Warren Buffett and Charlie Munger purchased Dairy Queen in 1998 for Berkshire Hathaway.
In this article, I’ll dissect the investment, highlighting the key facts and features that lead to Buffett and Munger adding this business to their portfolio.
Key facts about Buffett and Munger’s Dairy Queen Investment
When did Berkshire Hathaway buy Dairy Queen?
How much did Buffett and Munger pay for Dairy Queen?
What price to earnings multiple did Buffett and Munger pay for Dairy Queen?
In 1997, Dairy Queen earned roughly $57m in operating profits which would’ve resulted in roughly $35m in net income after taxes. Therefore, the P/E ratio was roughly 17x.
Why did Buffett and Munger buy Dairy Queen? What made it such a great business?
Warren Buffett and Charlie Munger have emphasised that paying a fair price for a wonderful business is the ideal path to follow in investing. A wonderful business is a business that can achieve high returns on capital consistently over time and ideally grow its earnings through successful reinvestment of that capital.
Below, I’ll discuss some key features which made Dairy Queen a great business!
(1) The business had very favourable economics
The economic model of Dairy Queen is very favourable. They franchise nearly all of their restaurants, meaning their invested capital is extremely small. Instead of Dairy Queen buying land, building a restaurant and then paying for all the equipment and expenses to run it, they simply take a 4% cut of all the gross sales each store makes, and the rest of the capital investment is to be made by the franchisee.
Buffett explained this below.
Dairy Queen also explained its business as follows in the 1996 annual report:
As explained above, we can see that both Dairy Queen and the franchisees benefit from this arrangement. The franchisees are able to pay a relatively small fee for the ability to run a restaurant with a nationally recognised name. Dairy Queen also benefits from requiring very little fixed assets and capital expenditures to generate its earnings.
(2) Dairy Queen’s revenues and profits were consistently increasing whilst its debt and shares outstanding were decreasing.
Let’s look at Dairy Queen’s financials from their last annual report before they merged into Berkshire.
Here are the 9-year compound annual growth rates observed from the data above.
Furthermore, Dairy Queen’s debt reduced by 90% over this period to the point where the debt to equity ratio was as low as 0.02.
(3) Dairy Queen had a long-standing management team that was allocating capital successfully
By dividing the net income by the invested capital in the business and the equity, we can calculate Dairy Queen’s return on capital metrics as of 1996. This is the result:
Note that return on equity was reducing, but it was simply converging to the return on invested capital since Dairy Queen was reducing its debt levels. DQ’s return on capital was consistently around 20%, which is well above the average for American businesses.
Here is the management team as of 1996.
They had been at Dairy Queen for decades, led the company’s success over recent times and were successful capital allocators and operators.
(4) Dairy Queen had a strong brand and distribution system, which gave them a wide economic moat
Dairy Queen described this as follows in its 1996 annual report:
Dairy Queen management understood they had a brand moat and that it was important to maintain and grow this over time.
This can be seen through the fee willing to be paid by franchisees. The fact that franchisees are willing to forego an initial fee plus 4% of their future sales and pay that to Dairy Queen to use their brand name shows that Dairy Queen has a desirable reputation which drives sales for the operator of the store.
Dairy Queen’s brand-based competitive advantage can also be seen in this quote from its 1996 annual report.
The fact that Dairy Queen could pass on inflationary impacts to customers without much negative impact to demand displays pricing power, which is one of the main features of a business with a brand moat!
Dairy Queen also had an established distribution system and program for training franchise operators, giving them cost advantages over newly starting franchise brands and also a desirable model for a franchisee.
Summary of why Dairy Queen is a wonderful business
Dairy Queen has a great business model, posted high returns on capital and had a wide economic moat guarding its profits from competitors. As we can see above, Dairy Queen is a great business!
What made Buffett and Munger’s purchase price “fair”?
Buffett and Munger paid roughly 17x net profit after taxes for Dairy Queen in 1998. However, after adjusting Berkshire’s $590m purchase price for Dairy Queen’s liquid assets of cash and marketable securities, the true purchase price was more like $549m.
Therefore, if Dairy Queen did not grow any further, the earnings yield of the business would be 6%. However, Dairy Queen could likely grow over time, without needing to reinvest these earnings to generate the growth. `This means the 6% earnings yield is for Berkshire to keep, and any growth from both same-store sales or an increased store count would simply add to the overall return.
According to StarTribune, Dairy Queen’s 2021 net income was roughly $84m, up from $34.4m in 1996. The increase is equal to a 3.5% compound annual growth rate over this period. Therefore, the true investment yield after accounting for this capital-light growth would’ve been close to 10%.
Clearly, the earnings multiple paid wasn’t dirt cheap, however, it provided Berkshire with a strong, durable stream of future cash flows which still has room to grow, nearly 25 years after the investment was made.
Overall, Buffett and Munger achieved strong returns by buying a wonderful business at a fair price!
The main takeaway from Berkshire’s Dairy Queen Investment
Franchisors have incredible economics and can be great investments provided the franchisee benefits from the arrangement and the store has a strong enough brand to continue to operate successfully over time
One of Buffett’s most important strengths is his ability to pick businesses that are incredibly durable. He recognised that the economics of a franchise business, characterised by very low fixed assets and high returns on capital due to earning revenue through a royalty paid by store operators, makes for a very successful business model that can thrive over time.
He also successfully recognised that Dairy Queen’s brand is very strong, and will not wither away over time. Though the business’ growth wasn’t extremely high over the last 25 years, the earnings stream delivered to Berkshire was consistent and extremely low-risk. This means Buffett had a constant stream of $40-80m being sent to him in Omaha which he could redistribute amongst his investment opportunity set.
Overall, a key lesson is that a strong restaurant brand can provide very high returns on capital for a long period of time, especially when the royalty fee is reasonable and franchisees experience successful financial outcomes too!
- 1996 Dairy Queen Proxy Statement, Securities Exchange Commission
- 1996 Dairy Queen Annual Report, Securities Exchange Commission