Hidden away in Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) is a company many investors might not have heard of, as it is certainly not the most exciting business. However, this business is a typical Warren Buffett (Trades, Portfolio)-style investment, even though it has razor-thin profit margins and relatively high costs.
The company I am talking about is the retail distribution group McLane. The group recorded revenues of just under $50 billion in 2021 and pre-tax earnings of $230 million, giving a pre-tax profit margin of 0.5%.
The business fits in Berkshire's manufacturing, service and retailing division, which generated net income of $11 billion for the group in 2021, approximately 40% of the group's net income excluding investment and derivative gains.
An important contributor
McLane's contribution to the net income figure was minuscule, but the company constitutes one of the most significant revenue contributors in the division. The corporation manages a wholesale distribution business that provides grocery and non-grocery products to retailers and consumer groups across the United States.
McLane provides wholesale distribution services to Walmart (WMT, Financial), which accounted for approximately 16.5% of McLane’s revenues in 2021. McLane’s other significant customers include 7-Eleven (approximately 13.9% of revenues) and Yum! (YUM, Financial) Brands (approximately 11.5% of revenues).
It also distributes distilled spirits, wine and beer to various companies. In total, this business supplies just under 50,000 retail units across the country.
McLane's edge is its size. The company's business model is based on a high volume of sales, rapid inventory turnover and stringent expense controls. The distribution industry has thin profit margins built into it. Even Amazon (AMZN, Financial), which one could argue has constructed the biggest and most effective distribution system in the United States in the space of a couple of decades, does not make a lot of money on the distribution side of the business. It has invested tens of billions of dollars building out distribution, earning only a negligible percentage return on its investment.
These economics of scale are both a benefit and a drawback for companies like McLane and Amazon. You could call it a necessary evil; without those razor-thin margins, they would have quickly lost out against competitors and never stood a chance of building out the networks they have today.
If any competitor wanted to recreate the distribution network either of these businesses has developed, they would have to spend tens if not hundreds of billions of dollars in order to achieve that operating efficiency and scale. And what would be the point? The payback would take decades, and the profit margins would be almost non-existent. There are so many better investments out there if you're looking for a quick buck.
As such, while McLane might not be the most profitable company around, it does have a wide and deep moat, just the sort of moat the Oracle of Omaha looks for in potential investments. This competitive advantage increases the odds that the company will be able to generate profits and cash flow for decades into the future.
Reinforcing the advantage
Being part of Berkshire only reinforces that advantage. McLane's customers know that the company is supported by a cash-rich conglomerate which is not going to pull the plug on the business.
Buffett explained why this was a good thing in 2003 after Berkshire sealed the deal for the firm:
"They know our check will clear, that we won’t, you know, make a proposition and then run into financing difficulties, or try to jiggle around the contract later on."
Berkshire is also the perfect owner because it does not compete with any of the firms McLane supplies and it can afford to invest to improve the level of service offered. Both of these qualities are vital for maintaining a reputation with the clients McLane serves:
"It’s a very narrow-margin business, obviously. I mean, when you get up to 22 billion of sales and you’ve got Hershey, and Mars, and people like that on one side, and you’ve got buyers like 7- Eleven and Walmart on the other side, they’re not going to leave a lot in between. But you have to perform a valuable service for them in order to earn, you know, say, one cent on the dollar, pre-tax. But McLane’s knows how to do it."
