Lessons in Competitive Advantage from My Visit to Warren Buffett’s Oriental Trading Company (Tech Strategy – Daily Article)

In Part 1 and Part 2, I went through Borsheims jewelry and Nebraska Furniture Mart. Both are good examples of retailers with somewhat similar consumer offerings. They both offer:

  • Quality physical products that consumers want to see in person before buying.
  • The largest selection of these products in town.
  • Low prices (i.e., value positioning).

And both companies have serious competitive advantages, which are mostly about local economies of scale.

This brings me to my final Omaha-based business of Berkshire Hathaway. Which is Oriental Trading Company, a specialty ecommerce business.

Company 3: Oriental Trading Company (OTC)

This is a fascinating ecommerce business that specializes in party supplies. It’s a strange market niche that gets cooler the more you think about it.

Oriental Trading Company (OTC) sells a very wide assortment of unusual items, such as rubber ducks, customized t-shirts, balloons, and streamers. These have historically been sold to schools, hospitals and other businesses. This is the ecommerce site a schoolteacher or hospital secretary goes to when he/she needs 100 streamers, 50 balloons, and a bunch of other random party favors for a company party in a few days. OTC describes itself as the “nation’s largest direct retailer of value-priced party supplies, arts and crafts, school supplies, toys and novelties.”

This business can be a bit confusing, so it helps to know the background.

  • OTC was founded in Omaha in 1932 by Harry Watanabe, a Japanese immigrant. It was mostly a gift shop with imported merchandise. It claims to be one of the first wholesalers of “value-priced novelties and gifts.” And it was family-owned and operated for most of its existence.
  • In the 1950’s, OTC was also a supplier of US carnivals (what do you sell to carnivals?).
  • In 1956, they moved into print catalogs. And they focused mostly on selling wholesale to businesses.
  • In the 1970’s, the founder’s son took over and added some retail to the wholesale business.
  • In 1986, they started selling more to schools, hospitals, and businesses. They moved online in the 1990s’.
  • In 2000, the company was sold to a PE firm, under which it grew from $150M to $300M in revenue.
  • In 2006, it was acquired by the Carlyle Group, and significant debt was added. That debt, plus the financial crisis, resulted in the company filing for bankruptcy. OTC emerged from bankruptcy in 2011.
  • In 2012, Berkshire bought the company.

When I visited the company, management explained how the sale to Warren Buffett happened. Not long after coming out of bankruptcy, the CEO sent an email to Warren on a Friday at around 10am, asking if he was interested in buying. He got a call from Warren directly about two hours later. They had a basic deal within a few days and the sale was closed within 45 days.

This crazy fast sale, like the Nebraska Furniture Mart sale, is now part of the Berkshire lore. However, I suspect Buffett had long been aware of this Omaha-based company. He knows all the best companies in his area. And he had probably been aware of OTC for fifty years. So it’s not that surprising that he able to move quickly.

Once OTC was a Berkshire company, it had access to unlimited capital (at very good terms). OTC launched new internal brands such as Learn 65, MarryMe and Fun365. And it did several acquisitions. Those included buying Fun Express, Mindware (games and puzzles) and SmileMakers (stickers for companies like hospitals). All of those expanded their portfolio of strange products. And while these deals were very small for Berkshire, Warren was involved in each of them directly.

This is really common for Berkshire. Every year, Berkshire’s big portfolio of companies do a ton of bolt-on acquisitions. And I believe Buffett is in charge of most of these. He is ultimately the master of allocating capital at the company.

As of 2018 (when I visited), OTC had 4 main businesses with 71% of revenue coming from party supplies. They were still mostly a B2B wholesale operations focused on selling party-supplies to hospitals, businesses, and education institutions.

Here are some factoids:

  • In 2018, OTC had 40,000 SKUS in +50 categories handled by 4 fulfillment centers. Print catalogs were still important but 90% of orders and fulfillment were happening through the webpage. The CEO said they spend their money making and sending catalogs, but the transactions are online.
  • OTC’s biggest selling categories were party supplies (#1), toys and novelties (#2), crafts, school supplies (#4), and weddings.
  • The average price per item was $8, far below what you would see on ecommerce sites like Amazon. However, the average order size was $75. Those two numbers are really important.

If you look at the OTC webpage, you can see they sell a huge number of weird items, such as costumes, banners, candy, Easter eggs, etc. Management said they sell a huge number of rubber ducks, which are customized for various company events. They gave us Warren and Charlie ducks as gifts (below).

We got a tour of the facility, and it is basically a big Amazon-like facility for assembling and shipping packages. Think one huge building completely full of chutes, conveyor belts and assembly points. And lots of staff using scans guns and putting things in picking trays. Unfortunately, we weren’t allowed to take photos inside.

The key operational activity for OTC is how they assemble lots of small, low-cost party products into customized packages. How do you quickly and efficiently put hundreds of streamers, balloon, rubber ducks and other items in packages and ship them out?

That unusual assembly and packaging activity is the key to understanding the business.

  • On one side of their big facility, OTC receives thousands and thousands of small, very cheap items like rubber ducks and streamers from suppliers. They hold a massive inventory of weird, cheap stuff (mostly coming from China).
  • Within the facility, they then pick from all these stored supplies and assemble customized packages for parties and events.
  • Then the assortment gets packaged and goes out the other side of the facility.

The operational metric that really matters is the assembly cost as a percentage of unit sales. It’s not the cost of the inventory (like for jewelry). It’s not the size of the showroom (like furniture). And it’s not the cost of delivery (although that matters). What is unique about OTC is the cost of creating these customized packages of hundreds of strange and very low-cost items.

And OTC appears to have economies of scale in this activity. This is a big fixed operating cost for assembly and packaging (which they can divide by their higher volume). Plus, there is the capital cost of building a big facility that is specialized for this type of assembly activity. That was my guess after walking through. But I have never seen their operating numbers and there really are no comparable businesses.

Overall, we see a Berkshire company with many of the same characteristics as Borsheims and Nebraska Furniture Mart:

  • It is service a circumscribed niche market with special customer characteristics.
  • It has unique operating activities to serve this market. In this case, OTC offers a wide spectrum of small, low cost unusual and fun items. And they allow customers to customize their orders.
  • It is a dominant business that has built economies of scale against this niche market, giving it a cost advantage.

Question: Does OTC Have a Competitive Advantage?

I have three standard questions for most businesses.

  1. What is the customer experience? What do they care about when they make their buying decision?
  2. What is the competitive advantage? Versus small and big rivals? Versus new entrants and substitutes?
  3. Are these factors changing with customer behavior, technology and/or regulation?

I’m skipping over the customer experience question as it’s pretty simple. In the previous two companies, I pointed to the unique consumer behavior for buying jewelry and furniture. But OTC is a B2B business, and the customer behavior is much simpler and more rational. OTC customers are businesses that are buying hundreds of little items for their company party in a few days. And they want three things:

  • A big selection of customizable goods to choose from.
  • Reasonable to low prices.
  • Convenience. Make it easy. It’s just a party. Order online and then the package arrives.
  • A reasonable past experience working with the company. There is going to be lots of repeat business.

The customer behavior is simple and logical. Unlike when you look at B2C business.

Question 2 is the interesting one. What are its competitive advantages? Against Amazon? Against local party shops? Against larger retailers like Walmart?

As mentioned, OTC has economies of scale in a circumscribed, niche market. This is important.

  • NFM’s market is circumscribed by geography, the need to see furniture in person and the cost of shipping furniture. They mostly don’t have to compete with furniture retailers in Florida.
  • Borsheims was circumscribed by geography and the need to see expensive jewelry and talk to the jeweler. However, this is fading.
  • But OTC’s market is circumscribed by its unique order-type. It’s not geography that is circumscribing the market. It’s its strange niche.

So, all three of these Buffett companies are serving circumscribed markets. This is critical if your advantage is based on being larger than a rival. You need a limited market so your competitors have no room to grow to your size (and eliminate your scale advantage). Local dominance based on scale usually requires a circumscribed market.

According to OTC’s CEO, the “lynchpin is fulfilment”. As mentioned, the fixed operating and capital costs of their fulfilment operations are significant percentage of their sales prices. The key number to know would be the percentage of fulfillment cost for the average order. Their higher volume plus their specialized facility should make them the low-cost supplier for this unique order type.

  • In 2017, OTC handled 67M units.
  • It had 400-500 employees working 3 shifts / 5 days per week.
  • It had 500,000 square feet of storage and 250,000 square feet for fulfilment. They say they could host 12 simultaneous football games in the facility.

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So, what is OTC’s  competitive advantage?

In terms of my frameworks, it’s pretty straight forward.

  • The barrier to entry is the difficulty and fixed costs of opening a highly specialized logistics facility. Creating such a facility costs money for sure. But it is also about the specialization of this facility. This facility probably cannot be used for anything else. While Amazon has lots of logistics facilities, I doubt any of them are specialized like OTC for the assembly of low-cost party items. The specialization of OTC’s operations are their main barrier to entry.
  • The competitive advantages are:
    • Economies of scale in the fixed operating and capital costs of the fulfillment operations.
    • Purchasing economies of scale? Possible. They can probably get their items cheaper than others. But they aren’t going to save that much on rubber ducks.

Now, think about how this plays out against rivals and new entrants:

  • Physical retailers can’t match them in terms of product selection and costs. Giant retailers like Walmart don’t want to carry tons of party favors. And specialized party supply retailers can’t match their 40,000 SKU inventory.
  • Certain ecommerce companies could be specialized in party gifts. But they don’t have OTC’s scale. So, they have fewer items and higher costs.
  • But what about Amazon? Couldn’t they do this if they wanted to? Yes. They can. But they don’t want to. It’s too small and specialized of a market for them to bother with.

Basically, they look like they are in a very dominant position in their strange niche market.

Last Question: Any Changes in Customer Behavior, Technology and/or Regulation?

I don’t see anything important here.

***

Once again, we see a Warren Buffett business where a unique market niche is dominated by a company with big competitive advantages. And it is not being impacted by changes in customer behavior, technology or regulation. When you go through enough Buffett companies in detail, you see this same pattern over and over.

That’s it for this article series.

Cheers, jeff

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Related articles:

From the Concept Library, concepts for this article are:

  • Economies of Scale
  • Ecommerce

From the Company Library, companies for this article are:

  • Berkshire Hathaway
  • Oriental Trading Company

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I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

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This content (articles, podcasts, website info) is not investment, legal or tax advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. This is not investment advice. Investing is risky. Do your own research.

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