Tuesday, February 26, 2008

Been to a Dairy Queen Lately? Concluded.



“Dairy Queen is a business that I like, run by an outstanding management team. Dairy Queen will be a great addition to the Berkshire family.”

—Warren Buffett, October 21, 1997

“Too many of our restaurants are simply not competitive…. Our name has been tarnished and aged because we have a system that is relatively inconsistent, lacking commitment and investment, and lacking enthusiasm and excitement.”

—Dairy Queen CEO Chuck Mooty in Restaurant Business, September 1, 2001

So which is it?

Is Dairy Queen “A great addition to the Berkshire family”? Or “Not competitive…tarnished and aged?”

By any standard, International Dairy Queen—the company’s official name—should have been the “great addition” promised by Warren Buffett, neatly fitting as it does his definition of a good business.

First and foremost, Dairy Queen possesses one of the most recognized brand names in America. This alone has kept customers coming through its doors or walking up to its stainless steel counters—“tarnished and aged” though they might seem, even to the company’s own CEO—for sixty seven years, and counting.

Good too is the fact that its signature product—soft ice cream—is not a luxury item, a fad, or prone to technological obsolescence. Consequently, sales tend to be steady in good times and bad.

And that strong brand name has one more benefit: it means Dairy Queen can raise prices in times of inflation, when a less well-known outfit might not have the clout—an attribute Warren Buffett especially admires, and seeks in the companies he acquires.

Digging deeper into the Dairy Queen business model, what at first appears to be a huge drawback—the fact that its stores offer a more limited menu compared to some competitors (many Dairy Queens do not even sell food)—turns out to be no great drawback at all. While the typical “DQ” generates only about one-third the revenue of a typical McDonald’s, the ‘footprint’ of a typical DQ unit is likewise smaller, and therefore cheaper to build and operate, than the typical McDonald’s.

Furthermore, another apparent disadvantage—that Dairy Queen has not always kept pace with changing American eating habits as aggressively as other “quick serve” restaurants—does not necessarily make it a less attractive business.

It may be true that Dairy Queen’s last major hit new product was “The Blizzard” ice cream treat, officially introduced more than twenty years ago. And the company’s ballyhooed 2005 introduction of the “GrillBurger” did not exactly set the world on fire, a “GrillBurger” being—brace yourself, now—a quarter-pound hamburger, with fixings.

McDonald’s—which introduced its quarter-pounder in 1973—expanded beyond burgers, fries and shakes early in its development and continued evolving, most notably through the introduction several years back of healthier salads with Paul Newman’s dressing, and this year’s nation-wide roll-out of espresso drinks in direct competition with Starbucks.

Still, all these new products cost money, thanks to the necessary equipment upgrades and labor training involved—costs borne largely by McDonald’s store operators. If the 2005 quarter-pound “GrillBurger” is any indication, Dairy Queen store operators have little to worry about when it comes to shelling out money for new equipment upgrades or better-trained in-store labor.

All in all, International Dairy Queen has a great brand name, a steadily growing business, pricing power in its major product line, little risk of obsolescence, and a low cost of operation.

What could be better?

Perhaps only this: if the company didn’t have to perform the down-and-dirty duties of actually owning and running the stores, but instead made its money by collecting license fees for the brand name from territory operators and franchisees and by selling Dairy Queen ice cream and paper products to the store operators at decent mark-ups.

And that is precisely how International Dairy Queen is structured.

Consequently, it is the men and women who own and operate the stores—and not the parent company owned by Berkshire Hathaway—who deal with the day-to-day aggravation of upkeep, scheduling, broken equipment, employee turnover, bad weather, utilities, employee theft and vandalism—not to mention the occasional insurance claim for whatever happened in the parking lot over the winter when the place wasn’t even opened.

Now, this is not to say that Dairy Queen territory owners and store franchisees haven’t done quite well for themselves.

They do, after all, reap the same benefits of a great brand name, steady business and pricing power as the parent company. In fact, estimates of the typical Dairy Queen store owner’s income have put the figure at roughly 15% of sales, about the same as the parent company. Furthermore, many operators now own their land and buildings free and clear, having long since paid off the mortgage.

Still, the next time you drive by a tired-looking, weather-beaten Dairy Queen down the road from a sprightly-looking McDonalds, or Dunkin’ Donuts, or even Starbucks, and you scratch your head wondering who’d want to own International Dairy Queen what with all those competitors serving cold treats to the parents and kids who used to go to the local “DQ,” keep in mind the owner of that Dairy Queen is likely buying supplies from, and paying license fees to, Warren Buffett’s company, year in, year out.


And that’s a good business.


All this does not, however, automatically mean Dairy Queen has been “a great addition to the Berkshire family,” as Buffett predicted in 1997.

First—as we saw while working through some rough calculations earlier—by paying for the company partly in shares of Berkshire Hathaway stock, Warren Buffett may well have reduced what could have been a spectacular return on his investment to something more ho-hum.

Furthermore, as International Dairy Queen’s own CEO has plainly admitted—and as anyone who has in fact been to a Dairy Queen lately may have experienced—the company’s store network does not necessarily measure up to the kind of standards normally associated with a “great” business.

Finally, when Buffett agreed to buy International Dairy Queen, he agreed to buy a company with not just a well-known brand and a steady business selling cups and ice cream to franchisees.

He agreed to buy a company with a lawsuit. And a class-action lawsuit, at that.

Filed in 1994 by six franchisees seeking to buy some supplies outside the Dairy Queen “system,” the suit charged International Dairy Queen with violations of the Sherman Anti-Trust Act. By the time the company had become a wholly owned subsidiary of Berkshire Hathaway, the suit had gained class-action status, reportedly involving about a third of the Dairy Queen franchisees.

Lawsuits in corporate America are, of course, commonplace, and investors don’t often see them rise above the general category of a nuisance. This one did, however, and in 2000 the company settled it (while denying any wrongdoing) for millions of dollars. Fifty million of them, in fact, according to published reports, including a six-year, $5 million a year commitment to a national advertising fund.

Details of the precise financial impact on International Dairy Queen’s income may never be known given the company’s small impact on Berkshire as a whole. But $5 million a year in extra advertising spend would have been the equivalent of nearly 10% of the company’s pre-tax income the year before Berkshire acquired it—assuming insurance did not cover the costs.

And the fallout from the lawsuit went beyond the financial kind, pitting as it did the company against the very franchisees upon which the health of the “Dairy Queen system” depended. CEO Mooty described the aftermath this way in an interview in QSR Magazine, 2001:

“We are a fragmented system in many respects, and we’ve gone through a real battle with a group of our franchisees in a litigation that took over eight years, and that creates erosion, fragmentation.”

He wasn't kidding.

Today there are Dairy Queens that sell food (usually under the mysterious “Brazier” logo), and there are Dairy Queens that sell only ice cream. Dairy Queen stores in warm markets are open year-round; hundreds of stores in northern states are closed for winter. Some Dairy Queen units are painted red, white and blue; some aren’t.

The parent company—Buffet’s company—doesn’t even set the retail price of its products: store operators have that power. And royalty rates to the parent are said to vary widely: in fact, some stores aren’t even obliged to pay any franchise fee at all.

I am not making that up.

All of which may help explain why Dairy Queen’s growth has lagged its competitors for so many years, both before and after it became a part of “the Berkshire family.”

McDonald’s, which did not start franchising until 1955 (when Dairy Queen already had 2,600 units opened in North America), now has more than 30,000 restaurants around world, five-times the current Dairy Queen total.

And if comparing the growth of a chain selling something as prosiac and discretionary as ice-cream to that of a hamburger chain such as McDonald’s seems unfair, then let’s compare it to a chain specializing in something equally prosaic and discretionary.

Let’s compare it to a chain of stores selling coffee.

This particular coffee chain did not exist prior to 1972, did not bother to expand outside its home market of Seattle, Washington until after 1987, and did not even go public until 1992. Yet it currently has over 11,000 stores in the U.S. and more than 4,500 internationally, generating over $9 billion in annual revenue with operating margins comparable to that of International Dairy Queen.

The coffee chain, of course, is Starbucks. And, current growing-pains aside, Starbucks shows what an aggressive, forward-thinking management team can do when it's willing to spend the dough to make growth happen.

But it's not just by comparison with hamburgers and coffee that Dairy Queen's growth seems paltry. Even the vendor of such a uniquely American specialty as fried chicken has grown faster and further around the world than Dairy Queen and its soft-serve ice cream.

Kentucky Fried Chicken—now known as KFC and part of the fast-food portfolio of Yum! Brands (yes! the exclamation point is part of the name!)—began franchising in 1952 and now has over 14,000 units around the world. In fact, there are more KFCs outside the U.S. than inside, and 2,000 in China alone.

Dairy Queen, meanwhile, recently opened its 100th store in China.

So, has Dairy Queen really been a “great addition to the Berkshire family”?

Warren Buffett would certainly say it has, given the excess cash flow generated by its steady, slow-growing business model. After all, Warren Buffett loves nothing in the world so much, perhaps, as cash flow he can invest wherever he sees fit.

And who wants to argue with Warren Buffett?

But let’s flip the question around and ask ourselves if Berkshire Hathaway has been a great home for International Dairy Queen.

To do this, we return to the original premise of John Mooty, the Dairy Queen Chairman at the time of the sale, who wrote the following in a letter to shareholders explaining the Board’s decision to sell to Berkshire Hathaway:

“In considering this merger, we took into consideration the best interest of the entire Dairy Queen system, consisting of our employees, our franchisees, our territory operators, our suppliers, our customers and our shareholders.”

As far as Dairy Queen employees go, at least one such employee—Mr. Mooty’s son Chuck, who was Chief Financial Officer at the time and now runs the place—must certainly be glad the company wasn’t sold to a less hands-off manager than Warren Buffett.

As for the Dairy Queen franchisees and territory operators, however, a few appear no happier as part of the Berkshire “family” than before. In 2006, just six years after the class-action suit was settled, the Dairy Queen Operators Association filed suit in Illinois “claiming the company is trying to force its mom-and-pop restaurant-owners out of business,” according to the Minneapolis/St. Paul Business Journal.

Regarding Dairy Queen's suppliers, it’s anybody’s guess how they're feeling about being part of the “family,” although some might wish they’d hitched their wagons to a more ambitious organization growing faster than what looks like a rather paltry one-quarter-of-one-percent annual unit growth rate.

And here we come to the end of Mr. Mooty's list: the shareholders of International Dairy Queen, including those who vocally complained about Buffett's seeming low-ball offer. Today those former shareholders are, most likely, of two minds about the 1998 transaction that transferred ownership to Berkshire Hathaway.

Shareholders who followed John Mooty’s own strong convictions and accepted $26 in Berkshire Hathaway stock—and watched it triple to a current value around $75 in the decade since—probably agree that Berkshire Hathaway has indeed been a “great family” to have joined.

Those who elected to take $27 per share worth of cash instead of Berkshire Hathaway stock, however, might still be ruing the day they went for the extra dollar, thereby missing out on another $48 for each of their shares that accrued over the years.

Of course, these individuals could certainly console themselves with the knowledge that since Berkshire’s acquisition, Dairy Queen has remained, on the surface at least, a sleepy, slow-growing entity left behind by its peers in parts of America and much of the quickly-developing world.

Still, they probably skip reading the stock tables starting with the letter “B.”


Jeff Matthews
I Am Not Making This Up


© 2007 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. Readers who make investment decisions based on this material are making a mistake. This commentary in no way constitutes investment advice, nor is it intended to be a solicitation of business in any way. It is intended solely for the entertainment of the reader, and the author.

10 comments:

smithycroftman said...

At the risk of sounding like one of Wall Street's Finest, I'd like to say thanks for a great set of articles, both the visit to Omaha and on Dairy Queen. Both Buffett and his mentor Ben Graham advise learning through case study and I have appreciated all the research and though you've out into these pieces.

When looking through Buffett's wholly owned investments he appears to have two sorts. First those with outstanding management in place like NetJets Rick Santulli, or Frank Rooney of Brown shoes, or he buys outstanding businesses that he can just allow to grow organically where management have to do something really dumb to kill the golden goose like the jewellery businesses or International Dairy Queen.

Comparing this business to McDonalds or Starbucks is probably a trifle unfair, you just can't possibly achieve the same kind of unit sales, I'd love to see the DQ version of Supersize Me! Krispy Kreme is probably a far better comparison and on that basis I think it is best to paraphrase the great man himself who said that many people find out that a great return multiplied by zero equals zero.

Thanks again Jeff, definitely the most thoughtful and fun business blog out there.

jb said...

Ditto the great work on writing up this DQ case study and the Omaha trip.

Given Buffett's age might we at some point ever consider the unwinding of this eclectic portfolio of businesses he has gathered under Berkshire.

It's interesting to speculate if Buffett's successor will have his hands tied regarding spinning off some of these Berkshire holdings like DQ?

If he can divest, could Berk one day resemble a private equity firm
like Blackstone or Lee Partners that is fueled by Berk equity instead of PE?

The new Berk CEO could spend his days dressing and cleaning up Warren's many adopted and slightly
scruffy children and send them back out into the world with their faces washed and a clean pair of underwear. He'd also be looking for new acquisitions.

Could the breakup of old Ma Bell be dwarfed by the breakup of old Papa Warren's empire of the scruffy? Instead of dividends, Berk could start handing out shares of these spin offs (tax free?). Would Warren roll over in his grave or would he just want one last taste of the Blizzard?

Michael said...

Dairy Queen faces resistance over new concepts

Jeff Matthews said...

Thanks, Michael.

Aaron said...

Jeff: I too want to thank you for the excellent series of articles on DQ. I think any reader can see the irony in John Mooty's statement when the board sold DQ to BKH that Mr. Mooty considered "the best interests of our franchisees". One can see with the number of lawsuits filed against DQ since the buyout that was clearly not the case.

Fran said...

Jeff -

Your series on IDQ was very good.

I hope you don't mind that I posted links to your series over at www.bluemaumau.org as part of my blog - I believe the readers will find it a very interesting read. BlueMauMau is a site dedicated to the discussion of franchising and IDQ has been a hot topic.

Not certain if you were aware that since IDQ is regulated through the FTC, you could find a lot about their past three year audited financials by examining their UFOC.

You can find a lot of franchisor UFOC's in PDF on file with the State of California but large franchisees like IDQ have taken advantage of an exemption clause (loophole) in California law that allows large franchisors (although the rules were meant for municipality type “franchises”) to avoid publicly filing their UFOC.

So, you’ll either need to find someone who received a UFOC from them to scan/copy it for you or shell out a couple of hundred dollars to buy one online.

Fran said...

Jeff -

Your series on IDQ was very good.

I hope you don't mind that I posted links to your series over at www.bluemaumau.org as part of my blog - I believe the readers will find it a very interesting read. BlueMauMau is a site dedicated to the discussion of franchising and IDQ has been a hot topic.

Not certain if you were aware that since IDQ is regulated through the FTC, you could find a lot about their past three year audited financials by examining their UFOC.

You can find a lot of franchisor UFOC's in PDF on file with the State of California but large franchisees like IDQ have taken advantage of an exemption clause (loophole) in California law that allows large franchisors (although the rules were meant for municipality type “franchises”) to avoid publicly filing their UFOC.

So, you’ll either need to find someone who received a UFOC from them to scan/copy it for you or shell out a couple of hundred dollars to buy one online.

Jessica said...

Wow. That was more about DQ than I ever knew there was to know.

I like Dairy Queen. :-)

Duke said...

It's all comfy and cozy at DQ. All except their new TV ad, featuring little girl, making eyes at little boy, cooing "like shooting fish in a barrel". SEXIST drivel. Expected more of a supposedly family brand.
My family will vote with their feet, and these feet will not darkening the doors of a DQ soon.

Anonymous said...

YES WE HAVE BEEN TO DAIRY QUEEN BUT HAD TO DRIVE ON THROUGH BECAUSE YOU HAVE NO SELECTION OF NO SUGAR SOFT ICE CREAM..NOBODY WANTS A FROZEN BAR WHEN WE HAVE HAD SOFT ICE CREAM FOR YEARS..BOTH MY HUSBAND AND ME ARE DIEABETICS AND I'M SURE A LOT OF YOUR CUSTOMERS ARE EATING DQ THAT SHOULD NOT BE BECAUSE OF THE SUGAR THAT IS ADDED..WE HAVE FOUND MANEY DIFFERENT ICE CREAM PLACES THAT OFFER SUGAR FREE BUT WE STILL REMEMBER HOW GREAT DAIRY QUEEN IS.PLEASE GIVE US THIS CHOICE,IF OTHERS CAN DO IT,YOU CAN ALSO.

WE MISSING DAIRY QUEEN