Q&A: Case Study of See’s Candy

“There was something special. Every person in California has something in mind about See’s Candies and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him… See’s Candies means getting kissed. If we can get that in the minds of people, we can raise prices.” —Warren Buffett

This post contains my answers to the questions posted at CSInvesting.org as part of the DEEP VALUE course and the case study on See’s Candy. Feel free to comment and share your own views, reflections and take-aways.

Company Overview

A brief description of See’s Candy as of today:

See’s Candy Shops, Inc. produces boxed chocolates and candies. The company offers chocolate assortments, nuts and chews, decadent chocolate truffles, milk and dark chocolates, brittles and toffees, truffles, lollypops, candy bars, gift cards, and kosher categories. It offers products online, as well as through its shops in the United Sates, Hong Kong, Japan, and Macau. The company was founded in 1921 and is headquartered in Carson, California. (Source: Bloomberg)

Financial Data and Operating Metrics

From the current description of the business, let’s turn back to the time when Buffett and Munger purchased See’s, that is in the beginning of the 70’s.

From the financials disclosed by Warren in his shareholder letters we can see that See’s development has been excellent. Growing sales revenues translating into higher operating profits. See’s excellence is, to a great extent, derived from its ability to raise prices along with and also above the rate of inflation and at the same time requiring very limited investment in tangible assets.

A look at the development in the number of pounds of candy sold shows that during the same time period (1972 to 1984) as revenues more than quadrupled, operating profit after taxes increased more than tenfold, the number of pounds of candy sold increased only 46%. That’s right, just 46% during this 12 year period, or at an average growth rate per year of 3.2%. So, the great growth rate shown by sales revenues, was not due to volume growth, but to price.

If we take a look at sales revenues, operating expenses (OPEX) and operating profit after taxes (OPAT) on a per-pound basis, it’s clear that at the same time as sales revenue grew, operating expenses were managed in a good way which resulted in great growth in operating profit after taxes.

Looking at the data broken down on a per store level the same can be seen even here. Rising revenues per store, rising OPEX (even though at a lower rate than the growth in revenues), which contributed to the great growth rate in OPAT per store. At the same time the number of pounds of candy sold per store was growing real slow, and even turned negative for three of the four periods for which averages are calculated (see table below).

And finally, from where can any support for the pricing power of See’s be derived? If growth in sales revenues is compared to volume growth from the number of pounds of candy sold, we get a rough measure of the price increase each year (before inflation, i.e., nominal amounts). Taking inflation into account in the next step then gives the real price increases, that is any amount of the total price increase each year that remains when inflation for the same period is taken into account.

A year-to-year comparison does not always show any clear signs, growth between single years can go in opposite ways even when the underlying trend during a couple of years tells another tale. Instead, from looking at longer time periods it can be seen that See’s has not just been able to raise prices to match inflation, See’s also was able to raise prices at a rate higher than inflation, i.e., in real terms. (Any input regarding the pricing power issue of See’s and how to derive it would be greatly appreciated. Does my thinking make sense, or should something maybe be reconsidered here in my attempt to try to find the key to the “untapped pricing power” of See’s (both in nominal and real terms) Feel free to comment!)

Describe the competitive advantages of See’s.

In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.)

—Warren Buffett, 1983 Letter to Shareholders

See’s moat most likely stems from:

• CAPTIVE CUSTOMERS through habit formation and maybe even some kind of emotional switching costs due to psychological reasons coming from the influence from mere-association tendency and the social proof tendency (both discussed by Charlie Munger in his speech The Psychology of Human Misjudgment), and
• LOCAL ECONOMIES OF SCALE in advertising and distribution.

For a hint on why it seems likely to assume the presence of LOCAL ECONOMIES OF SCALE even some decades ago, take a quick look at the map below showing some 186 See’s stores in California AS OF TODAY (Source: ca.sees.com). This concentration reminds me of the Walmart map that I posted in another post (see here).

Could this be a faster growing business if See’s sold through other marketing channels?

See’s most likely would be able to increase its growth rate (in volume) if it was sold through other marketing channels. But, would it still be as profitable? Probably not. But as we can see from an analysis of See’s moat and its sources, the moat sources are most favorable in California, and thus probably less so in other parts of the U.S.

How does Buffett analyze this business?

• Poundage volume
• Units sold per store

The poundage volume in our retail stores has been virtually unchanged each year for the past four, despite small increases every year in the number of shops (and in distribution expense as well). Of course, dollar volume has increased because we have raised prices significantly. But we regard the most important measure of retail trends to be units sold per store rather than dollar volume. On a same-store basis (counting only shops open throughout both years) with all figures adjusted to a 52-week year, poundage was down .8 of 1% during 1983.

—Warren Buffett, 1983 Letter to Shareholders

• Per-pound realization
• Per-pound costs
• Same store-volume

During 1984 we increased prices considerably less than has been our practice in recent years: per-pound realization was $5.49, up only 1.4% from 1983. Fortunately, we made good progress on cost control, an area that has caused us problems in recent years. Per-pound costs – other than those for raw materials, a segment of expense largely outside of our control – increased by only 2.2% last year.

Our cost-control problem has been exacerbated by the problem of modestly declining volume (measured by pounds, not dollars) on a same-store basis. Total pounds sold through shops in recent years has been maintained at a roughly constant level only by the net addition of a few shops annually. This more-shops-to-get-the-same-volume situation naturally puts heavy pressure on per-pound selling costs.

In 1984, same-store volume declined 1.1%. Total shop volume, however, grew 0.6% because of an increase in stores. (Both percentages are adjusted to compensate for a 53-week fiscal year in 1983.)

—Warren Buffett, 1984 Letter to Shareholders

What price did Buffett pay and why?

See’s is a slow grower, but its growth is steady and reliable—and best of all, it doesn’t take additional infusions of capital.

—Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

Purchase price for See’s amounted to $25 million, a business earning $4 million pre-tax and $2 million after-tax, from $8 million in tangible assets (25% after-tax ROC or 50% pre-tax ROC), which translates into these key ratios:

• 12,5 times after-tax earnings (8% yield)
• 6,3 times pre-tax earnings (16% yield)
• 3 times invested capital

In comparison, the 10-year treasury rate in January 1972 was 5.95 percent.

Harry See’s asked for $30 million, but Buffett and Munger weren’t willing to pay more than $25 million, since this was a lot higher than the capital invested in the business. Harry See’s finally accepted the price of $25 million and Buffett and Munger, through Blue Ship Stamps, acquired a great franchise.

Video & Notes: Warren Buffett Speaks with Florida University

“You have to understand the business. You can understand some businesses but not all businesses.” —Warren Buffett

Warren E. Buffett Lecture at the University of Florida School of Business October 15, 1998

 

A Few Notes and Quotes

Go here for full transcript of the above talk.

Below are a few great parts from the Buffett video that I like. There are many more, just watch the video and read the transcript to find them. I watched it yesterday night, and I have seen it a couple of times before. It’s really a great talk from Buffett with a lot of useable and important (and knowable) stuff to take away and remember.

Isn’t it wonderful, being able to read so much and look at great videos like this one. Too bad we didn’t learn this in school. But anyway, good to catch up now, having your own little Value Investing University. All you have to do is open up the Internet browser and start searching and learning. Awesome. Okay, so back to the quotes.

See’s Candies

“See’s Candy was a $25 million business when we bought it. If I can find one now, as big as we are, I would love to buy it. It is the certainty of it that counts.”

“It is a tough thing to decide but I don‘t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won‘t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don‘t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. 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.”

“What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine‘s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: ―What a friend we have in Jesus. (Laughter). It is a good business? Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody‘s birthday or more likely it is a holiday. Valentine‘s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three week period. Men buy on Valentine‘s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won‘t dare go home without a box of Chocolates by the time we get through with them on our radio ads. So that Valentine‘s Day is the biggest day. 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.”

Why Smart People Do Dumb Things

“But to make money they didn’t have and didn’t need, they risked what they did have and what they did need.”

Circle of Competence

“Everybody has got a different circle of competence. The important thing is not how big the circle is, the important thing is the size of the circle; the important thing is staying inside the circle. And if that circle only has 30 companies in it out of 1000s on the big board, as long as you know which 30 they are, you will be OK. And you should know those businesses well enough so you don‘t need to read lots of work.”

Understand the Business

“You have to understand the business. You can understand some businesses but not all businesses.”

“I like businesses that I can understand. Let‘s start with that. That narrows it down by 90%. There are all types of things I don‘t understand, but fortunately, there is enough I do understand.”

Macroeconomics

“I don‘t think about the macro stuff. What you really want to in investments is figure out what is important and knowable. If it is unimportant and unknowable, you forget about it.”

The Business to Buy

“So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten years from now.”

Buying a Business

“You really want your decision making to be by looking in the mirror. Saying to yourself, ―I am buying 100 shares of General Motors at $55 because…… It is your responsibility if you are buying it. There‘s gotta be a reason and if you can‘t state the reason, you shouldn‘t buy it. If it is because someone told you about it at a cocktail party, not good enough. It can‘t be because of the volume or a reason like the chart looks good. It has to be a reason to buy the business. That we stick to pretty carefully. That is one of the things Ben Graham taught me.”

Beta and Risk

“They thought that the Beta of the stock told you something about the risk of the stock. It doesn‘t tell you a damn thing about the risk of the stock in my view.”

Q&A: Case Study on Dempster Mill Manufacturing Company

“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).” —Warren Buffett

In this post I lay out my answers to the questions posted at CSInvesting.org as part of the DEEP VALUE course and the case study on Dempster Mill Manufacturing Company. Feel free to comment and share your own views, reflections and take-aways.

I do not think that these questions are that easy. But I have tried to come up with decent answers, since by not trying I won’t learn anything. So, take it for what it is and feel free to share our own thoughts, preferably over at the comment section at CSInvesting where you will find many others who also participate in the DEEP Value course.

How did Buffett find this investment and what ways did he reach an intrinsic value?

Buffett found Dempster since the “figures were extremely attractive.” In other words, a low price compared to book value.

How many margins of safety did he have?

When Buffett first acquired stock in Dempster the most important margin of safety was most likely in the great discount between price and book value.

Later on when Buffett realized that current management didn’t succeed he had Harry Bottle to take over as CEO. This provided sort of a second margin of safety, a great manager or management team is never a negative. And in Harry Bottle Buffett found himself a great CEO able to run the business in a way Buffett himself thought was most likely to create the most value. I put Harry as second, because I think that he was more important than any potential future improvement in earning power. The earning power was more likely to be an outcome of great operating management.

Third, possible improvement in earning power.

What “type” of investment is this—is earning power below Asset Value?

The investment in Dempster started out as a net asset value investment, this due to the great discount between price and book value. Buffett also wrote that “the figures were extremely attractive.” It wasn’t the qualitative aspects of Dempster that was the main reason why Buffett started acquiring stock, it was all based on the great discount to book value per share.

When Buffett started purchasing Dempster stock the earning power value was a lot lower than the value of the assets, even compared to net current asset value and Buffett’s valuation applying different discounts to each balance sheet item.

Buffett wrote that Dempster had “…earned good money in the past but was only breaking even currently.” Earning power value clearly had taken a hit, and was probably a big reason for the stock price trading at such a big discount to book value. As Graham & Dodd wrote in Security Analysis when discussing Westinghouse Electric and Manufacturing Company position; “…the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future.”

Buffett may have had some expectations for the earning power to come back and help support a higher stock price, even if this was far from a sure thing. The margin of safety was in the low price compared to book value. If earning power would be restored, that would serve as a bonus I think.

Is this a franchise? Why or why not is this occurring?

Dempster was not a franchise. Buffet wrote that “The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” Not the characteristics to be expected from a franchise. Buffett also wrote that Dempster was in a “fairly tough industry,” and it also had “unimpressive management.”

If earning power was to be restored it would probably, even in the best case, only support the net asset value, thus no excess returns and no earning power value greater than the asset value. This would indicate a business without any franchise value, i.e., no sustainable competitive advantage—or moat.

Was Buffett lucky in this investment? Why or why not?

I think luck always plays some part. But Buffett started to purchase stock due to the margin of safety he deemed to be present. So even if Harry Bottle had not come along, Buffett might have been able to sell out without making a loss. When already invested and taking control he used his skill as a business owner in a pretty good way I think, mostly through Harry Bottle taking care of the daily operating activities.

How would Graham approach an investment like this?

Not really sure about this one. Graham also invested in businesses situations that could be compared to Dempster. But even if Graham did so, maybe the most likely way he would look at Dempster would be purely quantitative. From what I can see, Dempster never was a pure net-net during the time Buffett was an owner. So maybe Graham would have stayed away from it.

What would have been the big difference between Graham and Buffett concerning Dempster Mills?

That Graham never would have bought because the stock wasn’t cheap enough to provide a margin of safety to an estimated liquidation value (current asset minus total liabilities). But I’m not really sure about this one. Will be interesting to see the comments to this question.

So, now I shall start reading the comments to see what all other participants have to say about these questions. Even though the case study was posted a few days ago I have not read any comments that’s been posted, since this would sort of “anchor” my own answers.

BTW. Today I received my King Icahn book in the mail. Look forward to start reading. But will wait until John says go.

All for now!

Moneyball: Baseball & DEEP VALUE investing

“We got to think differently.” —Billy Beane

“I believe there is a championship team that we can afford, because everyone else undervalues them, like an island of misfit toys.” —Peter Brand

”I hate losing more than I love winning.” —Billy Beane

”Your goal shouldn’t be to buy players. Your goal should be to buy wins. In order buy wins, you need to buys runs.” —Peter Brand

For a few more great videos, go to CSInvesting.