Saturday, February 02, 2008

Been to a Dairy Queen Lately? Part III



“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.”

—John Mooty, Chairman of the Board, International Dairy Queen, October 21, 1997



Thus the Chairman of International Dairy Queen Chairman explained, in a letter to his company’s shareholders, how it was that he and the rest of the Board had decided to sell an American icon to Berkshire Hathaway for approximately $26.50 a share—a price well below what some of those same shareholders considered fair value:

“He [Buffett] should be paying north of $30,” said [Bruce] Sherman... “There are a lot of shareholders unhappy with this deal. It's not that the company is being sold. It's strictly the price.”
—Bloomberg LP, November 6, 1997


In fact, one of those shareholders was so “unhappy” he sued to block the deal, but lost.

Still, nobody can say Mr. Mooty tried to mislead those shareholders or anyone else as to their place in the scheme of things. After all, in the above-quote letter where he enumerates the components of “the entire Dairy Queen system” taken into consideration during the Board’s deliberations, Mr. Mooty lists the shareholders dead last.

Even after “suppliers.”

Consequently, while Mr. Sherman and other shareholders might have disagreed with the end result, they at least ought to have appreciated Mr. Mooty’s straight talk.

Lawsuit and protestations notwithstanding, in the end Warren Buffett paid precisely the price he and the Dairy Queen Board had agreed on: $27a share in cash to those who preferred cash; or $26 in Berkshire Hathaway stock, to those who preferred stock.

No more, no less.

Looking back at Dairy Queen's weak performance prior to the deal, however, an observor might ask why all the beef over a nice pay-day for shareholders of a stock that had bounced anemically between $14 and $21 a share for more than half a decade?

Well, for starters, for a total price tag of $585 million, Buffett picked up roughly $50 million of cash and cash-equivalents already on Dairy Queen's books, meaning his net outlay to acquire the business was only about $535 million.

And $535 million amounted to only 9.2-times Dairy Queen’s annual pre-tax income in 1996, while shares of Dairy Queen’s most visible publicly-traded competitor, McDonald’s, were changing hands at nearly 15-times pre-tax income in the public market.

Of course, some might say the comparison between Dairy Queen and McDonald’s is not entirely fair. McDonald’s, after all, has a reputation for, and track record of, faster growth and greater innovation than the slow-moving Dairy Queen.

However for the first nine months of 1997—Dairy Queen's last year as a public company—its core revenue growth and earnings growth were only modestly lower than McDonald’s.

The numbers are as follows: excluding the impact of a divestiture, Dairy Queen’s sales grew nearly 4%, while operating earnings grew 3%. McDonald’s, meanwhile, reported full year 1997 sales growth of 7% and earnings growth of slightly less than 5%.

Thus the Board of a company with only marginally slower earnings growth than its largest public counterpart accepted a substantially lower valuation from Warren Buffett than Buffett would have had to pay for shares of that counterpart in the open market. And, for that discounted price, which Buffett negotiated directly with the Board of Directors, Berkshire got control of an entire company.

Is it any wonder some Dairy Queen shareholders griped?

Now, an astute observer would certainly argue that the valuation of McDonald’s in the stock market on a given day provids a meaningless yardstick of the true, underlying value of International Dairy Queen in a negotiated transaction between rational human beings.

After all, stock market valuations fluctuate from month to month, week to week, hour to hour, and minute to minute, depending on breaking news, political scandal, plague, war and federal economic policy, not to mention the serotonin levels in the brains of Wall Street traders apt to fly to pieces at the slightest whiff of something as momentous and earth-shattering as the replacement of an adjective in the Federal Reserve’s latest interest rate statement by a slightly different adjective.

Thus a more objective way to look at the sales price of Dairy Queen would be to simply compare it to the cost of money, which is how most rational buyers—Warren Buffett especially—determine valuation.

Let's start with the government's cost of money: in late 1997, the time of the Dairy Queen transaction, the ten-year Treasury note was yielding something in the neighborhood of 6%. A well-heeled AAA-rated buyer like Berkshire Hathaway would, of course, have a somewhat higher borrowing cost than the Federal Government, so we'll assume Berkshire could have borrowed the $535 million needed to acquire Dairy Queen (and its $58 million in pre-tax income) at an 8% interest rate.

8% interest on $535 million would amount to $43 million in annual interest payments. And $43 million in interest payments would be substantially less than Dairy Queen’s $58 million of annual income at the time.

In effect, Warren Buffett would be buying Dairy Queen with Dairy Queen’s own money, much like a leveraged-buyout.. Most galling to "DQ" shareholders, perhaps, is that Buffett would be paying practically no premium for the intangible but presumably substantial value of the Dairy Queen brand name.

Now, these observations are not meant to suggest the Dairy Queen Board did not do its duty.

First, the calculations are our estimates only: not actual numbers.

Second, no information anywhere exists to suggest that any alternative to the Berkshire offer was made to the Dairy Queen Board of Directors.

Third, as evidenced by Mr. Mooty’s letter to shareholders, there clearly was much more to the sale of one of America’s best-known brands than mere money—at least as far as Mr. Mooty and his fellow Dairy Queen Board members were concerned. And well there should be in any business transaction.

Finally, and most importantly, Berkshire did not pay all that $535 million for Dairy Queen in cash.

Rather, as we stated at the beginning, Buffett agreed to pay slightly more than half the purchase price in Berkshire Hathaway stock, the remainder in cash.

And stock, unlike cash, can appreciate over time, meaning Buffett gave the shareholders of Dairy Queen—at least those smart enough to take $26 a share worth of stock rather than $27 a share worth of cash—a chance to participate in the subsequent growth of Berkshire Hathaway.

That growth would prove to be substantial.

Shares of Berkshire Hathaway closed at $47,500 apiece the day the Dairy Queen transaction closed. They are now trading above $130,000 a share. Thus, the entire value of the Dairy Queen transaction has almost doubled, from the original $535 million value (net of DQ's own cash) when Berkshire’s stock was $47,500 a share to nearly $1.1 billion at today’s $130,000 a share price.

Recall Mr. Sherman, the broker whose clients owned 1.7 million shares of Dairy Queen at the time, complaining that the price should have been “north of $30.” In fact, thanks to the near-tripling of Berkshire's stock price, the current value of the deal amounts to well “north of $30,” .

It amounts to almost $50 a share.

Now, what precisely does Dairy Queen add to Berkshire Hathaway’s bottom line, in exchange for that $1.1 billion investment?

This is not an easy question for an outsider to answer.

For financial purposes, at least, International Dairy Queen has all but disappeared inside the $100 billion conglomerate that is Berkshire Hathaway. In fact, it is lumped anonymously into a segment labeled “Other Service,” along with airplane time-sharing company NetJets; pilot training pioneer Flight Safety; kitchenware outfit Pampered Chef; and the Buffalo News.

A kind of negative clue as to Dairy Queen’s current size and profitability can be gleaned from the fact that Dairy Queen does not even get a mention in the “management commentary” segment of Berkshire Hathaway’s public filings. This means “DQ” neither helps nor hurts Berkshire’s quarterly income enough to rise to the level of significance required for such disclosure.

Consequently, the only hint as to whether any dramatic changes in Dairy Queen’s operations or profitability have occurred under Berkshire’s ownership is the statement in Berkshire’s recent filings that Dairy Queen services “about 6,000 stores,” which is up a little more than 200 from the 5,790 units in operation at the time of the acquisition.

And 200 new units on a base of 5,790 amounts to only one-quarter of one percent annual growth over the last ten years.

Assuming no prices increases on top of the low unit growth, Dairy Queen’s current revenues may not much higher than when Berkshire first acquired the business—perhaps $440 million. If margins haven’t changed from the 14.1% last seen in 1996, the business would be generating roughly $62 million a year in pre-tax income.

Is a $62 million annual return on a $1.1 billion transaction up to Berkshire's usual snuff?

Think of Dairy Queen as a bond that Berkshire Hathaway paid $1.1 billion to acquire. Think of the estimated $62 million income as the current “coupon” on that bond. Berkshire Hathaway's yield on its Dairy Queen bond? A mere 5.6%.

5.6% is not much better than a risk-free government bond, and it is far lower than many current investment alternatives.

Of course, all this assumes our calculations are correct, which they are almost certainly not.

For example, Dairy Queen’s revenue growth might have been substantially higher than we guessed if the company had raised prices all this time. So let's assume prices rose 2 1/4 % a year over the last decade—bringing the annual revenue increase to an even 2.5% since the Berkshire acquisition. The current revenue contribution of Dairy Queen would rise to roughly $560 million, and our estimate of pre-tax income to $79 million, a “coupon” of 7.2% on Berkshire’s $1.1 billion outlay.

7.2% is, likewise, hardly eye-popping, and no better than a decent preferred equity available in today’s market.

Why such a low apparent return on one of Buffett's more cherished investments?

Unlike the cash half of the Dairy Queen deal, which is forever fixed, the stock half of the transaction amounted to a currency that could, and did, appreciate over time. In fact it appreciated far more rapidly—approximately 10% annually—than Dairy Queen’s paltry growth (assuming our calculations are within the bounds of reason).

Had Berkshire paid $585 million for Dairy Queen entirely in cash, and extracted the $50 million already in Dairy Queen's coffers immediately, the return on investment would be substantially better, turning that $79 million “coupon” into a handsome 15% yield on a $535 million net investment—double our estimate for the stock-and-cash deal structure.

Perhaps the only comfort to shareholders of Dairy Queen still ruing the day they accepted cash, instead of Berkshire Hathaway stock at $47,500, is the notion that Warren Buffett might, likewise, still be ruing the day he paid with Berkshire stock valued at $47,500, instead of cash.

Of course, if Buffett had not offered his stock to Dairy Queen's shareholders, he might never have clinched the deal, and Dairy Queen Blizzards would not have become a welcome, carb-loading reprieve at the Berkshire annual meeting.

This is because stock-for-stock deals are not considered taxable events, the way cash deals are, and individuals who control companies through stock acquired at negligable cost, such as John Mooty, whose investment in Dairy Queen dated back to 1972 generally much prefer stock deals to cash.

Furthermore, Mr. Mooty clearly enjoyed the prospect of becoming part of the Berkshire family, as opposed to becoming a relatively insignificant subsidiary of, say, McDonald's, or a mere holding in the vast portfolio of a heartless, numbers-obsessed private equity outfit.

Recall his letter to shareholders recommending approval of the transaction:

"Our family will vote our entire 35% of the voting shares of Dairy Queen in favor of the merger and will elect to receive Berkshire Hathaway Common Stock for all the Dairy Queen shares owned by us. We are not interested in trading our Dairy Queen shares for any other securities. I personally consider Berkshire shares to be one to the finest investments that our family could make and we anticipate holding the shares indefinitely."

You can't say he didn't warn 'em.


Having attempted to gauge how well the Dairy Queen deal served Berkshire Hathaway shareholders’ best interests, we will conclude by examining the original premise of the Dairy Queen Board of Directors and consider whether the transaction with Berkshire Hathaway served the best interests of the “entire Dairy Queen system.”


To be concluded…

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. This commentary in no way constitutes investment advice, nor is it a solicitation of business in any way. It is intended solely for the entertainment of the reader, and the author.





13 comments:

Finn Kristiansen said...

This series on Dairy Queen is just really solid. Some of us are not numbers people and this breaks it down on how to think about deal valuation.

Then too, having been to a Dairy Queen once, and disappointed, I've always wondered what factors went into the purchase and how viable the business is on an ongoing basis.

Chris said...

Really enjoying this series.

David said...

In the paragraph begining "And stock, unlike cash, can appreciate... " I think you've flipped the cash and stock prices.

Jeff Matthews said...

David,

Actually Buffett offered a slightly lower price in stock, and a higher price in cash.

Thanks for reading carefully, however, and any errors will be correctly quickly.

JM

V. said...

Quick note:

DQ had ~51M in net cash on its bal sheet as of the Q prior to the merger, so that would lower the enterprise value to ~$535M. DQ earned $52M pretax for the 9 months ended 1997, on a run-rate basis (not sure about seasonality effects) that'd be almost $70M. So pretax yield would be 70M/535M = 13% versus an at-the-time 6% risk free rate. Seems like a pretty good deal especially if you're paying for that with float that probably has a positive cost of carry. WB is a pretty smart dude.

http://sec.gov/Archives/edgar/data/51207/0000897101-97-001066.txt

-Emil

Jeff Matthews said...

v:

1. Seasonality is huge in the ice cream business. A good chunk of DQ's stores aren't even open in winter. DQ's quarterly income pattern ran roughly 15/30/35/20 in 1996, so you can't annualize the 9 months.

2. Also, Q1 1997 included a $3+ million gain on sale of a business. So the core business ran closer to $60MM operating income, not $70MM, all things being equal.

3. However, cash should indeed come out of the $585MM denominator, and return calculations will be adjusted.

Thanks very much.

JM

V. said...

Apologies, should've used TTM instead of run-rating. Point noted on the seasonality issue. Backing out the 3M gain on sale and 3M of net interest income (would be double counting if you back out net cash from enterprise value, yes?), gets you to ~$58M pretax TTM, or what the article stated in the first place.

58M/525M = 11% pretax yield

Thanks again for the great article/series.

Aaron said...

Hi Jeff. I agree with your posters, this, too is a great series and very instructive. My one question though is: if all-cash acquisitions allow for better ROI than all stock deals, why don't more companies do all cash as opposed to all stock deals? Is it really the tax treatment? The one merger disaster that immediately comes to mind was the AOL-Time Warner merger which, if I remember correctly, was all stock, and Time Warner's stock got cratered.

Kevin said...

If you are going to include the appreciation of Berkshire stock over the past 10 years as part of the purchase price, don't you also need to include the return on whatever investment the cash saved was used for?

Doesn't this also imply that companies should never use their own stock as currency unless they think the return on their own stock will be less than the risk-free rate of return on cash? I would think that most companies engaging in equity offerings think the opposite is true.

At the end of the day, I'm not convinced that Berkshire's share price today would be proportionally higher if you went back and exchanged the shares issued to DQ holders with the cash offered.

whydibuy said...

Disregarding the bonus performance of those that took BRK stock, I find it another two faced Buffettism to go directly to the board of directors and not the stockholders, as in, owners of the company. Funny when the shoe was on the other foot, Buffett talks about his childhood ownership of Citi Services stock in Roger Lowensteins book. " I wanted to see that little piece of paper that said I was the owner of Citi Services, and I felt that managers were there to do as I and a few other owners said. And I felt that if anybody wanted to buy that company, they should come to me "( pg 267 ) I guess when buffetts on the buy side, hes happy to bypass those meddlesome shareholders.

David said...

In that case, its the paragraph starting "Lawsuit and protestations notwithstanding..." (P8) that has the price typo.

Jeff Matthews said...

David, fixed and thank you.

JM

valuevista said...

One aspect one should consider in evaluating BRK's decision to purchase entire companies rather than partial purchases of publicly traded stocks is the effect of taxes.

By purchasing an entire company, the pre-tax income of the acquired business is taxed only once.

By purchasing a partial stake, the pre-tax income is taxed twice. Once at the subject company, and once again at BRK, either as income when dividends are paid, or as capital gains tax with appreciation on the investment.

Thus, a partial purchase by BRK of Dairy Queen wouldn't earn very attractive returns for BRK, but a complete acquisition might earn a respectable, but not outstanding return.

I think at some point Buffett conceded as much.

In any event, DQ would appear to fall into the same category as some of Buffett's utility deals -- deals to stay rich, not get rich.

Nice series.