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A Look at Berkshire's McLane Distribution Business

In 2018, the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) group produced revenues of $248 billion across its various divisions.

The largest business segment, in terms of total revenues recorded, was the group's "Sales and Service" division. In 2018 this arm of the conglomerate earned a total of $133 billion. The most significant single contributor to this total was distribution business McLane Company, which was acquired by Berkshire in 2003.

The distribution business

McLane is an interesting business. The company has the highest revenues of any service business in the Berkshire group, but it also reports the smallest profit margins.

In 2018, for example, the group reported pre-tax earnings of just $246 million, a profit margin of 0.18%.

So what does this business do, and why does Buffett like it? The company is described as follows in the 2018 Berkshire annual report:

"McLane Company, Inc. provides wholesale distribution services in all 50 states to customers that include convenience stores, discount retailers, wholesale clubs, drug stores, military bases, quick service restaurants and casual dining restaurants. McLane provides wholesale distribution services to Walmart, which accounts for approximately 22% of McLane's revenues. McLane's other significant customers include 7-Eleven and Yum! Brands, each of which accounted for approximately 11% of McLane's revenues in 2018."

These sorts of distribution businesses are not highly profitable, but they are a critical part of retailers' infrastructure, and this appears to be why the Oracle of Omaha was attracted to the company in the first place despite its razor-thin profit margins.

Walmart's sale

Berkshire initially acquired the business from Walmart (NYSE:WMT), which wanted to divest the asset and invest the cash received back into its business. As Buffett explained at the 2003 Berkshire annual meeting of shareholders:

"Walmart, for very good reasons, wants to specialize in what they do extremely well, and through Goldman Sachs and Company, we were approached by them a little while back about the possibilities of buying the business.

It's a -- it really makes sense for both sides, because Walmart knows what to do with the capital very, very well in their own business, and has lots of opportunities. And this was something of a sideline to them. On the other hand, their ownership of McLane's resulted in certain people that would be logical customers of McLane's not wanting to do business because they didn't want to do business with a competitor."

Berkshire stepped in as the neutral partner that had both the capital to acquire the business and no conflicts of interest.

While McLane does record tiny margins, it seems that it was the security of the income that Buffett was interested in. By becoming the business's parent, Berkshire essentially became McLane's competitive advantage.

A competitive advantage

As Buffett explained in 2003, that customers would "know our check will clear, that we won't, you know, make a proposition and then run into financing difficulties, or try to jiggle around the contract later on."

This security, as well as McLane's critical position in the supply chain, only reinforced the company's competitive position, cementing its hold over the market:

"It's a very narrow-margin business, obviously. I mean, when you get up to $22 billion of sales and you've got Hershey, and Mars, and people like that on one side, and you've got buyers like 7-Eleven and Walmart on the other side, they're not going to leave a lot in between. But you have to perform a valuable service for them in order to earn, you know, say, one cent on the dollar, pre-tax. But McLane's knows how to do it. It's a very efficient operation, and it will continue to deliver value to both their vendors and their customers."

That's why Buffett bought and continues to own this low margin business. It might be low margin, but the profit stream is highly defensive, and that's what he's always on the lookout for.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.