Media Industry Economics

It is well known that Warren Buffet only invest in businesses that he can understand and he has a superior understanding of business than most. But the lesser known fact is that he freely share his insights in his Berkshire Shareholder’s Letters. We combed through decades of shareholder’s letters to distill Warren Buffett’s business insights into a series of 7 articles.

·         Warren Buffett saw changes in the media industry economics that affects their valuation. “The economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.”(1991)

·         He categorizes companies between two spectrums – business and franchise. “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.” (1991)

·         “In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”(1991)

·         He foresaw that when 2 or more papers exist in a city, the one that had more circulation would pull ahead and emerged as the standalone winner. “The great majority of families therefore felt the need for a paper every day, but understandably most didn’t wish to pay for two. Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of newspaper jungle: Survival of the Fattest. (2006). “

·         Media business was traditionally considered a franchise. Because after competition disappeared, rates for both advertisers and readers would be raised annually.

·         However, upper limit on demand and growing new consumer choices resulted in the media industry losing some of its franchise. “Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength.” (1991)

·         Buffett also applied inversion to the question newspaper existence. “Simply put, if cable and satellite broadcasting, as well as the internet, had come along first, newspapers as we know them probably would never have existed.” (2006)

·         In addition to the impact on earnings, the changes also affected valuation.

·         When the media industry was considered a franchise, it had a higher valuation. Buffett gave the following example:

• Growing earnings at 6% p.a., without employment of additional capital
• Reported earnings were also freely distributable earnings
• Discount rate of 10%
• After Tax earnings of $1 million

Based on above, he calculated the appropriate valuation to be $25 million, which translates to P/E of 25x.

·         But, when the media industry was considered as a business, it resulted in a lower valuation. Using the same example, Buffett disregarded the growth of earnings and the resulting valuation was $10 million, which translates to P/E of 10x.

In addition to Warren Buffett insightful comments on the newspaper industry, my other takeaways are:

1. In the examples given, Warren Buffett used Gordon Growth Model on the appropriate earnings to obtain the valuation.
2. The same method is applicable across different industries because he mentioned that dollars are dollars whether they are from steel mills or media companies.
3. Based on the given parameters, the P/E for franchise and business is 25x and 10x respectively.

Retail Industry Economics

It is well known that Warren Buffet only invest in businesses that he can understand and he has a superior understanding of business than most. But the lesser known fact is that he freely share his insights in his Berkshire Shareholder’s Letters. We combed through decades of shareholder’s letters to distill Warren Buffett’s business insights into a series of 7 articles.

·       To begin with, WB thinks that retailing is a tough business. Retailing is a tough business… In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail. In contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business. For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades. (1995)

·       But WB saw something important in See’s candy. In our See’s purchase, Charlie and I had one important insight: We saw that the business had untapped pricing power. (1991)

·       Cash business with low inventory. Let’s look at the prototype of a dream business, our own See’s Candy. (2007). 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. (2007)

·      Product personality = Taste + Control on distribution + Service at store + modest price. 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. (1986)

·       Associated with pleasant experience. “There was something special. Every person in California 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… See’s Candies means getting kissed. If we can get that in the minds of people, we can raise prices.” (Q&A University of Florida)

·       The motivation to buy the product is everlasting despite changing times. 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. (1996)

·       Pricing power = Mind share + Greater value to customer.  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. (1983)

·       In this case, Value of intangible > value of tangible assets. 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. (1983)

Textile Industry Economics

·     In 1964, Berkshire Hathaway had an accounting net worth of US$22mn, but its intrinsic value was less because the assets were unable to earn returns that commensurate with their accounting value.

·      At the time of purchase, most Northern textile operations, which were unionized, were closing and Southern textile plants were largely non-union.  Buffett thought that it would give Berkshire Hathaway an important competitive advantage.

·      Berkshire further diversified into other business, using the cash generated by the textile operations to fund entry into insurance and other businesses.

·      Buffett intended to continue to support the textile operation despite more attractive alternative use for capital. After 1985, however, the textile operations consumed major amount of cash.

·      The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Most of the trouble of the industry was attributed to competition from foreign countries whose workers are paid a small fraction of the US minimum wage.

·      Berkshire had the option of making large capital expenditure that would have allowed the textile operation to reduce its variable costs. But many of the competitors, both domestic and foreign, were stepping up to the same kind of expenditures and their reduced cost became the baseline for reduced price industry-wide. Viewed individually each company’s capital investment decision appeared cost effective and rational; viewed collectively the decisions neutralized each other and were irrational.

·      It is instructive to look at Burlington Industries, the largest US textile company, to understand how a commodity business plays out. In 1964, Burlington had sales of US$1.2bn, by 1985 it had sales of US$2.8bn, but during the 1964-85 periods, the company made capital expenditure of about US$3bn. Nevertheless, Burlington has lost sales volume in real dollars and has lower return on sales and equity now than 20 years ago because CPI tripled in the same period and the invested capital has increased.

·      Another important investment lesson on book value and replacement cost can be learnt from the disposal of Berkshire equipments. While the equipment originally cost US$13mn, had a book value of US$866k, had a replacement cost of US$30-50mn and was in working condition, gross proceeds from the sale of the equipment came to US$163k. Allowing for pre- and post- sale costs, the net was less than zero.

·      In contrast, the economic goodwill attributed to the two newspaper routes in Buffalo or a single See’s candy store considerably exceed the proceeds that was received from the sale of tangible assets, which were able to employ over 1,000 people not too long ago, under different economic conditions.

Business Characteristics - the Great, the Good and the Gruesome

THE GREAT BUSINESS = HIGH RETURNS + POWER TO RAISE PRICES + ENDURING COMPETITIVE ADVANTAGE

·      The great business demonstrates high return on invested capital and can it grow its earnings with only minor additional investment of capital. In 1985 they [Nebraska Furniture Mart, See’s Candy and Buffalo Evening News] earned an aggregate of $72 million pre-tax. Fifteen years ago, before we had acquired any of them, their aggregate earnings were about $8 million pre-tax. While an increase in earnings from $8 million to $72 million sounds terrific - and usually is - you should not automatically assume that to be the case. You must first make sure that earnings were not severely depressed in the base year. If they were instead substantial in relation to capital employed, an even more important point must be examined: how much additional capital was required to produce the additional earnings? In both respects, our group of three scores well. First, earnings 15 years ago were excellent compared to capital then employed in the businesses. Second, although annual earnings are now $64 million greater, the businesses require only about $40 million more in invested capital to operate than was the case then. The average American business has required about $5 of additional capital to generate an additional $1 of annual pre-tax earnings. That business, therefore, would have required over $300 million in additional capital from its owners in order to achieve an earnings performance equal to our group of three. (1985).

·       A great business has the power to raise prices without losing business to a competitor.  An economic franchise arises from a product or service that:  (1) Is needed or desired; (2) Is thought by its customers to have no close substitute and; (3) Is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage. (1991).

·       Moat can widen or shrink; a great business has long term competitive advantage in a stable industry. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed. (2007).

·       Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. (1996)

·       One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. (1983)

THE GOOD BUSINESS = GOOD RETURNS ON INVESTED CAPITAL

·       Good returns on invested capital may require large incremental investment of capital. One example of good, but far from sensational, business economics is our own Flight Safety. 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. (2007).

·       High capital business requires high operating margins to achieve decent returns. At FlightSafety…as much as $3.50 of capital investment is required to produce $1 of annual revenue. With this level of capital intensity, FlightSafety requires very high operating margins in order to obtain reasonable returns on capital, which means that utilization rates are all-important. (2004)

THE GRUESOME = CONSUMES HUGE CAPITAL + LOW RETURN

·       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. (1983)

·       Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. (1982)

Warren buffett’s three “G” business framework: To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. (2007). There are only a handful of Great business; most businesses are Good or Gruesome.