Sequoia Fund Investor Day: Full Transcript – Page 3 – ValueWalk Premium
Sequoia Fund

Sequoia Fund Investor Day: Full Transcript

am fascinated by the performance and the way you explained it in the annual report. Where does it stand today? At 4% of your assets with a 4% return in a market with a 32% return, it is interesting.

Chase Sheridan:

As you said, Fastenal's results in 2013 were disappointing. It grew something on the order of 6%. What happened there was that management pulled back its part-time labor in the stores in 2012 as demand slackened, hoping to protect the company’s operating margin. Fastenal management is extremely cost-conscious. And I think management realized it pushed it a little too far. Historically, Fastenal's sales tend to track the sales labor force in the stores very closely. So when that number declined, it hurt sales. And the company realized that.

The remedy is very simple: Add energy to the sales force; the goal is 15% full-time equivalent labor growth for the store sales force. Historically, Fastenal outgrows its sales labor by a pretty good margin because the sales force becomes more productive over time. I call that “the hustle.” So what you are seeing is a bit of an experiment. We see a correlation between Fastenal's sales and its sales labor. Now we are going to find out how causal it is. So far, the signs are good and in my opinion, it ought to work. We are seeing Fastenal's pace pick up, relative to its competition, in an environment that is not terribly favorable to the company. Non-residential construction really needs to pick up for Fastenal's top line to take off and give you the numbers that you are used to seeing out of that

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

company. Fastenal is an absolute powerhouse in OEM fasteners but OEM fasteners are not growing much right now. So that is a bit of a drag.

There is no question that there are cyclical aspects to the company. But the secular growth of the company is more interesting. That will slow, undoubtedly, versus when we purchased the stock in 2001. Fastenal's valuation is always very high. The management gets a lot of credit from Wall Street, in part because the company returns any savings or cost benefits to the shareholder. Management is very shareholder friendly. Right now, the valuation is middling relative to the historical range. If the growth is slowing, you might say it is a bit on the high side. But keep an eye on the investment in sales force labor. What we are going to be looking for is a top line sales acceleration commensurate with that.

Bob Goldfarb:

One thing I would comment on in addition is that it still had a pretty strong performing year by any standards, other than those of Fastenal and companies of that ilk. But management took a real hit, if you look at the proxy statement, in its own compensation from levels that were not all that high for starters. I do not think I have seen any companies in that same situation where the top executives all took a really big hit. Chase, what were the numbers on compensation?

Chase Sheridan:

I am not sure what the hit was in the proxy. But I recall that the CEO's compensation was calculated to be 13% of the average CEO’s for a company of his size. He did not regard that as an insult. Instead, he said, “That is because I deliver the best value.” He was actually proud of that. To Bob's point, a few years ago there was a frivolous lawsuit against Fastenal, and the company settled for $10 million. Of course that hurt the shareholder, but what was interesting was that the company docked everybody's bonus. The company included that $10 million exceptional charge when calculating the bonuses of its people. Management really shares the pain.

Question:

I have another question about Valeant. Do you agree with Bill Ackman that GAAP earnings are immaterial in evaluating a company like Valeant?

Rory Priday:

Yes, I think for the most part, most of the things that Bill Ackman cited we agree with. If you are analyzing Valeant, you want to focus on what its

adjusted net income is, what management is adding back to get that adjusted figure, and what it is adding back to adjusted cash flow. The big items for adjusted net income are restructuring charges and amortization expense. We do not mind adding back the restructuring charges because we view it as once the business that the company acquired is consolidated, in the next year the synergies are going to be there so that the business will be a lot more profitable than it was.

Usually the way Valeant talks about it, management adds those restructuring charges back as part of the purchase price. Those are the two main differences from GAAP net income. There are some other non-operating add-backs that the company makes. The one area I would focus on maybe is legal expenses and whether you want to add back one-time legal expenses. Some people would say that those are ongoing. Definitely legal expenses are part of an ongoing pharma business, but Valeant expenses its ongoing legal fees. It is the one-time legal charges that the company tends to add back. On the cash flow side, management also adds back restructuring charges. Those are basically all cash.

I know a lot of people complain about Valeant. They say that management is playing games with the acquisitions. Sometimes when companies take big restructuring charges or reserves, they release some later on so that they can make their income look good. Valeant does not do that. Most of the restructuring charge is paid out in cash. I do not think management is playing games in that area.

The one thing I would look at, and I do not think Ackman mentioned it, is that the cash net income and the adjusted cash flow from operations do not always line up because of increases in working capital. Valeant has not shown a tremendous amount of organic growth; so one thing to watch out for is how much of the difference between the adjusted net income and the adjusted cash flow from operations is going towards working capital. It has been significant in the past two years or so, but the company has been growing overseas in emerging markets where if the government is a customer, Valeant is not going to get paid for a long time. That is one reason why working capital can rise. There are other reasons, but for the most part, we agree with most of the add-backs.

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

Jon Brandt:

Valeant is far from the only company for which we would make adjustments to the GAAP net income. We spend a fair amount of time adjusting all of our holdings for amortization and a million other things. You could look at Berkshire as a great example of a company whose GAAP net income is not representative of the owner earnings. Valeant is not some special case. There are hundreds of companies where the GAAP net income is not the true representative of the earnings.

Rory Priday:

I would just add that if you look at the pharma industry — I have spent a lot of time looking at what other companies do — there are not any adjustments that Valeant makes that are materially different from what the rest of the industry does in terms of add-backs. In other words if you were to go through the line items that Valeant adds back, you would find virtually all of those added back to some degree at most of the companies. Companies have different policies, but for the most part they tend to add back what Valeant adds back.

Question:

Please comment on World Fuel.

Rory Priday:

I think we said last year that we were disappointed with how fast the company has grown organically. For those of you who do not know, World Fuel is a fuel reseller. It buys and simultaneously sells fuel in the aviation market and the marine market and the land market. It is an interesting company because most of the capital that it puts up is working capital; the company will simultaneously receive the fuel and pay the supplier. The company sells it quickly, but usually there is a difference of maybe ten days between paying for the fuel and receiving payment for it. That is the capital that the company puts in. But the company has done a good job with challenging markets. The marine market has been pretty tough; it has been soft. Management noted there has not been as much volatility in the price of bunker fuel, and that has hurt the company in that market because it sells derivatives to its clients or helps them use derivatives, and that is a service line for them. If the markets are not moving around a lot, then the company cannot sell those instruments because the clients do not need them.

But I would say management has done a good job. We really like the team. We are disappointed with the growth. My view is that in order for the earnings to grow, a lot of the impetus will probably come from future acquisitions. The company acquired Watson Petroleum, a land fuel business in the UK. World Fuel spent about $200 million. To the extent that it can allocate earnings to acquisitions like that — management is pretty disciplined — my guess, looking at the company’s past acquisitions, is that it should earn a low double-digit return on its acquisitions. If you can spend all your earnings in one year on an acquisition and get a low double-digit return, then that should be okay. You have to weigh that against the lower organic growth or in some cases negative growth. But we like the management team and it is not an expensive stock.

Question:

You have such a small holding in Costco, and it is wonderful. The share price has doubled in the last few years. I wonder why you gave the girl the engagement ring but did not get married … add more stock.

David Poppe:

I think we get back to that answer of we are not very smart. We went out to see Costco in 1999 or 2000 and met with Jim Sinegal, the CEO. The stock was $27. It was probably 20 times earnings at the time — I do not remember what the earnings were back then. We came back and thought, “Wow, great company.” I have to say I do not have a lot of heroes, but he is probably one of my favorite CEOs I have ever met. He is everything you have ever read about him. We had a toehold position in it. Fifteen years later, it is $111. We still own about a 0.1% position. So we just missed it; it happens. A lot of times they do not get into Sequoia so you do not know about them. But the only thing I would say there is you can look at a lot of pitches and take strikes, and not strike out in this game so long as you hit the ones you do swing at. Costco is one that, unfortunately, we just took a strike right down the middle.

Question:

On May 26, Valeant is supposed to have a meeting and probably increase the price of its offer for Allergan. And there is talk in the press about a price of up to $200 to buy Allergan. At what price would you say, “Oh my gosh, management has lost its head… Ackman pushed Valeant up to too high a price.”

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

Bob Goldfarb:

Ackman is not going to push Valeant to pay more than makes sense. Management is very disciplined. Ackman is not going to dictate the terms of the offer.

Question:

What price is too high?

Rory Priday:

It is not a difficult analysis to figure out what they are offering for Allergan. In the past, one of the reasons we really liked Valeant was that it was acquiring companies for say five to six times operating profit. That implies a 15% to 20% pretax return. Then usually the company was borrowing 30% to 40% of the purchase price. You can get pretty heady returns because of the leverage and the minimal tax rate. With Allergan, it really depends on how you value the shares that Valeant is giving up in the deal. But the way that I look at it is that the company is paying, call it $45 billion. Post-synergies, Allergan is probably going to earn something close to $5 billion; so that is nine times operating profit. If Valeant goes up a lot higher than that, obviously, it could be ten times operating profit, it could be eleven times operating profit. My guess is that Valeant is not going to go a lot higher into the double digits just because it is already getting close to two times what it would normally pay for something. Some people may criticize the fact that Valeant is paying up for Allergan, but I would point out that Allergan has some of the best assets in the space such as Botox. People may cite other drugs, but Botox is cash-pay; the physician dispenses it. It has a brand on the cosmetics side. Women go in and they ask for Botox. There are a lot of reasons why it is a wonderful product. And you can pay up for that. If the company were paying something like fifteen times operating profit, $75 billion, then maybe we would look at it and scratch our heads.

Bob Goldfarb:

Rory, did you think that Allergan's forecast of its own earnings growth that it issued this past Monday was credible?

Rory Priday:

My personal view is that maybe the company was a bit aggressive on the top line. You saw AstraZeneca do the same thing with Pfizer. You do not want to get bought; so you have to put out a pretty rosy forecast. In Astra's case, the company is forecasting it is going to double revenues. It is

already a pretty big company, and Astra is going to do it in ten years. The forecast period is a really long period of time. Who knows what the company is going to be generating in revenue in ten years? It is in Allergan’s interest to put out pretty rosy projections.

That said, the company has great assets, and the top line, even if it does not grow 10%, could grow in the mid-to-high single digits. Certainly, if the company does not spend a lot more incremental money on SG&A or R&D, that is going to leverage and it should be able to get pretty high earnings growth. If it is not 20%, then maybe it will be in the high teens, potentially. It can do that with leverage as long as it gets the top line growth. The one thing we worry about, because we looked at Allergan before, is that it does have some drugs that could potentially face genericization. Restasis was one that we were particularly worried about. That is its biggest eye drug. The company staved that off. It may be able to have that drug for two

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