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Tag Archives: Competitive Advantages

Blackbaud: A Wonderful Little Niche

26 Thursday Sep 2013

Posted by punchcardblog in Moats

≈ 3 Comments

Tags

Blackbaud, BLKB, Case Study, Competitive Advantages, deferred revenue, floats, Local economies of scale, negative working capital, niche

This is the first of what I hope will be a series of articles on the software industry.  Why?  Quite simply, the software industry possesses very attractive economics.  The first company we will look at is Blackbaud, Inc. (BLKB).

Blackbaud Stock Performance, IPO – Present

Untitled

Background

Blackbaud makes software for non-profit organizations (NPOs).  This is a wonderful little niche. NPOs have unique needs requiring tailored software and services.  The recently deposed CEO described it thusly:  “First, we know more about non-profits and the relationship with their donors and supporters than anybody in the world. What drives non-profits, the relationships, and where they receive their funding is different from the for-profit world. If the non-profit knows you well, you will feel more connected to that organization, and therefore you will give more of your time and money. Bequests increase, lifetime share-of-pocket for donations increases, and if you are an advocacy-based organization, influence in advocacy increases.  Secondly, we offer specialized software that will help non-profits reduce their operating costs and help them be more efficient and effective in achieving their mission. People like to support organizations that are good stewards of their money.”  See Chart 1.

Chart 1 (Click to Expand)

Investor Presentation1

Source:  Company investor presentation

Their most popular product, Raiser’s Edge, helps NPOs manage their donor base.  This is known as donor relationship management (DRM) software as opposed to the more common customer relationship (CRM) management software made by companies like Salesforce.com.  The former CEO explained the difference:  “The typical CRM that is part of an ERP or the typical sales force automation program is about transactions and tracking sales opportunities.  Our programs are designed to help our customers follow their constituents longitudinally over the entire time that they are involved with an organization.”

Industry Economics

The economics of the software industry are reminiscent of what WEB said about the tobacco industry:  “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.” A good software product is no different.  Successful software companies routinely have gross margins of 80-90% and operating margins of 20-30%.  Returns on invested capital (ROIC) can be 30% or higher.[1]  What drive such great returns?

  • Customer Captivity:  Successful software companies experience high levels of customer captivity through high switching costs – that is, customers pay a high price in time and money when switching programs.  The benefit of changing from Program A to Program B is dwarfed by the cost of doing so.  For example, imagine a large company using a complex accounting program system like SAP or Oracle.  Years of data are stored in the program.  The company relies on the system to do basis tasks throughout each and every day.  Hundreds, if not thousands, of employees have been trained on the program.  The system has probably been tweaked and customized to suit their specific needs.  This plus sheer institutional inertia make it virtually impossible to switch providers.  Software companies knows this, so they take advantage of their customers’ reluctance to leave by charging them a bit more each year.
  • Low Asset Intensity:  Software can generate high returns on invested capital because there are no fixed asset needs beyond furniture and PCs.  Capex needs are infinitesimal.
  • High Free Cash Flow:  The level of customer captivity in the software industry is so high that the most successful companies can require that their customers pay in advance.  This takes the form of subscription fees (more on this below).  This, plus the low capex needs, drive very high FCF.  For Blackbaud, FCF is routinely 2 or 3 times net income.  This frees up more cash to distribute to owners.
  • Scalable:  The incremental costs of “manufacturing” a copy of the software for each new customer is virtually non-existent.  This is a business with almost no cost of goods sold.

Whenever I espouse the virtues of the software industry, I hear Buffett’s voice in my head telling me to steer clear of tech.  The risk of dramatic technological disruption is high in the software industry, of course, but we avoid it by focusing on software that appeals to business customers, rather than consumers, and is embedded in their day-to-day operations.  Companies falling into this category include Microsoft, Adobe, Oracle, and, as we shall see today, Blackbaud.  We steer clear of consumer electronics companies like Apple and entertainment companies like Xynga which are more exposed to faddishness and the pressure to constantly innovate.

Does Blackbaud Have A Moat?

Quantitative Evidence of a Moat

  • High ROIC:  Blackbaud has been able to maintain high returns on invested capital.  ROIC has averaged 49% over the last 10 years.
  • Free Cash Flow:  Blackbaud’s business model is designed to produce large amount of FCF.  FCF averaged 387% of net income over the past 10 years and has increased at a CAGR of 8%.  However, it has been bouncing around a bit over the past 3 years (see Chart 2).

Chart 2 (click to expand)

BLKB FCF

  • Stability of Market Share:  One of the hallmarks of a great business is very little competition.  It is difficult to get market share data for this niche.  Based on discussions on the Internet, Blackbaud is considered the 800 pound gorilla in the industry and their software is the gold standard.
  • Here is how Blackbaud compares to our standard, Moody’s (MCO):

(All data except market cap as of 12/31/12.)

Blackbaud

Moody’s

BLKB

MCO

Market Cap as of 9/24/13

1.77

13.42

Net Debt

                 202

           (166)

Revs

                 447

          2,730

OI

                   19

          1,090

Op Margin

4%

40%

NI

             6,583

              700

Net Margin

1%

26%

ROA

3%

20%

ROE

4%

647%

ROIC

13%

61%

Klarman Factors
Barriers to Entry

High

Very High

Capex/CFOA -10 year avg,

13%

7%

Reliable Customers

High

Very High

FCF/Revenue – 10 year avg.

28%

28%

5 Year FCF CAGR

7%

17%

10 Year FCF CAGR

8%

10%

The comparison is skewed a bit because of a very poor 2012 for Blackbaud.  In fact, it was so poor that the CEO was fired.  The key problem seems to have been integrating a major acquisition, the purchase of Convio for $335.7 million (more on the below).

Qualitative Evidence of a Moat

Blackbaud has several sources of competitive advantage: network effects and switching costs complemented by economies of scale.

The Power of a Niche – Local Economies of Scale

Blackbaud affords an opportunity to look at a source of competitive advantage that we have not looked at previously:  local economies of scale.  By “local”, we mean either within a geography or within a product space.  Companies can often have moats if they dominate a small/niche market that is too small for competitors to justify the cost of competing.  The market may only have a large enough profit pool to support 2 or 3 players.  Potential new players are deterred by the decreased returns on capital their entry will cause.  A simple example illustrates this point.  Let’s assume that there is a market generating $100 million of revenue per year.  Lets further assume that given the capital requirements of the industry, a company can make a reasonable return with $25 million of revenue.  Thus, the market can comfortably support a maximum of 4 participants.  What if the market suddenly started generating $1,000 million of revenue per year?  It could then support 40 viable competitors.  A highly fragmented market of 40 competitors is harder to dominate than a small market of 4.

Ralph Wanger, a famous and successful money manager, described this dynamic at work in the hard disk drive in the 1980s:  “Remember back in the early ’80ʹs when the hard disk drive for computers was invented? It was an important, crucial invention, and investors were eager to be part of this technology. More than 70 disk drive companies were formed and their stocks were sold to the public. Each company had to get 20 percent of the market share to survive. For some reason they didn’t all do it . . .”[2]

This problem is particularly acute in the software industry where the minimum efficient scale is very low.  A firm’s minimum efficient scale (MES) is the lowest scale necessary to achieve the economies of scale required to operate efficiently and competitively in its industry.  In software, the minimum efficient scale is usually small relative to the overall size of the market.[3]  Many companies can co-exist, although none will make out-sized returns.  But in a restricted market, the minimum efficient scale is much more difficult to achieve because it may have to capture 20% to 25% of the market – a difficult threshold to reach when each each incremental gain comes out of the incumbent’s existing shares.  But unless the new entrant reaches those levels, its economies will not come close to those of the incumbent.  A niche is therefore particularly powerful in the software industry.

Taken as a whole, these advantages caused Prof. Greenwald to write, “Barriers to entry are easier to maintain in sharply circumscribed markets.  Only within such confines can one or several firms hope to dominate their rivals and earn superior returns on their invested capital.”

Blackbaud Has A Dominant Position In The Nonprofit Software Industry

As stated above, Blackbaud focuses exclusively on software and service to non-profit organizations (NPOs).  Blackbaud is entrenched enough that a new entrant would need to incur large losses (or at least minimal earnings) before getting to scale and establishing itself as a credible player.  Moreover, as described above, the new entrant would then need to split a relatively small profit pool with Blackbaud reducing its potential return on investment

This is a relatively small market, so large competitors like Microsoft, Oracle or Salesforce.com pass it by.[4]  This makes sense for several reasons.  The most obvious is that the potential profit pool is too limited to catch their interest.  But there are other reasons as well.  Because fixed costs are only relevant within the product market in question, economies of scale apply only within the same product market.   Thus, Microsoft’s fixed advertising expense for operating systems do not spillover to the non-profit CRM market where Blackbaud operates. Network Effects are also similarly limited.  The network effect that Microsoft Office has does not spillover to the non-profit CRM market.

There is no shortage of smaller competitors.  But, because Blackbaud is so much larger, it will be difficult for them to ever match Blackbaud’s per unit cost advantage in development expense, advertising and marketing.   For instance, Blackbaud spent a little over $64 billion on R&D in the past year, or about 14% of total sales. This large R&D spend, which has gone on for yearss, translates into a wider range of products that have more features and of higher quality than the products of their competitors.

If one of the smaller competitors does get large enough to pose a threat, a deep-pocketed market leader like Blackbaud can simply buy them .

Network Effects

I have experienced the network effect in software in my own life.  I used to work for IBM.  When I first arrived in 2002, all employees were issued a laptop with the Lotus suite of programs.  For those of you to young to remember, this was a competitor to Microsoft Office and owned by IBM.  A number of IBMers had learned spreadsheets or word processing on the Lotus products and preferred them.  But as the employee mix changed due to natural attrition, employees began clamoring for Office.  I was one of them.  I had never used Lotus 1-2-3 and had no interest in using it.  Within a couple of years, IBM switched to Office.

I am no expert on the NPO labor force, but I would think a similar phenomenon takes place.  As Raiser’s Edge or another Blackbaud product grows in popularity, more and more people are trained on it and become comfortable with it.  As they jump to non-Blackbaud NPOs, they clamor for the Blackbaud products they are more familiar with.

Switching  Costs

As stated above, switching costs increase based on two factors:  (1) the extent to which the software is embedded in the customer’s daily workflow and (2) the extent to which core data is stored in the software.  Blackbaud seems to score high on both factors.

Enhancing Customer Captivity

Blackbaud management seems to understand that the principal source of their competitive advantage is customer captivity and has worked to intensify it.  Why has customer captivity important?  A company can extract more money of its customers if those customers are unlikely to move to a competitor.

Blackbaud encourages habit formation among its customers by moving from one-time charge sales of software to a subscription based model.  Customers are automatically charged each year for the right to use the software.  Even better, the  annual subscription fee increases each year.  The subscription model “encourage(s) repeated, virtually automatic and nonreflective purchases that discourage the customer from a careful consideration of alternatives.”[5]

Blackbaurd amplifies switching costs by making their products feature-rich.  By extending and deepening the range of services offered, Blackbaud makes the seemingly basic task of switching to other systems and mastering their intricacies more onerous.

The tactic of adding more features also increases search costs.  “Comparison shopping is more difficult if the alternatives are equally complicated but not exactly comparable.”  Few short-handed NPOs want to take the time required to analyze the pricing and features of competing software products. (See Chart 3.)

Chart 3 (click to expand)

Solutions

Source: Company investor presentation

Recurring Revenue

Another attractive aspect of the company is the increase of recurring revenues.   A key move for the company was the decision in 2006 to transition from a one-time charge model to a subscription or “Software as a Service” model.  Prior to 2006, Blackbaud charged its customers an up-front, one-time charge for perpetual use of its software.  This was similar to a conventional purchase of any tangible good, like when I buy an apple in a store.  Under the SaaS approach, customers are billed in advance for access to software over time.  Instead of actually taking possession of the software, they pay for access to it.

Currently, maintenance and subscription revenues make up about 67% of total sales, but over the coming years it will likely grow to an even greater portion. With a larger portion of predictable, annuity-like revenues and profits, Blackbaud will become a more attractive company.  (See Chart 4.)

Chart 4 (click to expand)

Recurring rev

Source: Company investor presentation

Deferred Revenue and Negative Working Capital

The SaaS model not only drives recurring revenue but high levels of deferred revenue as well.  Deferred revenue is advance payments or unearned revenue, recorded on the recipient’s balance sheet as a liability, until the services have been rendered or products have been delivered. Deferred revenue is a liability because it refers to revenue that has not yet been earned, but represents products or services that are owed to the customer. As the product or service is delivered over time, it is recognized as revenue on the income statement.

For example, a company that receives an advance payment of $100,000 for delivery of a product would book it as deferred revenue on its balance sheet. Once it delivers the product to the customer, the company would transfer the $100,000 from the deferred revenue account to regular revenue on its income statement.

Since 2006, the amount of deferred revenue on Blackbaud’s balance sheet has shot up – going from $75 million in 2006 to $174 million in 2012.  The presence of this large liability on the balance sheet as well as carrying no inventory and a relatively limited amount of accounts receivable drives Blackbaud into a negative working capital position.  That is, the cash tied up in assets is more than offset by advance payments from customers.  As a result, calculating working capital (which is simply current assets less current liabilities) yields a negative number.

What are the benefits of deferred revenue and negative working capital?

First, deferred revenue represents a large, interest-free loan from the customers to Blackbaud.  Obviously, an interest-free loan is far superior to other, expensive funding sources like debt and equity.  This very cheap cost of funding also gives Blackbaud a moat.  Blackbaud can fund its business at a much lower cost than its competitors.   As Buffett put it, the fact that deferred revenue is listed on the balance sheet as a liability is a great “accounting irony.”

In this way, Blackbaud’s deferred revenue is similar to the insurance float that has fueled much of Berkshire Hathaway’s gains.  “Over the last 45 years, Berkshire’s insurance float enabled the company to effectively borrow huge amounts of cash, with no set repayment date, and with no tangible collateral put up. Even more astonishing is the fact that this money costs Berkshire less than nothing,” wrote Professor Bakshi in an excellent presentation on floats and moats.

Second, the deferred revenue and the negative working capital drives very high returns on invested capital.  As stated earlier, I cannot use my normal ROIC formula because the negative working capital creates infinite ROIC.

Lastly, like pricing power, advance payments are a characteristic of a wide moat business.  The fact that Blackbaud can require payment in advance from its customers shows the strength of its bargaining position.  Only a company in a strong competitive position can get away with this.

Management

While there is a lot to like about Blackbaud, management has been able to drive it right into the ground.  Revenue has increased at an impressive 10% CAGR over the last 5 years, expenses have risen even faster.  Operating margins peaked at 27% in 2005 and plummeted to just 4% in 2012.  Even if you want to dismiss 2012 as a mere anomaly, the operating margin was just14% in both 2010 and 2011.  The trend is not good.  (See Chart #2)  Concurrently, after being largely debt-free for years, the company borrowed $200 million of debt to fund the Convio acquisition.  Management compounded this problem by botching the integration of the new acquired company into their existing operations.  Management also spent heavily on growth investments and growth capex.  Capex jumped  to $20 million in 2012 almost double what was spent in 2010.  SGA also jumped – increasing  by 41%in 2012 over 2011.  SG&A was 35% of sales in 2012.  EPS dropped to just $.15 in 2012 compared ot $.75 in 2011.  Not surprisingly, all of this bad news culminated in the CEO being fired earlier this year.  In response, the stock has skyrocketed (more on this below).

Another gripe, under both the old CEO and the current interim CEO, is that management insists on using non-GAAP numbers.  The biggest adjustment is stripping out stock option expense.   If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?

Management’s capital allocation track record is a bit mixed.  A regular dividend was initiated in 2007 and has averaged 31% of FCF over this period.  Management touts its share buybacks but the buybacks are only used to counteract the impact of generous stock option grants.  Buybacks only add value if there is an enlargement of the interests of all owners.  In other words, share buybacks to offset options given out to employees does nothing.  As for M&A, until 2012, the acquisitions were quite small.  While I remain open-minded about the Convio acquisition, it seems to have gotten the CEO fired, so it can be going to well.

Growth Opportunities Inside The Moat

As we have explored over and over again, growth investments are meaningless unless they are inside the moat.  Blackbaud estimates the total addressable market to be $16.5 billion, and Blackbaud has penetrated less than 3% of this market.  In our view, Blackbaud’s best prospects are in the $8 billion enterprise market, but, in any case, there is substantial room to grow.

Valuation

While there is a lot to like about Blackbaud, the current valuation makes no sense.  This can be seen plainly without using any fancy metrics.  The current market capitalization is $1,753 billion and the P/E is 113.  For shareholders to earn a 15% pre-tax return, the company would have to generate EBIT of $263 million per year.  It has never come close to earning that kind of money.  In fact, it has never earned 20% of that t.  Last year Blackbaud had EBIT of $19 million.  To get to $263 million, revenues will have to more than double and the EBIT margin will have to increase 6X to levels not seen since 2006.  If you needed more proof that the shares are overpriced, insiders have been selling like crazy.  I don’t sell short, but this seems to be an interesting candidate.


[1] Because software companies have negative working capital, using my normal ROIC formula, ROIC is infinite.  To make comparisons between companies meaningful, I have modified my formula to ROIC = EBIT / Total Assets – Non-Interest Bearing Current Liabilities – Excess Cash.  The formula comes from Competition Demystified.

[2] Quote via Prof.  Sanjay Bakshi.  He is posting transcripts of his excellent lectures at http://fundooprofessor.wordpress.com/

[3] In other industries – such as telecom and basic materials – the minimum efficiency scale is quite large due to the high ratio of fixed costs to variable costs. In these types of industries, only a few major players tend to dominate the space.

[4] Compare this with the much larger CRM market where heavy hitter like Salesforce, Oracle, SAP and Microsoft along with numerous smaller players are all duking it out.

[5] Greenwald, Bruce and Kahn, Judd, Competition Demystified, p. 47.

See’s Candy – The Prototype of the Wide Moat Company

02 Tuesday Jul 2013

Posted by punchcardblog in Moats

≈ 6 Comments

Tags

Brand, Competitive Advantages, Deliberate Practice, Franchise, GARP, Moats, See's Candies, Strategy, Wide Moat

Buffett often holds out See’s Candy as the prototype of the wide moat company.  What lessons can be learned from this case study?

Background

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.)

Key Stats:

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.

Capital Intensity

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!

Capital Allocation

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.

Cash Management

The product is sold for cash, so there is no need for accounts receivable.

 

Risks

Competition

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.

Inflation Risk

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.

Management Risk

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.”

Inventory Risk

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.

Unique Risks

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.

"I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better." - Warren Buffett

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  • An Ephemeral Form of Value: Thoughts on the 2015 Pershing Square Investor Letter
  • Time Warner (TWX): A Compelling Short?
  • OnDeck Capital (ONDK) & The Re-Engineering of Small Business Lending
  • Cable One:  A Starkly Different Approach to The US Cable Industry
  • Charter:  John Malone’s Return to The US Cable Industry
  • Q2 2015 Form 13-F Summary
  • Discovery Communications & the Uncertain Future of Pay-TV
  • Why Did John Malone Invest in Lions Gate?
  • Sirius XM Holdings & The Subscription Media Business
  • Live Nation Entertainment: An Unregulated Monopoly?
  • Conn’s (CONN): A Retailer Targeting the Subprime Segment
  • Follow-Up on Interactive Brokers Group (IBKR) Valuation
  • Interactive Brokers Group (IBKR)
  • C.H. Robinson and Two-Sided Markets
  • Do Financial Services Companies Have Moats? Part II, American Express
  • Pulse Seismic: A Wide Moat Company Drowning in Cash
  • Update on Weight Watchers International, Inc. (WTW)
  • Do Financial Services Companies Have Moats? Part I – Nicholas Financial (NICK)
  • RPX and the Broken Patent Market
  • Investing As A Career
  • Blackbaud: A Wonderful Little Niche
  • The Hershey Company and the Power of Brands
  • A Closer Look at Weight Watchers (WTW)
  • A Memo to Jeff Bezos Re: the Washington Post
  • Katkin Leathers: An Illusory Moat?
  • Measuring the Moat
  • Tilson Comments on Avis and Hertz
  • Introducing the Punchcard Investing Watchlist
  • Part II – Hertz (HTZ) – Rational Pricing Discipline?
  • What Would You Pay For These Businesses?
  • Disney’s Theme Park Moat
  • Links for Moat Hunters
  • Amerco (UHAL) and Hertz (HTZ): Emerging Moats?
  • How to Buy A Stock that Will Drop 50%: Goodyear Tire & Rubber Company (GT) – A No-Moat Company
  • See’s Candy – The Prototype of the Wide Moat Company
  • Welcome to Punchcard Investing

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