See’s Candy – The Prototype of the Wide Moat Company
Buffett often holds out See’s Candy as the prototype of the wide moat company. What lessons can be learned from this case study?
See’s Candy manufactures, distributes and sells high quality candy through retail outlets. These retail locations are located primarily west of the Rockies and are heavily concentrated in California; 110 of its 211 stores are in California. The shops have a distinctive look with a black and white décor and an old-timey feel patterned after the founder’s mother’s kitchen. See’s has a reputation in the West for high quality and the product is associated with holidays, namely Valentine’s Day and Christmas.
The boxed chocolate industry in which See’s competes is small. Sales are estimated at just under $2 billion per year with little growth. Its main competitors are Godiva, who maintains a luxury image and does not try to compete on price, and Fanny Mae who undercuts See’s on price.
Buffett, through Blue Chip Stamps, acquired See’s Candy in 1972. Since that time, See’s has turned in an enviable long-term track record.
Quantitative Evidence of a Moat
(All numbers are per Warren Buffett’s 1984 letter to shareholders and reflect the period 1973-1983.)
Operating Margin (10 yr) 8.68%
Sales CAGR (10 yr) 14%
NOPAT CAGR (10 yr) 19%
Average price increase 10% (as measured by Pounds of Candy Sold/Sales)
One metric is worth discussing further. See’s pricing power has often been extolled by Buffett. It can be seen here in the 10% annual average price increase. The ability to raise prices without hurting sales is one of the key hallmarks of a moat.
Qualitative Evidence of a Moat
1. Customer Captivity through Brand Loyalty
Brand loyalty leads to customer captivity when frequent purchases of the same brand establish a deep allegiance that is difficult to undermine. Here, See’s has produced legions have fiercely loyal customers by seizing a large portion of “mind share” in California. It did through association with positive experiences. “Every person in California has something in mind about See’s Candy 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 people want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices.”
A recent episode of “Mad Men” had a great description of this phenomenon of emotional attachment to a brand of chocolate. In the episode, the lead character, Don Draper, is pitching advertising work to two Hershey’s (HSY) executive. He describes Hershey’s chocolate as “the currency of affection.” The description is just as apt for See’s. The whole scene can be viewed here.
The psychological concept of “social proof” also seems to play a role here. Social proof is a psychological phenomenon where people assume the actions of others in an attempt to reflect correct behavior for a given situation. This effect is prominent in ambiguous social situations where people are unable to determine the appropriate mode of behavior, and is driven by the assumption that surrounding people possess more knowledge about the situation. Consumers in California searching for an appropriate Valentine’s Day or Christmas gift looked to the crowd to see what was socially acceptable. More often than not, the crowd told them if See’s was not actually mandatory, it would not get them in trouble either.
In any case, as a business analyst, we are not as concerned with the causes of brand loyalty as we are in the simple fact that it exists. Brand loyalty can be as difficult to understand as it is to undermine.
2. Economies of Scale – Regional Dominance
While not cheap, See’s can undercut its competitors like Godiva on price. This cost advantage is due to See’s reaping the advantages of its regional dominance in California. The business gets better the more stores it has in play in a given geographic area. The lower costs derived from See’s concentration strategy come primarily from three functions of the business. First, it spends less on distribution. The density of See’s stores reduces the distance its trucks have to travel and, therefore, lower gasoline expenses. Second, advertising expenses are reduced. See’s advertising expense is lower as a percentage of sales than its competitors because of the greater density of its stores and customers in the markets where they advertise. For example, See’s has 14 retail outlets within 20 miles of my parent’s house in Southern California. Godiva has 2. If we make the assumption that See’s also has 7 times the number of customers as Godiva, each dollar of See’s advertising in the region is reaching many more customers than Godiva. Even if we reduce the ratio by half, See’s strategy of regional dominance is generating much more bang for each buck spent on advertising.
The scale advantages produce a volume-price-volume virtuous circle. See’s achieves a cost advantage through scale and passes along its efficiency to customers through lower prices. These lower prices attract more customers, which further lowers the cost structure, permitting still lower prices and attracting yet more customers.
The capital needs of See’s are ridiculously low. Here is Buffett on this subject in the 2007 letter to shareholders:
“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).”
Assuming a 35% tax rate, just 6.7% of See’s net income was reinvested in the business from 1972 to 2007 despite a huge growth in profits.
Growth Opportunities Inside the Moat
As stated above, the boxed chocolate market in the US is growing very slowly – limiting See’s opportunities for growth. Further attempts to expand outside the West have not gone well. An expansion into Japan was abandoned. A slow expansion into the Midwest and East is underway now with unknown results. Instead of investing its profits in expansion, Buffett merely tells See’s management, Send the check to Omaha!
High returns on capital and excess cash flows are only useful if you have a management that is smart
about deploying it. Buffett’s skills as a capital allocator are well known and have been covered in many other books, articles, blogs and websites. Needless to say, there is little to any risk of poor capital allocation.
The product is sold for cash, so there is no need for accounts receivable.
How would a competitor penetrate the moat? If we had 1 billion dollars, could we take on See’s?
First, the boxed chocolate market in California is not big enough to attract much attention. Its not worth the trouble for a national or international competitor. This is true for many niche and local operators.
Second, It would be extremely difficult for a competitor to lure loyal customers away from See’s. Brand X, if they had deep pockets, could spend millions of dollars in advertising to try and steal mind share from See’s. Would it work? Could they build all of the retail outlets to compete with See’s? Even if the advertising worked, the competitor would have to run losses for years as the advertising expense per customer would be very high. See’s might very well respond to the competitive threat by lowering its prices. Unless Godiva or Fanny Mae have found a way to produce the item or deliver the service at a cost substantially below that of See’s, which is not likely, either the price at which they sell their offerings or the volume of sales they achieve will not be profitable for them, and therefore not sustainable. While Godiva has a well-maintained brand and a luxurious image, this does not translate into profits in See’s market area.
One competitor tried to compete on the cheap by simply copying the distinctive look of See’s stores. This tactic was struck down in court as a trademark violation.
Disruptive Technology Risk
In many industries, there is a constant threat that our current understanding of the market and the participant could be completely disrupted by the emergence of a completely new technology. As a very mature low-tech industry, the risk of disruptive technology seems quite low compared to say, the PC industry.
While we have gotten used to rather low inflation, there have been periods in US history where this was not the case. At the time, Buffett purchased See’s, in fact, inflation was high and would be for a number of years (see chart above). One of the great things about See’s is that it is almost impervious to inflation. Buffett famously raises prices each December 26 come rain or come shine.
Does management understand the moat? Are they trying to widen it? Management widens the moat by ensuring that customers will only have positive associations with See’s The company only sells candy of the highest quality. See’s chocolates are all preservative-free, and each box has the date it was filled and location in which it was filled so that the customer can see that they are getting the freshest product. Ingredients from suppliers are carefully examined by quality assurance teams at the factories for microbiologic compliance and purity. The company also emphasizes customer service. Again, per Buffett: “If you are See’s Candy, you want to do everything in the world to make sure that the experience . . . leads to a favorable reaction. It means what is in the box, it means the person who sells it to you . . . 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 every day. 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 Candy and something pleasant happening. That is what business is all about.”
One of the keys to the See’s business is the freshness of the product. The freshness is maintained by keeping the stores near the factories. This also reduces inventory risk as the factories are able to maintain just-in-time inventory.
See’s relies on the addictive power of sugar to drive sales. This is a common characteristic of a number of Buffett’s investments (ie., Dairy Queen, Coke, Heinz, etc.). (For whatever reason, making money off this addiction avoids the moral taint that comes with investments in tobacco companies or casinos.) Is it possible that Americans could reverse course on sugar as they did with cigarettes? Anything is possible, but we would not bet against sugar.