THE SCOTT FETZER COMPANIES: BUFFETT’S BEST INVESTMENT

THE SCOTT FETZER COMPANIES: BUFFETT’S BEST INVESTMENT

It’s hard to believe, but little nkown Scott Fetzer has been a better investment than the most heralded of Berkshire’s investments, Coca-Cola. Scott Fetzer is a diversified group of companies with 22 different manufacturing firms staffed by 7,500 employees-- but the majority of profits come from three firms: Kirby Vacuums, World Book Encyclopedias, and Campbell Hausfeld (air compressors).

Warren Buffett’s Berkshire Hathaway purchased Scott Fetzer fifteen years ago for US$230 million, and it has produced US$1 billion in pretax earnings since then-- enough to pay for Buffett’s entire Coca-Cola stake. Scott Fetzer’s market value has increased 15-times in fifteen years to about $3 billion. Best of all, Scott Fetzer companies now generate approximately US$150 million in annual pretax earnings with just $300 million in capital-- representing a 50% annual return on capital.

By comparison, Coca-Cola has grown 9-fold in fifteen years giving Buffett a handsome 24% annual rate of return. Coke gives Buffett look-through earnings of $160 million, which could only be realized if Buffett were to sell his 8% stake in the company and pay his taxes on the gains. Scott Fetzer is the superior investment for Buffett because 100% of pretax earnings are available for Buffett to allocate as he desires to maximize shareholder value. Direct control of earnings aside, Scott Fetzer’s $150 million annual return on Buffett’s $230 million investment is a 65% return on investment, far above Coke’s respectable 24%.

A Little History

In 1906, inventor James A. Kirby developed an early cleaner that used water. But it wasn’t until after the First World War, when Kirby joined with Scott Fetzer, a machine shop in Cleveland, Ohio, that the vacuum cleaner really began to take off. Working together, Kirby, Scott & Fetzer produced a vacuum cleaner called the Vacuette which sold a million units in the first five years. In 1925, the company introduced an equally successful electric model. By the mid-1950s, it was selling 200,000 vacuum cleaners a year. Kirby Vacuum was a market leader and generated a lot of cash, which allowed the owners to begin to consider acquisitions-- and by the mid-1970s Scott Fetzer had more acquired 30 other companies.

Unfortunately, as is often the case, unfocused corporate managers had created a large kingdom with no clear direction. Ralph Schey joined Scott Fetzer in 1974 and began to streamline operations by selling off some companies and combining others. One of his most important purchases was World Book, Inc., producers of the World Book Encyclopedia in 1978. World Book had a similar business model to Kirby Vacuum-- both selling direct to the consumer with a large national door-to-door sales force.

Sharks Smell Blood
In 1984, Schey and his senior management team offered to buy-out the company, but their offer didn’t go unnoticed by corporate raiders, including Ivan Boesky (who subsequently was sent to prison for insider trading) who quickly raised the offer based on the value of the business after breaking it into smaller salable parts. While Schey’s group offered US$331 million for a management buy-out, the sharks offered more than $400 million in a break-up strategy. Schey was unable to raise more money, so he began to search for a friendly suitor to take over the business.

At that point, Warren Buffett stepped in. Buffett had been interested in Scott Fetzer for a long time. By October 1985, he owned about 5% of the common stock. Sensing an opportunity, although he had never met Schey, Buffett wrote Schey a short note, We own 250,000 of your shares. We have always liked your company. We don’t do unfriendly deals. If you want to pursue a merger call me. Schey made the call on a Monday, met Buffett in Chicago on Tuesday, together they visited the company on Wednesday, and on Thursday they concluded the deal. In less than a week, Berkshire Hathaway purchased Scott Fetzer for US$315 million, and it was announced in a press release on Friday.

Acquisition: Buffett-style
Warren Buffett used the Scott Fetzer acquisition to explain Berkshire’s investing strategy in his 1985 letter to shareholders: Scott Fetzer is a prototype, understandable, large, well-managed, a good earner. The Scott Fetzer purchase illustrates our somewhat haphazard approach to acquisitions. We have no master strategy, no corporate planners delivering us insights about socioeconomic trends, and no staff to investigate a multitude of ideas presented by promoters and intermediaries. Instead, we simply hope that something sensible comes along-- and, when it does, we act.

Buffett went on to outline six acquisition criteria that are still published annually in his famed letters to shareholders: large purchases, consistent earnings, little debt, ongoing management, simple businesses, and an offering price.

Buffett was attracted to three key businesses within Scott Fetzer. The World Book was first published in 1917, and acquired by Scott Fetzer in 1978. At that time, World Book Encyclopedia hard-cover sets were found in 4 of every 10 homes in the US and Canada, and contributed 40% of 1990 Scott Fetzer group sales. The Internet dramatically affected World Book, and sales have fallen from $35 million to just $17 million, just 7% of group sales today. Campbell Hausfeld, which produces powered equipment such as air compressors, pressure washers, air tools, winches, generators and welders, was founded in 1836, and today contributes nearly one-third of Scott Fetzer group sales and profits.

The gem in the Scott Fetzer from the beginning is Kirby Vacuum. Today, Kirby continues to sell about 500,000 vacuum cleaners each year all over the world. Scott Fetzer sells Kirbys to about 835 factory distributors, who in turn sell to door-to-door salespersons. In the late 1990s, the distributors’ door-to-door sales system was accused of using high pressure sales tactics that took advantage of elderly and low income customers in a front-page Wall Street Journal article. Ralph Schey called Buffett for advice, but Buffett only calmly repeated earlier advice-- Be very careful that customers are treated fairly. Schey told the public that Kirby uses the same sales methods today as it has used since the 1930s and complaints from Kirby owners are insignificant over the last 70 years. Buffett added that Berkshire receives over 100 letters a year from disgruntled customers of their various companies-- but only about 1% come from Kirby customers.

Ralph Schey recently retired from Scott Fetzer at age 76. In Buffett’s year 2000 letter to shareholders, he commented, In 1985, we purchased Scott Fetzer, acquiring not only a fine business but the services of Ralph Schey, a truly outstanding CEO, as well. Ralph was then 61. Most companies, focused on the calendar rather than ability, would have benefited from Ralph’s talents for only a few years. At Berkshire, in contrast, Ralph ran Scott Fetzer for 15 years until his retirement... Under his leadership, the company distributed US$1.03 billion to Berkshire against our net purchase price of $230 million. We used these funds, in turn, to purchase other businesses. All told, Ralph’s contributions to Berkshire’s present value extend well into the billions of dollars. As a manager, Ralph belongs in Berkshire’s Hall of Fame.

Sage@wallstraits.com

The author, Curtis J. Montgomery, has extracted much of the information in this article from a book by Robert Miles, The Warren Buffett CEO (Wiley 2002). Wallstraits does not own shares of Berkshire or Scott Fetzer in the Wallstraits 8 Portfolio, or do business with any of the Scott Fetzer companies, nor with Berkshire Hathaway or any of its companies. We have a Disclosure Policy.