BURKE CANDY COMPANY In October, 1949, after a dispute between stockholders of the Burke Candy Company, Mr. A. K. Martin, a St. Louis businessman, agreed to act as chairman of a committee to establish a value for 1,000 shares of the common stock. At the time, there were 10,000 shares of common stock outstanding; these were owned by various descendants of Jeremiah Burke, who had founded the company in 1860. A majority of the shares were held by three grandsons of Jeremiah Burke, each of whom was active in the management of the company. The board of directors of the company included the grandsons, the company’s lawyer, and a commercial banker. A cousin, Mrs. Richard Wilson, who owned 1,000 shares, over a period of time had expressed sharp dissatisfaction with the policies and greed to buy Mrs. 7 However, the ideas of the son and her lawyer as to “fair value” were very different. Finally, each group agreed to the appointment of a three-man committee to establish the value of the shares. Each group named one man to the committee, and the two nominees together selected Mr. Martin as the third member and chairman of the committee. Realizing that his views as to the value of the stock might well prove decisive, Mr. Martin undertook an inquiry into the affairs and financial status of the company. He learned that the Burke Candy Company had long operated as a “gener line house,” that is, it manufactured a wide variety of candies with no one type of candy predominating. While most candy houses had started in this way, by 1948 most confectionery manufacturers had specialized in one or more lines, so that general-line houses accounted for only some 11% of total industry sales. Burke products included five-and-ten-cent specialty items, such as packages of mints and caramels; package goods, chiefly in the less than one dollar per pound retail category; bulk goods, such as hard “Christmas candy” and unpackaged chocolates; penny goods, such a8 small marshmallow eggs; and candy bars. The company was generally acknowledged as the first Ameri- can manufacturer of one of the popular types of chocolate bars. This candy was first marketed about 1900 in the form of large blocks, which the retailer cut apart to sell. The Burke company then furnished the retailer with small 105106 CASE. PROBLEMS IN FINANCE glassine bags in each box of blocks.so the retailer could cut the bar from the block and slip it into a bag as he gave it to the customer. A change in manufacturing was next introduced so that each bar was a separate piece of candy. This change was enthusiastically received, and the company then decided to wrap each bar separately and label each wrapper “Burke's Best-Bet Bar.” Despite its early success with the Best-Bet Bar the company did not go along with a general tendency in the industry toward specialization in bar goods or other types of candy, and sales of Best-Bet Bar did not grow relatively to competitive products. During World War II, however, the com- pany did sell large quantities of Best-Bet Bar and other bar items to the Army and Navy for sale in PX’s and Ships’ Stores. As military demand fell off, postwar sales returned to the prewar pattern of wide distribution among product lines. Like most candy manufacturers, Burke owned no retail outlets. The com- pany’s products were marketed through brokers and by the company’s own sales force. Direct sales effort was concentrated in Missouri and adjoining states and primarily on candy and tobacco jobbers and on grocery, variety, and drug chains. Sales through brokers were primarily made to candy jobbers. In an effort to compensate for declining military sales, the sales manager in 1946 and 1947 had expended substantial amounts in national magazines and in trade-paper advertising and other efforts to gain national distribution through brokers. Almost half of 1948 sales had been through brokers, many in distant areas. One broker in Texas had been particularly effective in producing volume. On the other hand, the advertising expense involved had been sub- stantial, and the company was forced to absorb almost all the freight in order to compete successfully in distant states. Further, the brokers, who operated on a 5% commission, appeared to concentrate their efforts on standard product items, which were easy to sell but carried a very low margin to the manufacturer. In general, competition among manufacturing confectioners was keen, except during World War II when sugar rationing limited production and demand was strong. Competition was particularly keen in unbranded candies, and with the exception of its candy bars, most of the Burke products were unbranded or had brands that meant very little to buyers. Two other candy manufacturers located in St. Louis competed directly with the company in the metropolitan area, and manufacturers in Chicago and Indianapolis also com- peted strongly in the St. Louis market area. ~ Reviewing the financial records of the company, Mr. Martin found that operations had been profitable during the 1920s. Severe competition had developed during the 1930's, and recurring losses were suffered owing to declining sales and an apparent tendency to change too slowly with the times. ‘The company had entered the depression in strong financial condition, how- ever, and had successfully withstood the drain of cash caused by unprofitable operations. Operations proved profitable in 1939, and the development of aBURKE CANDY company 107 sellers’ market during World War II contributed to very profitable years. lanagement officials pointed out, however, that the lack of profits during prewar years had given the company an unfavorably low base of “normal” earnings for purposes of excess profits taxation. Consequently, Burke’s excess Profits taxes were higher than those of its competitors with similar earnings before taxes. As is indicated in Exhibit 2, postwar operations were also profitable until 1948. ‘Mr. Martin talked at length with the management regarding the large losses suffered in 1948 and in the first eight months of 1949. The management explained that a large portion of the losses in 1948 had resulted from a very sharp and unexpected decline in the market prices for chocolate, sugar, and other major raw materials. The cost of raw materials accounted for almost 80% of total cost of sales, and the purchasing officer had made heavy forward commitments at fixed prices during 1947 and early 1948. At the same time that the market prices of these commodities were falling rapidly, a decline in the company’s own physical volume of sales set in. For competitive reasons it was necessary to reduce the company’s selling prices substantially. Further, management at first had diagnosed the decline in sales as a temporary development. Consequently, appropriate retrenchment measures were not taken for some months after sales declined. By August, 1949, a number of steps had been taken to ‘gten ta senate situation, and operations in August were profital “months. Purchasing methods had been revised so as to mini inne sheet further inventory price decline. Steps had also been taken to strengthen the “management of the c compa “young and aggressive qan with an 1al background, who had been highly success- ful Teanpr hanes sce of some 10 years. This man, the son of one of the “hajority sleeker hed bose sstabliched ‘as executive vice president and i inl jonisibilities for the overall direction of the company, In ‘given aulstania respons ‘irectio addition, major changes had bes ihe company’s sal gersonnal The sales foree hed boca Tae Gee ‘made to improve the cor ‘sales effort in the homie St. Lot Painstaking analysis had been made of the profitability of varfous product iteras and lines. As a result, a number of unprofitable items were dropped and sales effort was shifted to particularly promising and profitable items. New product development was also being pushed aggressively. In general, management officials were convinced that the new policies were well advised and would produce results. In the summer of 1948 the board of directors voted to suspend the dividend payments. It was then that Mrs. Wilson, whose only income from the company was in the form of dividends, expressed particular concern and sought the advice of her lawyer, Mr. L. K. Eagle, regarding her investment. Dividend payments since 1938 are shown in Exhibit 2. Since the stock was held only by members of the Burke family. and all transfers had been among various members of the family, no market for the108 CASE PROBLEMS IN FINANCE shares of the company existed. Investigation showed that there was no active market in the shares of any confectionery manufacturing company of compa- rable size and nature in the Midwest, so that no closely comparable market quotations were available as guides to the value of the Burke stock. ‘Acting in anticipation of difficulty in arriving at a satisfactory valuation, Mr. Roger Burke, the new executive vice president of the company, in September requested the Midwestern Company, local investment bankers, to undertake an appraisal of the value of the stock. Largely on the basis of the summary data given in Exhibits 1 and 2, slong with personal discussion of the firm’s affairs and policies with its officers, the Midwestern Company had arrived at a maximum valuation of $12 per share. Their report took the form of a letter, attached as Exhibit 3. Mr. Martin talked at some length with officials of the Burke company regarding the financial statements as of August 31, shown in Exhibits 1 and 2. He first sought to establish the validity of the book value of the stock as shown on the balance sheet. He was told that the accounts receivable consisted entirely of receivables from the trade for merchandise sold, The amount of receivables shown was netof a reserve for bad debts of $30,000, This reserve had been accumulated over several years and was considered more than ample to cover expected bad debt losses. The raw material inventory consisted primarily of cornstarch and syrup, chocolate, sugar, and nuts. Mr. Martin satisfied himself that the company maintained accurate inventory records and that the material concerned was in good physical condition. Inventories were valued at the lower of cost or market. Prepaid expenses consisted largely of prepaid insurance premiums. Company officials explained that the large in- vestment in United States bonds represented a temporary investment of funds earmarked to pay for machinery soon to be ordered.“This machinery was needed to modernize several of the company’s manufacturing operations, and management believed that the machines would pay for themselves in a few years by lowering costs. In the opinion of company officials the fixed assets of the company were very conservatively valued. Operations were carried on in a multistory con- crete building, which with an annex building occupied an entire city block in the center of an industrial area. Advanced construction ideas had been incorporated in the construction of the main building in 1909, and the building was considered in excellent condition and entirely adequate for the needs of the company. With the land it stood on, the annex building, carried in the balance sheet at $182,914 (net of the reserve for depreciation), was also of concrete construction and of multipurpose type. This building had housed certain operations of the company discontinued in 1938. At that time the building was leased to a bakery company that was expanding its opera- tions. When the 10-year lease expired in 1948 a shortage of factory buildings in the area existed, and the company was able to lease the 84,000 square foot building for one year at $0.55 a square foot, or $46,200. The lessee assumed all costs of the building except property taxes, which were about $10,000 a Yb Wo - jot — Bbw ee year. signe, cond struc coule for ta resal. mucl Tates reas comp: discur comp. busi. Fina Ttwi with ‘unus as hé liquie 80% « liquie. value atica prob no b eer mark- a wilh The thou, plant from to th: that liquie wouleBURKE CANDY COMPANY 109. year. In September, 1949, it was expected that a five-year lease would be signed at about $0.45 a square foot per annum, or $37,800 before taxes. The multistory building in which the operations of the company were conducted provided a total floor area of 133,400 square feet. Current con- struction costs of similar buildings were approximately $8 square foot. The management believed that with an unhurried sale of the main building, it could realize approximately $3.50 a square foot or approximately $466,900 for the building. The newer annex building was thought to have a normal resale value of about $4.50 a square foot. Yt *: E4000 > 3 3t0m~ The equipment of the company was considered fairly efficent, although much of it had been in use for many years. It was believed that depreciation rates had been appropriate, so that the balance sheet values represented reasonable values from the accounting point of view. \xuwv WA velo When Mr. Martin raised the question of realizable values in the event company was liquidated, the officials of the company appeared reluctant to discuss the subject. They commented that many of the 175 employees of the company had been with the concern for many years, that they had faith in the business, and that management had no intention of terminating the business. Finally, they did agree to discuss the value in liquidation of each major asset. It was believed that the net value of receivables could be collected completely, with perhaps a 10% excess of collections over the amount shown net of the unusually large reserve. The liquidating value of the inventory was regarded as hinging on the speed of liquidation. It was felt that in an unhurried liquidation the inventory could be completely worked off at between 60% and 80% of its book value. Much of the value of prepaid expenses would be lost in liquidation, so that an estimate of 25% was given as the realizable value. The value of the fixed assets in liquidation was regarded as particularly problem- atical. If a willing buyer was le, ted above, the the tno building probably coutd be sold af ap market for industrial real estate in the area was active, and it was thought that a willing buyer could be found within a few months "The value of the equipment in liquidation was highly uncertain. Tt was thought of most value to a candy manufacturer who would take over the entre plant. In 1947, the company had received and rejected informal inquities from two large manufacturers regarding the possibility of sale of the company to them for operation as a branch plant. No inquiries had been received since that time. Much of the equipment would be next to valueless in a hurried liquidation, and the total proceeds from equipment under such circumstances would probably be no more than 30% of the book value. hea Bp Cue 633, : aye cn GA S00 E expected to attract buyers only at a very much lower price. Currently, the110 CASE PROBLEMS IN FINANCE Exbibit 1 BURKE CANDY COMPANY BALANCE SHEET, AUGUST 31, 1949 Finished candies...... Packaging materials Other supplies © Paid-in surplus... Earned surplus January 1, 1949. lus tax refund to company. , 1949. Less loss since January 1 Earned surplus August 31, 1949... Net worth August 31, 1949...... Total liabilities... Total current liabilities. Common stock ($11.50 par). 2 Reserve for contingencies Exbibit 2 BURKE CANDY COMPANY SELECTED DATA Net Prot Ne or (Lass) Sales fore Taxes $ (38,934) 27.493) (25,647) 27,007 1,423,455 136,456 1,679,869 220,755 1,917,260, 193,343 1,914,799 216,407 2,073,594 201,531 2,636,122 316,302 41,769,103 (212,806) 700,495 19,283) $ 13,396 32,673, ‘$14,060 rr) «119,283 Net Profit or (Lass) after Taxes $ (38,934) 27493) : 25,647) Poy Out Dol 27,007 234 wil ay. 6s! sul, yh Mr. Roge: Burke Ce. 203 Wes St. Louis Dear M We have upon fins have giv statement opinion as As I told wer, prit. not justif, you com years, if r- only durine first eight the Burke the otherBURKE cANDY coMPANy 111. Exhibit 2—Continued Ne rene after Taxes [Net Profit or (Lass) after Tasos easy of NaS Ponte] Nor (ing) Cada Bots 1938. 1.5% 4.0% 3.8% .5)% 1939. J G.0) 5.9 (4.0) 1940. an 65 4.0) oa. 33 3 40 192. é 38 3 ba. “s 160 37 bt 2 21 3 28 32 Bs 35 19, 3 is 3 19 33 2 87 1948... 2.0)t 13.9 8.Dt Comparison of Salectad Ratios, 148 Tarnover of net worth. . Turnover of working capi Average collection period Current ratio...... * igure are the median f + 4 Belore tax refuad credit, wh Exbibie 3 2 BURKE CANDY COMPANY vg LETTER FROM THE MIDWESTERN COMPANY “a September 20, 1949 wr Mr. Roger Burke we Burke Candy Company 203 West Illinois Street St. Louis 6, Missouri DEAR MR. BURKE We have made an examination of the Burke Candy Company based principally upon financial statements furnished us by you, and other information which you hhave given us; and we have also examined the markets of stocks and finencial statements of other companies in similar lines of business, so 9s to arrive at an opinion as to a fair value for the stock of the Burke Candy Company. ‘As I told you over the phone today, this is a very difficult question for us to'an- Out Dav swer, principally because the pattern of sales and earnings of your company does not justify its comparison with the history of the other companies with which 4 you compete. These other companies in general have profits for most of the t years, if not all of the years, under review; while your company has made money : only during the war and the first year or two after the war, and during 1948 and the : first eight months of 1949 has lost a substantial amount of money. The stock of ‘ the Burke Candy Company, therefore, could not be valued on the same basis as the other stocks, being intrinsically more speculative.2 CASE PROBLEMS IN FINANCE ‘ Exbibit 3—Continued ‘The speculative aspects of the stock are increased by the fact that your company is now evidently changing its type of business and has not yet indicated any earn- ings possibilities from the new type of business. In addition, the change-over re- quires a relatively substantial capital expenditure which has depleted and will ( probably continue to deplete your working capital position. ‘The company has some teal estate holdings which might be used as a source of additional working capital if sold; but you have not indicated any such intention, and therefore I assume that the company will have to get along for capital ex- penditures and current operations on its present working capital position, aug- mented by profits in the future, if any. ‘As I told you, there is usually no relationship between market value and book value when valuing common stocks; in fact, any study of such relationship leads to such wide disparities that the only conclusion from such a study can be that there is no connection between market vah I believe the only likely buyer of stock of your company would be some person familiar with the type of business you are in, who would be willing to buy con- trol at a sacrifice price and take over the management of the company in the hopes of making operations profitable and therefore of making himself a sub- stantial profit by entering into the management. I do not believe it would be possible to sell the stock to investors in this area, because the company's record does not justify such an offering. ‘We are of the opinion that the stock of the Burke Candy Company, based largely ‘on the previous comments, is not worth over $12.00 per share. Iam sure that you will appreciate that the comments made above are not in any way a reflection on the management of the company, but are made from the point of view of an outsider looking at the figures and the company’s course of business in an effort to arrive at an impartial valuation of the stock. Very truly yours, MIDWESTERN COMPANY a/ (Signed) JouN K. Guuaes Vice President UPST During t* Mr. Nele- becomine possibilits offering » would b. Positions was larg had acct money p? At thie purchase 25 possiv rejected; money b. possibilit professio tive oppe sessed. Br no real pr increasing time to h: unemploy. In Feb a small ¢ plants, eq close to th known as Mr. A. 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