Jan Issue Vii Trial

8/6/2019 Jan Issue Vii Trial

1/21

He proudly considers himself a value

investor, but don't expect Eric

Ende to go into great detail about

his valuation methodology. Only a small

amount of our returns are from being clever

on valuation when we buy, he says.

More important is the compound growth

of high-return-on-capital businesses forwhich Ende has shown a knack in managing

what is now $1.2 billion in fund assets for

First Pacific Advisors. The FPA Perennial

Fund he has run since 1995 has earned a net

annualized 11.9% over the past 15 years,

vs. 9.3% for the Russell 2500.

Targeting small- and mid-cap U.S. com-

panies, Ende and co-manager Steven Geist

see opportunity today in such areas as auto

supplies, truck equipment, car auctions and

fluid-handling devices. See page 10

I N V E S T O R I N S I G H T

Eric Ende (l), Steven Geist (r)First Pacific Advisors

Investment Focus: Seek companies intemporary disfavor but with the businessmodels and management acumen to pro-duce high returns on capital over time.

ValueInvestorJanuary 31, 201

The Other Side of PopularIts when one-time market gems are perceived to have lost their luster thatWeitz Funds' Wally Weitz often steps in to do his most-profitable prospecting.

Inside this IssueFEATURES

Investor Insight: Wally WeitzFinding value by zigging when themarket zags in such companies asIron Mountain, Liberty Interactive,Aon and Omnicare. PAGE 1

Investor Insight: Eric Ende

Seeking a select breed of long-termvalue compounders, today includingCopart, Wabco Holdings, O'ReillyAutomotive and Graco. PAGE 1

A Fresh Look: Staples

Buying a market leader when timesare tough is typically smart, but thepayoff can involve a wait. PAGE 18

Of Sound Mind

It often makes sense to put off toughdecisions, but delay isnt always aneutral, or benign, act. PAGE 19

Editors' Letter

How value investing is like gravity;Parsing a management ploy to deflectunwanted attention. PAGE 20

INVESTMENT HIGHLIGHTS

Other companies in this issue:

Actuant, Apollo Group,Ascent Media,

Baxter International,Charles River Labs,

Dell, Grand Canyon Education, KAR

Auction Services, Lincare, Microsoft,

Noble,Office Depot, OfficeMax, Redwood

Trust, Texas Instruments,VCA Antech

Ende GameInvesting wisely in companies that themselves invest wisely has generated out-sized returns for First Pacific Advisors Eric Ende and Steven Geist.

The Leading Authority on Value Investing

INSIGHT

INVESTMENT SNAPSHOTS PAGE

Aon 7

Copart 14

Graco 16

Iron Mountain 5

Liberty Interactive 6

Omnicare 8

OReilly Automotive 13

Staples 18

Wabco Holdings 15

He has been co-managing two Weitz

Funds' equity portfolios with Brad

Hinton since 2006, but Wally

Weitz says that they are still learning to be

co-managers. If there's a weakness, it's

that we're too deferential to each other, he

says. Brad has trouble telling me when I

sound crazy. Were working on that.Weitz has been crazy like a fox since the

1983 founding of Wallace R. Weitz & Co.,

which now manages $3.7 billion. His flag-

ship Weitz Partners Value Fund has earned

a net annualized 12.1% over the past 20

years, vs. 9.1% for the S&P 500.

With current opportunities confined

mostly to 80-cent dollars, they are find-

ing the most upside in such areas as docu-

ment storage, drug distribution, TV shop-

ping and insurance brokerage. See page 2

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T

Brad Hinton (l), Wally Weitz (r)Wallace R. Weitz & Co.

Investment Focus: Seek companies thata rational buyer, despite the latest or nextquarters results, would pay significantlymore to buy than the current market price.
http://www.valueinvestorinsight.com/http://www.valueinvestorinsight.com/


2/21

I N V E S T O R I N S I G H T : Weitz Funds

Value Investor Insight 2January 31, 2011 www.valueinvestorinsight.com

Investor Insight: Wally WeitzWeitz Funds' Wally Weitz and Brad Hinton describe how experience served them well and poorly during the crisis,why their mood generally improves when the market goes down, why a changing of the guard among shareholderscan create opportunity, and why they see unrecognized value in Iron Mountain, Liberty Interactive, Aon and Omnicare

What did you learn about your strategy

during the financial crisis?

Wally Weitz: Weve made a good living

over time taking the other side of the pop-

ular trade. Overall that strategy was con-

firmed that if you're buying pieces of

businesses, managed by people you trust,

at the right prices, eventually you earn

good returns.

With financials it had almost gotten to

be reflexive that if the sellers were scared,we could make a lot of money by step-

ping up to buy. Wed done that half a

dozen times when the Fed was raising

interest rates or there was some other

externally driven restriction of credit. But

this time around it wasnt a Fed-induced

credit crunch, it was a mortgage melt-

down. While wed been conceptually

aware of the credit risk, we clearly under-

estimated what would happen when you

got into a negative-feedback loop where

the bad lenders with bad loans actuallyspilled over and wrecked the entire mar-

ket, affecting what we thought were good

loans from strong lenders. While I'm

proud of the fact we admitted our mis-

takes and got out much earlier than we

might have, four stocks, Countrywide

Financial, Fannie Mae, Freddie Mac and

AIG, caused some permanent losses.

Brad Hinton: Beyond that Id add that

while we saw an economic slowdown

coming, we were in retrospect too willingto look across the valley. Even though we

felt good about them long-term, we were

too early in betting heavily on economi-

cally sensitive companies like Martin

Marietta Materials, Eagle Materials and

Lowes. Given the depth and severity of

the recession, we were too quick to go

after what was most out of favor.

WW: Once we were out of those four

financial stocks that had kept me up at

night because I wasnt sure we had mod-

eled them right, I actually started to enjoy

the collapse. Given my nature, my mood

generally improves as markets go down.

We took our cash level down from 20%

or so in late 2007 to maybe 5% in March

of 2009, which is the lowest its ever been.

While we were early in some cases, I will

give us credit for not being paralyzed by

fear and for taking advantage of some ter-

rific bargains. That paid off for us in

2009 and 2010.

Having been through the valley, has any-

thing changed in how you do things?

BH: The overall methodology didnt

change, but one lesson from 2008 was

that we were guilty of having a failure of

imagination on the downside. We develop

a base, high and low case for each busi-

ness we analyze and one practical adjust-

ment weve made is to make our low

cases somewhat more draconian. Thatcomes into play in what were willing to

pay. Were more reluctant to buy a stock

that might look attractive relative to the

base case if the downside from the low

case is too great. Thats always been true

if the range of outcomes is wide, that

probably means the cash flows arent as

predictable as wed like and we require a

bigger discount but its even more of a

focus now.

Is it possible your attachment to manage-ments with which you've had great suc-

cess mortgage investor Redwood Trust

[RWT] comes to mind caused you at

times to not see the forest from the trees

in the business?

WW: Thats a fair question. Weve had a

tremendous experience with Redwood

Trust over the past 16 years and still

strongly believe in it. It is possible,

though, that our confidence in manage-

Brad Hinton, Wally Weitz

Through the Valley

In his first interview with Value Investor

Insight (August 29, 2005), Wally Weitz

was well aware of the froth creeping into

asset prices: [S]o much money has been

available and cheap in recent years that

speculative excesses exist in most asset

classes, whether stocks, bonds, residen-

tial and vacation real estate, leveraged

buyouts or certain hedge fund strategies.

Human nature is such that these excesses

are likely to continue to build until people

start to feel some real financial pain.

Despite the prescience of those words,

Weitz's equity funds were nonetheless hit

hard in 2007 and 2008. What's most

embarrassing and annoying to me is that

we foresaw many of the credit problems

that came to pass,he says, but we failed

to recognize the vulnerability of some of

our companies to the liquidity crisis that

occurred as the market had its emperor's-

new-clothes moment.

After two strong comeback years, how

does it feel to go from star, to has-been,

and back again many times over a 40-year

investing career? It comes with the terri-

tory, Weitz says. Your perceived IQ is

directly proportional to your latest 12

month's performance.


3/21Value Investor Insight 3January 31, 2011 www.valueinvestorinsight.com


ment contributed to our holding more of

it than we should have in the past couple

of years.

Do you have favorite reasons for why tar-

geted ideas have fallen out of favor?

BH: One common reason is a difference

in time horizon, where the market is dis-

appointed in short-term results and our

interpretation is that the long-term health

and quality of the business remains intact.

Thats a function of our having at least a

five-year investment horizon, rather than

trying to trade on any given earnings

report.

For example, we bought shares in

medical-products company Baxter

International [BAX] when the share pricefell into the lower $40s last fall. The com-

pany has strong global franchises in

hemophilia, plasma, vaccines and renal

care. While there are some cyclical head-

winds in the plasma business and the

margin outlook is somewhat threatened

over the medium term due to pricing and

reimbursement concerns, we believe those

negatives have been excessively priced

into the stock. We expect Baxter to gener-

ate a healthy, growing stream of free cash

flow over time that it can use to enhanceper-share value. [Note: BAX shares

recently closed at $48.60.]

WW: In many cases were getting

involved when a rapidly growing compa-

ny is slowing down or maturing. There's

a changing of the guard among the share-

holder base and as that happens, there's

often a disagreement over how quickly

the growth is slowing and whether the

slowdown is permanent. When youre

right that the market is overreacting tothe challenges faced, the investment result

can be quite positive. Dell [ DELL ] is one

example we own today, where we basical-

ly believe there's a good long-term trade

in assuming that while the company isn't

as good as it used to be, it is still better

than people think.

BH: Well speak in more detail about this

later, but Iron Mountain [IRM] is a good

example as well, where we have a variant

view versus the market about the sustain-

ability of its moat. Its in the business of

storing boxes filled with paper, and while

it doesnt get much duller than that, the

company was a growth-stock darling for

much of the past decade as they reinvest-

ed cash flow in building out a big physi-

cal network that is very difficult for com-

petitors to replicate.

The stock fell to $20 or so last

September, as investors were disappoint-

ed with the 2011 outlook. People who

were already worried about a move to a

paperless society seem to have extrapolat-

ed what we judge to be cyclical challenges

from the tough economy to be the start of

an accelerated secular decline in the

North American storage business. Were

taking the other side of that.

How did something like Texas

Instruments [TXN], not what wed con-

sider your typical kind of holding, attract

your attention?

WW: We actively seek out forums where

we can meet company management and

attended one last summer that included

Texas Instruments. I am certainly not a

semiconductor expert, but management

did an excellent job of describing how

the business had evolved, how theydbought a huge amount of manufacturing

capacity at 10 to 15 cents on the dollar in

the depths of the recession giving them

a cost advantage going forward and

how they were devoting almost all free

cash flow to share buybacks and increas-

ing dividends. They were saying all the

things we like to hear, regardless of the

business.

It so happened that Bill Gates of

Microsoft was there and challenged them

to explain why they werent just an unin

teresting commodity chip business. They

explained that the driver of the busines

was custom analog chips that go not only

into all sorts of glamorous consumer elec

tronics like iPhones, but are also used to

do things like retrofit motors to make

them more energy efficient. These are

low-ticket, high-value items that they can

sell millions and millions of and that are

designed into product platforms that can

last 10, 20 or 30 years.

The fact that Bill Gates was so skepti

cal initially was a clue maybe the compa-

ny was misunderstood, and seeing them

change his mind made me want to dig

into the story. It all came together and we

bought a lot of stock in the $23-24 range

The market seems to have caught on [theshares now trade around $34], but were

still happy to hold at this price.

To your point that its not our typica

holding, the technology companies we

typically own arent those characterized

by rapid-cycle change. Dell, for example

is more of a marketing, assembly and dis

tribution business it only incidentally

makes products people label as technolo

gy. Microsoft [MSFT], which we also

own, has done a mediocre to poor job in

the past of reinvesting its profits to develop new products, but because of near

monopoly market positions it is a super

tanker of cash generation. Buying it a

10x earnings is not like having to make a

call on whether Advanced Micro Devices

has an advantage over Intel in the nex

product cycle.

Youve been avid investor over time in

companies controlled by cable-TV pio

neer John Malone. Why?

WW: The most obvious reason is that he

made us a lot of money. More generally

theres often a significant amount of com

plexity in his companies that, not surpris

ingly, scares investors. We find those situ

ations can be a fertile area for opportuni

ty, as long as were able to build manage

ment relationships that engender trus

and provide us with a direct source fo

gaining understanding of the underlying

businesses.

ON MICROSOFT:

Buying it at 10x earnings is

not like having to call whether

Advanced Micro beats Intel in

the next product cycle.




Was your purchase last year of Ascent

Media [ASCMA] almost a blind-faith bet

on Malone?

WW: Ascent was spun off by Discovery

Communications and its assets a year ago

consisted of some fairly prosaic video

processing businesses and a lot of cash.

We got interested when John Malone

joined the board as chairman last Spring

and said he had some ideas on what to do

with the business. The company then

agreed to sell off nearly all its existing

operating businesses for more than $15

per share, leaving it with an empty canvas

and $40 per share in cash. Ascent has

since announced it will use roughly half

its cash hoard (and leverage) to buy

Monitronics, a security monitoring busi-ness, for $1.2 billion.

I can't show you a blueprint for how

Monitronics will perform over the next

ten years, but the economics of the secu-

rity-monitoring business are similar to

those of cable television a business

Malone knows better than anyone. I can

imagine a day when that original $40 per

share in cash becomes $40 per share of

equity value in an expanded security-

monitoring business. If it can earn a 15%

return on equity, that's $6 of annualgrowth in per-share business value in an

asset-light, recurring-revenue, free-cash-

generating business. If that happens, the

share price would almost certainly be sig-

nificantly higher than today's level [of

just over $38].

In more traditional cases, how do you

arrive at a stocks fair value?

WW: We try to figure out what a ration-

al, informed buyer would pay for thewhole business. Wed expect that kind of

buyer to base the price on how much

cash the business would generate over

the next 15 to 20 years in excess of

whats needed to run the business, so true

free cash flow. We use a standard 12%

discount rate as the hurdle rate that

buyer would want to earn.

Depending on the quality of the busi-

ness, predictability of cash flow, how we

feel about management and how we feel

about the industry, we might be willing to

pay 70% of our appraised value for one

business, but only 50% for another. Some

people might use different discount rates

to reflect those variables we use the

same discount rate, but just require a

higher margin of safety when we think its

appropriate.

Describe your selling discipline.

BH: Well typically start selling lightly as

the price-to-value gets above 80%, more

heavily as it moves above 90%, and we

should be gone when it gets to 100%.

The quality of the opportunity set can

impact that well be quicker to sell the

80-cent dollar, for example, when were

finding a lot of 50- and 60-cent dollars

out there.

You appear to have gotten out of

Coinstar [CSTR] before the latest earn-

ings warning slammed the stock. Lucky

or good?

WW: Weve gotten out way too early

plenty of times, but in this case, with the

stock in the upper $50s, it was near our

estimate of fair value and we were well

aware that any sign of slowing growth

could result in a period of big disappoint-ment on the part of the momentum guys

who had bid the stock up.

With the stock off 27% in one day two

weeks ago, is it now one of those change-

in-shareholder-constituency ideas you

described earlier?

BH: We love to return to old favorites,

but in this case we would need to see a

higher discount before coming back.

After worries over a changing regulatory

environment caused for-profit-education

stocks to crack last summer, you doubled

down on one holding, Grand Canyon

Education [LOPE], and dumped another

Apollo Group [APOL]. Explain why.

BH: We think Grand Canyon has severa

distinguishing characteristics: Its studen

mix is tilted to graduate and bachelors

degree students with previous college

experience, which has led to better-quali

ty outcomes. Its tuition levels are lowe

than most peers, making the affordability

of its programs a key bone of con

tention with regulators relatively better

Its program mix is anchored by nursing

and education, two in-demand fields

where it has a long history of successfullypreparing students for careers. Finally, in

an industry in which good management i

at a premium, the company has an expe

rienced and highly capable team led by

Brian Mueller, who was one of the key

players behind Apollos growth over the

past 20 years. Given all that, when the

market lumped Grand Canyon

prospects in with competitors that we

expect it to outperform, we saw that as

an opportunity to buy more.

WW: In light of the current politica

uncertainties, we have less confidence in

our projections of future free cash flow

than we would like. So despite the poten

tial upside in many of the stocks, we have

chosen to focus on Grand Canyon

because of its particular advantages.

Walk us through in more detail your the

sis on Iron Mountain [IRM].

BH: The company helps its customerstore, protect and destroy mostly physica

documents, including contracts, financia

records and human-resources-related

materials. It charges a per-box monthly

fee for storage, and there are additiona

service fees any time you want to move

access or destroy documents.

We very much like physical-network

businesses because of the competitive

moats that are built around them. The

document-management industry is frag

ON IRON MOUNTAIN:

We very much like physical-

network businesses because

of the competitive moats that

are built around them.




mented, but Iron Mountain is the largest

player with around 20% of the physical-

storage market in North America. The

biggest competition is do-it-yourself stor-

age, but once a customer has decided to

outsource this type of thing, its rare that

they cancel and ask for all the boxes in

storage to be returned. All that results in

high operating margins EBIT margins

are just under 20% and a strong and

stable recurring-revenue stream.

There is a cyclical, economic compo-

nent to the business, as less paper tends to

be created as business activity declines.

Counteracting that somewhat have been

increasing regulatory and legal require-

ments around what must be retained and

for how long. Certainly in the mutual

fund business what were required to

retain has gone up significantly.

How mature is the traditional business?

BH: The overall North American physi-

cal-storage market isnt expanding, but

Iron Mountain has the potential to grow

here through share gains and price

increases. It also has established interna-

tional businesses in the U.K., Australia

and New Zealand and is investing in

faster-growing regions of Latin America

and in Europe. The non-U.S. business is

25% of sales today, growing at a double

digit rate over our planning horizon.

The tug and pull on the stock revolves

primarily around the speed and extent to

which increasingly digital document man

agement impacts the business. The com

pany has invested heavily in building ou

digital-document and e-mail imaging and

storage services, which now account for

about $230 million in revenue on an

annual base of $3.1 billion. Its a lower

margin but still decent business, with

EBITDA margins of around 25%, vs

40% on the physical side.

As the company navigates this digita

transition, what assumptions are you

making about growth?

BH: All in, were expecting revenue

growth in the mid-single-digit range

Management has been slow to increase

prices as the company built out its net

work and captured share, but has now

stated that pricing will be a focus in

North America, which should help mar

gins expand. Were counting on EBIT

margins increasing from 19% currently

to about 22% by 2015.

With 9-10% annual EBIT growth, fla

interest expense, and fewer shares outstanding as a result of aggressive share

buybacks we would expect to see mid

teens growth in free cash flow per share

over the next few years.

With the shares trading around $24.70

how are you looking at valuation?

BH: Now that theyve slowed capita

spending, free cash flow is substantially

higher than reported earnings. Our esti

mate for 2011 free cash flow per share is$1.85, so the shares currently trade at a

multiple on that of around 13.4x.

Using a 13x multiple on our 2015 esti

mate of free cash flow, accounting for the

cash flow earned between then and now

and discounting that all back, we value

the business today in the low $30s. Now

that this is a free-cash-flow story, we

expect healthy per-share growth rate

combined with smart capital allocation to

generate considerable shareholder value.

Iron Mountain(NYSE: IRM)

Business: Provider of records-manage-ment services, including the storage, pro-tection and destruction of documents, tocommercial and governmental customers.

Share Information(@1/28/11):

Price 24.7252-Week Range 19.93 28.49Dividend Yield 3.0%Market Cap $4.95 billion

Financials (TTM):

Revenue $3.12 billionOperating Profit Margin 19.1%Net Profit Margin (-0.8%)

THE BOTTOM LINE

Wally Weitz believes the market is misjudging cyclical weakness in the company'sdocument-handling business as the start of a secular decline. Through price increas-es, international growth, margin expansion and share buybacks, he expects mid-teensannual growth in free cash flow per share. His appraised share value: in the low $30s.

I N V E S T M E N T S N A P S H O T

IRM PRICE HISTORY

Sources: Company reports, other publicly available information

40

35

30

25

20

152009 2010 2011

Valuation Metrics(@1/28/11):

IRM S&P 500

Trailing P/E n/a 18.2Forward P/E Est. 20.1 13.6

Largest Institutional Owners(@9/30/10):

Company % Owned

Davis Selected Adv 20.2%Goldman Sachs 5.3%Vanguard Group 4.7%

Schooner Capital 4.6%Capital World Inv 3.4%

Short Interest (as of 12/31/10):

Shares Short/Float 7.0%

40

35

30

25

20

15




Highlighting another of your John

Malone-related picks, describe the upside

you see in Liberty Interactive [LINTA].

WW: This is one of three tracking stocks

for Liberty Media. Its primary business is

the QVC home shopping network, but it

also includes LIbertys public ownership

stakes in Expedia, HSN, Interval Leisure

and Tree.com, as well as some small pri-

vate online retail properties like

Backcountry.com and Bodybuilding.com.

The complicated structure is going to be

simplified, as Liberty Interactive is sched-

uled to become an independent company

later this year.

BH: QVC has been around for 25 years

and is the undisputed leader in its field,reaching 195 million cable households

worldwide, roughly 100 million of which

are in the U.S., with the rest in Europe

and Japan. It broadcasts 24 hours a day,

selling a wide variety of discretionary

household and personal items to a loyal

target audience primarily of middle-aged,

more-affluent-than-youd-expect women.

Overall, QVC accounts for nearly 90% of

Liberty Interactives total revenues.

The business held up quite well

through the recession, and without thecapital requirements of bricks and mortar

retailers it generates nice free cash flow.

Adjusted EBITDA fell less than 10%

from 2007 to 2008, and is expected to be

back at 2007s level of $1.65 billion for

2010. QVC's revenues were roughly flat

from 2007 to 2009, and we estimate that

they grew by 6% in 2010 to a new high

of $7.8 billion.

To what extent do you consider online

competitors like Amazon a threat?

WW: The TV network offers an enter-

tainment element that sets it somewhat

apart and has proven to have legs against

Internet competition. The sales mecha-

nism is quite sophisticated a chef selling

her cookware on QVC, for example, has

the producers whispering in her ear and

suggesting she point to the purple pot

because call volume picks up whenever

she does that. Theyre constantly refresh-

ing the product mix and can adjust it on

the fly based on whats selling at that

moment.

BH: Theyve also been very good at incor-

porating the Web into their own business

model online sales accounted for rough-

ly one-third of QVCs U.S. business last

year. As the Internet becomes more video-

oriented, they actually have a more

robust selling proposition online because

of all the raw material they can plug in

from the TV side. Were well aware of the

risks from someone like Amazon.com,

but we believe QVC can more than hold

its own.

How are you valuing the stock, now trad

ing at $15.85?

BH: We estimate QVC generated jus

over $1 per share in free cash flow in

2010, in a not-so-healthy environment

We expect that to increase to about $2 by

2015, driven mostly by top-line growth

internationally and a recovering con

sumer retail environment in the U.S.

Using a low double-digit multiple on

our 2015 free cash flow estimate reason

able given that capital reinvestmen

demands are fairly low and discounting

back at 12%, we arrive at a current busi

ness value for QVC of $16-18 per share

Liberty Interactive(Nasdaq: LINTA)

Business: Liberty Media tracking stockrepresenting primarily the QVC shoppingnetwork; also includes minority stakes insuch firms as Expedia, HSN and Tree.com.



Financials (TTM):

Revenue $8.76 billionOperating Profit Margin 12.7%Net Profit Margin 7.6%

THE BOTTOM LINE

Uncertainty over the timing and final terms of its formal spinoff from Liberty Media iscausing investors to underestimate the resilience and competitive strength of the com-panys QVC shopping network, says Brad Hinton. He pegs the current value of QVCand other marketable securities the company owns at $21-23 per share.


LINTA PRICE HISTORY


20

15

10

5

02009 2010 2011


LINTA Nasdaq

Trailing P/E 14.2 12.8Forward P/E Est. 21.4 16.1


Company % Owned

T. Rowe Price 11.7%

Southeastern Asset Mgmt 11.1%Dodge & Cox 9.9%

Harris Assoc 3.3%Vanguard Group 3.2%



20

15

10

5

0


7/21



The marketable securities at current prices

are worth another $5 or so per share.

Are there any risks around the spinoff?

WW: There is an ongoing suit, expected

to be heard in February, by Liberty Media

bondholders claiming that the security of

those bonds will be impaired by this spin-

off. That uncertainty probably leaves

some investors cold, as does the fact that

Liberty has reallocated assets among the

tracking stocks in the past and could do

so again before the spinoff gets done. We

dont consider either of those a big risk,

because we trust Liberty management to

insure that the value they said would be

delivered to LINTA shareholders will be

delivered.

What attracted you to insurance broker

and HR consultant Aon Corp. [AON]?

WW: We owned Hewitt Associates when

Aon agreed to buy it last year. Aon was

on our monitor list because we like the

insurance brokerage business and the

shares were reasonably priced. When the

acquisition was announced and Aon

stock came under pressure, we took the

other side of what the arbs were doing,selling them our Hewitt stock while buy-

ing Aon.

What do you like about the insurance-

brokerage business?

BH: Its another capital-light business and

basically an oligopoly, with Aon, Marsh

& McLennan and Willis Group control-

ling a significant share of the large-corpo-

rate-client market. It generates 20% oper-

ating margins for Aon even in a soft mar-ket, with 20%-plus returns on capital and

significant free cash flow.

Because of the economic contraction,

insurance risk-unit demand has been

weak globally, as companies have less to

insure or choose not to insure certain

risks. Excess supply among insurers has

also exacerbated a soft pricing market,

which hurts Aon because it gets two-

thirds of its brokerage revenues from

commissions. On top of all that, interest

rates have been low, limiting what they

can earn on their float.

So is your bet primarily on those nega-

tives going away over time?

BH: Thats certainly an important part of

it risk units will come back as the glob-

al economy recovers and sooner or later

we will have a hard insurance pricing

market. But we dont have to build in

much optimism on those fronts to see this

as attractive.

We see room for margin expansion in

both brokerage and HR consulting.

Pretax margins in the brokerage business

have increased over the past few year

from 16% to an estimated 20.5% in

2010, but we think theres still room for

improvement as the business turns up and

management keeps a lid on costs. On the

consulting side, we expect margins to

increase from todays 16.5% as Hewitt i

integrated. Aon has targeted $350 million

in cost synergies from the merger, which

more than tripled the size of Aons con

sulting business. On top of that, manage

ment sees considerable revenue synergie

from cross-selling among practice areas

Weve chosen to wait and see on that, bu

that would cause an incremental bump to

earnings and margins.

Aon Corp.(NYSE: AON)

Business: Provider of insurance brokerageand related risk- and human-resources-related consulting services to primarily cor-porate customers worldwide.



Financials (TTM):


THE BOTTOM LINE

Expecting only modest improvements in global demand for insurance risk units and inwhat has been a soft insurance pricing environment, Brad Hinton believes the companycan earn $5.75 per share in cash earnings by 2015. Using a 13x terminal multiple anddiscounting back to the present, he believes the shares today are worth closer to $65.


AON PRICE HISTORY


50

40

302009 2010 2011


AON S&P 500

Trailing P/E 18.8 18.2Forward P/E Est. 13..2 13.6


Company % Owned

Southeastern Asset Mgmt 8.7%T. Rowe Price 7.1%Capital World Inv 5.7%

State Street Corp 5.6%Vanguard Group 4.6%



50

40

30


8/21



At a recent $45.30, how cheap do you

consider the stock?

BH: The shares trade at less than 11x our

$4.25 per share estimate of cash earnings

in 2011. Were expecting cash earnings to

increase to $5.75 per share by 2015.

Using a conservative 13x terminal multi-

ple and including the present value of

cash generated in the interim, our current

appraised value is in the mid-$60s.

WW: This is a classic example of the

kind of opportunity we pursue. Other

investors who like the business, its man-

agement team and even its share price

are deterred by the soft insurance mar-

ket. They seem to think theyll magical-

ly be able to buy just before the marketfirms. We believe theyll pay a higher

price at that point, which could start a

sharp revaluation upward. Wed rather

own it now and benefit fully when that

happens.

Youve traded in and out of drug distrib-

utor Omnicare [OCR] for years. Why is it

interesting now?

WW: Almost in spite of itself, the compa-

ny has staked out a strong leadershipposition in selling pharmaceuticals to

geriatric clients living in nursing homes,

assisted-living facilities and long-term-

care facilities. Its value-add is in packag-

ing the drugs in ways meant to improve

compliance and accuracy of usage, and it

uses its scale to negotiate better terms

with suppliers and to fend off smaller

competitors.

While there are challenges to the busi-

ness overall, the biggest negative to the

story in our opinion was removed lastAugust when the board replaced the long-

time CEO, Joel Gemunder. He tended to

pick fights with executives internally and

scrimped on customer-facing sales and

service, all the while paying himself a lot.

The interim CEO was board member

Denny Shelton, with whom we had an

excellent experience when he was CEO of

Triad Hospitals several years ago. He has

since become non-executive Chairman

with the naming of John Figueroa, who

had been president of McKessons U.S.

drug-distribution business, as the perma-

nent CEO.

On what should management be focused?

WW: A lot of it is just making simple

operating improvements: Support the peo-

ple in the field interacting with customers.

Create an internal culture in which every-

one is working toward common goals.

Take better advantage of the companys

scale in areas like procurement.

Without assuming anything heroic, we

expect EBIT margins to expand from a

current 8.5% to 9.5% or so in 2015.

Thats driven both by a continued shift in

the product mix toward generics on

which Omnicare earns higher margins

and from nuts-and-bolts operating

improvements.

Is the business growing?

BH: The number of beds served, a

around 1.4 million, has declined slightly

over the past four years, but we do expec

the sales and service upgrades to help turn

that modestly around. Were projecting

4% annual top-line growth over our fore

cast horizon, which with margin expan

sion translates into mid-single-digit annu

Omnicare(NYSE: OCR)

Business: Purchases, repackages and dis-tributes pharmaceuticals to nursing homes,hospices and assisted-living centers repre-senting 1.4 million beds in 47 states.



Financials (TTM):


THE BOTTOM LINE

With its long-time CEO having been replaced, Wally Weitz believes the companysgreater emphasis on sales and service combined with nuts-and-bolts operatingimprovements can drive free cash flow growth from an estimated $3 per share thisyear to $4.70 by 2015. With those assumptions, he values the shares today at $35.


OCR PRICE HISTORY


35

30

25

20

152009 2010 2011


OCR S&P 500



Company % Owned

Harris Assoc 5.0%Glenview Capital 5.0%Schroder Inv Mgmt 3.8%

Wallace R. Weitz & Co 3.8%Vanguard Group 3.7%



35

30

25

20

15


9/21



al EBIT growth. It all gets more interest-

ing on a per-share basis, given the compa-

nys opportunity to use free cash to signif-

icantly shrink the share count over the

next five years. We estimate free cash

flow of $3 per share in 2011, rising to

$4.70 by 2015.

What upside do you see in the share price,

now around $26?

WW: Our appraised value today is

around $35, and we believe the stock

could move to that level simply by regain-

ing respectability in investors eyes. If

they generate the earnings growth we

expect, we could easily see a premium to

the 13x multiple we assume for 2015.

The stock traded at $60 a few years agoand theres no reason it couldnt again.

What are the key risks?

WW: We expect continued pressure on

reimbursement rates, but we are assum-

ing that as the company gets squeezed, it

will figure out how to adjust in order to

maintain the spread. If it doesnt succeed

in doing that, our margin estimates will

be too high.

In an operating turnaround, theres

also always execution risk. In addition to

our having faith in new management, the

good news here is that the comparisons

should prove to be fairly easy.

Wally, you mentioned your mood

improving as stocks get cheaper. How is

your humor today?

WW: The stocks in our portfolio are obvi-

ously not as undervalued as they were a

year ago, and are certainly much more

expensive than they were two years ago.In March 2009 the average stock we held

sold for less than 50% of our estimate of

business value, and that was with

extremely conservative expectations.

Today our stocks on average sell at about

75-80% of appraised value, a level from

which weve earned reasonable returns in

the past, but not one that gets us very

excited.

We've been selling into the rally and

now have 15-20% cash in our two larges

equity portfolios. If the market keep

going up the cash will be a drag on our

performance, but the opportunity cost o

having some extra cash right now doesn'

strike us as particularly high. Buying

opportunities seem to crop up when, and

where, you least expect them.

Morningstar calls your funds perform-

ance streaky but good. Are you OK

with that?

WW: Given that our funds are concen

trated both in the absolute number opositions we hold and in the number o

industries that are represented, it's natu

ral for our performance to be lumpy. I

the alternative is being consistent and

mediocre, we would much prefer to be

streaky but good. VII
http://www.valueinvestorinsight.com/http://valueinvestingcongress.com/?utm_source=VII&utm_medium=A&utm_campaign=W11VIID&ocode=W11VIID%20[%20http://valueinvestingcongress.com/?utm_source=VII&utm_medium=A&utm_campaign=W11VIID&ocode=W11VIIDhttp://www.valueinvestorinsight.com/


10/21

I N V E S T O R I N S I G H T : First Pacific Advisors


Investor Insight: Eric EndeFirst Pacific Advisors' Eric Ende, Steven Geist and Gregory Herr explain what matters most in identifying stocks theyhold for an average of seven years, the mistake they find most difficult to avoid, why theyre on the cowardly side inestablishing positions, and why they see particular upside in O'Reilly Automotive, Copart, Wabco Holdings and Graco

Your strategy descends from none other

than Warren Buffett and Charlie Munger

(see box on this page). Describe its basic

outlines.

Eric Ende: Your recent interview with

Morris Mark (VII, December 2, 2010)

kind of took away our thunder, as most

of what he said about strategy sounded

awfully familiar. We put the same empha-

sis on companies that earn high returns

on capital and have attractive reinvest-ment opportunities. They have strong

balance sheets, with debt accounting for

no more than 35% of total capital and

usually much less. For example, our com-

panies today have on average about 10%

net debt.

We believe the most important con-

tributor to the long-term investment per-

formance of the companies we own is

earnings growth, not a change in valua-

tion. Because growth is driven by earning

high returns on capital and successfullyreinvesting cash flow, we tend to be very

long-term investors our average hold-

ing period runs about seven years in

order for this virtuous process to bear

fruit. Because of that orientation, we put

primary emphasis on market structure,

the sustainability of the businesss com-

petitive advantage, and managements

track record in creating shareholder

value over time.

If you step back and think about the

basics of what were doing, were interest-ed in companies that are better than their

competitors and which have shown the

ability to take the cash they earn and do

something smart with it. Theres nothing

earth-shattering about that, but to the

extent you can apply it, understand the

business dynamics and not pay foolish

prices for things, theres no reason you

shouldnt get the attractive long-term

returns we believe we and our predeces-

sors have produced.

What constitutes not paying foolish

prices for things?

EE: Were basically willing to pay average

or below-average valuations for compa-

nies we believe will continue to have bet-

ter-than-average performance. Relative to

more elaborate valuation disciplines you

may hear about from others, ours is rela-

tively simple. Historically weve managed

to pay mid-teens trailing earnings multi-

ples for pretty good companies, low-teensif were really fortunate. If you have

enough time, paying a high-teens multiple

can work out, but its more of a burden.

If you have to compromise somewhere,

however, our view is that compromising

on quality is not a good thing to do pay-

ing a little more for a consistently good

business is the better way.

No discounted-cash-flow models?

Steven Geist: We find that even using aconsistent discount rate you can come up

with anything you want in a DCF model.

You often see these 2x2 or 3x3 valuation

tables in Wall Street research that give

share-price targets under a mix of

assumptions on the key inputs, and they

conclude the true number is somewhere

in the middle of the box. The problem is

that the range of supposedly legitimate

potential outcomes can be a share price

from $10 to $100. The assumptions you

have to make tend to be so uncertain thatwe dont find it a particularly useful way

to look at a company.

Describe how you define your circle of

competence.

EE: Were looking at companies that

trade primarily in the United States with

market caps between $500 million to $5

billion. We try to avoid fast-changing

businesses with short-life-cycle products

Eric Ende, Steven Geist

Down the Line

While they took unconventional paths to

become investors Eric Ende worked for

13 years in corporate finance, while

Steven Geist spent a comparable period

as an engineer they both had the good

fortune to land at First Pacific Advisors

under the wing of George Michaelis.

Dubbed by one author as the apostle of

return on equity, Michaelis delivered mar-

ket-trouncing returns at FPAs Source

Capital closed-end fund before dying in a

bicycle accident in 1996. Ende took over

Source that year, and now co-manages it

and the FPA Paramount and FPA

Perennial mutual funds with Geist.

Michaelis' mentors were none other than

Warren Buffett and Charlie Munger, who

independently bought shares of Source in

the mid-1970s when the floundering fund

traded at 50% of net asset value. Theyredirected it under Michaelis to focus on

high-quality businesses that can com-

pound shareholder value at high rates for

many years. The strategy, still in place

today, informed Buffett and Munger's orig-

inal thesis for Source Capital itself. It's all

very good to buy $1 for 50 cents, says

Ende, but if that $1 is being managed

incompetently or following a dumb strate-

gy, then maybe it's not a very good deal.


11/21

because theyre inherently more difficult

to forecast. We also tend to avoid compli-

cated technology and biotechnology busi-

nesses, where we have to ask what our

competitive advantage is in analyzing the

business.

So we focus on relatively easy-to-

understand businesses, often with fairly

concentrated industry structures. We

recently went through the portfolio and

found that roughly one-third of the

names, and probably representing a high-

er portfolio weight, were companies in

industries that were essentially two-firm

oligopolies. You can have an irrational

market whether there are two firms or

ten, but most of the time the more con-

centrated businesses are well-behaved,

which is quite helpful for profitability and

allows companies to make rational rein-vestment decisions.

We were surprised to see decent represen-

tation in your portfolio of highly cyclical

oil-services stocks, like Noble [NE] and

FMC Technologies [FTI].

EE: Were generally reluctant to invest in

crummy-return businesses, and historical-

ly thats been true of those tied to com-

modities. Theres a legitimate question as

to whether the world has changed in com-modities, but over time in the past they

havent done better than provide com-

modity returns, so we didnt care.

We consider oil services different in its

fundamentals from the exploration and

production side of the business. Theres

clearly a strong cyclical component, the

impact of which can be reduced by the

length of our time horizon, but we also

believe that the way the companies are

managed can generate incrementally

higher returns on capital. Noble, forexample, has done an excellent job over

time in timing capital investments, deliv-

ering capital projects on time and on

budget, and leasing out capacity on new

deepwater vessels and rigs prior to actual-

ly committing the cash to buy them. All

that greatly reduces risk and has resulted

in better-than-average returns.

After hoarding capital the last few

years, Noble last June announced the

$2.7 billion acquisition of smaller com-

petitor Frontier Drilling, and also

announced $1 billion in spending to buy

two ultra-deepwater drillships, backed by

10-year contracts from Royal Dutch

Shell. Those deals increase Nobles back-

log from $7 billion to $13 billion, second

in the industry only to Transocean. More

important, they demonstrate an ability to

add well-priced assets at an opportune

time, which should result in good returns

for shareholders.

How do ideas tend to get on your radar

screen?

SG: We maintain a list of companies that

meet all the criteria Eric mentioned and

monitor it to identify when the market is

giving us an opportunity to buy. Often

its as simple as a missed quarter or a

change in analysts estimates, which is alla lot of noise much of the time and isnt

relevant to whether the company is in an

attractive business and is likely to rein-

vest its money successfully over a five- or

ten-year period.

Gregory Herr: Well often follow a busi-

ness for years until for company-specific

reasons or due to market conditions an

opportunity presents itself. A good exam-

ple of that in the portfolio today is VCA

Antech [WOOF], the largest operator ofanimal hospitals and veterinary diagnos-

tic labs in the U.S. This had been a buy-

out by Leonard Green & Partners, the

private-equity firm, which came public in

2001 and caught our attention for the

attractive reinvestment potential in buy-

ing veterinary practices and for the excel-

lent profitability of the lab business,

which is a duopoly. It had everything we

like in a business, but the valuation

reflected that until the downturn in late

2008 and we were able to buy it at a price

that made sense.

In this case, the price has remained

attractive because the volumes at the ve

hospitals have been anemic for the last 18

to 24 months. You wouldnt think spend

ing on pet healthcare would be that dis

cretionary, but people have clearly been

putting off or skipping some treatment

for their pets. Thats still weighing on the

stock, but we dont believe that tendency

will persist for the long term.

VCA Antech was an example of a

company whose debt we owned in

Source Capital [First Pacifics closed-end

balanced fund], that eventually became

attractive as an equity investment

Another example of that we own is

Actuant [ATU], a small conglomerate o

energy-focused industrial businesses thawas split off from the electronics busines

of Applied Power maybe 10 years ago

As bondholders, we knew the company

well and as it paid down debt, the bal

ance sheet became clean enough that we

were able to invest in the equity a couple

years ago.

Your portfolios tend to hold 30 to 40

positions. Why have you decided on tha

level of concentration?

EE: When we see competitors holding 75

100 positions, with 75-100% annua

turnover, were either very impressed with

their ability to keep track of 150 or more

companies or were skeptical of their

ability to credibly follow that many com

panies. We dont have anywhere near tha

many good ideas in a year.

Given our number of holdings and our

turnover, we can devote 10 times the

amount of time some others can spend on

any given position, which means weshould know the business better, reducing

the possibility that things are going to hi

us from left field. That depth of knowl

edge, combined with the quality of the

businesses we want to own, is our pri

mary risk-management tool.

How do you size positions?

EE: We consider a position full at abou

3% as were purchasing it, but we tend to



ON DIVERSIFIED RIVALS:

Were either impressed they

can track 150 or more compa-

nies . . . or skeptical of their

ability to credibly do so.


12/21

be on the cowardly side at the beginning,

starting with 50- to 100-basis-point posi-

tions. Were most comfortable buying

stuff that is going down, so well take our

time building a position and hopefully the

passage of time will increase our under-

standing of the business and our confi-

dence in what the future looks like. If the

share price cooperates, well buy up to the

3% position. At the same time, if we buy

and the stock pops 20%, we dont feel

compelled to move from a less than full

position.

Larger positions are mostly the result

of success. We bought well, the company

has performed, and weve owned it for a

long time. When something like that gets

to 6-7% of the portfolio, well probably

start trimming it back. Thats doubly truewhen the valuation is also pushing the

upper limit of what we would consider

reasonable.

Can you generalize about where youve

tended to make mistakes?

EE: Given our focus on companies that

reinvest wisely, we spend a lot of time try-

ing to understand how management has

reinvested cash flow in the past and the

criteria for how they plan to do so in thefuture. The problem thats very hard to

foresee is when management acts totally

out of character and makes a horribly

destructive investment. The most vivid

example of that was four or five years ago

when what was then called Oshkosh

Truck [now Oshkosh Corp.], after ten

years of making smart acquisitions in

related businesses they understood well,

bought a company called JLG Industries.

It was outside their core business, highly

cyclical, and they overpaid for it. Whenthey announced the deal the stock went

down 15-20% and we got out as quickly

as we could. The only consolation was

that we avoided it going from $45 down

to $4 in the financial crisis.

Did something similar happen with

Charles River Labs [CRL] last year?

EE: In many ways, yes. The companys

core business of selling research models

basically rats and mice is a great busi-

ness, with dominant worldwide market

share and low-30% operating margins.

They had been adding to that core with

related businesses that support healthcare

research or drug development. Then in

April of last year they announced they

planned to pay $1.6 billion to buy WuXi

PharmaTech, the leading Chinese

provider of early-stage drug development

services. While there was a legitimate

strategic rationale for the deal, the price

was 6x WuXis sales and 30x EBIT, at a

time when Charles River shares traded at

2x revenues and 11x EBIT. We also saw

significant integration risks in the acquisi-

tion, primarily the challenge of keeping

WuXis two thousand Chinese scientists

happy. The deal made us lose confidence

in managements ability to intelligentlyreinvest cash flow, so we sold immediate-

ly. As an addendum to the story, some of

the remaining shareholders revolted and

with the help of new activist owners

forced the company to abandon the deal

in July.

How did you handle long-time holding

Lincare [LNCR] after healthcare regula-

tory concerns knocked a third off the

share price last summer?

EE: Weve owned Lincare, which is the

leading provider of home oxygen equip-

ment, since 2000. In almost all respects

its superior to its competitors, but theres

a good deal of uncertainty, to put it mild-

ly, about where reimbursement rates are

going for its products and services. In July

the Center for Medicare Services

announced the results of a competitive

bidding process in which overall prices

fell more than expected, and Lincare lost

the ability to take on new customers in

certain test markets.

Our thesis has been that Lincares cos

advantage over its competition will allow

it to earn decent returns while others lose

money and withdraw from markets. Tha

should result in it taking significant mar

ket share, prior to regulators backing of

on price cuts because of sharp declines in

service levels. Needless to say, this thesi

is controversial. We continue to hold ou

position and with new rates going into

effect in the test markets now, we should

know relatively quickly whether our

argument is valid.

Walk through your investment case today

for OReilly Automotive [ORLY].

GH: O'Reilly is one of the three big auto

parts retailers in the U.S., along with

AutoZone and Advance Auto Parts

What sets it apart is its traditional cus

tomer mix, with roughly 50% of the busi

ness from the professional mechanic and

garage trade, and 50% from the retail do

it-yourselfer. Serving the professiona

trade requires bigger investments in dis

tribution and service, but the resulting

higher sales productivity per store ha

generated excellent returns for OReillyover time.

The story here revolves around the

July 2008 purchase of CSK Auto, which

resulted in a 70% increase in O'Reilly's

store base and gave it a national platform

to roll out its dual-market strategy. CSK

was in almost all respects a suboptima

operator and commercial sales represent

ed only about 10% of its revenues, so

there was significant opportunity for

OReilly to enhance the productivity of

the acquired stores as it merged them intoits infrastructure and strategy.

Over the past two years managemen

has been methodically integrating the two

businesses. They have completely over

hauled the inventory and layout of CSK

stores, while significantly improving part

availability and service by adding new

distribution capacity. Thats critical to

success on the commercial side of the

business, where mechanics typically work

with time-sensitive schedules.



ON MISTAKES:

Its very hard to foresee when

management acts totally out

of character and makes a hor-

ribly destructive investment.




The results of all this have already

been positive, but we believe the biggest

upside is still to come. The CSK stores

were generating around $1.4 million in

average sales prior to the acquisition, and

management and Wall Street are focused

on that getting before long to around

$1.8 million. But if the productivity ulti-

mately gets to the level of OReillys tra-

ditional stores, average sales will be in

the $2.5-2.7 million range. To put that in

perspective, if they get to $2 million per

store, with 1,300 stores youre talking

about an additional $300-350 million in

sales over current levels worth proba-

bly 25 cents per share in earnings. If they

ultimately get to $2.7 million, youre

talking $1.2 billion in extra sales and

maybe 75 cents in incremental EPS.

Theres no guarantee they get there, but

we believe its a legitimate possibility

over the next five years.

Whats the competition doing while all

this is going on?

EE: Advance Auto Parts doesnt have a

presence in the Western markets in which

CSK was strong, which leaves AutoZone

as the main competitor. The key point

there is that the company is controlled by

Eddie Lampert, the hedge fund manager,

who has been very skilled at getting cash

flow out of the business one way of

which to do so has been to minimize rein

vestment. Thats been financially success

ful, but it has made AutoZone a much

more benign competitor. Thats been true

for years and we expect it to continue.

Does OReilly face a headwind if the new-

car market continues to improve?

GH: The auto-parts business is somewha

countercyclical, as an economic slow

down causes people to hold on longer to

their old cars, which require mor

upkeep. But given the magnitude of what

can happen with the CSK stores, we don

expect growth to be overly impacted by

an uptick in new-car sales.Theres also growth potential outside

of the CSK stores. OReilly is still mostly

absent in Florida and in the Northeast

and theres opportunity to fill in where

they already have a store footprint. They

opened 150 new stores in 2010, expec

another 170 this year, and believe 200

225 per year is a reasonable expectation

in coming years. Overall, from new store

and increased sales at existing stores

wed expect annual top-line growth o

around 10%. With higher margins andthe fact that theyre embarking on their

first-ever share buyback plan, EPS growth

may be closer to 15% annually.

With the shares at $56.50, how are you

looking at valuation?

GH: The company likely earned about $3

per share in 2010, with consensus esti

mates calling for $3.50 this year and bit

under $4 in 2012. We dont pay tha

much attention to forward multiples, buthe earnings-growth potential here i

good enough that a 19x trailing multiple

is more than palatable. We think there

an argument for earnings power within a

few years of closer to $5 per share.

One balance sheet issue Id mention i

that the company just refinanced its cred

it facility, which had limited OReillys

use of vendor financing because invento

ry had to be pledged as collateral. Tha

restriction has gone away, and we expec

OReilly Automotive(Nasdaq: ORLY)

Business: Retailer of automotive aftermar-ket parts, tools, supplies, equipment andaccessories sold to both professional anddo-it-yourself customers in the U.S.



Financials (TTM):


THE BOTTOM LINE

The market isnt recognizing upside still available from integrating acquired CSK Autostores into the companys infrastructure and strategy, says Gregory Herr. While some-what pricey on trailing earnings, the shares are far more attractive against the $5 pershare in earnings power he believes the company can generate in the next few years.


ORLY PRICE HISTORY


80

70

60

50

40

30

202009 2010 2011


ORLY Nasdaq



Company % Owned

T. Rowe Price 13.0%Vanguard Group 4.9%State Street Corp 3.4%

Lone Pine Capital 3.3%Select Equity Group 3.2%



80

70

60

50

40

30

20


14/21

the company to free up working capital

by increasing its payables-to-inventory

ratio from a current level of around 48%.

Every 500-basis-point increase in the

ratio is worth $100 million in cash flow.

For comparison, Advance Autos

payables/inventory ratio is 71%, while

AutoZones is 107%.

EE: Weve met OReilly management at

least 15 to 20 times over the years and

they are absolute straight-shooters you

ask a question, they give you an honest

answer with no spin. We trust them, and

the track record over a long period of

time justifies that.

Staying within the automotive world,

describe what appeals to you about car-auction company Copart [CPRT].

EE: Coparts primary business is manag-

ing auctions for salvage vehicles. If an

Allstate client has an accident and the

determination is made that the car cant

be fixed at a reasonable cost, Allstate will

contract with Copart to haul the car

away, store it and then auction it off to

the highest bidder, retaining a percentage

of the proceeds as a fee.

The auctions are done entirely on theInternet, which has expanded the poten-

tial buyer base significantly, especially

outside the U.S. Just because Allstate

decides not to fix a car in Los Angeles,

that doesnt mean someone in Nigeria or

Venezuela or Poland, where there are dif-

ferent regulations and cost structures,

cant fix it economically.

We like that the business has substan-

tial barriers to entry. The primary assets

are the holding lots, which you need a lot

of to minimize hauling distances. Thereal estate itself can be difficult to find,

and getting zoning approvals can make it

even harder. Broad scale is also impor-

tant, as national insurers prefer to deal

with a salvage company with a national

footprint.

As a result of all this, there are only

two companies of size in the market,

Copart and KAR Auction Services

[KAR], which share around 75% of mar-

ket. Profitability levels are quite high,

with Coparts operating margins typically

coming in above 30%.

What are the key demand drivers?

EE: The most important generator of

demand is accident frequency, which is

tied almost entirely to miles driven, mak-

ing it modestly correlated with economic

activity. The severity of accidents is also

important, and here there has been a sec-

ular increase in the percentage of acci-

dents that result in cars being totaled.

Thats a result of more expensive stuff

being built into cars, such as airbags and

fancier lighting systems. When they go,

the car is more likely to find its way to

Copart.

Are there other growth opportunities?

EE: Copart still does make acquisitions in

the U.S., which basically involves buying

holding lots in order to better serve cus

tomers and to reduce the distance the car

have to be towed.

The company expanded into the U.K

a few years ago and now has a leadership

position there, with some 25% of the

market. Theyve shown an ability to suc

cessfully take their model outside the U.S

and we think there are other markets in

Value Investor Insight 14January 31, 2011


www.valueinvestorinsight.com

Copart(Nasdaq: CPRT)

Business: Seller through online auctions oftotaled and high-mileage cars for insurancecompanies, fleet owners, banks, charitiesand auto dealers in the U.S. and U.K.



Financials (TTM):

Revenue $800.1 millionOperating Profit Margin 30.3%Net Profit Margin 19.3%

THE BOTTOM LINE

The company has capitalized on its strong market position and expanded successfullyinto new geographic and product markets that leverage its online selling platform, saysEric Ende. With expected annual EPS growth in the double digits and a managementteam with an owners mentality, he expects to hold on to this for a number of years.


CPRT PRICE HISTORY


50

40

30

20

2009 2010 2011


CPRT Nasdaq



Company % Owned

Concert Wealth Mgmt 10.7%Baron Capital 5.6%Capital Research Global Inv 4.2%

Neuberger Berman 4.1%Wasatch Adv 3.6%



50

40

30

20


15/21

continental Europe, including Germany

and France, with similar potential.

They have also built a profitable busi-

ness selling what they call high-mileage

vehicles, which might be cars coming off

lease, or repos, or fleet cars that dealers,

banks or companies may be looking to

unload on a regular basis. Because of

their buyer base and established online

selling platform, they believe they can get

attractive prices compared to the used-car

auctions of companies like Manheim.

This business now accounts for 20-25%

of Coparts vehicles sold, and has the

potential to continue to grow nicely.

While still not back to pre-crash levels,

the stock at a recent $39 has done quite

well lately. Has it gotten pricey?

EE: On estimated earnings for the year

ending in July of $2.30 per share, the

multiple is around 17x. A recent tender

offer to buy back 15% of the outstanding

shares has helped push up the price.

Weve held on to our shares because

the company has proven it can deploy

capital to grow and earn attractive

returns, which we believe can drive annu-

al EPS growth in the low double digits.

Management runs the business with anowners mentality the founder is still

Chairman and his family controls about

10% of the stock and is willing to

return capital to shareholders as condi-

tions warrant. We would expect to hold

on to this for a number of years.

Why are you so high on prospects for

truck supplier Wabco Holdings [WBC]?

EE: Wabco was founded as Westinghouse

Air Brake Co. 140 years ago and wasspun off in 2007 from American

Standard. It is a leading worldwide man-

ufacturer of technologically advanced

heavy-truck components, including air

disc brakes, electronic braking and stabil-

ity control systems, and automatic trans-

missions. Its a global business, headquar-

tered in Belgium, with major operations

in developed markets in Europe, the U.S.

and Japan, as well as in rapidly growing

countries like China, India and Brazil.

The market has two premier players,

with Wabco holding a 40-50% global

share, followed by Germanys Knorr-

Bremse at #2. Emerging-market competi-

tors are generally limited to low-end

products, where Wabco is less active.

Given the premium in the market on tech-

nological innovation, quality and safety,

we wouldnt expect Wabcos competitive

position to be under threat for some time.

The downturn hit the company hard,

with revenues falling from $2.4 billion in

2007 to $1.5 billion in 2009. But theyve

done an excellent job of using that adver-

sity to cut costs. They eliminated 23% of

their global workforce and have acceler-

ated shifts in manufacturing and the

sourcing of parts and materials from

high- to low-cost countries. As revenue

bounced back to an estimated $2.2 billion

last year, we believe operating margin

came in at 10.3%, up from 2.9% the year

before. As revenues continue to grow rap

idly which we expect the lower cost

base should result in margins easily sur

passing the peak level of 12.3% in 2005.

Whats behind your optimistic revenue

outlook?

EE: Part of it is just an expected rebound

in unit truck production in the U.S. and



Wabco Holdings(NYSE: WBC)

Business: Develops, manufactures andsells braking, stability, suspension andtransmission-control systems primarily forcommercial trucks. Based in Belgium.



Financials (TTM):

Revenue $2.01 billionOperating Profit Margin 8.6%Net Profit Margin (-12.5%)

THE BOTTOM LINE

Eric Ende expects a rebound in truck production in the U.S. and Europe, continuedtruck-demand growth in emerging markets, and increased penetration of the compa-nys high-end components in all markets to fuel growth in revenues and profits that hebelieves will make todays 16x trailing multiple on the stock appear exceedingly cheap.


WBC PRICE HISTORY


80

70

60

50

40

30

2010

02009 2010 2011


WBC S&P 500

Trailing P/E n/a 18.2Forward P/E Est. 15.2 13.6


Company % Owned

T. Rowe Price 10.6%Lord Abbett 9.0%Fidelity Mgmt & Research 8.2%

Vanguard Group 4.4%Times Square Capital 3.4%



80

70

60

50

40

30

2010

0


16/21

Western Europe, where build rates fell by

two-thirds in the recession and have only

recently started to pick back up as those

economies show signs of life. The compa-

ny has guided to 40% revenue growth in

North America this year and mid-teens

growth in Europe.

Another key factor is that expanding

economies need trucks to transport

goods, making Wabco an excellent vehi-

cle for participating in emerging-market

growth. Unit truck production in China,

India, and Brazil grew probably 40% in

2010 and those countries now account

for about a quarter of the companys

sales. The recent growth pace wont con-

tinue, but these markets for Wabco are

anything but mature.

The final part of the growth story isincreased content in each truck produced.

The value of Wabco content on a new

truck varies widely from market to mar-

ket, from perhaps $300 in China, to

$1,000 in the U.S., to $3,000 in Europe.

All these numbers are very likely to go up

as government regulators, manufacturers

and buyers put increased emphasis on

safety and improved productivity.

Revised regulations, for example, are in

process to require shorter stopping dis-

tances in the U.S. requiring moresophisticated brakes electronic stability

control in Europe, and anti-lock braking

systems in Brazil. All of this plays to

Wabcos strength as an innovator and

technology leader.

The story has not gone unnoticed, with

the shares having more than doubled in

the past year to a recent $57.30.

EE: The stock has gone up a lot and now

trades for just over 16x estimated 2010earnings of $3.50 per share. You could

argue thats expensive for a cyclical busi-

ness, but we believe the secular growth

story, enhanced by the operating leverage,

is fairly profound. The company has sug-

gested that it can earn operating margins

in the 25-30% range on incremental rev-

enues. The question then is how much

revenues will grow. Its tough for us to be

terribly specific about that, but weve

made the stock one of our largest posi-

tions on the expectation that the surpris-

es are much more likely to be positive

than negative.

Explain your case today for long-time

holding Graco [GGG].

SG: This is not the Graco that makes

baby strollers and car seats, but a manu-

facturer of industrial equipment that is

used to pump, mix and dispense a wide

variety of fluids and semi-solids. Its a

classic razor/razor blade type of business,

with the pumps as the razor and the

related hoses and nozzles which tend to

wear out quickly as the blades.

Roughly 50% of total revenues come

from delivering replacement products to

its installed base.

The company is known for the high

quality of its products, for investing in

new-product development, and for stric

manufacturing cost control, all of which

helps produce excellent returns on equity

that are running north of 30%. Tota

operating margins are just above 20%

which most companies would die for, bu

which will improve at Graco when over

all economic conditions more fully recov

er. We also like very much that their non

U.S. business generates roughly half o

total sales.



Graco(NYSE: GGG)

Business: Global manufacturer of fluid-handling equipment used in a wide varietyof industrial, processing, construction andmaintenance applications.



Financials (TTM):

Revenue $693.1 millionOperating Profit Margin 20.1%Net Profit Margin 13.4%

THE BOTTOM LINE

Cyclical rebounds in car, truck and housing markets and secular growth in the usageof paint-spraying equipment should help drive EPS growth of more than 10% per year,says Steven Geist. Given the company's strengths, he says, we're likely to do verywell from here even if the multiple is a bit higher than a new buyer might like.


GGG PRICE HISTORY


50

40

30

20

102009 2010 2011


GGG S&P 500



Company % Owned

Mairs & Power 5.4%Select Equity Group 4.6%Vanguard Group 4.6%

Waddell & Reed 3.9%Franklin Resources 2.6%



50

40

30

20

10


17/21

So is the basic bet on recovering econom-

ic conditions?

SG: We see a few levers to the upside. The

Industrial business segment, which

accounts for around 55% of revenues,

serves original-equipment manufacturers

in markets, like cars and trucks, that fell

off a cliff in the downturn. As that pro-

duction ramps back up and, as Eric

mentioned, there are early signs of life

Graco will benefit.

The Contractor business unit, which

generates around 35% of sales and sells

things like paint sprayers to painters and

striping equipment for highways and

parking lots, has both cyclical and secular

upside. The decline in the housing market

has hurt both revenues and profits in thisbusiness, where operating margins are

running at roughly half the more typical

levels of 25% or more. No one is count-

ing on a imminent turnaround, but any

reasonably good news on housing would

clearly have a positive impact on the com-

panys results.

The secular trend working in Gracos

favor is increased usage of spraying

equipment by painters in international

markets. The U.S. has been well ahead of

the world in replacing brushes androllers, but that is changing over time as

penetration levels steadily increase in

both Europe and Asia.

With the shares trading at around $42,

isnt the valuation more than 20x con-

sensus 2011 EPS estimates a bit on the

high side?

SG: Yes, which youd expect to an extent

for a company coming off depressed earn-

ings. Our feeling is that over time therecovery and expansion of the revenue

base will drive annual growth rates in

earnings per share in the low double dig-

its. If we can own a market leader in good

industries, with a great balance sheet, high

returns on capital and that kind of long-

term profit growth, were likely to do very

well from here even if the multiple is a bit

higher than a new buyer might like.

Have you held this for a long time?

SG: In fact, we first bought shares in

1996 at a split-adjusted $4 per share. So

at todays price, before dividends, weve

earned a 16% annualized return.

Are any macroeconomic views particular-

ly influencing the makeup of your portfo-

lio today?

GH: One that is certainly not unique to

us and that weve been talking about for

some time is our expectation that the U.S.

dollar will weaken over time. That con-

tinues to result in our gravitating toward

businesses with significant geographic

diversification in their operations. Those

to-date have been listed almost exclusive-

ly in the U.S., but were making a concert-

ed effort to look at non-U.S. equity mar-kets as well.

SG: Were also quite aware of the debt

o

Date post:	08-Apr-2018
Category:	Documents
Upload:	david-tawil
View:	217 times
Download:	0 times

Jan Issue Vii Trial

Documents