Profits from the Berkshire Hathaway's Shoe Group jumped from $28.8m in 1993 to $55.8m in 1994 with about nine-tenths of the increase down to Dexter coming into the fold. And Buffett and Munger were looking forward to 1995, “Management was pleased with Dexter's 1994 performance and better results are anticipated during 1995. This optimism results from the fact that recent wholesale price adjustments should help mitigate the effects of prior years' increases in Dexter's costs. Additionally, operating efficiencies are anticipated in connection with the start-up of Dexter's new computerized distribution center and from advanced manufacturing technologies.” (1994 Letter)
But rather than profits moving up another notch they fell, down to $37.5m. Buffett put a brave face on it, pointing to the even worse performance of other US manufacturers. “Our shoe business operated in an industry that suffered depressed earnings throughout last year, and many of our competitors made only marginal profits or worse. That means we at least maintained, and in some instances widened, our competitive superiority.” (1995 Letter)
And he looked forward to a “climb back to top-grade earnings” in 1996 as the managers capitalised on opportunities resulting from loss-making competitors closing and lowered production and administration costs.
He asked Berkshire shareholders to view the 1995 result as a “cyclical” problem – just a bad year in a cycle of good and bad - and not as a “secular” one, a long term trend.
He was right, to some extent, as profit crawled up to $41m in in 1996; the managers exploited a slightly improved marketing environment and had indeed cut costs. Buffett anticipated further operating profit increases during 1997.
But it wasn’t to be, the trend was very much secular for Dexter, after all. Profits fell to $32.2m in 1997 and operating profit margin to 7.4% on revenues down by $18.9m to $542m.
Dexter was now clearly identified by Buffett in the annual report as the problem area. Its sales were down about 12% in one year. But, nevertheless, Dexter’s management were “repositioning its brand to be more competitive in a highly discount oriented retail environment.” (1997 Letter). Berkshire’s shareholders were told that Dexter’s managers anticipate a recovery of a substantial portion of the lost volume in 1998.
After waiting another year shareholders were shocked to discover shoe profits to be down yet again. They were now less than half those of 1994, at $23m from sales of only $500m “The unfavorable results represent a continuation of a trend which began three years ago. Manufacturers such as Brown, Lowell and Dexter are facing reduced demand for their products. Additionally, major retailers are offering promotions to generate sales which is resulting in an ongoing margin squeeze.” (1998 Letter)
Still Buffett gave the benefit of doubt to the people running these operations, saying they are working to align production activity to the reduced sales level. Hopefully their genius at an operational level will cause profits will rise to a satisfactory level.
Despite their efforts, 1999 was dreadful. Profits halved again, to £11m on turnover down another $2m. Buffett noted that all businesses in the Berkshire stable had “excellent results in 1999” except Dexter.
He identified the problem not as one of managerial capability. Dexter’s managers were every bit the equal of the other Berkshire’s managers in terms of “skills, energy and devotion”. No, the core of the issue was that “we manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low-cost labor is the rule.” (1999 Letter) Thus, the issue was strategic; Dexter lacked competitive advantage to contest overseas producers.
Belatedly, the reluctance of The Shoe Group to manufacture a significant proportion of output in low-cost countries dissolved. “We have loyal, highly-skilled workers in our U.S. plants, and we want to retain every job here that we can. Nevertheless, in order to remain viable, we are sourcing more of our output internationally” Buffett wrote in his 1999 letter. Some US plants were closed in 1999 and the Group had to bear the costs of severance and relocation.
Buffett is not perfect
In 2000 all the remaining goodwill attributable to Dexter was written off and more factories were closed, with others scheduled to close in 2001. Buffett took the blame on himself for the tragedy. His mea culpa drew attention to mistakes across his career, “We try…to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.” (2000 Letter)
He was being far too hard on himself. While there were errors in these areas, we know, firstly, that successes elsewhere far out-weigh those mistakes. Second, resources from Blue Chip Stamps, Berkshire’s textile business and Diversified Retailing were taken from unproductive areas and reallocated to highly profitable investments in other industries such as candy (See’s Candy), insurance (e.g. National Indemnity) and in stock market listed shares such as Capital Cities and Coca-Cola which went on to multiply 6- or 20-fold.
What Buffett was doing in dwelling on mistakes was impressing on himself and others the need to remember the logic.……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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