Sequoia Fund Investor Day: Full Transcript – Page 6 – ValueWalk Premium
Sequoia Fund

Sequoia Fund Investor Day: Full Transcript

the cash payments for the restructuring charges that it is going to have to pay, Valeant might generate cash flow approaching $2.5 billion to $3 billion. The debt is five to six times cash flow.


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

That is on the high end of what we would feel comfortable with. Historically if you look at Sequoia companies, they have not had a lot of debt. But that is just part of the model. At least in the short term, Valeant is looking to reduce its debt burden and one way it could do that is by merging with Allergan, which would reduce the leverage ratio. It depends on the terms because as it stands, management said it can reduce the ratio of debt to EBITDA to three times. But Valeant is going to be making a higher offer, it sounds like, in two weeks and that higher offer will probably result in a higher leverage ratio unless the company decides to issue more equity for the deal. But it is something that we definitely watch out for. Valeant is at the very high end of the range of where we would feel comfortable.

Bob Goldfarb:

Earlier, we were talking about The Outsiders. Over 40 years, we have owned a number of these companies, and we made the mistake of not having a big enough investment in them. When you find someone as unusual as Mike Pearson, you ought to recognize his uniqueness by having a very sizable position and by not selling that position too early as we did with three of the companies featured in the book, General Cinema, Ralston Purina, and Washington Post. As for the debt, we have mentioned before that the company is extremely tax efficient because of its tax domiciles. And the debt makes them even more tax efficient because the debt resides in the United States. The interest is deductible and creates tax losses in the United States so that Valeant has been able to transfer its IP to low tax venues. The company does incur a tax liability on that transfer, but the tax deduction of the interest on the debt and the resulting NOLs have enabled the company to transfer the IP or to license the IP without having to pay cash taxes.

Rory Priday:

Just one more thing. We would be more worried about the debt if Valeant were less diversified than it is. The largest individual product is probably 2% to 2.5% of sales. The largest segment, contact lenses, right now at $758 million, is right around 9% of the business. But that contact lens segment is split up among a bunch of different geographies as well. So there is not a lot of product concentration. And there would not be that much even if Valeant succeeds in merging with Allergan. Everybody thinks of Botox as a cosmetic product, but there are dozens of therapeutic indications that account for half of its

sales. We would be more worried if Valeant did a big deal and all of a sudden 20% of the earnings came from one product or something of that order. In some respects, Mike is pretty aggressive. But in other respects, he has been fairly conservative. One of the things that he has been conservative about is trying to have a diversified business model or diversified business.


A few questions with regard to Rolls-Royce. To what extent has the company's competitive advantage changed over the years? You discussed making accounting adjustments when you analyze a company. What kind of accounting adjustments do you make to Rolls-Royce's earnings? How do you think about its valuation relative to what the company could be earning five years from now?

Arman Kline:

I am going to try to remember all those and I might come back to you on some. But in terms of the competitive position, in the core civil aero engines business, its competitive position is as good as it has ever been. Rolls is the sole source on the A350 airplane, a 1,600-plus engine platform. It has about 40% share on the 787. Those are the two planes that are going to drive the majority of volume in the wide body segment, which is the high value segment of that market. There is some talk in the trade about a re-engined A330neo, but neither Boeing nor Airbus is talking about any truly new airplanes. The 777X, which is a derivative of the 777 that is currently flying, has a new version of the GE90 on it, and that is going to be the only player in that market, arguably for at least a decade, maybe even two. There is potentially a 757 coming out but that is not really a wide body. That is a single aisle long-range plane. But Rolls’ competitive position is excellent. The point that the company always makes is that it is going to deliver in the next five years the same number of engines it has delivered in the last two decades.

In terms of the accounting adjustments, it is probably the most complicated income statement of any company I have ever looked at. There was a little bit of excitement around that after the earnings announcement at the end of the year because the FRC in the UK, which is like the FASB here, had the company change the way it accounts for some of what is called risk and revenue sharing partnership income. The accounting change alters what Rolls reports as earnings, but the new requirement


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

has no effect on the company’s cash flows or the essential economics of its business model.

The core question that you need to ask yourself about Rolls is when the company sells an engine, and it stays in operation for 20 to 30 years, what is the return Rolls gets on that engine through its life? If it is a good return, then placing an engine should be considered a value-enhancing activity. There are different ways of treating the accounting because Rolls sells the engines for either zero profit or maybe even a loss on a big engine order. So you have essentially negative cash earnings initially and as the spares volume supports the engine over the years, you have positive. How do you account for that in terms of value? If you account for it just in terms of the cash losses, then in years when Rolls is delivering a lot of engines, it is going to report lower earnings, which might suggest that the business is worth less. That does not quite make sense to me because the engine sales are enhancing the value of the business.

Rolls sells an engine as a package with a service contract that is usually ten or fifteen years in duration. The airline pays a fee per hour of use for the length of the contract. To price the package, Rolls takes into account what it figures will be the total cost of the engine, spare parts, and service, and estimates a margin for the entire deal. As revenue from the airline comes in, Rolls books a margin on each dollar. The cash is going to be lower initially when Rolls is delivering all the engines, but higher than reported earnings in the out years when revenue is mostly coming from spares. And the beauty there is your spares business is regulated. If you fly your airplane for 100 hours and the part is perfectly good, it does not matter; you still have to change it regularly. Every 100 hours you go in and you do your inspection; you change XYZ in parts. Unraveling the economics of the business is complicated, but the company does give you an immense amount of detail. The earnings release runs 70 pages. So you have all the detail you need. You just have to make judgment calls on what you think you want to pay for the business. That is the civil side.

The marine side, the defense aerospace side and the energy side are different. They do not sell the OE equipment for a loss. The sales from these businesses do generate cash income up front. You make a margin up front and you make money on the spare parts down the line.

Then you had a third part, valuation. The valuation has come down since the FRC investigation came out. It has historically been mid-single-digit revenue, low double-digit earnings grower. Through time, again using the metrics the company uses, which is value versus cash, that is probably a reasonable estimation of the growth of the business going forward. It trades for a low teens multiple. That seems pretty reasonable. You can look at it as a company whose earnings, using the adjusted figures, are going to grow at those moderate rates for a long, long period of time given the very large backlog; or you can say it is going to earn less cash today but that cash earnings stream is going to grow fast. After these engine deliveries start to wind down, and the spares start to deliver the margin, you are going to start to get a lot of cash coming in.

Bob Goldfarb:

I would say on the competitive side that I think when we bought Rolls, Pratt & Whitney, which is owned by United Technologies, was pretty quiet. The company seemed to have lost interest in risking the kind of capital that you need to build a new engine. But Pratt subsequently came back with a geared turbofan engine. We would prefer a duopoly to a three-player market, but Pratt’s reentry will not affect Rolls-Royce's earnings from its big engines for eons.

Arman Kline:

Right. Just to add to that, Pratt & Whitney today is in the narrow body segment where Rolls is essentially not a player. That segment is a duopoly with GE and Pratt. Pratt is not in the wide body, where it is a duopoly with Rolls and GE. As Bob said, it will be many, many years before we see all three players in the same markets.


You guys mentioned Ritchie Brothers earlier. I was wondering if you could go into why you think the business is so protected. You mentioned that you do not think anyone can come in and replicate it. What are the barriers to entry that you see?

David Poppe:

The business is protected on the auction side. I think it has been proven out over the last few years by companies that have tried to enter. As I mentioned before, Ritchie runs unreserved auctions. It takes a huge amount of trust to convince a person who owns a $500,000 bulldozer to drop that into an auction — and by the way, you have got no guarantee of what price you will get for it. You


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

might have to sell it for $100,000. That person cannot pull the equipment out once he has signed a contract.

There are other auctioneers including some reasonably good-sized ones — none of them operates that way because they cannot get the sellers to cooperate. But if you get the seller to cooperate and he has trust that you are a good marketer, you will attract an audience. For the buyers it is much more attractive to come and feel like “I could actually buy this $500,000 piece of equipment for half of what it is worth.” It does not happen but the perception that it could happen is really important. Everyone has to feel that it is a fair process. So the seller is taking risk in a Ritchie Brothers auction that most of them do not want to take. This is his business. That might be the most valuable asset the company owns or the seller owns. So that is important. Ritchie built a level of trust. It built it by performing at auction, by bringing big crowds to these auctions. I do not know if you have ever been to one, but it is sort of amazing how many people show up just to watch. Half of them are not even bidders or sellers; they are just there for the entertainment value.

IronPlanet runs on-line auctions and in that one respect it seems like it would be very efficient. You do not have to have physical sites. But in fact people, if they want to buy a $500,000 bulldozer, they kind of like to sit in it and make sure it is what it is. The physical site turns out to matter a lot. So on the auction side, it is very well protected. It is a very good model.

That said, several Caterpillar dealers run CAT Auction Services and there is still a big world out there of Komatsu dealers and independent brokers who may have different economic priorities. Caterpillar might decide that what it needs to do is have a very robust used equipment business so that it gets a bigger share of parts and service on those used machines. CAT dealers could overpay customers who want to trade in a bulldozer because they like to keep that equipment in-house. It is a very, very competitive marketplace. As I said, we think Ritchie has a good model, a protected model. It is not surprising that Caterpillar really dislikes Ritchie and really wishes it would go away, although it is not good when the giant in your industry hates you and you are much smaller than it is.

But there is a stronger cyclicality to the industry than we maybe thought there was when everything was booming and Ritchie looked like it was a secular grower. It has been an interesting period since '08

when you have had very low interest rates, so that people have been able to hold machinery at pretty low cost. Maybe as business picks up, that will change.


I have a couple of questions. The first one is about China. I was curious as to what your feelings were about China and if you were looking at some investment opportunities over there. The second is about Berkshire Hathaway. Do you think that Warren and Charlie are setting up Berkshire with these capital intensive businesses so that when they are no longer there, there will be opportunities to deploy cash with basically a guaranteed return?

Jon Brandt:

On the China part, I would say with every company we study, we look at all the end markets, and if a business is in China we might expect that business to grow more than others. But as Will was saying before about cyber security, we are not really top down. We do not say, “Let's find something in China and do it.” We do have somebody who is fluent in Mandarin and who is over there quite a bit. So he might want to comment on that a little bit. And if there were a business that had a huge exposure to China and it was growing fast, we would be excited about that if the company were domiciled in a place where we were sure the shares were actually ours and the people running it were trustworthy.

To answer your question on Berkshire, it is true that if you get reasonable returns in the utility and in the railroad, that makes the job of capital allocation somewhat less critical because it reduces the amount of cash flow that is


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