Charles A. See, a salesman from Ontario, opened the first See’s Candy shop in Pasadena, Calif. in 1921, with his mother Mary See. Exactly 50 years later Warren Buffett picked up his first See’s candy and gave it a try. After hearing about See's from his West Coast colleague Charlie Munger (in 1971), an eternal synergy blossomed with a blue chip buy-out of See’s Candy the following year.
“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.”
It is no mystery that See’s Candy is one of the most profitable and important investments Buffett has made in his career. When Buffett purchased See’s in 1972, he and Charlie Munger had said they would not have been willing to pay one cent more than $25 million using the float of blue chip stamps to purchase the shares.
Introduction
See’s Candy is a textbook example of a magnificent business with a continually widening moat, characterized as above average return on assets, incredible return on invested capital, pricing power and a negative operating cycle. These effects are due to superb management (See’s family, Chuck Huggins and now Brad Kinstler), high customer captivity, low to non-existent capex (and maintenance capex) and proficiencies in industry jousting (game theory/prisoners dilemma).
Buffett realized all of the following when he made his purchase for $25 million, $17 million of which was economic goodwill or what others refer to as intangible “brand equity.” He demonstrates this knowledge when talking (over the years and in the quote below) about the Pavlov association of both Coca-Cola and See’s Candy.
“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.”
The Growth & Valuation
See’s had roughly $4 million pre-tax profits, $2 million after tax earnings, $30 million in sales and $8 million in tangible assets at the time of acquisition. Buffett had agreed to pay roughly 12.5x earnings or 6.25x pre-tax, not astronomical considering what was to come from the candy cash flow machine. Ironically, he mentioned he and Munger would have walked away if the price were even a penny higher, likely a huge mistake.
| See’s Candy 1972-2007 | |||
| Year | Tangible Assets | Earnings | ROA |
| 1972 | $8 Million | $2 Million | 25% |
| 1983 | $20 Million | $13 Million | 65% |
| 2007 | $40 Million | $82 Million | 205% |
We now know with hindsight that See’s grew sales volumes relatively slow, from 16 million pounds of candy in 1972 to 31 million pounds in 2007, only annual growth of roughly 2%. But over the same time sales grew from 30 million to 383 million, roughly a 7.5% CAGR. The discrepancies between the two growth rates can be attributed to the continual rise in price per pound (5.5% annually) and directly dropping to pre-tax earnings (all else equal).
“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.”
Provided Buffett could see the future, how much would a rational person be willing to pay in 1972 for $4 million pre-tax earnings with 7.5% growth in perpetuity? Assuming a required return of 10% we would arrive at a present value of roughly 160 million [4,000,000 / (0.10-0.075)] or almost 6.5x what Buffett was willing to pay. If there were no growth, the present value (in 1972) would be $40 million, a large difference thanks to pricing power (growth).
Widening the Moat
See’s boasted something uniquely similar with other successful investments of Berkshire (BRK.A, Financial)(BRK.B, Financial), that being, a negative operating cycle, customer captivity, pricing power, above average ROIC/ROE/ROA and excellent management.
- Negative Operating Cycle
Essentially, See’s was able to sell the majority of the annual volume in the months of December and February (Christmas and Valentines Day) for cash, utilizing short-term debt and minimizing overhead. At the time, due to the suspected length of accounts payable being around 30 to 60 days (other than wages) and accounts receivable being eliminated due to immediately receiving cash (or an equivalent), a seasonally negative operation cycle was born and a very short-term float present for Buffett to utilize.
“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.”
- Customer Captivity
Customer captivity can be the product of many different variables at work within a business. Briefly speaking, it is the condition of being imprisoned or confined to a particular brand, product or service due to either qualitative/psychological factors; a monopoly or oligopoly being present, customer satisfaction, or opportunity costs/switch costs to the customer. Customer captivity is what leads to the ability to gradually raise prices (pricing power) at a pace faster than inflation, because the customer is “confined.” There is much to be said about customer captivity and the discussion must be kept short. Psychological factors can be a wide swath of biases and influences but the most notable are the effects of association and habit.
Association and Habit (refer to Pavlov and his dog) are no strangers to Coca-Cola (KO), as Coke targets being associated with happiness and the experiences that are had while drinking Coke. The more the same coke or chocolate is consumed the more likely the customer is to re-purchase due to out implicit/procedural learning styles. Much like smokers who do not change brands. See’s Candy is a similar scenario, meaning that during each Christmas season and every Valentines Day, men across the country have become accustom to buying chocolate from a particular company (in this case See’s) and will pay the price required, due to the association of memorable times, the brand imagery (think Starbucks) and for fear their lady may not be satisfied if they cheap-out this year. The all encompassing “brand strength” would be included in psychological factors.
See’s thought and still thinks local, originally servicing a niche market and organically growing slowly to other areas around the world, exploiting the effects of habit and association. By thinking local, delivery times were kept minimal, (ensuring product quality remained high) existing factories, warehouses and equipment (assets) were being utilized efficiently and brand familiarity was built. Most important of all, CUSTOMER SATIFCATION came first. Today 110 of its 211 stores are in California, and “thinking local” is still deeply ingrained in their business DNA.
“In my early days as a manager I, too, dated a few toads. They were cheap dates - I've never been much of a sport - but my results matched those of acquirers who courted higher-priced toads. I kissed and they croaked. After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous). Said the pro: "Practice doesn't make perfect; practice makes permanent." And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.”
- Honest & Integral Management
It is always impossible to put a numerical figure on great management, as Buffett states in his famous quote, it is very hard to overpay a truly remarkable CEO albeit he also notes the species is rare. I am sure having Chuck Huggins and now Brad Kinstler is and has been a huge advantage for See’s Candy. Huggins regularly inspected plants, ensuring quality was high, acknowledging employees on a first name basis (names were also stitched to lab coats) and encouraging employees to eat as much candy as they like. Kinstler picked up where Huggins left off, looking to expand to the east coast in the coming years. Both CEOs were long-time Berkshire family members and have the Berkshires interests in heart/mind. Both CEOs always put customer satisfaction and product quality first and foremost on their minds.
- Above Average ROIC & ROA
The astronomical ROIC and ROA are both thanks to a combination of low working capital, low capex and low maintenance capex. These favorable business characteristics were a by-product of an industry that was not subject to rapid change, had slow per-capita consumption growth, disproportionate seasonal sales, strong pricing power and non-cannibalizing competitors.
“There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.”
The competitors within the industry realized that rather than cannibalize on the slow (a meager 2% annual per-capita consumption) growth by competing on price they would be better off collectively (albeit non-collusive) raising prices annually like true prisoners dilemma champions.
“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).”
- Conclusion
In "Security Analysis" Ben Graham wrote, “It may be pointed out that under modern conditions the so-called “intangibles,” e.g. good- will 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.”
Buffett was lucky to learn the value of intangibles not correctly reflected in the financial statements, through his acquisition of See’s Candy. Buffett once said, “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect, but that's what it's all about.” With a tangible book value of $7 million his probable loss would have been 72%. The probable gain could be quickly conceptualized by taking 5% expected growth (EBIT / k –g) or 4,000,000 / 0.10 – 0.5 = 80,000,000 or 220% probable gain. Given the range and numbers of probabilities Buffett may have assigned at the time, I will take a 30/70 weight on the two single variables leading to an expected probable gain of 132%.
This is not an exact science and uses quick heuristics, but I am led to believe these are the focuses of Warren Buffett and how he analyzes companies. Regardless of how undervalued he believed See’s Candy to be, it was a great investment and likely produced the cash flow ($1.35 billion) for other great investments along the way, proving the economic value to be higher, in terms of opportunity cost. See's Candy is the perfect business to emulate when looking for investment ideas, and I think Buffett relized that as other famous investments came a short period after. It is also fair to remeber Buffett and Munger may have cast a Pavlovian effect onto See's, enabling sales to materialize that may have not otherwise.
"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too. It's one thing to own stock in a Coca-Cola or something, but when you're actually in the business of making determinations about opening stores and pricing decisions, you learn from it."
Further Reading
http://www.berkshirehathaway.com/letters/1992.html
http://www.berkshirehathaway.com/letters/2007ltr.pdf
