<THE BORING PORTFOLIO>
See's and FightSafety
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Dec. 23, 1998) -- On Monday, we continued with our brief introductions of the various Berkshire business units. Though each one might be brief, there are a ton of individual companies that are part of the Berkshire family. So let's continue with our look at Berkshire's retailers.
We left off with See's Candies and talked about some of the lessons Berkshire's ownership of this franchise property have to teach about the way Berkshire does business. The existence of a cash cow such as this enhances the company's operations in numerous significant ways. For instance, in the reinsurance business, timing differences can exist between the generation of economic underwriting gains and taxable underwriting gains. For long-tail insurance, the taxable event can pre-date the actual earning of the premiums. If the premiums are invested in equities or a non-liquid investment, the timing difference can cause problems in how investment decisions are made with that long-tail insurance float. The existence of that earnings stream and earnings streams like that in other Berkshire businesses allow the insurance business to make optimal investment and underwriting decision- making.
To this point, just having a bunch of real cash earnings from semi-bulletproof businesses such as See's, FlightSafety International (which we'll get to), the Buffalo News, H.H. Brown, etc., allows the management of Berkshire to enter into new businesses either through taking minority positions in publicly traded companies or through buying companies outright. Think about the fact that a dying textiles company like Berkshire Hathaway, which the Buffett limited partnership bought into in the 1960s as a "cigar butt" type of value position, has now become the second-largest publicly traded company in the world, as measured by GAAP net worth. That falls into the category of maximizing what you have. And it also reflects the culture that exists at Berkshire, where cash flow generated by a dying business such as a textile mill doesn't have to be reinvested in the textiles business. The cash flow goes where the company thinks it can generate the best returns. The following quote from the 1992 Chairman's letter shows how they think about things at Berkshire:
"Our look-through earnings in 1992 were $604 million, and they will need to grow to more than $1.8 billion by the year 2000 if we are to meet that 15% goal [by the way, look-through earnings in 1997 were $1,930 million]. For us to get there, our operating subsidiaries and investees must deliver excellent performances, and we must exercise some skill in capital allocation as well.
"We cannot promise to achieve the $1.8 billion target. Indeed, we may not even come close to it. But it does guide our decision-making: When we allocate capital today, we are thinking about what will maximize look-through earnings in 2000."
Just to refute the notion that this is a closed-end fund, it just so happened that Coca-Cola Co. (NYSE: KO) offered the best use of the $1.3 billion dollars in capital Berkshire invested in the company between 1988 and 1994. If there were a similarly attractive or more attractive private company available at that time, Berkshire probably would have taken advantage of that. The division between private companies and public companies that is used to characterize Berkshire is not instructive. A good investment, no matter what the form of Berkshire's ownership in it, will add value. Would Berkshire be a closed-end fund if none of its investments were made in publicly traded equities? No. And it's not now. It just so happens that a couple publicly traded companies have large effects on the economics of Berkshire because they were such good investments. But that isn't a useful model for looking at the company going forward.
Of course, insurance is the biggest service at Berkshire. But there are other significant portions of the company that fall into this rubric. Most notably, FlightSafety International. Behind super-catastrophe insurance underwriting, GEICO, and investment results (including off-income statement investment results), FlightSafety was the largest source of reported income and value added for Berkshire in 1997:
FlightSafety's mission statement includes the following:
"A Singular Corporate Mission
"Since the very beginning, the corporate mission of FlightSafety International has been kept clearly in focus. We are a training company, which means that training is our service, our area of specialization, our reason for being. Training is our business.
"Within the broad realm of training, we have carved a special niche that involves the preparation of our customers for the safe and effective operation of complex, high-risk equipment. In most cases, the context is aviation; we train over 50,000 pilots and aircraft maintenance technicians each year. Through MarineSafety International we also train ships' officers - individuals who, like pilots, rely on proficiency for their safety, as well as the safety of others."
FlightSafety not only trains civilian and military transportation personnel at locations in North America, Europe, and China, but it also designs software and systems used in that training. And this isn't simple software here, either. We're talking about highly complex systems that replicate the operating environments of all major commercial passenger jets, as well as ships.
FlightSafety is a business with a lot of market-position characteristics we like. First, there are barriers to entry afforded by the complexity of the systems a potential competitor would need to put together. To satisfy all the parties involved -- civil and military aeronautics authorities, insurance companies, pilots and various unions, airlines, and aircraft manufacturers -- of the effectiveness and verisimilitude of the systems would take some doing after getting together those systems. Then the competitor would have to be able to locate their simulators in numerous locations throughout the U.S. and abroad. Then it would have to meet FlightSafety's pricing, which does not produce an abnormally high return on capital at the moment.
These are daunting challenges that give FlightSafety a cushion against major competitive incursions against its position as the industry leader. Furthermore, I can't see how civil or military aviation authorities will ever agree to a diminishment in training time for pilots, so there is a natural regulatory barrier that protects the company, in some ways similar to a patent. Finally, Berkshire paid an excellent price for FlightSafety, which is hard not to like. Lifting information I put together for a post on the Boring message board a month or so back, here's some data on FlightSafety from its last full year of operations as a separately traded public company:
Asset turns: 0.398
Operating profit margin: 35.8%
Average leverage: 1.41
Net cash flow from operations: $140 million
Free cash flow: $50 million
Enterprise value to operating profits: 11.5 times
Enterptrise value to invested capital: 2 times
With an acquisition price around $1.5 billion not counting the excess cash that was on FlightSafety's balance sheet at the time of the deal, we like this price, considering the growth potential of commercial aviation globally as well as the characteristics of this business.