Berkshire Part 1: See's and PetroChina
You've probably read Warren Buffett's 2007 letter to shareholders that was released a week ago. If not, stop everything you're doing, and read it now.
Below are a few comments I have on some of the things Buffett mentions in the letter. The second part of this post should be up later today.
On See's Candy
The best part of the letter is the section entitled "Businesses - The Great, The Good, and the Gruesome." In it, Buffett talks about the qualities of a great business using See's Candy as an example.
Six months ago I wrote a two part story on See's Candy. In Part I of Quality Without Compromise I talk about the history and background of the See's acquisition. In Part II, I discuss some of the technical and qualitative aspects of the purchase. (Click here for a single PDF version of the articles.)
In the letter, Buffett reveals some interesting new information about See's and his mindset regarding the business.
Fun with numbers:
Pre-tax profits in 2007 were $82 million.
Over the years, total profits distributed come to $1.32 billion.
Current Return on Capital is 205%.
Since the purchase, only $32 million in additional capital was required.
Profits at acquisition were about $5 million, so total increase has been $77 million over the 35 year period. This comes out to a return on incremental capital invested of 241% ($77/$32).
For every $1.00 Berkshire sent to See's, they got back $41.19.
Talking about some of the reasons for the high Return on Capital, Buffett made the comment: "First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was sort, which minimized inventories." Working capital is one of the major reasons businesses must invest more capital to keep up with sales growth. Fixed assets are another requirement where See's has advantages. There are relatively few production facilities. More recently, the internet has allowed See's to sell more pounds of candy (to anywhere in the country) with little to no additional capital expenditures.
Low volume is a problem at See's, but the ability to raise prices made up for it: "Last year See's sold 31 million pounds [of candy], a growth rate of only 2% annually." In See's early years (the 11 years after Buffett's purchase), prices per pound of chocolate were raised about 10% per year. These increases accounted for 86% of sales gains over the period. Small volume gains accounted for the rest.
See also: Shai Dardashti asks if See's Candy is a Magic Formula Stock from 1972. I like Shai's conclusion that "See's Candy is effectively a (rising) royalty on love men pay, annually, in the state of California."
Buffett goes into a little more detail on the sale of Berkshire's stake in PetroChina. In October I wrote up a short case study on the investment in PTR, which you can see here. He confirms in writing that when they sold PTR back in September, he believed it was fairly valued. This echoes the research I did on the gap between price and value over the years (and the effect of oil prices on that value).
"By 2007, two factors had materially increased its value: the price of oil had climbed significantly, and PetroChina's management had done a great job in building oil and gas reserves. ... We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government - defense, social security, you name it - for about four hours."
On Selling Market Puts
Stay tuned for Part 2...