Disclosure: I am not receiving any compensation for any of the links provided. I have no business relationship with any company or individual mentioned in this article. I have no position in any stock mentioned.
A few days ago I found the podcast episode “Taxi! Taxi!” from Grant’s Interest Rate Observer. The episode contains an interview with Hubert Horan about the economics of Uber, with a focus on the fundamentals of Uber’s business model and whether or not it will prove strong enough to make it possible for Uber to earn any sustainable profits going forward to support its lofty valuation.
This interview is definitely worth listening to since it provides a lot of great insights into the fundamentals of Uber’s business model and competitive capabilities. If you’d like to improve your understanding of the Uber business, check it out here.
Below, my own short transcript of the introductory parts of the interview.
Evan Lorenz: You’re work on Uber showing that most of the cost are variable, and that losses scale as revenue scales has been incredible. How did you come to your conclusion?
Hubert Horan: All I was doing was collecting numbers from other published reports, you know, and putting them into one place so you could see; “Wait a minute,” this has been unprofitable from day one and it’s still getting worse in year seven.
HH: And so, when you see a lot of the recent news reports you will now see something very in paragraph five or six, by the way you know, they lost billions of dollars last year. But you know, this is, none of this is confidential information, none of this, you know the accuracy of this has been confirmed completely. But the idea that this is a company that’s got, shall we say, problematic economics is still not of great interest to a lot of reporters.
EL: What actually made you start looking into Uber?
HH: Just having been in transportation my entire career, and on the sort of strategic business planning end of things. All of a sudden all of these stories started coming out about Uber five, whatever, years ago saying that it was the, you know, biggest most, you know, highly valuable private company in the world history. And it was going to compete and solve all the problems in urban transport and we’re going to replace private car ownership at some point. And I sort of scratched my head and said; “That’s interesting, wonder how they did that?” And everything that was being claimed in all of these articles completely contradicted everything that I and anyone else had known about the economics of transportation. And digging a little more, and digging a little more, and suddenly found sort of the empty core.
Hubert Horan has written a few articles on the subject of Uber worth checking out:
The story of H&M goes back to 1947 when Erling Persson – father to Stefan Persson (Chariman of the Board) and grandfather of current CEO Karl-Johan Persson – opened the first store. Since then, H&M has grown and expanded its business internationally. At the end of its latest full fiscal year in 2015 it operated a total of 3,924 stores in 61 different markets around the globe with total sales of 181 billion (fiscal year 2015). As of 31 August 2016 the group had 4,135 of which 176 were franchise stores.
The Persson family is the dominant major shareholder and controls 69.7% of voting rights and 37.7% of total shares outstanding (see table below). H&M is more of a publicly listed family company. This could be one of the reasons explaining H&M’s poor quality when it comes to financial reporting and the disclosures presented in the annual report.
This text focuses on H&M’s annual report for fiscal year 2015 (1 December 2014 to 30 November 2015).
Expansion has been nothing but extraordinary with each year offering new store openings and growing total revenues. Focusing on revenues, H&M has delivered some pretty solid growth. But, the further down the profit and loss statement we go, the worse it gets. Profitability has not kept up with the growth in sales, putting pressure on profit margins.
During the last nine years, that is 2007 to 2015, H&M grew its revenues at a compounded annual growth rate (CAGR) of 8.7%, from 78,346 million in 2007 to 181,861 million in 2015. Gross profit and operating income during the same period grew at a CAGR of 8.0% and 3.9%, respectively. The lower CAGR in gross profit and operating income put pressure on profit margins, with gross profit margin going from 61.1% in 2007 to 57.0% in 2015, and operating margin from 23.5% to 14.9%.
The last decade has offered a solid mix of challenges for H&M; a financial crisis, currency movements, weather and fashion trends as well as growing competition from e-commerce and online retailers. The problem is not in the revenue growth itself, it is that profitability has significantly declined.
For most businesses growth comes at a cost. To maintain and grow its store count – from 1,522 in 2007 to 3,924 stores in 2015 – H&M spent a total of 56 billion in tangible capital expenditures. Then we also know most businesses have costs for growth SG&A and increasing working capital needs that comes with a certain amount of growth. H&M also spent an increasing amount of cash on its online sales business, either expensed directly through the income statement or capitalized on the balance sheet. Other operating expenses have increased from 8.9% of sales in 2007 to 10.8% in 2015. Intangible capital expenditures amounted to 5 billion, of which 4 billion was spent in 2012-2015.
The high level of investments together with declining profitability have resulted in a lower amount of cash, with cash and cash equivalents steadily declining from 20.9 billion in 2007 to 13.0 billion in 2015 (8.7 billion per Q3 2016). H&M is no longer able to found its yearly dividend from free cash flow, and the dividend has been maintained at about the same level in the latest five year period thanks to cash in the bank from prior years. Of course this could be solved to some extent by H&M if they decided to stop or reduce its growth capital expenditures (and other growth expenditures) or manage to increase profit margins and cash flows. The unpleasant part in this equation is that lowering capital expenditures would most likely result in a lower future growth rate (fewer store openings each year, even if compensated in the best case to some extent by rising online sales), or no future growth at all and in a worst case scenario with declining future total revenues.
Average return on equity (excluding cash and cash equivalents) has averaged 88% in 2007-2015, from a high of 134% in 2007 to a low of 52% in 2015. Returns are still great, but it’s also obvious that what we’ve got here is a negative trend in the underlying profitability. The main question for investors today is what H&M’s future profitability will look like? With the retail industry, and especially the fast-fashion sector being one of heavy competition it’s not entirely obvious what the future has to offer. Historically, H&M has made its long-term shareholders very wealthy. The question going forward isn’t about whether H&M has been great or not in the past – we all know it has. The question is what future performance H&M will be able to offer? And the last 5, 7 and 10 year periods may all have made a reasonable answer to this make-or-break question a little gloomier. But, it may still be as great as its always been, or? Since we don’t know in which areas H&M deploys all its growth expenditures and the mix between the “old H&M” and the new growth initiatives and brand building that has been ongoing for some time.
As always, we know what’s been but not what will be. H&M is currently trading at 234 per share, a level first reached in 2010. In the middle of 2013 the market changed its view of H&M and the share price went from 230, reaching an all-time high of 368.50 in 2015. Since then the share price is down about 36%.
It’s been almost a decade of declining profit margins and profitability. With a great annual report at hand we would be able to search for potential answers and understand in a good enough way what goes into this negative trend in profitability. But I’m afraid we don’t have one, since H&M seems to be following more of a “non-disclosure” policy than the other way around– sad but true, at least for outside passive investors. Let’s take a look at a few different areas in the 2015 annual report to see what’s missing.
Quality of Financial Reporting
Reading H&M’s annual report for fiscal year 2015 provides some great insights into the business. Although there are a few things that an outside passive investor would probably very much like to know, about which H&M says nil.
When reading an annual report and thinking about a specific business, ask yourself; What financial and non-financial metrics would I want if I was the one running the business? A few things you probably would like to know about are:
Sales per region, per country, at the store level, as well as sales per square meter – for each major brand in the portfolio.
The profitability of the business – that is, profit margins and invested capital turnover, together making up the return on invested capital – and any changes occurring and the reasons explaining any significant changes in underlying trends – again for each major brand in the portfolio.
Tangible and intangible capital expenditures – both maintenance and growth – split between the major brands in the portfolio.
Revenue growth – probably on a quarterly basis, but at least year-over-year – per region, per country, and at the store level – and again you’d want to know this for each major brand.
Does management tell you the business facts that they themselves would want to know if their positions were reversed? Let’s find out, but as a primer – you might become a little concerned about the state of things if you keep on reading.
Same Store Sales Growth. H&M no longer discloses monthly same store sales data. That’s fine with me if we talk about monthly data, but I would very much like to know what same store sales, at least year-over-year, look like. Especially in a case like H&M were growth in new stores could mask the performance in the current and old store count. Too bad, H&M does not provide this data to outside investors. Of course the relative value of this metric declines as online sales makes up a greater part of total sales. But, since H&M does not break out its online sales, should outside passive minority investors interpret this as a fact that online sales makes up a non-material part of total sales? Because if online sales made up a material and significant part of total sales, shouldn’t this information be disclosed in the annual report?
Same store sales growth is a relevant metric as long as there are physical retail stores making up a material portion of total revenues. And with the current strategy of maintaining a high growth rate and expanding the total number of retail stores, it seems unreasonable to expect this to change for some time. Thus, same store sales data is a metric of interest to investors and should therefore be disclosed, at least on a yearly basis in the annual report.
Total square meters. What are the total square meters of all of H&M’s retail stores? Management knows, you don’t since this is a non-financial metric that is not disclosed. A highly relevant metric, one could argue, for a retailer to make it possible to track revenue, profit, and invested capital per square meter for its physical retail stores. This metric should also be disclosed (at least in the annual report).
Operating Segments. Below is note 3 Segment Reporting from the 2015 annual report. There is only one issue with this note; the way it is structured and presented. It doesn’t provide anything of real value to someone trying to understand, analyze and assess the underlying business fundamentals. Maybe that’s what management want? To make it as hard as possible for others to get a glimpse of how different regions are performing. I don’t know. All I know is that this disclosure from H&M about their operating segments is of no value to me when evaluating and valuing H&M as a going concern. Right now a great part of the total operating profit belongs to Group Functions which makes it a little less useful when it comes to analyzing and assessing the development for each operating segment.
One has to assume that this segment information is in line with the requirements in IFRS 8, but one also has to assume that management does not want to provide any real value to readers. If they had wanted to do so they would have designed it in a different way.
H&M should provide information about the different geographical segments (at a proper level), different brands and their sales and profit margins and invested capital. Regarding online sales, this should also be separated and reported on a stand-alone basis. More about this below.
Share of Online Sales. How much of total revenues is generated from H&M’s online business? No one knows, except for management. You could look around and try to make an educated guess, and that might be good enough, but a disclosure about revenue from online sales is nowhere to be found in the annual report.
One could elaborate on the question regarding at what level of online sales in relation to total sales that would require H&M to disclose this key metric. If H&M’s online business accounts for as much as 10-12% of the total 2015 sales revenue, that is around 21 billion to 25 billion (Source: Bernstein via just-style), one could argue that this is material information to investors, and therefore should be disclosed in the annual report.
It will be interesting to follow how this develops and whether we’ll see any online sales figures in the upcoming annual report for fiscal year 2016.
Profitability of Online Sales. As much as we want to know how much sales the online business generates, we also would like to know any profitability of such sales. But, there’s no information about this in the annual report. I guess we could all agree on the importance of online sales for fashion retailers from now on. The question is what profitability looks like in this area? An educated guess is that it might not be the high-margin, high-profitability business that we’ve gotten used to in the past where most of the sales was generated via H&M’s physical retail stores.
E-commerce is no cash cow for fast-fashion retailers, whose thin profit margins from high volume sales are slashed by free shipping and returns. As the retail market as a whole is moving online, however, H&M—which was late to the game—is finally making the necessary investments to compete. “The penetration rate of online sales for apparel is just going to increase over the next five years, so if you don’t have an e-commerce website, your customers are likely to go elsewhere,” said Grant. (Source: Forbes)
Sales and profitability of different store brands. H&M discloses total revenues (hey, that’s great – ain’t it?), revenue per country and also revenue per region (in their segment reporting). What’s missing is a breakdown of revenue between the different brands, and also the split in revenue between physical retail stores and online sales. Further, no information is provided about operating income and invested capital for each brand.
CEO comments. The CEO comments is a great chance for a CEO to talk directly to all the shareholders and outside passive minority investors. Many CEO’s are either not good enough to express themselves and their business strategy in writing, or they just don’t want to make an effort great enough to do so in a proper way (at least seen from the perspective of an outside passive investor). CEO comments when it comes to H&M might be good, but I still think it could be improved a lot from here since much of the information provided doesn’t really offer any great insights into the business more than on a consolidated level.
Marketing and other operating expenses. H&M does not disclose its marketing expense and not any expenses related to IT. By putting together the different expense categories (rental, payroll etc.) disclosed in H&M’s annual report we can calculate how much of total operating expenses that is made up of other expenses – see table below.
Total operating expenses to sales increased from 76.5% in 2007 to 85.1% in 2015, mostly explained by higher COGS to sales (+2.3 pp), depreciation to sales (+1.1 pp), and other expenses to sales (+3.3 pp). Rental, labor, and amortization was almost unchanged. Other expenses made up 12.7% of total operating expenses in 2015 compared to 11.7% in 2007. It would be interesting to know what makes up these other operating expenses and how they have changed in composition during 2007-2015.
Earnings Call Transcripts.This is not an issue that is specific to H&M, neither to the annual report itself. I bring this up just because I think all listed Swedish companies should be required to provide transcripts of earnings calls in their investor relations section. Fortunately, there are external parts providing transcripts. See here for some H&M earnings call transcripts provided via Seeking Alpha.
Nine-Month Report 2016
A quick look at the most recent nine months shows an increase in net sales of 5.6%, compared to an increase in total store of 12.5%. H&M opened 264 (206) stores and closed 53 (42) stores, i.e. a net increase of 211 (164) new stores. The group had 4,135 (3,675) stores as of 31 August 2016, of which 176 were franchise stores.
Revenue growth slowed significantly in the first nine months in 2016 compared to the same period in the prior year. The negative trend in both gross and operating profit continued to put pressure on margins and profitability. Earnings per share declined in Q3 2016 (-9.3%) as well as for the nine months 2016 (-17.2%).
Inventory increased with 23.9% year-over-year to 31.231 million at the end of Q3 2016. Total capital expenditures amounted to -9.288 million (tangible capital expenditures of -8.087 million and intangible capital expenditures of -1.201 million).
Also, H&M raised 3.724 million in short-term loans in the first nine months 2016. Without this short-term loan H&M’s cash and cash equivalents would have been 4.956 million instead of 8.680 million at the end of Q3 2016, compared to 10.963 million in Q3 2015.
Final words and valuation
To wrap this up, H&M is a good business and I have liked it earlier on and might come to do so again in the future depending on how it all plays out. What I don’t like is to invest in a business I think is a good one – especially when the historical track record has been great (which could have a significant impact on the quality of your own judgement) – just to realize later on that it wasn’t such a good business as I originally thought (and by then running the risk of a permanent loss of capital).
Currently H&M is trading at a P/E (TTM) of 21.2 and EV/EBIT (TTM) of 16.1, in line with its 10-year average. If H&M is able to maintain or even turn around the negative trend in earnings and keep growing the business, the current share price probably would be considered a great entry point for investors in hindsight, most likely somewhat of a bargain. If this is not the case, that is, profitability will decline even further along with slowing revenue growth, the current share price is at a high level and you should look elsewhere for ways to invest your hard-earned money.
Personally, the last decade and the negative trend in profitability coupled with increased importance of having a presence in the online sales field and the tough competition in the retail business makes H&M a too uncertain investment case for me, at least at the current price level. There are many other great businesses out there with more favorable characteristics and less uncertainty. Let’s go try find some of these instead.
If you want to make your own assessment of the quality of H&M’s financial disclosures, click here to read H&M’s annual report for fiscal year 2015.
Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.
“Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.”
How to Value a Business
Excerpt below from Warren Buffett’s 2000 letter to shareholders. Emphasis added.
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.
Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT – Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.
At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation – in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it – is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Last year, we commented on the exuberance – and, yes, it was irrational – that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.
Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.
This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.
What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street –a community in which quality control is not prized– will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
Lately, the most promising “bushes” have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point.
“A moat that must be continuously rebuilt will eventually be no moat at all.”
Excerpt below from Warren Buffett’s 2007 letter to shareholders. Emphasis added.
Businesses – The Great, the Good and the Gruesome
Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. 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.
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.
At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
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. 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 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.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.
Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
In his 2005 letter to shareholders Warren Buffett discussed the topic of competitive advantage, or moats in his own words (emphasis added).
Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.
Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were running those long before we came along; our only function since has been to stay out of the way. If you see these heroes – and our four heroines as well – at the annual meeting, thank them for the job they do for you.
But, as sure as times change, the same goes for moats. So, if you manage to identify a moat that you may even assess as sustainable, remember that nothing lasts forever, not even wide moats (at least I’d say that’s the most probable and likely outcome if you were asked to make a bet on any given business).
As an example, let’s take a look at the newspaper industry and how it has changed during the latest decades.
Newspapers in the ’70s: Moat-Widening
Thanks to a reader of the blog, I was made aware of an article published back in 1977 in the Wall Street Journal and entitled The Collector: Investor Who Piled Up 100 Million in the ’60s Piles Up Firms Today. In this article the author wrote about Warren Buffett’s taste for cash-generating newspapers with moats:
Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. Warren likes owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.
Going back through the years and the letters to shareholders written by Warren, we find an extensive discussion about the state of the newspaper industry in his 2012 letter (emphasis added).
We Buy Some Newspapers . . . Newspapers?
During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds. Second, the properties we purchased fell far short of meeting our oft-stated size requirements for acquisitions.
We can address the second point easily. Charlie and I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company. Addressing the first point requires me to provide a more elaborate explanation, including some history.
News, to put it simply, is what people don’t know that they want to know. And people will seek their news – what’s important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost. The relative importance of these factors varies with the nature of the news and the person wanting it.
Before television and the Internet, newspapers were the primary source for an incredible variety of news, a fact that made them indispensable to a very high percentage of the population. Whether your interests were international, national, local, sports or financial quotations, your newspaper usually was first to tell you the latest information. Indeed, your paper contained so much you wanted to learn that you received your money’s worth, even if only a small number of its pages spoke to your specific interests. Better yet, advertisers typically paid almost all of the product’s cost, and readers rode their coattails.
Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more “news.” Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.
In turn, the local paper was indispensable to advertisers. If Sears or Safeway built stores in Omaha, they required a “megaphone” to tell the city’s residents why their stores should be visited today. Indeed, big department stores and grocers vied to outshout their competition with multi-page spreads, knowing that the goods they advertised would fly off the shelves. With no other megaphone remotely comparable to that of the newspaper, ads sold themselves.
As long as a newspaper was the only one in its community, its profits were certain to be extraordinary; whether it was managed well or poorly made little difference. (As one Southern publisher famously confessed, “I owe my exalted position in life to two great American institutions – nepotism and monopoly.”)
Over the years, almost all cities became one-newspaper towns (or harbored two competing papers that joined forces to operate as a single economic unit). This contraction was inevitable because most people wished to read and pay for only one paper. When competition existed, the paper that gained a significant lead in circulation almost automatically received the most ads. That left ads drawing readers and readers drawing ads. This symbiotic process spelled doom for the weaker paper and became known as “survival of the fattest.”
Now the world has changed. Stock market quotes and the details of national sports events are old news long before the presses begin to roll. The Internet offers extensive information about both available jobs and homes. Television bombards viewers with political, national and international news. In one area of interest after another, newspapers have therefore lost their “primacy.”And, as their audiences have fallen, so has advertising. (Revenues from “help wanted” classified ads – long a huge source of income for newspapers – have plunged more than 90% in the past 12 years.)
Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.
Even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size. Publishers – including Berkshire in Buffalo – have offered their paper free on the Internet while charging meaningful sums for the physical specimen. How could this lead to anything other than a sharp and steady drop in sales of the printed product? Falling circulation, moreover, makes a paper less essential to advertisers. Under these conditions, the “virtuous circle” of the past reverses.
The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter’s powerful example, it’s only been in the last year or so that other papers, including Berkshire’s, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.
In a the recent Politico Playbook interview Warren Buffett shared his bearishness on newspapers.
Buffett is bearish on newspapers:
“Newspapers are going to go downhill. Most newspapers, the transition to the internet so far hasn’t worked in digital. The revenues don’t come in. There are a couple of exceptions for national newspapers — The Wall Street Journal and The New York Times are in a different category. That doesn’t mean it necessarily works brilliantly for them, but they are a different business than a local newspaper. But local newspapers continue to decline at a very significant rate. And even with the economy improving, circulation goes down, advertising goes down, and it goes down in prosperous cities, it goes down in areas that are having urban troubles, it goes down in small towns – that’s what amazes me. A town of 10 or 20,000, where there’s no local TV station obviously, and really there’s nothing on the internet that tells you what’s going on in a town like that, but the circulation just goes down every month. And when circulation goes down, advertising is gonna go down, and what used to be a virtuous circle turns into a vicious circle. I still love newspapers! You’re talking to the last guy in the world. Someday you’ll come out and interview me, and you’ll see a guy with a landline phone, reading a print newspaper.”
The table below shows how advertising revenue has declined between 2003 and 2014. A slide that most likely is going to continue.
As summarized by The 13th annual Pew Research State of the News Media Report about the current state-of-play when it comes to newspapers:
It has been evident for several years that the financial realities of the web are not friendly to news entities, whether legacy or digital only. There is money being made on the web, just not by news organizations. Total digital ad spending grew another 20% in 2015 to about $60 billion, a higher growth rate than in 2013 and 2014. But journalism organizations have not been the primary beneficiaries. In fact, compared with a year ago, even more of the digital ad revenue pie — 65% — is swallowed up by just five tech companies. None of these are journalism organizations, though several — including Facebook, Google, Yahoo and Twitter — integrate news into their offerings. And while much of this concentration began when ad spending was mainly occurring on desktops platforms, it quickly took root in the rapidly growing mobile realm as well.
In hindsight, everything looks pretty clear, right?
The trick is being able to continuously evaluate businesses and industries and identify any data that may indicate a coming, or ongoing, moat-erosion. But that’s some topic for another post.
Even though this blog post was about the past, the key take-away from it is that moats change, and we gotta be aware of this and make the best we can out of it we look into the unknown future. At least if we’re hunting for, and investing in, companies supposed to enjoy sustainable competitive advantages.
“Of all the ‘old’ media, newspapers have the most to lose from the internet.”
“When investing, we view ourselves as business analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
—Warren Buffett, Letter to Shareholders, 1987
The Buffett/Munger Investment Checklist: A Framework for Business Analysis and Valuation
How to go about when performing a business analysis, and what to look for in doing so, is nothing but the holy grail of investing. A business analysis could be carried out in a number of different ways. You just have to make sure that you have a way that works for you, a process for analyzing and evaluating businesses that is continually updated along the way as you learn about new facts and circumstances.
When building your own framework for business analysis, you should always remember to keep things simple, since it most likely will tend to get hard enough anyway in the end. Also, you don’t have to come up with your own stuff, you are perfectly free to use everything there is from great men that’s come before, as Charlie Munger noted when he said:
I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.
To set the scene to sort of create an investing map to follow it’s worth considering what Warren Buffett once wrote:
In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About Market Prices.
To be able to value a business, you have to understand the business. And to be able to say that you understand a business you would likely want to know about its products/services and revenue sources, operating leverage, financial leverage, competitive position, industry characteristics, etc. These questions all belong to the first section of the Buffett/Munger Investment Checklist, i.e., understanding the business.
When you understand a business and its management, and have evaluated the long-term prospects as favorable, the next step is to value the business, i.e., come up with an estimate of intrinsic business value that is to be compared to the current market price of the business. If you manage to, and have the luck, to check each of the four main parts of the checklist, you most likely have an investment worth making.
In his 1977 letter to shareholders Warren Buffett explained his and Charlie’s process for analyzing and evaluating businesses.
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.
So, already back in 1977 Warren Buffett laid out the checklist that he and Charlie go through when evaluating a business. This will serve as a good starting foundation for anyone who wants to build their own investment checklist. Each checklist point could then be expanded to included a number of supporting sub-questions needed for coming up with a conclusion about the “main” checklist question being evaluated.
From the above quote and discussion, keep in mind the foundations of our Buffett/Munger Investment Checklist:
Understand the business
Favorable long-term prospects
Operated by honest and competent management
Very attractive price
To make it easier to remember the top four checklist points, memorize the acronym “UFOV.” That’s easy to remember, right? It’s just “UFO” plus a “V.”
As always, when talking about the subject of checklists, make sure to use them in an appropriate wat and also remember Warren Buffett’s words that “A checklist is no substitute for thinking.”