See’s Candies Case Study Deep Value Course (Supplement to Chapter 3, Deep Value) See’s Candies www.csinvesting.org Page 1 See’s Candies Case Study Prepared by John Chew This case is compiled from various sources and, though repetitive, there are important lessons in this case. This case along with Buffett’s “Inflation” Article is critical for your understanding. This purchase was the big shift in approach for Buffett because he left behind his focus of “cigar-butt” investing (buying below asset or liquidating value) and moved into franchise investing. He bought companies whose main value would be earned in the future (See’s, Coke, Gillette, etc.). Describe the competitive advantages of See’s. Could this be a faster growing business if See’s sold though other marketing channels? How does Buffett analyze this business? What price did Buffett pay and why? -- Short background on See’s Candies (Source: The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers by Robert P. Miles (2002) See’s Candies is particularly interesting because of both the business and the operating managers. Mr. Huggins was not part of the founding family and didn’t participate directly in the ownership of the company. Therefore, he could well serve as a model of what Berkshire management will be like 50 years from today. See’s Candies is often described by Warren Buffett as the perfect business. It was one of the first wholly owned businesses purchased by Berkshire and was the first investment for which vice chairman Charlie Munger influenced Buffett to pay a premium for quality. It was the first multigenerational family-owned business to be added to the Berkshire family of businesses. It was also the first Berkshire-owned consumer franchise with a built-in ability to raise prices from 50 cents a pound during the 1929 stock market crash to $12 per pound today (2002). Without the See’s Candies purchase, there may not have been a major investment in Coca-Cola 20 years later. With superior management, sustainable competitive advantages, scarcity of close substitutes, ability to raise prices without losing customers, high profits, low capital investment, and extraordinary returns on capital, it’s the perfect business for any student of business, management, and investment. See’s Candies fulfills all the criteria Buffett looks for. The business is profitable and has no debt. It has a solid franchise brand name and is a multigenerational family business that maintains uncompromising business values. A long-term management team is in place, and the company is able to grow without any additional influx of capital. Critical to See’s Candies’ success has been the management by Chuck Huggins. -- Factors behind success: Offering greater insight into the investment process and management tenets of Chuck Huggins, Buffett wrote, “See’s has a one-of-a-kind product ‘personality’ produced by a combination of its candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees. Chuck rightfully measures his success by the satisfaction of our customers, and his attitude permeates the organization. Few major retailing companies have been able to sustain such a customer-oriented spirit, and we owe Chuck a great deal for keeping it alive and well at See’s. The secret to investment success is a durable competitive advantage based on a franchise. The motivation that causes a consumer to buy and consume chocolate was the same 50 years ago and will be the same 50 years from now. (Human habit and psychology). Two management tenets that Huggins insisted on early to ensure See’s survived when other retail candy stores failed:
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See’s Candies Case Study
Deep Value Course (Supplement to Chapter 3, Deep Value) See’s Candies www.csinvesting.org Page 1
See’s Candies Case Study Prepared by John Chew
This case is compiled from various sources and, though repetitive, there are important lessons in this case. This
case along with Buffett’s “Inflation” Article is critical for your understanding. This purchase was the big shift
in approach for Buffett because he left behind his focus of “cigar-butt” investing (buying below asset or
liquidating value) and moved into franchise investing. He bought companies whose main value would be earned
in the future (See’s, Coke, Gillette, etc.).
Describe the competitive advantages of See’s. Could this be a faster growing business if See’s sold though other
marketing channels? How does Buffett analyze this business? What price did Buffett pay and why?
--
Short background on See’s Candies
(Source: The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers by Robert P. Miles (2002)
See’s Candies is particularly interesting because of both the business and the operating managers. Mr. Huggins
was not part of the founding family and didn’t participate directly in the ownership of the company. Therefore,
he could well serve as a model of what Berkshire management will be like 50 years from today.
See’s Candies is often described by Warren Buffett as the perfect business. It was one of the first wholly owned
businesses purchased by Berkshire and was the first investment for which vice chairman Charlie Munger
influenced Buffett to pay a premium for quality. It was the first multigenerational family-owned business to be
added to the Berkshire family of businesses. It was also the first Berkshire-owned consumer franchise with a
built-in ability to raise prices from 50 cents a pound during the 1929 stock market crash to $12 per pound today
(2002). Without the See’s Candies purchase, there may not have been a major investment in Coca-Cola 20 years
later. With superior management, sustainable competitive advantages, scarcity of close substitutes, ability to raise
prices without losing customers, high profits, low capital investment, and extraordinary returns on capital, it’s the
perfect business for any student of business, management, and investment.
See’s Candies fulfills all the criteria Buffett looks for. The business is profitable and has no debt. It has a solid
franchise brand name and is a multigenerational family business that maintains uncompromising business values.
A long-term management team is in place, and the company is able to grow without any additional influx of
capital. Critical to See’s Candies’ success has been the management by Chuck Huggins.
--
Factors behind success:
Offering greater insight into the investment process and management tenets of Chuck Huggins, Buffett wrote,
“See’s has a one-of-a-kind product ‘personality’ produced by a combination of its candy’s delicious taste and
moderate price, the company’s total control of the distribution process, and the exceptional service provided by
store employees. Chuck rightfully measures his success by the satisfaction of our customers, and his attitude
permeates the organization. Few major retailing companies have been able to sustain such a customer-oriented
spirit, and we owe Chuck a great deal for keeping it alive and well at See’s.
The secret to investment success is a durable competitive advantage based on a franchise. The motivation
that causes a consumer to buy and consume chocolate was the same 50 years ago and will be the same 50 years
from now. (Human habit and psychology).
Two management tenets that Huggins insisted on early to ensure See’s survived when other retail candy stores
failed:
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1. Concentrate the efforts of all employees in all departments to attain ever-increasing excellence in
customer services and product quality.
2. Never compromise quality ingredients or quality service over profits.
--
See’s Candies Teaches a Lesson from Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire
Charlie Munger (2000).
See’s Candies—with its motto “quality without compromise” –represents more to Munger than an after-dinner
delicacy. The acquisition of See’s Candies was among the earliest deals that he and Warren Buffett did together
and it was one of the first companies they purchased outright. But most important, the experience of See’s
Candies taught Charlie and Warren a lesson that caused a major improvement to their investment style.
In 1972, using the float of Blue Chip Stamps, Buffett and Munger acquired the small Los Angeles-based See’s
Candies for $25 million. It was a major step for Charlie and Warren because it was their biggest purchase up to
that time.
It was big news in California, where See’s black and white candy shops are part of the local culture. A 16-year-
old Cher was working at See’s when she met Sonny Bono and left her job to move in with him as his housekeeper.
Mary See was 71 when she opened a small, Los Angeles neighborhood candy shop in 1921, although she had the
help of her son Charles.
Charles A. See had been a pharmacist in Canada, but changed careers after his two pharmacies were destroyed
when a forest fire swept through the town where he did business. He took up work as a chocolate salesman and
dreamed of starting his own candy company using recipes developed by his mother. In 1921, he moved his
family, including his widowed mother, Mary, from Canada to Pasadena, the beautiful and refined Los Angeles
suburb that Charlie would later adopt as home. During the 1920s, Los Angeles was a booming city of 500,000
residents. It wasn’t an easy go for the Sees, since there were hundreds of competitors. See and his partner, James
W. Reed, decided to concentrate on building a reputation with a high-quality product.
When the stock market crashed in 1929 and the Great Depression hit, See’s was forced to cut the price of a pound
of candy from 80 cents to 50 cents. He survived by persuading landlords to reduce his rents, arguing that lower
rent was better than no rent. But he also had an opportunity to expand his markets as other candy-makers went
bankrupt. A second crisis came during WWII when sugar was rationed. Rather than compromise quality with
inferior ingredients or altered recipes, See’s decided to produce as much high quality candy as possible with the
ingredients that were allocated to the company and no more. Customers lined up around the block to buy the
limited supply of chocolates, and once the supply was gone, the shop closed for the day. No matter what time the
store closed the sales staff was paid for a full day of work. This turned out to be a smart marketing ploy, since the
waiting crowds added to the candy stores cache.
See’s was already 30 years old when Charles Huggins joined the company in 1951. The head office was then in
Lois Angeles. But Huggins started in the San Francisco facility. When Harry See, Mary’s grandson, took over
the company after his brother’s death, Huggins was given responsibility for expanding the company’s business.
Harry See, Huggins said, “He enjoyed life tremendously, was a world traveler, established vineyards in Napa
Valley. After a while the family decided collectively to sell the company and cash in their chips. Chuck Huggins
was coordinator and liaison for that.
“We started in the spring of 1970. We had a couple of very serious suitors, such as a big-four sugar company
from Hawaii that owned C&H and others. The family wanted a pretty heady ransom for the company and that
dissuaded several buyers.”
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One company began an in-depth due diligence, examining the business, its many contracts, and so on, to the
extent that even Huggins thought they were overly meticulous. “At the eleventh hour, literally at midnight the
day before they were to sign the purchase agreement, they backed out. No harm was done, except the energy I
expended. We’ve kept in touch for years, they were such nice fellows,” said Huggins.
About that time, Robert Flaherty, an investment advisor to Blue Chip, heard that the premier chocolate chain was
for sale. He contracted William Ramsey, a Blue Chip executive, who was enthusiastic about buying See’s.
Ramsey called Buffett from Flaherty’s office.
“Gee, Bob,” Buffett said. “The candy business. I don’t think we want to be in the candy business.” For some
reason, the phone line then went dead. Ramsey and Flaherty hurriedly tried to call Buffett back. Finally, after the
secretary misdialed the number and several minutes elapsed, the reconnected. Before they could speak Buffett
burst out: “I was taking a look at the numbers. Yeah, I’d be willing to buy See’s at a price.”
Warren immediately flew out to visit Harry See.
That was in November 1971, recalled Chuck Huggins. There were two things to be resolved—how much to pay
and how the business would be run. Warren said, ‘Harry, we need to talk to you about the price privately.’
Warren then said to Harry, ‘if we go through with this, we don’t run companies. I need to know who will run the
company.’”
“Harry looked around the room and saw me, and said, ‘Chuck will.’.
Warren explained to Huggins that first the purchase had to be settled, but, “if that happens, here are a couple of
things that are expected. First, we want you to run See’s as president and CEO, and second, we don’t want any
Sees left with a relationship to the company. Some of the people have been around for a long time. Make a
settlement and they can go their way.”
Huggins said Warren and Charlie wanted him to have full control. “We want you to maintain company ethics
and standards,” said Buffett.
The See family was asking $30 million. But because of See’s low book value, Buffett and Munger decided not to
go above $25 million. The talks ended, but later See called back and accepted the $25 million. Munger and
Buffett purchased See’s Candies on Jan. 3, 1972, paying three times book value, something they’d never done
before.
See’s makes more than half of its profits at Christmas.
“While Blue Chip owned us, it was clear Warren, Charlie, and Rick were the owners,” said Huggins. Warren
said, “Do what you’ve been doing. Let us know if there are danger signs, trouble, but just keep us informed.
Figure out some way to do that.’ He said, ‘If you can build on what the See family has done, make it more grand
that would be good.’”
Then Buffett added an observation about the candy itself, “You’re priced well below the market.”
Huggins’ immediate challenge was to convince loyal customers that See’s would not change under the new
owners.
Once the dust settled, See’s started expanding into markets in Missouri, Texas, and Colorado and even as far
away as Hong Kong. Sees participated in the 1982 World’s Fair in Knoxville, Tennessee, and the exhibit was
such a success that See’s opened a shop in Knoxville.
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During the same period, the Retail Clerk’s Union attempted to organize the sales force in the stores. See’s since
has triumphed in four attempts to organize by the Retail Clerk’s Union, mainly by paying higher than union-scale
wages.
At one time, See’s came under attack by a major candy producer from the Midwest. In 1973, Russell Stover
Candies (which traditionally was sold through other retailers) went heavily into their own stores. They decided to
put on a campaign with See’s and beat us out in our own marketplace,” recalled Huggins. “They put in stores that
looked exactly like See’s, called Mrs. Stover’s. They duplicated our identity and tried to grab out market. Of
course, I informed Charlie and Warren about that fact.”
Munger said, “If they are infringing on our trade mark in any way, we can go after them.” Stover’s eventually
backed off.
Part of See’s competitive advantage is that it is a leader in its market. “In some businesses, the very nature of
things is a sort of cascade toward the overwhelming dominance of one firm,” said Munger. “It tends to cascade to
a winner-take-all result. And these advantages of scale are so great for example, that when Jack Welch came into
GE, he just said, “To hell with it. We’re either going to be number one or number two in every field we’re in or
we’re going to be out.” That was a very tough-minded thing to do, but I think it was a correct decision if you’re
thinking about maximizing shareholder wealth.”
Munger went on, “See’s has stayed out of a lot of traps.”
“The ordinary candy company puts in too many stores,” Charlie continued. “You have this huge overhead you’re
carrying through July and August, and you just can’t get well at Christmas. But See’s has always had the
discipline of knowing their own business. That’s harder on the employees, by the way. They have this huge
crunch in the stores at Christmas, but it is part of the secret of See’s.
“And of course the fanaticism about the quality of the product and service is the heart and soul of the
business. I love the fact that this room is full of long time customers and long time suppliers. You get suppliers
who are good and who are trusted because they deserve trust, and you behave the same way toward your own
customer, then you are a little part of a civilization that is a seamless web of deserved trust. This is the way the
world ought to work. It is a better example for everyone else. It is the right way to build up a state or a
civilization. It was marvelous for us to become associated relatively early in our business careers with a culture
that was so fundamentally sound. It is Ben Franklin (or his business philosophy) all over again, alive and well at
See’s after all these years.”
See’s Candies—with its motto “quality without compromise”—represents more to Munger than an after-dinner
delicacy. The acquisition of See’s Candies was among the earliest deals that he and Warren Buffett did together
and it was one of the first companies they purchased outright. But most important, the experience of See’s
taught Charlie and Warren a lesson that caused a major improvement in their investment style.
“See’s Candies,” reminisces Munger. “It was acquired at a premium over book (value)
and it worked. Hochschild, Kohn, the department store chain (in Baltimore), was bought
at a discount from book and liquidating value. It didn’t work. Those two things together
helped shift our thinking to the idea of paying higher prices for better businesses.”
When they bought See’s Charlie and Warren still were bottom fishers. But as they learned and as the business
grew, change was necessary. “You could once find value by just rooting around in the less traveled parts of the
world—the pink sheets—you’d find a lot of opportunity,” said Charlie.
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It was only luck that Blue Chip was able to buy See’s at the price they paid. Munger credits Al Marshall for
giving the final push toward the correct decision. Ira Marshall said you guys are crazy—there are some things
you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the
criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively
and learn from it. If you take the indirect lessons we learned from See’s, you could say Berkshire was built on
constructive criticism.
“If they had wanted to just $100,000 more for See’s, we wouldn’t have bought it,” said Munger. “We were that
dumb back then.”
Even so, “When we bought the business, almost nobody was having much success selling boxed chocolates
except See’s, and we wanted to know why that was, and if the success was sustainable,” said Buffett.
When See’s turned out to be an excellent, ongoing business, Munger and Buffett realized how much easier and
pleasanter it was to buy a good business and just let it roll along, then to buy a deeply discounted but struggling
business and spend time, energy , and sometimes more money setting it straight.
“If we hadn’t bought See’s, we wouldn’t have bought Coke,” said Buffett. “So thank See’s for the $12 billion.
We had the luck to buy the whole business and that taught us a whole lot. We’ve had windmills, well, I’ve
had windmills. Charlie was never in the windmill (Dempster Manufacturing) business. I’ve had second rate
department stores, pumps, and textile mills….“ which he decided were nearly as problematic as the windmills..
Munger says he and Buffett should have seen the advantages of paying for quality much earlier. “I don’t think it’s
necessary to be as dumb as we were.”
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. At Berkshire, Warren and I raised the prices of See’s Candies a little faster than others might have. You
will get a few opportunities to profit from finding under pricing. There are actually people out there who don’t
price everything as high as the market will easily stand. And once you figure that out, it’s like finding money
in the street—if you have the courage of your convictions.
“We’ve tried 50 different ways to put money into See’s, “explained Buffett. “If we knew a way to put additional
money into See’s and produce returns a quarter of what we’re getting out of the existing business, we would do it
in a second. We love it. We play around with different ideas, but we don’t know how to do it.
Munger added, “By the way, we really shouldn’t complain about this because we’ve carefully selected a bunch of
businesses that just drown in money every year.”
Munger told Berkshire shareholders that there are a large number of businesses in America that throw off
lots of cash, but which cannot be expanded very much. To try to expand would be throwing money down a rat
hole, he said. Such businesses don’t stir acquisition desires in most corporations, but they are welcome at
Berkshire because he and Buffett can take the capital invest it profitably elsewhere.
From See’s, said Munger, “We’ve learned that the ways you think and operate must involve time-tested values.
Those lessons have made us buy more wisely elsewhere and make many decisions a lot better. So we’ve gained
enormously from our relationship with See’s.
--
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1983 Letter to Berkshire Shareholders
See’s Candies Shops
The financial results at See’s continue to be exceptional. The business possesses a valuable and solid consumer
franchise and a manager equally valuable and solid.
In recent years See’s has encountered two important problems, at least one of which is well on its way toward
solution. That problem concerns costs, except those for raw materials. We have enjoyed a break on raw material
costs in recent years though so, of course, have our competitors. One of these days we will get a nasty surprise in
the opposite direction. In effect, raw material costs are largely beyond our control since we will, as a matter of
course; buy the finest ingredients that we can, regardless of changes in their price levels. We regard product
quality as sacred.
But other kinds of costs are more controllable, and it is in this area that we have had problems. On a per-pound
basis, our costs (not including those for raw materials) have increased in the last few years at a rate significantly
greater than the increase in the general price level. It is vital to our competitive position and profit potential that
we reverse this trend.
In recent months much better control over costs has been attained and we feel certain that our rate of growth in
these costs in 1984 will be below the rate of inflation. This confidence arises out of our long experience with the
managerial talents of Chuck Huggins. We put Chuck in charge the day we took over, and his record has been
simply extraordinary, as shown by the following table:
52-53 Week Year Operating Number of Number of
Ended About Sales Profits Pounds of Stores Open
December 31 Revenues after Taxes Candy Sold at Year End
The other problem we face, as the table suggests, is our recent inability to achieve meaningful gains in pounds
sold. The industry has the same problem. But for many years we outperformed the industry in this respect and
now we are not.
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. This small
decline was our best same-store performance since 1979; the cumulative decline since then has been about 8%.
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Quantity-order volume, about 25% of our total, has plateaued in recent years following very large poundage gains
throughout the 1970s.
We are not sure to what extent this flat volume - both in the retail shop area and the quantity order area - is due to
our pricing policies and to what extent it is due to static industry volume, the recession, and the extraordinary
share of market we already enjoy in our primary marketing area. Our price increase for 1984 is much more
modest than has been the case in the past few years, and we hope that next year we can report better volume
figures to you. But we have no basis to forecast these.
Despite the volume problem, See’s strengths are many and important. 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.) The quality of customer service in our shops - operated
throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful
personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business
that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters
the quality of customer service delivered by Chuck Huggins and his associates.
Because we have raised prices so modestly in 1984, we expect See’s profits this year to be about the same as in
1983.
--
Goodwill and its Amortization: The Rules and the Realities
See’s Candies used as an example
This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For
example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill.
(AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.)
And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic
Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting.
When a business is purchased, accounting principles require that the purchase price first be assigned to the fair
value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the
deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned
to an asset account entitled "excess of cost over equity in net assets acquired". To avoid constant repetition of this
mouthful, we will substitute "Goodwill".
Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except
under rare circumstances, it can remain an asset on the balance sheet as long as the business bought is retained.
That means no amortization charges to gradually extinguish that asset need be made against earnings.
The case is different, however, with purchases made from November 1970 on. When these create Goodwill, it
must be amortized over not more than 40 years through charges – of equal amount in every year – to the earnings
account. Since 40 years is the maximum period allowed, 40 years is what managements (including us) usually
elect. This annual charge to earnings is not allowed as a tax deduction and, thus, has an effect on after-tax income
that is roughly double that of most other expenses.
That’s how accounting Goodwill works. To see how it differs from economic reality, let’s look at an example
close at hand. We’ll round some figures, and greatly oversimplify, to make the example easier to follow. We’ll
also mention some implications for investors and managers.
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Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net
tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition
proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of
debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such
earnings seemed conservatively representative of future earning power in constant 1972 dollars.
Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be
expected to produce earnings on such assets considerably in excess of market rates of return. The
capitalized value of this excess return is economic Goodwill.
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net
tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial
leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium
rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with
consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than
its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of
economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as
television stations, and an enduring position as the low cost producer in an industry.
Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17 million over net tangible
assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that
$425,000 be charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such
charges, the $17 million had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue
Chip and, therefore, also 60% of See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of
See’s Goodwill, or about $7.5 million.
In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to
the "pooling" treatment allowed for some mergers. Under purchase accounting, the "fair value" of the shares we
gave to (or "paid") Blue Chip holders had to be spread over the net assets acquired from Blue Chip. This "fair
value" was measured, as it almost always is when public companies use their shares to make acquisitions, by the
market value of the shares given up.
The assets "purchased" consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned
the other 60%). What Berkshire "paid" was more than the net identifiable assets we received by $51.7 million,
and was assigned to two pieces of Goodwill: $28.4 million to See’s and $23.3 million to Buffalo Evening News.
After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two components: the $7.5
million remaining from the 1971 purchase, and $28.4 million newly created by the 40% "purchased" in 1983. Our
amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12
years, 2002 through 2013.
In other words, different purchase dates and prices have given us vastly different asset values and amortization
charges for two pieces of the same asset. (We repeat our usual disclaimer: we have no better accounting system to
suggest. The problems to be dealt with are mind boggling and require arbitrary rules.)
But what are the economic realities? One reality is that the amortization charges that have been deducted as costs
in the earnings statement each year since acquisition of See’s were not true economic costs. We know that
because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance
indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill.
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In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic
Goodwill increased in irregular but very substantial fashion.
Another reality is that annual amortization charges in the future will not correspond to economic costs. It is
possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or
anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in
constant, dollars – because of inflation.
That probability exists because true economic Goodwill tends to rise in nominal value proportionally with
inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business.
When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net
tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but
needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets,
that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In
contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in
"honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" –
even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a
world of continuous inflation.
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two
businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with
inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and,
assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net
tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both
good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in
receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably
just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The
motivation for this investment is the survival of the business, not the prosperity of the owner.
Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit
an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had
a burden over twice as large – a need for $18 million of additional capital.
After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value
of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for
every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added
money to a savings account.)
See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the
same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the
owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1
invested.
Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in
additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets
to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply
are hurt the least.
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And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on
tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural
resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-
heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the
inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for
acquisition of new businesses.
In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose
from ownership of operations that combined intangibles of lasting value with relatively minor requirements for
tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been
largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in
the communications business. That business has required little in the way of tangible investment – yet its
franchises have endured. During inflation, Goodwill is the gift that keeps giving.
But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there
is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price,
the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends
up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such
circumstances it might better be labeled "No-Will". Whatever the term, the 40-year ritual typically is observed
and the adrenalin so capitalized remains on the books as an "asset" just as if the acquisition had been a sensible
one.
* * * * *
If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest
one final item to ponder.
Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has
internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some
important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per
share, or 25%.
With such economics, it might sell for $100 per share or more, and it might well also bring that price in a
negotiated sale of the entire business.
Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a
corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge
annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true"
earnings of $3 per share cause him to rethink his purchase price?
--
The Predictability of See’s
Obviously all businesses change to some extent. Today, See’s is different in many ways from what it was in 1972
when we bought it: It offers a different assortment of candy, employs different machinery and sells through
different distribution channels. But the reasons why people today buy boxed chocolates, and why they buy them
from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See
family was building the business. Moreover, these motivations are not likely to change over the next 20 years, or
even 50.
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Question: You covered half of it which is trying to understand a business and buying a business. You also
alluded to getting a return on the amount of capital invested in the business. How do you determine what is
the proper price to pay for the business?
Buffett: 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 Candies in 1972, See’s Candies was then selling 16 million 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 (16% pre-tax
earnings yield) 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
Ca. 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. 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 Candies 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 will 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 Candies 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 Candies 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.
If you are See’s Candies, you want to do everything in the world to make sure that the experience basically of
giving that gift leads to a favorable reaction. It means what is in the box, it means the person who sells it to you,
because all of our business is done when we are terribly busy. People come in during those weeks before
Christmas, Valentine’s Day and there are long lines. So at five o’clock in the afternoon some woman is selling
someone the last box candy and that person has been waiting in line for maybe 20 or 30 customers. And if the
salesperson smiles at that last customer, our moat has widened and if she snarls at ‘em, our moat has narrowed.
We can’t see it, but it is going on everyday. But it is the key to it. It is the total part of the product delivery. It is
having everything associated with it say, See’s Candies and something pleasant happening. That is what
business is all about.
Question: If I have every bought a company where the numbers told me not to. How much is quantitative
and how much is qualitative?
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Buffett: The best buys have been when the numbers almost tell you not to. Because then you feel so strongly
about the product. And not just the fact you are getting a used cigar butt cheap. Then it is compelling. I owned
a windmill company (Dempster Mills Manufacturing) at one time. Windmills are cigar butts, believe me. I
bought it very cheap, I bought it at a third of working capital. And we made money out of it, but there is no
repetitive money to be made on it. There is a one-time profit in something like that. And it is just not the
thing to be doing. I went through that phase. I bought streetcar companies and all kinds of things. In
terms of the qualitative, I probably understand the qualitative the moment I get the phone call. Almost every
business we have bought has taken five or ten minutes in terms of analysis. We bought two businesses this year.
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. Now I did a lot of work in
the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would
call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in
some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see
every coal company. I would ask every CEO, “If you could only buy stock in one coal company that was not
your own, which one would it be and why? You piece those things together, you learn about the business after
awhile.
Funny, you get very similar answers as long as you ask about competitors. If you had a silver bullet and you
could put it through the head of one competitor, which competitor and why? You will find who the best guy is in
the industry. So there are a lot of things you can learn about a business. I have done that in the past on the
business I felt I could understand so I don’t have to do that anymore. The nice thing about investing is that you
don’t have to learn anything new. You can do it if you want to, but if you learn Wrigley’s chewing gum forty
years ago, you still understand Wrigley’s chewing gum. There are not a lot of great insights to get of the sort as
you go along. So you do get a database in your head.
(Source: Buffett Lecture to the University of Florida, 1998)
--
Warren used See’s Candies to explain inflation and the consumer monopoly. In 1972, See’s was earning around
$2 million on $8 million of net tangible assets. That means that See’s plant and equipment and inventory
produced, after all expenses and taxes, $2 million in net earnings. The company was earning 25% on its net
tangible asset base ($2 million / $8 million = 25%).
Berkshire paid roughly $25 million for See’s which equates to an after tax return of 8% ($2 million / $25 million
= 8%). Compare this to government bonds in 1972 which were paying a pretax rate of return of 5.8%, and See’s
after-corporate-income-tax annual rate of return of 8% doesn’t look too bad. (Note comparison.)
Now let’s say that a steel manufacturer with poorer economics than See’s produced $2 million in net earnings, on
$18 million in net tangible assets.
Two different businesses, both with net earnings of $2 million. The difference is that See’s produces its $2
million on a net tangible asset base of $8 million and the steel manufacturer produces its $2 million on a net
tangible asset base of $18 million.
Now add in inflation. Over the next ten years, prices double, as do sales and earnings. Thus both our businesses
experience a doubling of earnings, to $4 million. It’s easy to figure out because all you have to do is sell the same
number of units at the new inflated price, which everybody pays for with their new inflated salary.
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But there is a problem. Equipment wears out and eventually needs to be replaced. When these two companies go
to replace their net tangible asset bases, the one that had a base of $8 million, See’s, is going to have to come with
$16 million. Prices doubled not only for candy but for plants and equipment. But the steel manufacturer with a
net tangible asset base of $18 million is going to have to come with $36 million.
The steel manufacturer is going to require $20 million more of investment ($36 million - $16 million) to produce
the amount of earnings equivalent to See’s.
Think of the advantages a business has if it almost never has to replace its plant and equipment and has the
capacity to produce high rates of return on a small net tangible asset base—as See’s does. (Source: Buffettology
by Mary Buffett, 1997)
When Berkshire paid $25 million for See’s, it was reporting $4.2 million a year in pretax net earnings. This
equates to Berkshire’s earning an initial pretax annual return of 16.8% ($4.2 million / $25 million = 16.8%). By
1999, See’s had $74 million in pretax net earnings, which equates to a 296% pretax return against a 1972
purchase price of $25 million. See’s managed to grow its pretax earnings at an annual rate of 11.2% due in part to
inflation and an increase in the number of its retail outlets. (Source: The New Buffettology by Mary Buffett, 2002)
--
In 1982, Buffett was offered $125 million to sell See’s--five times the 1972 purchase price or equivalent to 20%
CAGR. Buffett decided to pass. A wise decision. Over the last eleven years, See’s has returned to Berkshire
$212 million—cash—in after-tax earnings. During that same period, See’s required $44 million in capital
expenditures, roughly equal to the $39 million that it depreciated and amortized. (Source: The Warren Buffett
Way by Robert Hagstrom, Jr., 1995
--
From Valuegrowth Investing by Glen Arnold: See’s Candies
The See’s Candies Shops story illustrates the benefits that can flow from a company that has a powerful market
position, excellent management and only a small need for additional capital as it grows sales and profits.
An affiliate company of Berkshire (Blue Chip Stamps) bought control of See’s, a West Cost manufacturer and
retailer of boxed-chocolates, in 1972. The sellers were asking for $40 million. The company had $10 million of
excess cash and so the true offering price was $30 million. Munger, who through his own inv3estment fund had
an interest in Blue Chip Stamps and therefore See’s, and Buffett had not yet fully developed their investment
philosophy based on the value of an economic franchise. Buffett, in particular, was still strongly influenced by
Graham’s ideas. This meant that they refused to offer $30 million as See’s had a mere $7 million of tangible net
assets. The highest they would go was $25 million. Fortunately, the sellers accepted the offer.
Over the next 20 years annual pre-tax profits increased from $4.2 million to $42.4 million. This may sound
impressive, but before judgment is passed the analyst needs to know how much extra capital was needed to
produce it. Take, for example, a steel producer with $4.2 million profit making use of $40 million of capital.
Conventional investors may value this company more highly than See’s, given the additional asset backing
(assuming similar profit projections). However, Buffett would value the steel producer at much less because of
its great need for additional capital as it grows. Let’s imagine that both firms increase output and profit by ten-
fold. The steel producer is now producing profits of $42 million while making use of $400 million of capital.
See’s produces the same profit, but its capital has risen from $7 million to $70 million (in this hypothetical and
simplified case). The steel producer has had to come up with an additional $360 million to invest in plant
machinery etc., while See’s needed only $63 million. Compared with the steel company See’s can distribute an
extra $297 million to shareholders to invest elsewhere.
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In actual fact See’s has been so well managed that 20 years after purchase by Berkshire it operated comfortably
with only $25 million of net worth. The starting capital base of $7 million was supplemented with only $18
million of reinvested earnings. Profits rose ten-fold to $42.4 million, but capital usage has risen less than four-
fold. This allowed See’s to distribute an astonishing $410 million to shareholders over those 20 years. Not bad
for a $25 million investment.
See’s has pricing power because of a high reputation for the quality of its product and service given to
customers. This pricing power was largely untapped in 1972, but with the arrival of Chuck Huggins it was
exploited forcefully. At the same time Huggins bore down on costs and capital employed, producing the
wonderful economics described above. At the same time Huggins bore down on costs and capital employed,
producing the wonderful economics described above. Some indications of the way that Huggins delivered those
returns can be seen in Table 1 below covering the first ten years, 1973-82. He did not go for large scale store
openings. Nor did he try to increase the sales figures dramatically by, say, reducing prices. The number of
pounds of candy sold per store barely budged during the decade, but the price per pound rose significantly. See’s stuck to its niche and grew the profit margins on a very restricted capital investment program. If only more
managers could resist the temptation to expand outside of those areas of activity (and geography) where they have
competitive advantage, spending vast sums in the process and producing poor returns on capital.
Table 1: See’s Candies Shops Data
Year Ended Revenues Profit after
taxes
Number of pounds
of candy sold
Number of stores
open at year end
31 Dec. 1982 123.7m $12.7 24.2m 202
31 Decd
1973
$35.1m $2.1 17.8m 169
Over the 27-year period to 19999 See Candy’s earned a total of $857 million pre-tax and it still requires very little
capital. Chuck Huggins is still there at the age of 74. Buffett has noted a law—to be called Huggins law: when
Huggins was 46 See’s made approximately 10 per cent of his age expressed in millions. When he reached 75 the
ratio was 100 percent. Buffett says that after discovering this mathematical relationship ‘Charlie and I now
become giddy at the mere thought of Chuck’s birthday’.
Buffett’s Mention of See’s Candies in Letters to Shareholders of Berkshire Hathaway, Inc.
1984 Letter
See’s Candies Shops, Inc.
Below is our usual recap of See’s performance since the time
of purchase by Blue Chip Stamps:
52-53 Week Year Operating Number of Number of
Ended About Sales Profits Pounds of Stores Open
December 31 Revenues After Taxes Candy Sold at Year End