Been to a Dairy Queen Lately? Part II

Warren Buffett, as we noted at the end of Part I in this series, owns Dairy Queen.

Actually, Berkshire Hathaway owns Dairy Queen—or “International Dairy Queen,” as the well-known purveyor of soft ice cream is officially called—but it was Buffett’s idea to buy the business in the name of Berkshire, which he did in early 1998.

Buffett is a lifelong fan of “DQ” ice cream, having grown up 300 miles from the first plant of ‘Grandpa’ McCullough, who invented the stuff, in Davenport, Iowa. For years Buffett not only ate the ice cream, but kept his eye on the business the same way he keeps his eye on thousands of publicly traded businesses: by reading the company’s annual report each year.

The numbers in the Dairy Queen annual report, as you’d expect for a successful franchise operation with a great brand name, were quite good. Revenues from royalties and the sale of food and paper products to the franchisees grew steadily along with the store base, and pre-tax margins consistently averaged 13% or so, in good years and not-so-good years.

Most importantly, the business generated lots of Buffett’s favorite thing: excess cash flow.

This is due to its franchise model, in which the cost of opening new Dairy Queens, as well as hiring, firing and training employees, and just plain running the business day-to-day, falls on the Dairy Queen franchisees.

That leaves the home office with plenty of cash flow and not much to spend it on—precisely the kind of simple, steady business Warren Buffett wants to own.

Even before coming to the rescue after the death of a car dealer caused a block of Dairy Queen voting stock to come on the market in late 1997, threatening to throw the company to the wolves, Buffett had approached the Dairy Queen Board about buying it.

He was turned down flat…by the same Board of Directors that only one year later would agree to let him buy it for a price that some shareholders—with reason, as we shall see—judged too low.

Ten years later, if the Dairy Queens in our part of the country are any indication, not much has changed about Dairy Queen since the Berkshire deal closed in early 1998. And that’s the way Warren Buffett likes it. He has no interest in managing anything except Berkshire’s capital, and is content to leave the management that built the business up in the first place free to run it as they see fit after it becomes part of the Berkshire family.

Thus, while no detailed financial information on Dairy Queen is published, the business most likely has remained pretty much the same as it was before Berkshire bought it—which is to say, sleepy but profitable.

Hard to believe, then, that Dairy Queen was once the largest and fastest-growing food franchisor in the U.S.

In fact, Dairy Queen was a hyper-growth company in its early days. Founder J.F. ‘Grandpa’ McCullough, who started manufacturing ice cream in Davenport, Iowa in 1927—300 miles east of Omaha on Route 80—experimented with “soft” ice cream until he hit on a formula that proved popular at a friend’s ice cream store in Kankakee, Illinois.

The key to making “soft” ice cream was delivering the stuff at a slightly higher temperature than regular ice cream, and it wasn’t until ‘Grandpa’ found a partner who could manufacture the right type of freezer that the company could begin opening stores.

The first official Dairy Queen opened in Joliet, Illinois, in 1940, and business was very good.

Afraid that Dairy Queen’s popularity could diminish for any number of reasons, ‘Grandpa’ and his family licensed territories with abandon, inadvertently pioneering the franchising model for quick serve restaurants thirteen years before the McDonald brothers began franchising rights to their San Bernardino, California hamburger restaurant.

Sharp-eyed territory owners eventually got together and organized a national business out of Dairy Queen, and began opening lots of units quickly. The new chain grew from less than 10 stores in 1941 to an astonishing 2,600 in 1955—the year Ray Kroc opened his first McDonald’s in nearby Des Plaines, Illinois.

That’s a compound growth rate just shy of 50% each year—and it includes the years during World War II when new stores couldn’t open for lack of materials to build the freezers.

With that kind of torrid growth, of course, comes problems, and “DQ” got caught up in a tangled legacy of territory disputes and franchisee complaints that hobbled the company for a time, as competitors—including McDonald’s—began to grow.

Incorporated rather fancifully as “International Dairy Queen” when local investors took over the business from its founders in 1962 (Starbucks would no more think of calling itself “International Starbucks” than McDonald’s would call itself “Worldwide McDonald’s”), the company also began diversifying into ski-rentals and camping gear until the 1970’s, when ownership changed again, and new management paired refocused on the soft ice cream business.

The company began living up to its ambitious name, with stores opening in Japan, South America and the Middle East, and during the mid-1970’s bear market, management cannily bought back more than half the shares outstanding at low prices.

And while Dairy Queen’s store growth remained anemic—from 1955 to the time of Berkshire’s acquisition, the store count grew a bit less than 2% annually—the company hit the jackpot in 1985, with the launch of “The Blizzard,” which mixed OREO cookies and candies with ice cream.

It was a novel idea at the time and proved wildly popular—becoming the ice-cream equivalent of the iPod. Dairy Queens around the world dispensed more than 175 million Blizzards that first year, and the company’s revenues and earnings boomed. Pre-tax income jumped 50% in 1985 and again in 1986, and the stock—which had traded over-the-counter since 1972—went on a five year tear.

The company used the bonanza to buy popcorn and candy shop Karmelkorn in 1986 and a year later the Orange Julius franchise, which was somewhat ahead of its time in offering fresh juice drinks. International Dairy Queen’s stock became a favorite among a small but loyal following of growth-stock investors on Wall Street.

With many imitators and no hit follow-up to the Blizzard, however, and two unappealing acquisitions behind it, growth slowed in the 1990s and Dairy Queen stock price lost its zing. The shares were almost unchanged from 1991 to 1996—an eternity on Wall Street—and grow-fast investors began to question the appeal of a company with a go-slow mentality.

Consequently, by the mid-1990’s, a company which possessed one of the most enduring and familiar consumer brand names in the country, was, ironically, not well known as a public company. Far from representing global domination, the “International” in the name was little more than a quaint reminder of grand ambitions largely unmet, especially by comparison with McDonald’s.

Yet the company was able to stay independent, thanks to the relatively small number of shares outstanding (23 million) and the fact that insiders controlled many of those shares by means of two classes of stock—“Class B” share, which had voting rights, and “Class A” shares, which didn’t. Thus management had the freedom to run the place more or less like a private company, without paying attention to the whims and earnings models of Wall Street’s Finest.

And run it like a private company they did.

While McDonald’s earnestly cultivated Wall Street analysts and became a favorite stock holding among institutional investors and small investors alike thanks to its ambitious growth strategies, new product innovation and quick adoption of new technology, Dairy Queen never strayed far from its slow-and-steady business model.

A timeline on the Dairy Queen web site shows a seven year gap between the introductions of “Mr. Misty” slush treats and the “Buster Bar,” while its first store in Japan opened in 1972—one year after McDonald’s.

And while McDonald’s had started its first national television campaign in 1967, Dairy Queen’s web site notes with pride its first full year of national television advertising…in 2004.

Nor did management make great efforts to grow the shareholder base. In fact, the company continued to shrink the shares in the public market by buying back stock using the surplus cash flow from the business. This made perfectly good economic sense for a company that didn’t need much capital for opening new stores—the franchisees carried that burden—but it was unusual for a public company to buy stock back as consistently as Dairy Queen in those days.

Today, of course, buying back stock is almost as common as declaring a dividend. And while it is true that buying back shares at cheap prices is a great way for a company to spend its money—far better than making an ego-driven acquisition or putting up expensive new buildings—a decade or two ago company managements weren’t easy to sell on the benefits.

For one thing, companies like to grow, not shrink. It’s human nature. Buying back shares and shrinking the capital base tends to go against the built-in wiring of a typical big-company manager. It also can go against their paycheck: management incentives are usually based on growth—growth in revenues, margins, and earnings.

Not only that, but buying in shares—when it’s done as aggressively as the folks at Dairy Queen did it—changes the kind of shareholders a company has. That’s because the fewer the number of shares that trade, the fewer investment funds there are that can own the stock, no matter how great an investment it might seem to be.

This last might strike some readers as odd, even counter-intuitive, but for the average institutional investor, the first consideration when looking at a new stock is not “How profitable is this company?” or “How good is management?”

It is “Can we buy enough stock to matter, and could we sell it if something went wrong?”

I had that lesson drilled into me early in my career, when I came across an exciting little company with a new product that helped oil drillers improve their productivity and was selling like gangbusters. The company hadn’t been public very long, so the stock wasn’t well known on Wall Street—this was before CNBC and “Mad Money,” kids—and I couldn’t wait to get our portfolio managers to buy it.

The very first question they asked, however, had nothing to do with the product, the management, or the earnings.

It was, “How much does it trade?” It wasn’t so much that they wanted to be able to buy a lot of stock: they wanted to be able to get out in case I was wrong.

It seemed like the wrong way to look at a business—asking how big the door was in case you wanted to leave the building—but it’s one reason why, despite a highly profitable business model with large amounts of free cash flow, not many institutional investors owned shares of International Dairy Queen, and only a handful of analysts kept tabs on the company.

Then a Minneapolis auto dealer died in 1997, and everything changed.

Rudy Luther, a Twin Cities car dealer and part of the investor group that had taken over the Dairy Queen in the early 1970’s, had owned 3.2 million voting shares, and his estate was going to sell those shares. This might have depressed the stock price or prompted a hostile bidder to get involved, or both.

So the company asked Warren Buffett—who had approached the company through a Chicago investment bank, William Blair, the year before, only to be rebuffed by the Board of Directors—if he wanted to buy those shares.

Buffett declined to buy anything less than the entire company. A discussion between Buffett and the Chairman of the very same Board that had previously rejected him, John Mooty, apparently had its effect. Mooty and the Board now decided it would be a good thing to sell out to Berkshire.

Why the change of heart?

Despite being a decade old at this writing, the proxy statement laying out the terms of Berkshire’s acquisition of International Dairy Queen is an interesting document when it comes to grasping one of the intangible advantages Buffett has in acquiring businesses coveted by others: he leaves them alone.

“I don’t want to manage your business,” Buffett is known to tell the managers of the companies he buys, and he’s not kidding.

Here in the proxy statement, amidst the bland, legalistic prose spelling out the dry financial terms of the transaction, is a discussion of the reasons the Dairy Queen Board of Directors recommended shareholders approve the deal.

Normally such reasons are laid out in strictly financial terms, with a great many words and numbers spelling out the price paid as compared to similar transactions—much the same way real estate agents provide the “comps” to a potential home-buyer—along with a laundry list of future risks that might occur should the company not do the deal.

Very few proxy statements, however, include anything like this reason for approval:

“…that Berkshire’s historical practice has been to retain management, and, in this connection, the stated intention of Mr. Buffett [is] to retain Dairy queen management and to keep Dairy Queen’s general offices in Minnesota…”

In other words, Warren Buffett was going to leave them alone.

When Dairy Queen announced it was selling out to Berkshire Hathaway one fine October day in 1997, not a few shareholders were miffed that the offer was probably not the best that could have been obtained.

After all, Berkshire paid $585 million for a company with approximately $50 million of cash on the books, doing over $58 million a year in pre-tax income—a modest transaction price of only 9-times the value of the income stream. (Just recently, Campbell Soup came under fire from some of its shareholders for selling the Godiva chocolate business to a Turkish company for more than 15-times the value of the income stream—an earnings multiple 50% higher than what Dairy Queen got from Berkshire.)

Even Dairy Queen’s proxy statement for the transaction revealed that values of deals recently completed at that time (late 1997)—compiled by Dairy Queen’s own investment banker—were 20% higher than the price paid by Berkshire (a median of 12.25-times pre-tax, pre-interest income).

Public shareholders squawked—with one going so far as to sue, unsuccessfully, to block the deal. Buffett did offer a choice of either $26 a share worth of stock in Berkshire Hathaway for each share of Dairy Queen or cash in the amount of $27 per share of Dairy Queen.

Either way, the fact that management controlled the voting stock made the outcome, as they say, a “done deal.” In a remarkably straightforward letter to investors, DQ Chairman Mooty gave his reasons for voting his family’s 35% share with Berkshire:

“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.” It is a paragraph that could have been written by Warren Buffett.

In the end, slightly more than half the $585 million was paid in stock, slightly less than half in cash.

Those shareholders of Dairy Queen who took only the cash—in return for the extra $1 a share—undoubtedly avoid reading the stock pages these days. The shares of Berkshire they would have received on January 8, 1998 were valued at $47,400. Last trade: $131,000.

Given that roughly half the price paid for Dairy Queen was in Berkshire stock, which has nearly tripled, the original purchase price of $585 million is closer to $1 billion at today’s prices.

Whether it was a worthwhile transaction for Berkshire Hathaway, as well as Dairy Queen shareholders, is a question we will explore in our next installment.

To be continued… 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.