achieved a 1.9% or greater pre-tax free cash flow margin, each share of Tweeter would be worth at least double today's price of $1.71.

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Posted by Geoff Gannon at 01:27 AM | Permalink | Comments (0) | TrackBacks (0)

By Max Olson

There is no question that Warren Buffett is one of the greatest investors of all time. To study his investment methods, there are the Berkshire Hathaway (BRK.B) annual letters, biographies, and dozens of other books written on the subject of value investing. But, Buffett’s specific investments are rarely examined within the context of the time he made the purchase – and without the benefit of hindsight. To more fully understand Buffett's past successes, “reverse engineering” his purchases is essential. One investment in particular interested me, both because I like the business and because it is one of the only investments Buffett made where he disclosed an estimate of intrinsic value. That business is The Washington Post Company (WPO).

Background

Buffett began acquiring shares of the Washington Post Company in early 1973. By the the end of the year, Berkshire held over 10% of the non-controlling "B" shares. After multiple meetings with Katherine Graham (the company's Chairman and CEO), he joined the Post's board in the fall of 1974.

According to Buffett 's 1984 speech The Superinvestors of Graham-and-Doddsville, in 1973, Mr. Market was offering to sell the Post for $80 million. Buffett also mentioned that you could have "…sold the (Post's) assets to any one of ten buyers for not less than $400 million, probably appreciably more." How did Buffett come to this value? What assumptions did he make when looking at the future of the company?

(Note: All numbers and details in this article are from the 1971 and 1972 annual reports of The Washington Post Company and Buffett: The Making of an American Capitalist by Roger Lowenstein.)

Analysis

The purpose of this exercise is to reverse engineer Buffett's analysis of the Washington Post Company. In other words, to construct a reasonable analysis given the facts as of 1973 that will lead us to the same conclusion Buffett arrived at. Before I began my research, I thought it would take much longer to come to a conclusion than it actually did. After reading the annual reports and doing some outside research on the company and its history, I had a pretty good feel for how the business worked.

In 1973, the Washington Post Company consisted of three distinct segments: the flagship newspaper, Newsweek magazine, and five television/radio stations. The Washington Post (like most other local papers at this time) had a strong, durable competitive advantage that was certain to increase in the future. The paper had a dominant share of the Washington D.C. market. But, despite its commanding market share, the business side was flagging. As a business, The Washington Post was underperforming other major metropolitan dailies.

Newsweek also had competitive advantages – though they were not as great as those enjoyed by a dominant big city newspaper. At the time, Newsweek held a 30% share of the readership contested by the three leading news magazines. In 1973, the Post's other operating segment, network-affiliated TV stations, had extremely high barriers to entry due to government regulation. As a result, profit margins at these stations were quite robust.

From 1971 to 1972, the Washington Post Company's total revenue grew a little over 13%. Advertising revenue in the newspaper segment had grown almost 20% while magazine ad sales grew 8%. Pre-tax margins improved from 8% in 1971 to about 10% in 1972. These were both about 1-2% lower than their average in prior years. According to Lowenstein's book, the Post's margins were significantly lower than those of most other big city newspapers in the early 1970s.

Because of the relative steadiness of the Post's operations, I attempted to estimate the future cash flows adjusting for growth, margins, and return on capital. I tried to use reasonable assumptions that Buffett might have made at the time. I tried, as best I could, to prevent my knowledge of the company's post-1973 performance from contaminating my thinking.

I assumed top-line (revenue) growth of 12% for the next five years, 8% for the five years after that, and 4% in perpetuity. I thought there was a good chance margins would improve (at that time Katy Graham began to focus her attention on improving operations); so, I also assumed after-tax margins went up 2% over these years. This would push the company's after-tax return on invested capital to 25%, which I used as the incremental return on capital in perpetuity. In other words, for every dollar of reinvestment in the future (4% per year), the Washington Post Company would earn a 25% profit.

After performing the discounted cash flow calculation, I came up with an equity value of about $380 million using a 10% required rate of return. Without messing around with the inputs too much, this was fairly close to Buffett's $400 million figure. Judging by the balance sheet alone, the company's book value and approximate replacement cost were $80 million and $100 million respectively. This means that when Buffett made his purchase of the Washington Post Company, Berkshire was paying no more than 100 -125% of book value and less than replacement value for a growing company with a large moat to protect its profits. This low purchase price was Buffett's "margin of safety". The Washington Post's franchise and growth value alone was almost $300 million, more than triple the price of the stock. Even if I lowered my assumptions to be more conservative, the value of the business comes nowhere near as low as the price the stock was selling for.

Conclusion

The importance of sustainable competitive advantages ("a large moat") played a major role in the value of this investment. However, the above-average stock performance was made possible by the bargain price that Buffett paid. If it wasn't for the extreme market irrationality at the time, Buffett wouldn't have had the opportunity to buy such a great business at such a great price. Mr. Market was in a terrible mood and Buffett used that to his advantage.

So, what was Buffett's rate of return on his investment in the Washington Post Company? Using my estimated cash flows, the approximate annual rate of return after an 11-year holding period would have been 28%. According to Lowenstein's book, Berkshire's original $10 million investment from 1974 had grown to $205 million in 1985, for an annual return of 32%. In other words, my guess was fairly close.

During this time, Buffett had convinced the Post to buy back almost 40% of shares outstanding; these purchases (at undervalued prices) substantially enhanced returns. Over the same 11-year period, the S&P 500 returned 16% including dividends.

I will end this article with two relevant quotes from Buffett’s 1984 speech:

[On beta] “I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each.”

[On margin of safety] “You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Posted by Geoff Gannon at 10:11 PM | Permalink | Comments (0) | TrackBacks (0)

By Max Olson

In this article I would like to examine a few aspects of capital allocation. Instead of just explaining them, I think it's useful to use K-Swiss (KSWS) as a case study. I choose KSWS because it is a company I have looked at in the past and it provides some interesting examples. As this article is not specifically about the company, I won't go into any business details other than to say that KSWS is a niche footwear company whose competitive advantages lay in cost structure and local dominance of its product space.

K-Swiss has an amazing return on invested capital. It makes a lot of money without having to plow that cash back into hard assets in order to keep earnings up.

Here's the problem: K-Swiss makes too much money. Too much money you say? How can that be? Well, in and of itself it's not a bad thing; but, it becomes a problem when there is no place to put the cash but the bank. This is the capital allocation process at work.

Some businesses keep cash for a reason. They need that money to ward off competition or to weather a cyclical downturn in their industry. Microsoft (MSFT) is a shining example of using this to their advantage. At the moment, Berkshire Hathaway (BRK.B) has too much cash for its own good (Buffett has stated that they need only about $10B). But, Buffett is in his own world and he has earned my patience – as I know that cash will be put to good use at some point.

I don't believe this is the case at K-Swiss. Do they really need almost $200M in cash earning four percent a year? Let's say that out of the $190M in cash they have, $40M is needed for running the day-to-day business (I think this is very conservative, considering their low capital requirements & high cash generation). This leaves $150M in cash. The athletic shoe industry and KSWS (historically) do have some cyclicality. So, let's say they keep another $50M for a rainy day (or in this case, a rainy few years). That still leaves $100M, and in 2005, after share buybacks and such they added about $50M.

Cash Flow Statement

Taking a look at the cash flow statement for '05, depreciation approximates cap-ex which is most likely 99% used for maintenance and not growth. K-Swiss prefers to grow sales with advertising and other intangible assets; that's why they have such a high ROIC. In 2005, K-Swiss decreased working capital (as it had in 2004) and paid out $6M in dividends.

So now, with the retained earnings plus the decrease in working capital, what did they do with the money? They paid down some debt incurred in 2004, and bought back $26M in stock. After all this, there was still $53M that wasn't spent and went right into a money market account.

When you subtract excess cash when calculating ROIC, you have to assume management is going to reinvest earnings at those same returns in the future; otherwise, you might as well leave that cash in the equation.

I like to think of the cash flow statement as the "capital allocation" statement. This is where you get to see how much money came into the business, and where management is putting that cash to use. Profitable growth? Unprofitable growth? De-leveraging? Share buybacks? Dividends?

What Can K-Swiss Do With Its Excess Cash?

There are a few options:

1) Buy back more stock, or do one large tender offer

2) Pay out a larger dividend (I'm not a fan of this option)

3) Reinvest in the core business through invested capital or more advertising

For any business that has barriers to entry and returns on capital in KSWS's range, the third option is my favorite choice by a large margin. But with KSWS, that might (I'm no expert here) do more harm than good. One advantage of KSWS is that it has (for the most part) stayed out of the range of bigger players like Nike and Adidas/Reebok.

Getting bigger and bigger might make sense to grow earnings in the short-term; but, in the long-term, doing so would lead to direct competition with the big players. This leads to lower margins/lower volumes, and hence a lower ROIC. All of this essentially means that K-Swiss has reached the limits of their franchise. As a result, their returns on incremental capital are completely different from the ROIC of their core shoe business.

Assuming that the stock is still cheap, the best option would be to buy back more stock or to invest more in the European business (the latter choice is preferable only if K-Swiss can create the same competitive advantages it enjoys in North America). Investing in other ventures like Royal Elastics could also be a good option if they can get the same returns.

Worst case scenario: if management cannot find high return investments within their competency range, and shares are not significantly undervalued, then returning capital to shareholders with a large one-time dividend becomes the only reasonable option.

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Posted by Geoff Gannon at 02:14 AM | Permalink | Comments (0) | TrackBacks (0)