Sequoia Fund Investor Day: Full Transcript

Ruane, Cunniff & Goldfarb Investor Day St. Regis Hotel, New York City – May 16, 2014

making any predictions. It is looking more and more likely over time, but we will see what happens.

I have no insight into the company’s growth prospects beyond what is already out there and published. I look at what eMarketer puts out — growth in US desktop clicks and revenue is not very strong. So there are mature businesses within Google. But growth in mobile is still going like gangbusters, and Google has a greater share of mobile search than it has of desktop search. It is still penetrating some of the less-developed markets throughout the world. But eventually you have to wonder what the potential of the un-penetrated market, the remaining white space, is because Google’s penetration is rather high.

There are so many projects that Google is investing in, some of which may bear fruit. But there are two areas that I think it has yet to monetize really well. One would be the video market. Through YouTube Google has access to some of the ad dollars that go into television spending, and it is hard to see where that is going at the present moment. But there is a huge, huge pool of advertising money out there for an aggressive and innovative company to tap, and Google is in as good a position as any to try to access that. Google still has a lot of work left to do to monetize local advertising through Google Maps or Google Now. The company is putting a lot of effort into doing that. So we will see. But relative to the growth that we can see, the valuation really is not terribly demanding.

Question:

Another company you own that has been involved in a merger is Omnicom, which is a smaller position. You have had differences with management in the past, and any disinterested observer looking at the whole merger process the company went through would have to say that at least at some point if not at all points, shareholder interests were not paramount. If you want to comment on that, that would be good. Also, I would like to know when you are looking at a good business with perhaps bad management, how do you make the decision whether to stay with a company like that or to cut the cord?

David Poppe:

The Omnicom-Publicis merger was interesting. We never really saw that there was a lot of synergy to get out of it. The companies would talk about some synergy in media buying because they both are very large … the second and third largest advertising agency holding companies in the world. Omnicom announced last summer that it intended the merger to be of equals. I am sure most of you saw that the merger came apart in the last few weeks, and they are not going to be able to consummate it.

I never thought there was a ton of synergy to get. These are holding companies with literally dozens of agencies inside them. The agencies actually compete pretty vigorously against one another. There is not a lot of cooperation. There are a few back office efficiencies that you can get. There is some benefit in scale in producing TV commercials, utilizing TV studios, and in media buying. But we did not think there was a lot of synergy.

That did not mean we were opposed to the deal or that we thought it was shareholder unfriendly. My personal feeling — which nobody has confirmed, so take it how you want — is that Mr. Lévy at Publicis did not have a successor lined up and was looking for the best home for his business and thought Omnicom would be that best home. They struck a deal that looked like a merger of equals but Omnicom treated it as if it were a soft acquisition. Omnicom would control the management over time. The deal that they struck made John Wren, the Omnicom CEO, the CEO of the combined company after two and a half years. And while the number of directors on the board from each company would be the same, the directors from the Omnicom side had the right to pick the next two CEOs after Wren retired — which means, practically, you could have 25 years during which Omnicom would control the business.

My understanding is that there was an agreement up front that Omnicom would control the financial portion of the business as well, which makes sense because if John Wren were going to be the CEO, the financial function was not going to be in Paris; it was going to be in New York. When the deal came apart, that was one of the things that were

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Ruane, Cunniff & Goldfarb Investor Day St. Regis Hotel, New York City – May 16, 2014

cited. But I am not sure that was ever really an issue. I think Publicis struck a deal and then was not crazy about the deal that it struck. It was not really a merger of equals; it was a soft takeover. Because there was not a ton of synergy, I do not think that the market ever really responded very positively to it. Omnicom’s stock ran up, but it only ran up with the market. It did not outperform. There was not a positive response that suggested that this was going to generate a lot of value. It was struck as a merger but I am not sure Omnicom ever treated it as a merger. There were also some regulatory issues. They structured the merger in a way to have the tax headquarters in the UK but the business headquarters in the Netherlands, and that ultimately was likely to draw regulatory scrutiny.

The good business, bad management — actually my feelings about Omnicom are somewhat complicated. But I think it is a good business with good management. Management has very tight financial controls. It runs three of the top five advertising agencies in the world. TBWA, BBDO and DDB are really good compared to the peer group. It is a self-interested management team that has compensated itself really, really well. You have to stand up sometimes and say, “How much is enough?” But that does not mean that management is not good at what it does.

Question:

Can you share your thoughts on IBM? It seems like there are doubts on the Street regarding the company’s long term prospects. Sequoia seems to have a relatively small position. I am just wondering at this point what your view is and what your view of its valuation is.

Will Pan:

I will start with the valuation question first because that is a very important factor. The valuation is not demanding. It is ten times earnings, eleven times free cash flow. At that valuation, when the company is buying back 5% of its stock consistently a year, you do not need the business to do extremely well for it to work out for you as an investment.

In the long term, we keep track of the prospects for the company. We monitor those very closely. We think that management is making the right moves for the long term. The issue with IBM is that it has been so successful in the past. It completely dominated mainframes. It still does, but that is not a business that is growing very quickly, if at all. So IBM has this enormous anchor behind it. But at the same

time, we see the company seizing on new opportunities like the move to the cloud. IBM has made a lot of progress on that front. The cloud enables IBM to deliver technology infrastructure as a service and so it can compete with Amazon for the small and medium-sized business IT market as well as for the smaller departments within large companies.

Over the last eighteen months, IBM has built a promising service platform by putting its middleware on top of IT infrastructure and delivering it in a way so that large companies, which are its major customers, can connect all the systems that they built in-house over the years with their new systems in what is called engagement. People are interacting with companies on mobile devices more and more, and companies are managing themselves through mobile devices more and more. So IBM can play a role in connecting the two. Even in what you might consider IBM’s stodgier chips business the company announced a promising new initiative whereby Google, for example, actually says it is going to build its third generation data center, possibly, around one of IBM’s chips. A year ago, two years ago, you would have never thought that a company like Google at the vanguard of what you would consider Internet technology and technology in general would go to IBM for one of its chips.

So it shows that IBM is on top of things technologically. Management is thinking properly long term about how to improve the prospects for the business. But you do have to remember that it is a large company and it has a significant base of business that is not going to grow very quickly over time. In the meantime, the valuation is undemanding and management is doing the right things with capital by buying back a lot of stock.

Question:

Last year you noted that Ritchie Brothers is in a large part levered to the US housing market, which I would probably broaden to include the construction market overall, and noted that it would probably muddle along until the market improves. I have a few questions surrounding the company. First, was this the original thesis when the shares were acquired in late 2008 to ’09? And broadly, how do you think about or manage against thesis creep? Were you specifically looking for housing or construction exposure at the time? How did you end up with Ritchie as opposed to something like a Sherwin-Williams or a rental equipment company like RSC? Then lastly, from a portfolio construction

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Ruane, Cunniff & Goldfarb Investor Day St. Regis Hotel, New York City – May 16, 2014

standpoint, how long are you willing to hold small positions that have not been working, and how often do you reevaluate to see if there is a better opportunity someplace else for the capital?

David Poppe:

I think the answer that you are looking for is we are not very smart. We have owned Ritchie Brothers for about five years. Management built a business model that reminds me a little bit of the Fastenal business model. It is really simple; it is deceptively simple. But it is almost impossible for somebody to replicate.

Ritchie Brothers sells used construction equipment, a lot of CAT machinery in particular, Komatsu machinery through auctions. It is an unreserved auction, which means if you are a seller and you put it in the auction, you cannot take it out. Somebody bids a dollar; you sell that forklift for a dollar. It is really scary for a seller, but it is the only way, really, to run a legitimate auction where the buyers have confidence that they can potentially get a great deal and that the prices are in fact genuine. A lot of the auctions are run so that the sellers can pull their gear out if they do not get a price they like. For the buyer, it is a sucker’s game. If you overpay, you can keep it — but if you get a good deal, you cannot. So Ritchie has a really good model. Again, no one has ever been able to replicate that. Caterpillar is trying with little success, so far. There was another company, IronPlanet that tried to do an online version. Some of you may know IronPlanet filed to do an IPO four years ago and that has never gone anywhere. So I think we got that right. Ritchie Brothers has a very good model.

The part that we missed is that Ritchie Brothers’ heyday was during the US housing boom, and everybody was really busy, and contractors were getting tons of work. They needed to buy machinery, and machinery was very fluid. Ritchie Brothers has a good model. But there are ways competitors can fight back. CAT has fought back really hard, not wanting to lose that used machinery business and the parts and service that sometimes goes with that when you can keep the machinery in your system.

Ritchie Brothers had grown right through the recession in ’01 – ’02, but we were clearly surprised by the magnitude of the housing bust and the collapse of the construction market. I think also we probably missed — as did a lot of other people — that it is a stronger model in Canada, which is a more resources-based economy. So we got

it wrong. It is a cyclical grower. That said, the market respects it. It trades at a high P/E even when it is not doing very well, because it is basically an impossible model for somebody to replicate. It ought to do well if and when the United States construction market ever becomes healthy.

It is small; it is a good quality group of people. I think it was not aggressively enough managed. Maybe management was a little overly self-satisfied coming into this downturn. But we will have a new CEO announced shortly and we will take a long look at that person and see if we want to continue. But the short version is we made a mistake. We certainly did not buy it in ’08 thinking that it would be as modest a performer as it has been. Although I will say in our defense, when your losers are winners, you are still okay.

Question:

Could you comment a little bit on Fastenal? I