Sequoia Fund Investor Day: Full Transcript – Page 5 – ValueWalk Premium
Sequoia Fund

Sequoia Fund Investor Day: Full Transcript

equal to reported net income since Warren acquired it. Railroads are capital intensive, but in part through some borrowings, in part through the benefits of accelerated depreciation or what they call bonus depreciation, the railroad has been quote/unquote “a capital intensive company” but even with all it spent on capital, I am pretty sure it has dividended out as much free cash flow as it reported in earnings. So it is not quite as bad as it sounds. There could be some reversal of that bonus depreciation, but I still think free cash flow should be a decent percentage of the reported earnings. Same thing with the utility.

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

Question:

I have a two-part question. First, from a public welfare perspective, do you think the government should consider policies such as issuing longer patents if more and more pharma companies pursue Valeant's model, stripping out R&D and focusing on cash flow? Then I was also hoping you could talk about Advance Auto. It looks like the General Parts acquisition was very accretive to free cash flow, given the low cost of the debt and synergies, and it is more of a commercial business now. I was also curious about your thoughts as to how O'Reilly has been able to outperform its peers so consistently.

David Poppe:

I think on lengthening the patents held by pharmaceutical companies, we do not have any great insights there.

Rory Priday:

We sold maybe 80% of our Advance position. We sold it into the announcement of the GPI acquisition. We really like the management team there. We really like Darren Jackson. It is a pleasure to meet with him. We have dinner with him at least once a year and we have a couple of meetings with him. He is always thinking outside the box. He likes to visit other companies to learn their business models and how he can improve Advance.

We think that business is a good business. You have a good management team and a good business. Generally speaking, our issue is with the execution. If you look at the numbers, the execution was not really there. Last year, O'Reilly's comp was 4.3% and Advance had a negative comp. Advance is doing better now but it really was not executing at the store level. Management brought in George Sherman; he has streamlined the structure so that there is not as much top-down management of the stores. The GMs at the stores used to have 50 to 60 reports that they had to file with their superiors and George Sherman came in and he cut 75% to 80% of those reports. He basically told the GMs and the field force, “You have to focus on three things: sales, profitability, and customer service.” It really simplified everything. I think you are seeing progress in the results. Advance had a very slight positive comp in the fourth quarter. It just reported yesterday that the comp in the first quarter was 2.4% after having multiple quarters of negative or flat comp. Clearly, George is having an impact on the field force.

Management is doing a good job. But we felt for a long time that the team was not executing as well as some of its competitors. That is why we sold down our position. We thought there was a good opportunity to sell into the GPI deal. I would just say that, yes, the GPI deal should be very accretive to the company because of the fact that it levered up to make the acquisition using very low cost debt and will generate cost savings as well. But just after the initial accretion, the earnings might not grow as fast, necessarily, because of the execution. That was our concern.

O'Reilly has consistently performed — I think it is just the culture. The company has an extremely strong culture. The management is very competitive. It is also more car parts oriented than Advance is. O’Reilly also just knows how to expand into a new region. When O’Reilly puts new stores in, management goes after the best car parts guys in the area. Management tries to incentivize them to come work for O'Reilly. It is just very focused on doing whatever it takes to convince the commercial garages to work with O’Reilly. The company has a better position with the national accounts too just because of the history of the business. There has been a focus on the commercial side by O'Reilly for a long time. It has had this hybrid 50 – 50 commercial/retail model and that is one reason the company has done well. It also benefitted to some degree from the CSK acquisition. The stores O’Reilly acquired in that acquisition were not the greatest stores, but their performance has clearly benefitted from O’Reilly’s expertise on the commercial side of the business.

Bob Goldfarb:

On your first question about the drug patents, the current patent lives were very sufficient in the heyday of big pharma companies when they were discovering a lot of very profitable drugs. Big pharma made tremendous returns on capital. The problem really has not been the patent lives. The problem has been the poor record of drug discovery by big pharma. There have been very significant drug discoveries but mostly by the biotech companies. So I do not think extending the patent lives would necessarily result in better R&D from big pharma.

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

Question:

Sequoia Fund acquired a position in Canadian Natural Resources some years ago. It is my impression that you have never added to it. What are your thoughts about that company? Are you interested in investing in other energy stocks?

David Poppe:

Canadian Natural is a very fine company. Very entrepreneurial, good assets. The thing I like the most about it is that it has a clear line of sight of production increases going out for decades. It has a huge resource in Alberta in the oil sands and it is a very efficient producer. Unlike an Exxon, which has a very difficult time replacing its production every year, Canadian Natural has 6% to 7% production increases going out as far as the eye can see. The oil sands is a very rich, long-lived resource; it is also a very expensive resource. So you own the high-cost producer. You are making an implicit bet that the price of oil will be above $80 a barrel or CNQ does not really work. So you own a big resource but you own a high cost resource. We bought a little bit, I want to say it was winter of '08 or beginning of '09 when prices were really crushed, and we thought the price was far below the replacement cost of the assets, even in a low resource price environment. But it quickly recovered and we did not feel like chasing it.

Bob Goldfarb:

I think also when we bought it, we perceived a real competitive advantage in that it had friendly oil that could be sold into the United States and shipped into the United States. But with the astounding growth in development and exploration of oil in the United States there is less of a need, and that edge diminishes.

Question:

What is the investment thesis on Novozymes?

Arman Kline:

Novozymes is actually a spinoff of Novo Nordisk, which is the world's largest maker of insulin. Using similar technology, Novozymes has developed ways to produce industrial enzymes going into, for instance, the food we eat, enzymes that prevent bread from going bad during transport through the supply chain and on the shelf at the store. They go into the detergents we use in our dishwashers and washing machines, all sorts of goods. It has an incredible core business. I think we

can safely say it dominates its end markets with greater than 70% share in most of the markets it plays in.

It is an expensive stock. The reason for the price is the value of the core business and some opportunities potentially in two segments. One is bio-agriculture. The company just signed a JV with Monsanto. Monsanto paid Novozymes $300 million for the rights to its R&D, as well as what is currently in its pipeline. There is a lot of interest in producing non-chemical-based products to help increase yields at farms. Then a second business which the company is well-positioned in is cellulosic ethanol. Widespread use of cellulosic ethanol in the US looks unlikely to happen any time soon, but there is a fair amount of interest in it in countries like Brazil, which already uses much more ethanol in its fuel.

So it is an excellent business; I would say it has one of the better management teams. It has a very, very strong position in its primary end market. And it has a couple of opportunities to grow the size of the business significantly, potentially. The CEO came out a couple of months ago and said the bio-ag opportunity alone could double the size of the business. And that is just one opportunity.

Question:

I was wondering if you could talk about Jacobs Engineering. It looks like it is a new position in the portfolio in the past year or so. What is the investment thesis there, and what has kept you from making it a bigger position in the portfolio?

Arman Kline:

We actually owned Jacobs maybe eight or nine years ago. We initiated a position, which we later closed out due to some concerns at the time from our research. We reinitiated it. It is an engineering and construction company. We have always known it was well-run. It has an unusual culture in the engineering and construction world. If you compare Jacobs’ results over the years to those of others, the incidence of, let us call them blowups, contracts that really go against you is really much lower, and the magnitude of those problems is also lower. Jacobs goes after smaller contracts. It has about 95% retention with its customer base. It runs a very relationship-based business.

What got us interested is tied to what is going on with natural gas here in the United States. That has created a renaissance in the chemical industry. Jacobs was getting more than its fair share of that.

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

But the projects were not moving forward into the construction and detailed design phase as fast, and that has led to the stock underperforming, even though the backlog is growing, because the earnings have not grown. So we found that to be an interesting opportunity and we took advantage of it at the time. And in terms of owning more, I will let David comment on that.

David Poppe:

We have a lot of price discipline, and we hope to have it be a bigger position. We bought it originally for Sequoia with hindsight at a very, very good price, did not chase it. As time has gone by, we see really good opportunities for the business and hopefully we will get a price to be able to take the position up in size. It is a very good business but price discipline takes you a long way in our business.

Question:

Are there Sequoia positions that stand to benefit from IT spending on Internet security, which is certainly a significant issue today?

Will Pan:

I do not know that we generally take a top-down view and try to benefit from some particular industry trend. But certainly security is one of the things that IBM is very much on top of. Clearly the threats are becoming more pervasive. A lot of companies that are IBM’s customers stand to lose reputation if they experience a security breach, not to mention loss of IP. IBM is very much on top of finding new ways to help improve security for its customers. The company’s new approach is to assume that there are bad things going on. You can no longer just build a firewall and try to keep everybody out. You have to assume that there are people doing bad things, whether it is in your company or coming from the outside into your company. IBM approaches it as a Big Data and analytics problem. IBM analyzes all of the activity that is going on inside and outside your company and tries to find the patterns that are indicative of misuse.

IBM’s approach has a different slant on it from that of some other companies. It looks like it will be successful. The company has acquired several companies in that arena. One thing that we thought was positive is IBM has come to the point where it has been willing to acquire a company. That was not the case in the past. IBM used to feel that it needed to build everything in-house. But now management

has developed some expertise in M&A, and it has brought in a fellow from an acquisition to run that division and he seems to be doing a good job. IBM is going to have to make more progress in that area, but that is certainly one way that we are benefitting from increased spending on IT security.

Bob Goldfarb:

I think earlier it was commented on that IBM is not a large position in Sequoia. And the business that Will is talking about is not a huge percentage of IBM's earnings. So if you want to make a bet on cyber security, I think you ought to look elsewhere. Do not count on us for that.

Question:

What do you think your potential is to invest more of Sequoia’s cash in the near term?

Bob Goldfarb:

We have been very modest net sellers this year. There is not a lot on the front burner that would consume most of that cash.

Question:

Two related questions on Valeant. There has been a lot of focus on the income statement. Can you talk a little bit about the balance sheet and how it has evolved over time? Second, how do you think about portfolio construction and position sizing, given your level of comfort with the company's balance sheet?

Rory Priday:

With the balance sheet, obviously the debt has gone up quite tremendously. I do not know offhand but a year ago maybe it might have been around $10 billion to $11 billion. Today the net debt is around $17 billion. One of the issues with companies that are doing a lot of acquisitions and doing them very rapidly is that they have to borrow money — or they can issue shares as well — but it requires a lot of capital. Usually when people look at debt, they say the leverage ratio is the net debt to EBITDA or the net debt to operating profit. Valeant is pretty high on that metric.

But I would say that it is a little misleading because Valeant pays taxes at such a low rate. It is generating quite a bit of free cash flow relative to the debt load. So this year, if you were to exclude some of

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