Warren Buffett (Trades, Portfolio) detailed in a written letter what you should know about the business economics of the jewelry industry in general, and specifically, Borsheim’s. The letter was written shortly after the acquisition was made in 1989. Emphasis is my own with additional comments added throughout original excerpts.
First, Buffett explains very simply the economics of the existing jewelry industry.
1) High overhead.
2) Average margins.
3) High fixed costs.
The high overhead is based on low inventory turns, a small majority (25% to 30%) likely coming from inventory holding costs, insurance and shrink. Another direct result of low inventory turns is the amount of capital that is “tied-up” in working capital, essentially diluting returns on capital as it sits idle in inventory.
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“To begin with, all jewelers turn their inventory very slowly, and that ties up a lot of capital. A once-a-year turn is par for the course. The reason is simple: People buy jewelry infrequently, and when they do, they are making both a major and very individual purchase. Therefore, they want to view a wide selection of pieces before zeroing in on a single item.
Given that their turnover is low, a jeweler must obtain a relatively wide profit margin on sales in order to achieve even a mediocre return on their investment. In this respect, the jewelry business is just the opposite of the grocery business, in which rapid turnover of inventory allows good returns on investment though profit margins are low.
In order to establish a selling price for their merchandise, a jeweler must add to the price they pay for that merchandise, both their operating costs and desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more.
The math is simple: Jewelers charge $1 for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents they typically pay 40 cents for operating costs, which leave 10 cents of pre-tax earnings for every $1 of sales. Taking into account the massive investment in inventory, the 10-cent profit is adequate but far from exciting.”
Now let us think…
If we were in charge of running the businesses and tossed in as the CEO tomorrow, what changes would we implement, what would we leave the same?
What would be the optimal strategy to pursue?
At first glance, we would likely come to the conclusion we need to turn our inventory quicker, we need lower fixed costs and we need higher gross margins. What we need is a higher capital turnover ratio (Sales / Invested Capital).
But how can a higher capital turnover be achieved?
We need to either increase the numerator (sales) or decrease the denominator (Invested Capital), or a combination of both.
“At Borsheim’s the equation is far different from what I have just described. Because of our single location and the huge volume we generate, our operating expense ratio is usually around 20% of sales. As a percentage of sales, our rent costs alone are fully five points below those of our typical competitor. Therefore, we can, and do, price our goods far below the prices charged by other jewelers. In fact, if they priced to match us, they would operate at very substantial losses. Moreover, in a virtuous circle, our low prices generate ever-increasing sales, further driving down our expense ratio, which allows us to reduce prices still more.
How much difference does our cost advantage make? It varies by competitor but, by my calculation, what costs you $1,000 at Borsheim’s will, on average, cost you about $1,350 elsewhere. This is called the “Borsheim’s Price”. There are very few instances where we are unable to offer you those great savings due to restrictions, but you will always know upfront if an item is non-discountable.”
Borsheim’s charges roughly 26% less for merchandise than competitors. It is enabled to do so because of the low fixed costs (rent, property tax, insurance, etc.) and huge volume (higher inventory turns, lower overhead in the form of lower inventories on hand, lower variable costs due to scalability) created through direct selling.
“Our “shop-at-home” program brings Borsheim’s to our qualified customers. Simply contact Borsheim’s to describe what you’re looking for – to any degree of detail. We will assemble selections that best reflect your wishes and send them to you. Then, in the comfort of your own home or office, you can conveniently and leisurely select the item(s) you most prefer, or return the entire selection. Our results from this “shop-at-home” program have been amazing. Customers have loved it and keep coming back for more. Each year, we send out several thousand packages, ranging in value from $100 to $500,000.”
The business economics described above are not new and can be seen when examining Nebraska Furniture Mart (1983 acquisition) and the famous Dell business model that everyone seems to relate it to. Because of the single location, roughly 5% mark-up can be forgone by the product vendor and passed onto the consumer in the form of price savings. I like to call these feedback loops or cycles, “the ratchet up effect,” essentially leading to a virtuous cycle or prosperity for the low cost producer or leader.
“I can remember well how helpless I used to feel in a Fifth Avenue or Rodeo Drive jewelry store, where the only thing I knew for sure was that the operator had extraordinarily high overhead – and that they had to cover it in their sales price. I was also wary of the 'upstairs' solo operator who operated on consignment merchandise, since that would have cost them more than merchandise bought outright, and would necessarily have inflated their retail price."
Key Take Away
- In a commodity business, high inventory turns are crucial.
- The lower the business overhead, the better.
- More units sold and spread across a smaller base of fixed costs results in a higher return on capital.
- Selling on consignment is not usually beneficial in a commodity type business.
- Direct selling reduces fixed costs and increases inventory turns, if done correctly.
- Capital turnover ratio signifies how much $1 invested can produce in revenue.
- A cost advantage is a competitive advantage susceptible to “the ratchet up effect”.
I will write up something in more detail later in the week regarding the cost of capital, the return on capital, growth and how they are all interrelated. Thinking deeply about capital invested and the return on that capital as well as their relationship to growth is something I would encourage all investors to do routinely. Look for reasons why the ROIC is above or below average (9% is the median according to “Valuation” by Mckinsey & Company) and how the advantage is created or lost.
“Constantly think about how you could be doing things better and keep questioning yourself.” – Elon Musk
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"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain