Friday, January 8, 2010

Living La Vida Cocoa: Warren Buffett, Berkshire Hathaway and the Chocolate Wars (BRK.A; BRK.B; CBY; KFT; HSY)

This is a grab-bag of things Warren and chocolate.
From the 2007 Annual Report- Pulling $1.35 Billion cash out of the $25 Million Investment in See's Candies:
...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.

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.)...MORE
In that same Chairman's letter he made reference to a story we had copied out of the 1988 Annual Report for our November 2007 post "How Buffett Made a Killing in Chocolate, And Warren's Letters to Shareholders":
Warren on arbitrage:
Some offbeat opportunities occasionally arise in the
arbitrage field. I participated in one of these when I was
24 and working in New York for Graham-Newman Corp.
Rockwood & Co., a Brooklyn based chocolate products
of limited profitability, had adopted LIFO
valuation in 1941 when cocoa was selling for
50 cents per

In 1954 a temporary shortage of cocoa caused the price to
soar to over 60 cents. Consequently Rockwood wished to
unload its valuable inventory - quickly, before the price
dropped. But if the cocoa had simply been sold off, the
company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained
an arcane provision that eliminated the tax otherwise due
on LIFO profits if inventory was distributed to shareholders
as part of a plan reducing the scope of a corporation’s business.
Rockwood decided to terminate one of its businesses, the sale
of cocoa butter, and said 13 million pounds of its cocoa bean
inventory was attributable to that activity. Accordingly, the
company offered to repurchase its stock in exchange for the
cocoa beans it no longer needed, paying 80 pounds of beans
each share.

For several weeks I busily bought shares, sold beans, and
made periodic stops at Schroeder Trust to exchange stock
certificates for warehouse receipts. The profits were good
and my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown,
but brilliant Chicagoan, Jay Pritzker, then 32. If you’re
familiar with Jay’s subsequent record, you won’t be surprised to
hear the action worked out rather well for Rockwood’s continuing
shareholders also. From shortly before the tender until shortly
after it, Rockwood stock appreciated from 15 to 100, even though
the company was experiencing large operating losses. Sometimes
there is more to stock valuation than price-earnings ratios.

This story is from the 1988 Letter to Shareholders of
Berkshire Hathaway. I have Warren on dead trees (WODT)
but BRK has put the letters online,if you would like
to read of his other adventures.
From our October 2007 post "SEC Pressed on Climate-Change Disclosures and When will Warren Buffett get on Board the Love Train?*" :

...What the heck are we going to do with Warren Buffett?

Nowhere in the Berkshire Hathaway annual report is there any discussion of how global warming will affect See's Candies!

Sure, the man, through Berkshire Hathaway runs some insurance stuff** and some other businesses*** but certain high-quality analysts go straight to the See's results (ho-hum) or the stores (Ho-Ho-Ho) and care more about Ghanaian cocoa than winding down some silly-assed derivatives book you didn't want in the first place....

...I'm sure they want to know: "What's Buffet hiding, re: Global Warming risk to See's?"...
(besides melting and/or bloom)

With the recent hubbub over Kraft's Cadbury bid, "Mean Street: Buffett Shows ‘Em How to Negotiate (BRK.A; CBY; KFT)" and the New York Post's "Buffett's Mars bar":

Billionaire Warren Buffett's decision to weigh in on Kraft's hostile pursuit of Cadbury may land him in hot water with Uncle Sam's antitrust cops.

In voicing his opposition Tuesday to Kraft issuing more shares in order to raise its offer for the British candy maker, sources familiar with the matter said the Oracle of Omaha may have tipped his hand about wanting to protect another candy company in which he has deep ties: Mars.

"To the extent Kraft pays less [for Cadbury], it can be less aggressive in the marketplace" this person said.

Added an antitrust lawyer familiar with the workings of the US Federal Trade Commission: "I think the triggering event [for the FTC to investigate Buffett] could be if his attempt to muck up Kraft's deal was done to protect his position in Mars.">>>MORE

We end with a snapshot from Inside Futures:

COCOA—Mar cocoa prices are consolidating moderately below last month’s 30-year nearest-futures high. Bullish factors include (1) speculation that global cocoa production this year will trail demand for a fourth straight year, (2) the cut by BNP Paribas Fortis in its global 2009-10 cocoa production estimate to 3.57 million tons, down from a Nov estimate of 3.61 million tons, and (3) ICO’s report that the 2008-09 Ivory Coast cocoa harvest was 1.22 million tons, a 14-yr low. Bearish factors include (1) the recent rebound in the dollar index to a 4-month high, and (2) ICO’s hike in its forecast for a 150,000 MT global cocoa surplus for 2010. Large specs as of Dec 29 reduced their large long position to 39,935.