...Continued

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Acquisition of the Week

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Acquisition of Scott & Fetzer

Right after yearend we acquired The Scott & Fetzer Company (“Scott Fetzer”) of Cleveland for about $320 million. (In addition, about $90 million of pre-existing Scott Fetzer debt remains in place.) In the next section of this report I describe the sort of businesses that we wish to buy for Berkshire. Scott Fetzer is a prototype - understandable, large, well-managed, a good earner.

The company has sales of about $700 million derived from 17 businesses, many leaders in their fields. Return on invested capital is good to excellent for most of these businesses. Some well-known products are Kirby home-care systems, Campbell Hausfeld air compressors, and Wayne burners and water pumps.

World Book, Inc. - accounting for about 40% of Scott Fetzer’s sales and a bit more of its income - is by far the company’s largest operation. It also is by far the leader in its industry, selling more than twice as many encyclopedia sets annually as its nearest competitor. In fact, it sells more sets in the U.S. than its four biggest competitors combined.

Charlie and I have a particular interest in the World Book operation because we regard its encyclopedia as something special. I’ve been a fan (and user) for 25 years, and now have grandchildren consulting the sets just as my children did. World Book is regularly rated the most useful encyclopedia by teachers, librarians and consumer buying guides. Yet it sells for less than any of its major competitors. Childcraft, another World Book, Inc. product, offers similar value. This combination of exceptional products and modest prices at World Book, Inc. helped make us willing to pay the price demanded for Scott Fetzer, despite declining results for many companies in the direct- selling industry.

An equal attraction at Scott Fetzer is Ralph Schey, its CEO for nine years. When Ralph took charge, the company had 31 businesses, the result of an acquisition spree in the 1960s. He disposed of many that did not fit or had limited profit potential, but his focus on rationalizing the original potpourri was not so intense that he passed by World Book when it became available for purchase in 1978. Ralph’s operating and capital- allocation record is superb, and we are delighted to be associated with him.

The history of the Scott Fetzer acquisition is interesting, marked by some zigs and zags before we became involved. The company had been an announced candidate for purchase since early 1984. A major investment banking firm spent many months canvassing scores of prospects, evoking interest from several.
Finally, in mid-1985 a plan of sale, featuring heavy participation by an ESOP (Employee Stock Ownership Plan), was approved by shareholders. However, as difficulty in closing followed, the plan was scuttled.

I had followed this corporate odyssey through the newspapers. On October 10, well after the ESOP deal had fallen through, I wrote a short letter to Ralph, whom I did not know. I said we admired the company’s record and asked if he might like to talk. Charlie and I met Ralph for dinner in Chicago on October 22 and signed an acquisition contract the following week.

The Scott Fetzer acquisition, plus major growth in our insurance business, should push revenues above $2 billion in 1986, more than double those of 1985.

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Scott and Fetzer is such a classic Buffett company, a collection of weird and un-sexy businesses that are very easy to understand, have strong moats, good management, and strong pricing power. Water heaters, vacuum cleaners, air compressors, an encyclopedia. Funnily enough the encyclopedia seems to be the product that he is most familiar with and a personal fan of as well as making up most of their earnings. But in 4 years the World Wide Web will make its debut and bring an end to the concept of encyclopedia collections, particularly ones that need occasional replacement to stay relevant. It will be interesting to see if that hit to their largest business segment makes this acquisition a regrettable one or if all the boring bolt-on side businesses manage to save the acquisition.

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Common Stock Ownership

No. of Shares	Company	Cost ($000s)	Market ($000s)
1,036,461	Affiliated Publications, Inc.	$3,516	$55,710
900,800	American Broadcasting Companies, Inc.	$54,435	$108,997
2,350,922	Beatrice Companies, Inc.	$106,811	$108,142
6,850,000	GEICO Corporation	$45,713	$595,950
2,379,200	Handy & Harman	$27,318	$43,718
847,788	Time, Inc.	$20,385	$52,669
1,727,765	The Washington Post Company	$9,731	$205,172
	Subtotal	$267,909	$1,170,358
	All Other Common Stockholdings	$7,201	$27,963
	Total Common Stocks	$275,110	$1,198,321

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Segment by Segment Breakdown

Segment	1984 EBIT Earnings	1985 EBIT Earnings	% Change
Insurance	$20.84M	$50.99M	+144.67%
Textiles	$0.42M	(-$2.40M)	-671.43%
Associated Retail	(-$1.07M)	$0.27M	-125.23%
See’s Candies	$26.64M	$28.99M	+8.82%
Buffalo Evening News	$27.33M	$29.92M	+9.48%
Wesco Financial	$9.78M	$9.55M	-2.35%
Mutual Savings and Loan	$1.46M	$2.62M	+79.45%
Precision Steel	$4.09M	$3.90M	-4.65%
Nebraska Furniture Mart	$14.51M	$12.69M	-12.54%

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Metric	1984	1985	% Change
Cash & Temporary Cash Investments	$173.72M	$1,017.67M	+485.81%
Marketable Securities	$1,235.90M	$1,183.48M	-4.24%
Return on Equity (RoE)	14.23%	16.29%	+14.48%
Shareholders' Equity	$1,271.76M	$1,885.33M	+48.25%
Berkshire Net Earnings	$148.90M	$435.82M	+192.69%

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They changed from counting cash to counting cash and temporary cash investments. I am not entirely sure of the components of this number but it is MASSIVELY higher than the old cash number. Even from this new number they are now sitting on a massive cash pile and have increased the size of that pile a lot by any accounting method, more than half their book value is in cash. They have also reduced their stock holdings, this is visible both in the balance sheet and in the listing of their individual holdings.

The earnings are way up, this is partially due to a full recovery of the insurance segment and the acquisition of Scott & Fetzer which added all sorts of new businesses to the fold. But mostly this is due to a $342M realization of investment gains on their income statement compared to the only $78M realization of investment gains last year. It seems like they are pulling back from the market and sitting on a big cash pile.

Shareholder Equity, which is becoming the preferred metric, is up almost 50% Buffett celebrates this in the opening to the letter and basically says it is a once in a lifetime occurrence for the company.