“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”
–Warren Buffett, 2007 Shareholder Letter
A reader recently sent me the following clips from the 2007 Shareholder Letter that pertains to a topic that we’ve discussed quite a bit here: the concept of return on capital, why it’s important, and how to think about it.
[drizzle]For those interested, you could review all the previous posts on the concept of ROIC here.
Basically, I just thought I’d make a few brief comments on Buffett’s ideas here, but largely just clip a few portions of the letter, since I think this is a really useful topic to think about.
In this 2007 letter, Buffett groups businesses into three general categories based on their ROIC profile, and explains the differences between those three categories.
Category #1—High ROIC Businesses with Low Capital Requirements
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.
Buffett then talks about the return on incremental capital and how he thinks about ROIC:
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.)
I used this general back of the envelope math when thinking about return on capital (see this post for details on how I think about calculating incremental ROIC). It’s helpful to know roughly how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.
So See’s invested an incremental $32 million over the life of the business which produced an additional $1.35 billion of aggregate profits over that time, an astronomically high return on capital. Obviously, See’s is a “capital light business” and the ROIC is high because the denominator is low. See’s couldn’t reinvest that cash flow at high rates of return, so it had to ship the cash to Omaha for Buffett to reinvest elsewhere.
Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital
Companies like See’s produce huge returns on the small amount of capital that it previously invested. These are rare businesses that can grow their earning power without capital investment. In See’s case, this was largely done through pricing power. But See’s is a rare business, and as Buffett points out, companies that can reinvest capital at high rates of return are still attractive businesses to own:
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