* * *

Most everyone has heard of the “Type A” and “Type B” personality classifications. In Dan Pink’s book Drive, he adapts MIT management professor Douglas McGregor’s ideas to put forth two more classifications: Type X and Type I. Type X behavior is fueled by extrinsic motivation—external rewards like money and recognition. Type I behavior is fueled by intrinsic motivation—the inherent satisfaction of the activity itself. “I don’t mean to say that Type X people always neglect the inherent enjoyment of what they do, or that Type I people resist any outside goodies of any kind,” Pink says. “But for Type X’s, the main motivator is external rewards. Any deeper satisfaction is welcome, but secondary. For Type I’s, the main motivator is the freedom, challenge, and purpose of the undertaking itself. Any other gains are welcome, but mainly as a bonus.”

Pink lists some well-known examples of both types: Warren Buffett, Oprah Winfrey, and Bruce Springsteen are Type I’s. Donald Trump, Jack Welch, and Simon Cowell are Type X’s. So it’s clear that both personalities can be successful. People can also change over time. But Type I’s almost always outperform in the long run. They’re also the people you want working for you.

On April 30, Biglari Holdings announced that its new compensation agreement with CEO Sardar Biglari would provide him with 25% of the gain in Book Value over an annual hurdle rate of 5%. So if the Book Value of the company went up 13%, Biglari would receive 2% of the company’s equity. At its current size, that amounts to around $7 million, including his regular salary.

In and of itself, this compensation agreement isn’t inherently bad. It’s a typical “pay for performance” scheme that many private investment funds use, including our own. (In fact, Biglari’s hurdle is slightly more generous than ours, but thankfully I haven’t had any complaints—yet.) I won’t delve into the more technical reasons I dislike the agreement—other than to say that a public company is not comparable to a private investment fund for a variety of reasons. I think the bigger implications are with the revelation of Type X behavior and how it affects the culture and future strategy of the company.

Type X behavior is fairly common among the CEOs of public companies. So it’s obviously not a disaster. In this particular case however, I think it permanently damages reputation. Aside from Warren Buffett’s history of good deeds, it gives people (shareholders, company managers, etc.) comfort that he isn’t in it for the money and is on equal financial footing with other partners. The strategy of Biglari Holdings is also that of “growth through opportunistic acquisitions.” Acquiring companies when you have a reputation for selfishness and hostility can be a difficult undertaking. Also, regarding the people already working for Biglari Holdings, this behavior may have the effect of changing company culture for the worse.

Braewick Holdings LP still has a long position in Biglari Holdings (BH). We reserve the right buy or sell shares in BH at any time.

The following are some excerpts from a great interview of Bébéar done by Michael Villette (mentioned in Malcolm Gladwell’s essay “The Sure Thing”). In the interview, Villette’s goal was to test the common belief that Bébéar took more risks than others (both in business and insurance), was a business innovator, and took advantage of others using insider “industry” information.

MV: Explain to me how starting in 1981 you managed to carry out an uninterrupted sequence of acquisitions in France and then in other countries. I would like an explanation with no magic, with facts and figures.

CB: There’s no magic in any of it, nothing extraordinary. The first coup was Drouot, which we bought at a bargain price, because of the panic after the left won the elections.

On the Drouot acquisition:

… the result: we acquired for 250 million francs a company that was valued at 5 billion francs four years later. . . .

MV: Why was Drouot worth so little to start with and so much later?

CB: It’s just like Equitable. People study the issues very poorly. They look at things superficially. Drouot was a company with a very good business that had done some stupid things in real estate. It was taken over hastily by Bouygues. Bouygues knew nothing about the profession of insurance, so he stuck with thinking like a financial analyst, that is, in the short term. He said to himself: “Oh, there’s a hole in this business, it’s terrible!” He didn’t see the value of the underlying business. We bought at a very low price because it seemed to be a company practically on the skids, but since we were insurance professionals, we restored the business immediately, we increased premiums, and so on, and the business took off very quickly. When we bought it, it was losing 200 million. The following year, the budget was balanced, and the third year it earned 200 million.

On the Equitable acquisition:

The entire financial press thought the company was done for, and Wall Street was expecting a bankruptcy at any moment.  … I went to New York, I took a look, I talked with the management, and I said to myself: “This one too has a fantastic business.” So I had to see how big the financial hole was, in comparison with the value of the business. We studied the company for five months, something no one else was doing. We made a bet on a sure thing. . . .

What’s marvelous in this story is that when we did the deal, the head of the company said to me: “Claude, now you know more about the company than I do.” And it was true. We had studied it thoroughly. To do deals like that, you have to be in a profession you know, do a very thorough study, and have the ability to make quick decisions. These were the advantages we had over the others. There was no miracle.

On what constitutes a “good deal”:

MV: If I understand you correctly, correct me if I’m wrong, to do a good deal, you take advantage of a moment of vulnerability of the other party (which doesn’t mean you treat him badly, you can be elegant) and you play on the asymmetry of information.

CB: Absolutely.

MV: You’re not against that interpretation?

CB: No, not at all. You know, in a company, there’s the objective and the subjective. In addition, a company can be worth something for me, considering the business I’m in, considering the know-how I have, and for the next businessman it could be a catastrophe, a millstone. We were just talking about Bouygues: he bought an insurance company by chance, he realized it was not his kind of business, and boom. He went away. It was a good decision by a company head.

On taking insurance risks:

We took small risks in the area of reinsurance, but not on a large scale. It’s easy to do reinsurance. You can sign up to whatever you want. We didn’t want to buy shares in a reinsurer but to learn the business ourselves.

On whether is made his money by being an “innovator”:

MV: In writing the history of major businessmen, to explain their careers, it is often said that they were innovators. And you? You never present yourself as an innovator?

CB: In France, the inventor of modern automobile insurance was a man named Jacques Vandier. He was the head of Macif. He really invented new criteria. I have to admit that I never invented anything. What I was able to do was to recognize the weakness of other companies and exploit that weakness. That is, when opportunities came up, I dared to do what other’s didn’t, but without taking considerable risks. This was simply because facing me were timorous people, bureaucrats, notables.

On his interest in business:

Your last question is why I’m not richer than I am? The explanation is simple. First, I’m the son of civil servants, my parents were teachers, I was more tempted by business and power in business than by wealth. Second, I joined a mutual company where, normally, you’re not supposed to get rich. . . . Later, I started to get wealthy when stock options became legal in France. . . .

You know, it’s never entertaining to manage a company. What’s entertaining is to make progress, to try to do better than the others, to do things that the other’s don’t do. That’s the entrepreneurial spirit.

Claude Bébéar is very much a value investor (protecting himself from risk and uncertainty) whether he calls it that or not. Definitely no Warren Buffett, but an interesting story nonetheless.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

Of course, investors aren’t counting on Apple’s revenue doubling anytime soon, and the law of large numbers just means it’s more difficult for them to grow, not that it’s impossible. But to me, the more relevant model to use for Apple’s future growth is that of the Red Queen Effect.

In Lewis Carroll’s follow up to “Alice in Wonderland,” Alice comes across the Red Queen (not to be confused with the more popular Queen of Hearts) and for no reason at all they both begin to run. Alice notices that, despite their tireless efforts, they have remained in the same spot. The Queen informs her that she must keep running just to stay put (see the above quote).

In biology, the Red Queen’s race is translated into the principle that “for an evolutionary system, continuing development is needed just in order to maintain its fitness relative to the systems it is co-evolving with.” I think the Red Queen effect is an apt analogy for Apple’s current situation. Here’s why:

• Most of Apple’s growth in sales over the past 2 years has been from the iPhone (68% of growth to be exact).  The iPhone was launched in 2007, and most of these sales have been to new iPhone users. Certainly there are much more non-iPhone users to “convert,” but at some point most iPhone purchases will come from current users who are upgrading. This has already happened with the iPod – as seen in the chart above with iPod unit sales tapering off lately.
• Most future growth will have to come from new iPhone users, iPad sales, and any new products that Apple introduces.
• To justify Apple’s current valuation, the company must consistently come out with new (and popular) products to both maintain and grow profits. In other words, they have to keep running just to stay in the same place.

The one part of Apple’s business that isn’t susceptible to the Red Queen effect is their share of media/app sales through the iTunes & App store. Because of their closed system (disregarding the downside to this model), Apple controls and gets a cut of almost every application and piece of media consumed on their devices.

The iPod/iPhone/iPad act as mobile “delivering devices” for entertainment and productivity applications. If Apple can maintain their closed system – and Clayton Christensen’s prediction continues to be wrong – their share of content distribution will continue to rake in profits.

But as an investment, I don’t think there’s much of a margin of safety if Apple stops “running” and a new product launch fails. Investor’s high expectations have put Apple on a Hedonic Treadmill of sorts that only a fall in price can cure.

Disruptive Portable Music?

Before MP3 players, the only real option for portable music was a CD player. The first MP3 players were introduced in 1998, and had very low capacities. They could hold at most one or two CDs worth of music. In 2000, Creative released its NOMAD Jukebox, which had a capacity of around 1,200 songs. However, it was expensive and had limited usability.

The first generation iPod (5GB) was released in 2001 and could hold an average of 1,000 songs, or about 79 CDs at an equivalent quality. The cost of music (content) was low at first: consumers who already had a CD collection could transfer their songs to the iPod, or download them from the (usually illegal) filesharing programs on the internet.

The total cost per portable song for an iPod 1G was $1.48 or $0.39 if users converted old songs. This compares favorably to a CD player’s $1.95 cost per song (assuming someone can carry around a maximum of 10 CDs without it becoming too much of a burden – see notes for details). Despite this ability to carry more music for an incrementally cheaper cost, like earlier players the high total cost of the device—and the lack of convenience to use its capacity—confined sales to “fist adopters” and high-end users who were willing to convert their old music collection.

So at first, the iPod was a sustaining innovation relative to other portable music devices. Although it wasn’t made by a current industry leader, it was a breakthrough improvement upon other portable music devices and the performance metrics that customers valued (quality, capacity, cost per portable song, etc.).

The release of the iTunes store in April 2003 significantly reduced the barrier of purchasing and managing new music/content for the iPod. The store would offer individual songs for 99 cents or an album for $9.99 (also comparing favorably to CDs). As you can see in this chart, iPod sales go from an average of 123,000 a quarter to 545,000 a quarter immediately after the store’s release.

Although the iPod itself was not disruptive, the iPod/iTunes combination seems like a low-end disruptive innovation relative to both CD retailers/distributors and (to a lesser extent) record companies. It disrupted the “channel” of the music industry by coming in at a lower price point, a much lower cost structure, and more convenience for the end user. *

(* I should note that, unlike some innovations, the iPod & iTunes don’t neatly fit into any of Christensen’s categories. In the end, labels don’t really matter, though it does help to see where the product fits in and where its evolution may take it in the future.)

The value network of the industry was well situated before iTunes came along: Artists > Record companies > Music devices / CD manufacturers > CD retailers. Each constituent made money this way, and so their strategies were focused on lowering costs and satisfying current customers (CD purchasers). In the new network, the iPod/iTunes combo filled the roles of medium, device, and distribution. But it also had the ability to bypass record companies and distribute directly from artists. So although the record companies still play a major role, by disrupting their product channel iTunes forced them redefine how they made money.

Performance Oversupply

According to Clay Christensen, performance oversupply occurs when the performance of a technology under a certain attribute (whether it be quality, capacity, reliability, etc.) increases beyond what the market demands. Once market demands of that attribute are met, other attributes whose performance has not yet satisfied demands becomes more highly valued. Companies pursuing both sustaining & disruptive technologies will seek to use this “new” attribute to sustain and differentiate their product.

Both song capacity and purchasing convenience were what vaulted the iPod past CD players and other music devices. But as seen in this chart, the metric of song capacity (and in turn cost per song) quickly surpassed average market demand (though high-end users were still served by this ever increasing performance).

A typical pattern of attributes, according to Christensen, is the evolution from functionality to reliability to convenience to price. Price competition is usually the endgame once each dimension of performance has been fully satisfied. For the iPod, it seems that the most important attribute evolved from capacity to convenience to features—and finally to price:

When the iPod was competing for features (photos, bigger screen, video playback), it essentially branched out into the iPhone and iPod Touch. Although both have much less capacity than an iPod classic, they have enough capacity to satisfy average market demand along with the features that are now more important.

While the iPhone is a completely separate product, it evolved from the iPod’s value network and technology, and was an improvement upon existing cellphone designs. It is a sustaining innovation relative to both iPods and smart-phone devices. The iPhone (& Touch) transformed the iPod from a portable music device into a portable communication / productivity / entertainment device (with iTunes and the new app store acting as content distributors).

I’ll talk more about the iPhone—and where the iPad may fit in—in part II of this post.

Average song size is 5MB (Apple figures size is just over 4MB, though the actually average is probably higher). If you assume that for every 30 individual songs purchased the user purchases 1 album (13 songs for $9.99), the average cost per song is 92.3 cents. For the measure of song capacity, to partially adjust for the inclusion of “other media” (photos, videos, etc.) after the iPod 4G, it is assumed that 25% of the iPod’s capacity is not used for music, and in that space each “song” is an average of 100MB in size.

For any number that is estimated above, I tried to err on the side of caution so that if I was off it wouldn’t necessarily invalidate any conclusions.

There are two types of disruptive innovations: new-market and low-end. New-market disruptions create a new value network (the context in which customers and firms within an industry define what attributes are most important), with different performance attributes. They usually serve customers who would normally not be using the product at all (i.e. personal computers, Bloomberg terminals). Low-end disruptions attack the least-profitable and most overserved customers along attributes that the market currently values (i.e. discount retailing, steel minimills). Both types of disruption eventually end up overtaking or completely replacing current offerings as their performance improves.

There are also two types of sustaining innovations: incremental and breakthrough. Most sustaining innovations are simple, incremental year-to-year improvements. Others are dramatic, breakthrough advances that surpass all current offerings (i.e. contact lenses replacing glasses, airliners replacing other long-distance travel). Many people confuse the terms disruptive and breakthrough. Christensen further distinguishes them by pointing out that disruptive innovations usually do not entail technological breakthroughs. Instead, they package current technologies into a disruptive business model.

Practical Use

So why does it matter if a technology/business model is disruptive or sustaining? To consumers, it doesn’t matter. If a new innovation provides “…a way to do something better than it’s ever done before,” (David Neeleman) then its classification or origin is of no concern. But to both investors and the companies that create the innovations, where they fit in can make a big difference.

Established companies and leaders are usually very good at developing sustaining innovations. It is clear to these firms that their future profits depend on constantly improving technologies/practices, so they invest heavily in creating products and services with higher performance. After all, that’s what their current customers want. It is difficult for a startup or small company to develop a sustaining technology because they lack the resources of the established players.

Disruptive innovations turn things around. Here, the resources and processes of established companies are a hindrance. In the face of disruption, good management is the primary reason incumbents fail. Their downfall is because they listen to their customers and invest in better performance. Startups have the edge here because they can serve different customers (at first) and build their company and cost structures around the new innovation. Along the way, they gain experience, market share, and other first-mover advantages.

In my next post, I’ll take a look at Apple’s products through the lens of the above framework.

The Innovators Dilemma talks a lot about a company’s culture, and why incumbent leaders of a certain technology are restrained from participating in a disruptive technology’s upside. Christensen names these attributes as the incumbent’s downfall: (1) Current customers aren’t served by new market; (2) New market is too small for large companies; (3) Use of new technology isn’t fully known yet; (4) Processes that help them with current business hurt them with new business; and (5) New technology isn’t good enough yet to meet higher-end market demand.

One solution to the above issues is to acquire another company that can take advantage of the disruptive technology. If done correctly, this can solve numbers 1, 2, 4, and 5 above.

Christensen breaks down the factors that affect what a company can and cannot do into Resources, Processes, and Values. Resources are people, equipment, brands, technology, customers, etc. Processes are how companies transform those resources into products or services of greater value. Values are standards by which employees make and prioritize decisions (think of a company’s “Core Values” of the Jim Collins variety).

So when strategically acquiring a company, you’re either acquiring it for its resources, or its processes and values.

Processes and Values are extremely difficult to change once they’ve been ingrained in a company’s culture. So if they are the drivers behind the success of an acquisition (i.e. if the target’s culture is very important), the acquirer should never try to integrate themselves with the new company. No synergies here. Integration will destroy the desired processes and values, so the acquired company should be left alone.

But if a company’s resources are the primary target, then integration makes complete sense. This is where the elusive synergies can be found. Employees can be moved, technology can be exploited, brands can have new distribution, and customers can be transferred.

Christensen sites the example of Daimler’s acquisition of Chrysler. Chrysler’s success was rooted in its creative product design processes. Sure, it also had some great resources. But when Daimler integrated the two companies, performance immediately was impacted, and the acquisition turned out to be a disaster.

It’s obvious which type of acquisitions get screwed up the most. “Often, it seems,” says Clayton Christensen, “financial analysts have a better intuition for the value of resources than for processes.”

The Acquisitions of Berkshire Hathaway

Most of Buffett’s acquisition candidates are financial and not strategic. But they can still be looked at using the above framework. A majority of Berkshire’s subsidiaries are great companies because of their culture: they may have good brands and good people, but it is their culture that ultimately drives their success in the long run. And Buffett leaves them alone.

However, Berkshire does make some “resource” based acquisitions. Below is a list of some recent acquisitions and their categorizations:

• Culture: Burlington Northern, Iscar, Business Wire, Marmon
• Resources: Russell Corp. (to Fruit of the Loom), PacifiCorp (to MidAmerican), Railsplitter Holdings (to GenRe), Burlington Northern (to ??)

Yes, I included BNI in both categories. Burlington was acquired for both, although currently (and in the near future) it will probably be left alone in favor of their successful processes. But their resources may have further potential value in the future.

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

“The Restaurant Investor” by Max Olson

In March, 2008, Sardar Biglari won the most important victory of his life. In an activist campaign to gain control of the board of directors of The Steak n Shake Company, Biglari and his partner received nearly triple the number of votes of the directors they were replacing.

It hadn’t been easy—their proxy fight with incumbent management had been going on for more than six months. Biglari and the entities he controlled first purchased seven percent of Steak n Shake during the summer of 2007. In August, the initial filing was made with the S.E.C. stating that Biglari had been in discussions with management. At this point, as with many activist investors, Biglari hoped that management would be open to his suggestions and criticisms of the company. He was the third largest owner of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Only days earlier, C.E.O. Peter Dunn had unexpectedly resigned, stating his intent to “pursue other interests.” It seemed like the perfect time to reform the faltering restaurant chain.

Yet, after Biglari’s initial meeting with the Board and interim C.E.O., he was denied representation and otherwise rebuffed from any involvement with the company. To management, he was as a nuisance—one that if ignored, would go away. But Biglari was not the kind of investor to be ignored. While continuing to accumulate shares, he launched the first blow in the proxy fight on October 1. Along with an official solicitation to shareholders, Biglari wrote a brief letter outlining his intentions and frustration with the performance of Steak n Shake.

During the proxy fight, Biglari’s demands were relatively mild. His initial goal was to obtain two Board seats—one for himself, and one for Philip Cooley (Biglari’s mentor and business partner). But as the Board continued to fight, and Steak n Shake’s performance continued to decline, he determined that simple representation wasn’t enough. The current Chairman and interim C.E.O., along with the Lead Director, had to go. Biglari launched a website titled “Enhance Steak n Shake” and went as far as buying billboard space in the company’s hometown of Indianapolis.

After months of back-and-forth between Biglari and incumbent management, the minority share owners of Steak n Shake made the overwhelming choice to replace current leadership with Sardar Biglari and Phil Cooley. During the contest, some claimed that Biglari was nothing but a corporate raider, only interested in Steak n Shake to pursue short-term profits at the expense of the company. Now, he would have the chance to prove them wrong.

Of course, this wasn’t the first time Biglari had successfully launched a hostile Board takeover of a public company. Despite his relatively young age of thirty-years, this wasn’t even the first restaurant he had pursued.

Continue Reading “The Restaurant Investor”

As Ray Kroc sat in his car, he watched a miracle unfold. The parking lot was full, the lines were long, and customers were leaving with an arm-full of food and a smile on their face. Kroc stopped a few to see what was going on: “You’ll get the best hamburger you ever ate for fifteen cents. And you don’t have to wait and mess around tipping waitresses.” He had travelled the country selling milkshake machines, visiting countless restaurants of all types. But he had never seen a merchandising operation like this. It was 1954; fourteen years after the McDonald brothers opened their small burger drive-in in the town of San Bernardino, California.

The brothers—Mac and Dick McDonald—had started the fast-food stand in 1940, but didn’t achieve real success until eight years later. It was then that they turned the kitchen into a mechanized assembly line—with each step in the cooking process being stripped down to its essence and accomplished with minimum effort. They got rid of the carhops and indoor seating, replacing them with a system where customers would order directly through outdoor service windows. By concentrating their efforts on keeping costs down, the brothers could maintain low prices for a consistently good product. This inevitably led to a high rate of customer turnover. “Our whole concept was based on speed, lower prices, and volume,” Dick McDonald recalled. “We were going after big, big volumes by lowering prices and by having the customer serve himself.” By 1954, they had haphazardly licensed ten other drive-ins, many of which were poorly managed and had no consistent system. They were McDonald’s only by name.

This is where Ray Kroc, a spunky salesman from Illinois, entered the picture. Kroc was a visionary. No matter what kind of business he had pursued over his life, he dreamt big. From selling milkshake machines to flipping real estate in Florida, his goal was always to be the best. There was no settling for second place. So when he pitched his franchise idea to the McDonald brothers (he had already tried with Carl Karcher and Harry Snyder), he didn’t hesitate to think big. “Visions of McDonald’s restaurants dotting crossroads all over the country paraded through my brain,” Kroc later recalled. At first, the brothers politely declined. They were content with the decent living they made running just one store in California. Kroc persisted, explaining that he would help open all the stores—doing all the hard work—and the brothers would just sit around and collect royalties. They agreed. A contract was drafted that day, and Kroc was on his way back to Chicago.

Before he could begin selling franchises, Kroc had to build his own McDonald’s to perfect all the procedures. He went fifty-fifty with a friend on a location in Des Plaines, Illinois, which opened its doors on April 15, 1955. All the cost and time saving mechanisms had to be the same—the layout of the griddles and fry vats were essential to the operation’s efficiency. But most of all, Kroc was adamant about maintaining the consistent quality of the food. They had some initial difficulties replicating the San Bernardino store’s success. Leaving the potatoes outside in California, it turned out, produced a completely different french fry than in Illinois. Kroc’s attentiveness paid off: “Ray, you know you aren’t in the hamburger business at all,” one of his suppliers told him. “You’re in the french-fry business. I don’t know how the livin’ hell you do it, but you’ve got the best french fries in town, and that’s what’s selling folks on your place.”

Although the Des Plaines location wasn’t doing as well as the California McDonald’s, it had made money from day one, and Kroc now had the confidence to start lining up franchisees. Just over a year after the 1955 opening, there were already eleven franchised stores across the country. Another year later, in what would become the beginning of a breakneck growth pace, there were twenty-five more units opened.

Through his agreement with the McDonald brothers, Kroc was earning a paltry 1.9 percent of the gross revenues of all McDonald’s franchises and 25 percent of that went to the brothers. (In 1960, despite having system-wide revenue of $75 million, McDonald’s earned only $159,000.) Something had to be done to earn extra income. Harry Sonneborn, the company’s financial wizard, came up with the idea of purchasing the real estate under franchised locations and leasing it back to the operator. Franchise Realty Corporation was set up in 1956 to act as the landlord to current and future franchisees. As the operators began paying ever-increasing monthly rent, Franchise Realty soon became one of McDonald’s biggest generators of profit.

In 1959, the decision was made that the company should build and operate ten or so locations in addition to their franchise operations. To finance the expansion, they received a loan from three insurance companies for $1.5 million in exchange for 22½ percent of McDonald’s stock. After the first McOpCo (McDonald’s Operating Company) store was established, the loan would provide the basis for McDonald’s rapid growth during the sixties.

Despite the new income from McOpCo and Franchise Realty, Kroc was unhappy about his agreement with the McDonald brothers. In 1961, he asked them to name their price, and bought the company and the name for $2.7 million. At the time, he balked at the price and viewed the brother’s offer as outlandish. Yet in hindsight, the buyout would turn out to be one of the best investments Kroc would ever make.

Kroc stepped down as C.E.O. in 1968, but he still played an active role in the company. Despite a bad economy during the seventies, he pressured the company’s leaders to increase the rate of growth. “Hell’s bells, when times are bad is when you want to build!” Kroc screamed to his executives. “Why wait for things to pick up so everything will cost you more?”

At the time of Kroc’s death in 1984, the McDonald’s system had grown to just under eight thousand restaurants in thirty-two countries around the world. Using the same methods that Kroc obtained—and perfected—from the McDonald brothers, the company continues to maintain its role at the top of the fast-food world. In 2008, it narrowly inched-out Subway in terms of the number of total locations—coming in at 31,672. With average sales per store of $2.2 million, McDonald’s remains the undisputed leader with system-wide sales of over $70 billion. That seventy billion in volume comes from serving over twenty-one billion customers in 2008—meaning that, on average, every person on the planet visited a McDonald’s three times last year. Even Ray Kroc couldn’t picture that.

* * *

So, aside from great leadership and the luck that is inherent in any success story, how did McDonald’s achieve these results? Examining the company’s history, there are three elements that stand out: their franchising model, their leadership in cost and time efficiency, and their ability to convey those benefits into the minds of customers.

Once you have a good brand and model that works well with customers, the concept of franchising is very appealing to any businessman. You provide the name, image, procedures, product and some training, they do the rest of the work and you receive perpetual royalties. The amount of capital needed to grow a franchising operation is minimal, which makes it even more appealing from a return on investment standpoint.

With McDonald’s, from day one, Ray Kroc made sure that franchising was the main focus. “[T]he corporation is in the hamburger restaurant business, and its vitality depends on the energy of many individual owner-operators,” Kroc reminded his colleagues. “We are an organization of small businessmen. As long as we give them a square deal and help them make money, we will be amply rewarded.” During his tenure at McDonald’s, Kroc maintained a delicate balance between top-down, system-wide standards and a decentralized, entrepreneurial environment at both the franchise and corporate level.

Throughout its history, McDonald’s has been intimately involved in the development of their operator’s locations. By the time Kroc left the company, franchise owners were asked to spend five-hundred hours working in another location first, and to attend Hamburger U, the company’s training facility for managers and operators. At times, the company scouted real estate locations for their operators years in advance.

But the franchise relationship was a two-way street. Over the years, operators developed successful additions to the menu such as the Big Mac, Filet-O-Fish, and Egg McMuffin. In 1963, the marketing idea of two Washington D.C. operators was soon used across the entire chain, and has been promoting the company ever since. Ronald McDonald, the “Hamburger-Happy Clown,” was created by Willard Scott, a local television announcer, to appeal to kids and their families. Always a fan of catchy marketing gimmicks, Kroc loved the idea.

However, without a great concept in the first place, franchising falls flat on its face. The ability of McDonald’s to have both the fastest and most cost efficient procedures gave them a persistent advantage over rival fast-food chains.

In the 1960s, they realized the need for more sophisticated mechanical equipment and electronic aids to help speed up the food preparation process and make their products more uniform. The McDonald’s Research and Development Laboratory was established to address these issues. Technicians and engineers worked on everything from a dispenser that gave the exact right amount of ketchup every time, to the Fatilyzer—a testing device that allowed operators to analyze meat shipments as they were delivered. With regard to continually lowering costs and improving operations, Kroc was relentless. “[P]erfection is very difficult to achieve, and perfection was what I wanted in McDonald’s. Everything else was secondary for me.”

But all the cost and operational efficiencies wouldn’t matter if they didn’t bring in more customers. When someone thinks of McDonald’s, it is likely they think of cheap, fast, consistently quality food. (And by quality, I mean a good, not great or healthy meal.) There’s no sitting down and waiting—you order from the wide variety of options, get your food almost immediately, and go.

In Kroc’s autobiography “Grinding it Out,” he succinctly describes some of the reasons why McDonald’s works so well with both customers and franchisees:

We wanted to build a restaurant system that would be known for food of consistently high quality and uniform methods of preparation. Our aim, of course, was to insure repeat business based on the system’s reputation rather than on the quality of a single store or operator. This would require a continuing program of educating and assisting operators and a constant review of their performance. . . . the key to uniformity would be in our ability to provide techniques of preparation that operators would accept because they were superior to methods they could dream up for themselves.

In the minds of customers, creating a uniform and consistent product is one of the most important aspects of McDonald’s success. No matter where you go, once you see the ubiquitous “golden arches” you know exactly what you’re going to get. Especially when you’re in a hurry, why take the chances with someplace else? They’re not known for high quality food, service, or atmosphere—but as evident from the enormous amount of customers they serve, McDonald’s is the clear leader in cost, speed and consistency.

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. [From the 1991 Berkshire annual report]

The first sentence basically lays out—in only a few words—the definition of a competitive advantage. So a company can be either a franchise or a business. But the separation between the two doesn’t have to be that clear cut.

Some franchises can be much more lucrative and powerful than others. Both Coca-Cola and Pepsi have moats, but Coke has the upper hand when it comes to customer mindshare. Because of this, Coke has always maintained higher worldwide and domestic market share than Pepsi.

Some companies can have both qualities: they are in extremely competitive industries (where lowest-cost wins), but also share some of the benefits of a franchise. The sit-down restaurant business is extremely difficult to operate in—but chains like In-N-Out and Steak ‘n Shake have created a brand that holds a special place in the minds of customers.

One more thing: I think when Buffett talks about mis-management, he really means short-term mis-management. A long period of poor management can have significant impact on any franchise—even one like Coca-Cola. And even with a strong economic franchise, every investment needs to be monitored just in case the moat starts to shrink (like newspapers over the last few decades).