Berkshire Hathaway’s recent announcement to acquire Heinz has a close parallel to one of its early acquisitions — See’s Candies, a popular candy maker based in California.

Warren Buffett’s first acquaintance with the food business was through See’s Candies which came along indirectly through his acquisition of Blue Chip Stamps — the holding company of See’s. Berkshire’s investment in Blue Chip went from 36.5 per cent in 1977 to 60 per cent in 1979, and finally resulted in 100 per cent merger in a stock swap in 1983.

Blue Chip Stamps had originally acquired See’s Candies for $25 million in 1972. At that time, See’s was earning a profit after tax of $2 million and had net tangible assets (book value of equity) worth $8 million with zero leverage. This works out to an implied price-to-book (P/B) multiple of 3.1 for the company that was generating about 25 per cent return on tangible assets (equity).

When Berkshire acquired the remaining 40 per cent of Blue Chip in 1983, it indirectly acquired 40 per cent of See’s Candies as well for $36.4 million.

At that time, See’s was earning a profit after tax of $13 million and had net tangible assets (book value of equity) worth $20 million. This works out to a price-to-book multiple of 4.6 for the same company that was then generating nearly 50 per cent return on tangible assets (equity).

Change in mindset

The See’s acquisition through Blue Chip was a marquee transaction for Buffett as it indicated a change in mindset from buying companies at a discount to tangible book value (which was the Graham school of thought) to paying a premium to tangible book value for companies with strong economic goodwill (which was the Munger school of thought).

Economic goodwill represents value over and above tangible assets, for example, the value of intangibles such as brand, and so on, that enable a company to generate high return on capital relative to peers

In fact, Buffett in his 1983 shareholder’s letter goes on to state that:

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.

Goodwill, the gift

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. During inflation, Goodwill is the gift that keeps giving.

Going back to our See’s example, we can see how the economic goodwill of the business increased between 1972 and 1983 — as the company grew its return on equity from 25 per cent to over 50 per cent. In plain English, the company just kept getting more profitable. How could that be?

The answer lies in the simple DuPont model that breaks return on capital into profit/sales multiplied by sales/capital.

Firstly, the company could generate more sales from relatively less additional capital — for example, this could happen when same-store sales increases year-on-year and you don’t need to expand the store or build another one.

Irresistible chocolates

Secondly, the company was able to increase the price of its products, thanks to its branding power and introduce high-end products that generated higher margins (profit/sales). Also, as brand recall increased over time, the company could generate more sales for less marketing expenses.

As Buffett mentions — men in the west coast of the US would rather spend extra money to buy See’s candies for Valentine’s Day than bear the risk of settling for a cheaper alternative. In some sense, the brand ‘See’s’ became synonymous with premium sweets.

Lastly, on the durability front, we all know that chocolates are here to stay and so is people’s addiction to them. No technological advancement is going to get rid of the human urge to consume chocolates — so one can forget about chocolates disappearing from the face of the earth like the analogue camera.

Nearly 30 years after the 100 per cent acquisition of See’s, today, the company generates profits of around $83 million from approximately 375 million of sales and the capital required to run the business is only about $40 million.

So we are talking about a return on capital (equity) of around 200 per cent! The interesting thing is that during this period the company’s sales volumes barely grew by 2 per cent p.a.

Due to healthy cash flow and minimal re-investment required, the company was able to dividend out more than a billion dollars of profits to Buffett’s Berkshire Hathaway in the interim.

Paying for a brand

Now fast forward to Heinz. Heinz is to food what See’s is to chocolates. In the US, Heinz is synonymous with Ketchup. In the UK, it is known for Beans. But Heinz is also a leader in Nutrition (Complan), frozen potatoes, frozen entrées and other food products.

Heinz’s products are sold in more than 200 countries across North America, Europe, the Asia Pacific region as well as a variety of other international markets. So what Warren Buffett is buying is not really the world’s favourite ketchup company, but a brand that is synonymous with tasty, high quality food for over 140 years.

Warren Buffett and 3G capital would be jointly paying $23 billion for the equity portion of Heinz. Since shareholder’s equity in the company is around $3 billion and after-tax earnings is around $1 billion, this translates to return on equity of about 33 per cent and an implied equity valuation of the deal of around 8 times price-to-book.

On the face of it, the valuation seems pretty steep compared to the See’s transaction. However, if one were to hypothetically deduct the cash on books of ~ $1 billion (assuming it can be dividend out) from the equity figure of $3 billion, the return on equity increases to nearly 50 per cent.

This return on equity has the potential to go up further as the company’s investments made in various emerging markets begin to payback.

For instance, today, the emerging market share of sales is only about 20 per cent. With less and less time to prepare a meal, branded foods and accompaniments will only continue to grow and Heinz has a major share of this market.

Given the pricing power that the company’s brands possess (that is, the ability to pass on cost increase by increasing product price), it is unlikely that its margins will fall below the current 9 per cent — in fact it may just expand. That makes it a huge plus since food inflation is bound to push raw material costs higher in the future.

All said and done, Buffett has paid almost double the valuation that he did for See’s. So over the long term, this deal may not generate more than half the returns that Buffett is making on See’s. That’s no mean task because currently the annual returns that Berkshire earns from See’s profits is over 100 per cent of the initial capital investment.

(The author is a business consultant. The views are personal. Feedback can be sent to perspective@thehindu.co.in)

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