Market Comment
This week we are celebrating an anniversary of sorts. It was almost exactly one year ago that the NASDAQ market hit its all-time high of 5011. Last week it closed at 2187, or down 54% in 12 months. While the broad market has done better than the tech stocks, the S&P is down 9% for the last 12 months, and the Wilshire index, which is the best gauge of the over all market, was down 15%. As I have said before, the thing that makes me happiest as a money manager is to be up when the market is down. In this regard, the news keeps getting better. Our performance relative to the averages for the last 12 months is the best in the company's history. Composite gain for managed accounts was 36.19%, versus a loss of 15.44% for the Wilshire index. This amounts to a net over performance of 51.63%.
I am not very good at forecasting the market, but one prediction I can make with almost absolute certainty is that we are not likely to to beat that number again.
The 450,000 Square Foot Furniture Store
Last month the Nebraska Furniture Mart announced that they were building a new store in Kansas City. No big deal you say? What is one furniture store more or less, to a company the size of Berkshire Hathaway? Maybe, but this is no ordinary store. If you have never been inside the NFM, it's easy to underestimate the significance of this announcement. If my guess at the sales of the Nebraska store is correct, it will add about the same amount of revenue as the acquisition of Jordan's furniture in 1999.
Depending upon whom you believe, the store is either a little bigger (furniture trade magazine) or a little smaller (Kansas City Star) than the Omaha Store. At 450,000 square feet, it is huge by any standard. To put this number into perspective, Home Depot just opened a new store close to my home in Orlando. It is 135,000 square feet, so NFM's Kansas City store will equal 3.33 Home Depots. Perhaps a more relevant comparison is with a furniture retailer here in Orlando. Kane's Furniture just completed the biggest expansion in its history. It opened five new stores (some replacing old stores). This expansion makes them the largest furniture retailer in Orlando. Kane's new stores are about 50,000 square feet. In other words their whole program only amounts to 250,000 square feet or about 56% of our new Kansas City store.
I have been a fan of NFM for a long time. and have often wondered why Warren did not take the concept national and become the Home Depot of furniture. But retail furniture is a difficult business, and so far most of the companies that have tried to go national have ended up in bankruptcy. Furniture retailing today remains mostly a fragmented, high markup business with no dominant national brand.
So what? No big impact on Berkshire right? Let's do some math. NFM will have 3 stores in three states. Lets say, for arguments sake, that the population served by these stores is 4 million. A little simple math says that the country could support 212 450,000 square foot furniture stores. At $200 million per store, it would cost about $42 billion in capital to build 200+ stores.
In 1994 (the last year before the R.C. Willey acquisition and therefore the last year where we have stand-alone figures for the Omaha store) NFM had $240 million in sales and just one store. It was growing revenue at an average of 9.4% per year in the 5 years prior. If they have continued revenue growth at this same pace the sales for the Omaha store in 2000 would have been around $365 million. That's more than the total sales of CORT, about the same revenues as Jordan's in 1999, and over $100 million more than the sales of W.C. Willey's seven stores when we purchased the company. That is for ONE FURNITURE STORE.
A furniture retailer with 212 stores and $400 million in revenue per store would generate $84 billion in sales per year. (That is more than five times Berkshire's revenue in 1999 from the insurance business.) Berkshire manages an operating profit of about 9% on its home furnishing retail operations that would equal about $7.5 billion if the revenues were $84 billion.
So is Berkshire going build 200 furniture stores? Probably not—but they could if they felt like it. And there is nobody else in the furniture business that could.
Furniture Store Moats
A 450,000 square foot furniture store comes with a huge moat attached and bus load of alligators. People will drive a long way to find just the right piece of furniture for their home, especially if they know that the price is going to be cheaper than a local store. My experience at last year's Berkshire Hathaway annual meeting example.
There was a new shareholder in front of us on the plane from Atlanta when my wife and I flew into Omaha last year. She asked what there was to do in Omaha besides going to the annual meeting. I told her that next to the meeting the most important thing to do in Omaha is to go to Borsheim's and Nebraska Furniture Market. She laughed. She must have thought I was making some crack about women and shopping, but I was serious. If you want to understand Berkshire you have to go to the Nebraska Furniture Market.
If you have never been there, imagine the biggest furniture store you have been in, and multiply times 10. The place is huge; a typical first reaction is, "What the hell is this thing doing in Omaha?" The reason it is in Omaha is because of Mrs. B and because when Warren buys a business, he wants the managers to start throwing crocodiles into the moat.
My wife and I had been looking for a curio for a few months and had pretty well covered all the furniture stores in Orlando. Before we left Orlando for the annual meeting, she had decided on one and had checked all the prices. The same piece was available in at three stores in Orlando. Sears had the best price $699+ $42 for tax and $45 for delivery, or $786.00. At Robb and Stuckeys (upscale, lots of ambiance, and free cookies) the same curio was $849 plus $59.43 tax or $908, but no delivery charge. At a third store the price was in between these two.
So when we were in the NFM on the Monday after the meeting, just for fun, I decided to compare prices. I had no intention of buying there. I figured there was no way they could ship one piece furniture half way across the U.S. and compete with the price at a local store.
In Orlando most stores had two or three pieces in the color we needed and some had none. At NFM there where fifteen. I found the identical piece we had decided to buy. The price on the floor was $549. I figured the delivery was going eat up the difference, but I asked the salesman anyway. Guess what the delivery from Omaha to Orlando is – $120 for 1400 miles vs. 45 bucks for the local Sears to take it out of their warehouse and carry it half way across Orlando.
But that's not the best part. The shareholder's price (during the annual meeting week-end) was $395. They did not charge me sales tax, so I got it delivered to our house in Orlando and set up for $515 net. $271 less than the local Sears and $393 less than Robb and Stuckeys. (But hey, they do have great cookies.)
It will be interesting to see how the furniture business develops. Will our different chains remain independent? How fast will they expand? And what kind of stores they build? It is my recollection that R.C. Willey announced last year that they were building a 175,000 square foot store in Las Vegas. That is not 450,000 square feet, but as I remember they had only smaller stores when Berkshire bought them.
Principle of Intermediate Fragmentation
On the list of Charlie's favorite books is Guns, Germs, and Steel written by a professor at the UCLA Medical School, Jared Diamond. It is a book about human systems and the impact they have on history. Professor Diamond then discusses the economic implications of his theory in How to Get Rich. Professor Diamond is attempting to use history as a laboratory to identify optimal methods for business organizations, and his theories generate two fundamental conclusions:
- Societies that are isolated fail, because, "Most innovations come in from the outside, rather than being conceived within that society..." In addition, intellectual mistakes that lead to behavior that makes no economic sense are inevitable within any human society. In an isolated society these mistakes can lead to intellectual and economic retreat. It is "competition between human societies that are in contact with each other that what drives the invention of new technology and the continued availability of technology."
- The principle of intermediate fragmentation describes the ideal business structure, and the best size for groups within that structure, "You want your human society or business to be broken up into a number of groups which compete with each other but which also maintain relatively free communication with each other." If a society (business) gets too big the people at the top use secrecy as instrument to concentrate and maintain power, this restricts communication within the organization and eventually destroys its power to compete.
Guess who Professor Diamond points to for example of properly organized company? "Microsoft has lots of units, with free communication between units, and each of those units may have five to ten people working in them, but the units are not micro-managed, they are allowed a great deal of freedom in pursuing their own ideas. That unusual organization at Microsoft, broken up in to a lot of semi-independent units competing within the same company."
So what does all this have to do with Berkshire Hathaway? Well it looks like we are going national with the furniture business, but the model is decidedly more Microsoft than Home Depot. We now have the Nebraska Furniture Market in the Midwest, R.C. Willey Home Furnishings in the west, Star Furniture Company in Texas, Jordan's Furniture in New England, and Cort Furniture. We have five separate furniture companies. Any other parent would have consolidated these purchases to achieve the obvious synergy and economies of scale, but not Charlie and Warren.
My first reaction was to see this as a sort of quaint, old fashioned Buffettism. But read "How to Get Rich" and you get a different thought. In the furniture business we have five different companies with managers that have spent their life in the furniture business. Surely the collective wisdom of all these different managers, is greater than that of the one best manager (if you could figure out who it is). So instead of trying to decide who is the best manager so they can put one person in charge, they leave the old structures intact to compete and communicate.
Maybe this is the way you build an organization to compete in the 21st century. You have a company with lots of units, with free communication between the units, the units are not micro-managed, and they are allowed freedom to pursue their own ideas. These units still have to compete with the other units in the company and the other companies in their markets, so stupid ideas are allowed to fail. The problem with micro-management is the stupid ideas that come from the top tend to get stuck in the system.
Viewed in this light, Berkshire's structure seems not quaint, but perhaps, leading edge; the first company on the planet to do this particular thing. If it works, it will become a new paradigm. Fifty years from today maybe this is what they will teach in business school. If it does not work it is not going to have a big impact on Berkshire, so the risk is low and potential for reward very high.
If applied throughout the company (you can make the argument that it already has been in a limited way) it allows Berkshire to keep growing at 15%, or better, for a very long time. Maybe it allows Berkshire to be the first American company to reach one trillion dollars in market cap. It should also be noted that once the system is up and running, it is not dependent on a dominant technology or any particular individual (sorry Warren) to keep it running.
Berkshire is not just an insurance company anymore. What it is, is hard to define and changes from day to day. But it is not too difficult to envision a point in the not-too-distant future where the revenue from its operating companies will pass that of the insurance business. How large will the home furnishing business get? I doubt that anyone has the answer to that question today. But the size of the Kansas City experiment suggests that Executive Jet may not be the only Berkshire subsidiary capable of massive revenue expansion.