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We’re also looking more closely at agricultural commodities. Historically, large global demand shocks for such commodities have resulted in permanent structural increases in prices, where old highs become new lows in the pricing cycle. We believe we’re going through such a demand shock now, driven by 500 million people in China and India alone seeing the type of increase in purchasing power over the last ten years that directly impacts the quality of food they eat. Because we don’t believe global supply will be able to keep up with the increased demand, the chances of that resulting in a structural price increase are high. It’s early yet to know how best to take advantage of all this, but it is an area we’re interested in. MM: We don’t expect commodities to just zoom off from here. We’re in a world in which there’s still a very large output gap, but in the past few months many commodity prices rallied 50% off their lows. We feel no need to chase that. You mention India and China, but don’t appear to have invested much in either place. Why? MM: One of the great challenges for value investors is to link the macro to the micro. We acknowledge that there’s a long-term pent-up consumption opportunity in those markets, but the share prices of individual, prudently run businesses would indicate that the path between today and tomorrow is more linear and more quickly fertile than we believe will be the case. AD: We do have indirect exposure to India and China through many of our companies, whether it’s a giant company like Nestlé or a smaller one like Essilor, the glass-lens company. That’s a much lower-risk and cheaper way to go. Chinese stocks, on average, trade at 40x earnings! Fixed income has always been part of what you do. How would you characterize the opportunities you see there today? June 30, 2009 AD: We don’t play in the most speculative parts of the high-yield market – where many people have been finding opportunity over the past six to nine months – so we’ve actually seen our fixed-income exposure decline. As stocks sold off and we could buy things like 3M [MMM] at a 5% dividend yield, we weren’t devoting much capital to high-yield bonds. If stock prices continue to run up and the highyield market stays around today’s level, that of course would change. ON BONDS: If we’re certain the equity value is positive, the bonds should be money good and we might want to take a look at them. Can you give an example of the type of debt opportunity you’re finding today? AD: Sometimes when we look at the equity of a company, we’re fairly certain the intrinsic value is more than zero, but there’s so much debt that we can’t narrow the value range down enough to invest. But if we’ve concluded the equity value is positive, that means the bonds should be money good and we should take a look at them as well. That process led us to invest earlier this year in the subordinated debt of Sealy, the mattress maker. We own the 8.25% subordinated debt maturing in 2014, which after a recent recapitalization has the earliest maturity among their debt issues. The housing-market collapse has been terrible news for bed manufacturers – we estimate roughly 10% of industry capacity has gone away through various business failures and cutbacks. The #2 in the industry, Simmons, is in serious trouble and is working to restructure its debt to keep operating. As the market leader, though, Sealy still generated around $50 million in free cash flow over the past 12 months, after paying $60 million in debt interest. www.valueinvestorinsight.com INVESTOR INSIGHT: First Eagle The bottom line is that we believe Sealy’s business is viable and will continue to earn more than enough free cash flow to support our debt payments. We also take comfort in having a roughly $180 million equity market cap cushion beneath us. So with what we think is almost no risk of default, we’re getting a nearly 13% yield to maturity at today’s price. We consider that a more than acceptable risk/return. Your global portfolio has always been highly diversified, with 200 or so positions. Is there any reason to expect that to change? MM: In broad strokes, we have 20% of our assets in cash or gold, our top 35 positions make up another 50%, and the rest is a diversified portfolio of “seed” positions that we increase or decrease based on share prices relative to the business fundamentals. It’s a formula that has worked well over time and I don’t see much reason to change it. Turning to specific ideas, describe one of your top Japanese holdings, Fanuc [6954:JP]. MM: Fanuc is a Warren Buffett-type high-quality company, a global leader in factory automation software and equipment. Roughly 60% of its revenues come from selling computer numeric control [CNC] systems that are central to multiaxis machining, a market in which they have around 60% global market share. The other 40% of revenues comes from robotics, where they’re also the global market leader. The two businesses work hand-in-hand for almost any precisionengineering application. As Japan grew as an industrial power, you saw a massive shift on the factory floor away from basic machinery to higher-end capital-goods machinery. That same shift is in the early stages in developing markets like China and India, creating a tremendous opportunity for Fanuc, which owns important intellectual property required for the next-generation factory floor. Value Investor Insight 4
Is patience a key with this investment? MM: As a capital-goods provider in the worst recession in the post-war period, the company is not going to have anything impressive in the way of earnings power over the next 12 months. But if you take a longer-term perspective, through previous cycles Fanuc has generated mid-30% EBIT margins, which given the strength of its market positions we fully expect to return. We don’t have to get the timing of the recovery absolutely right because there are no financial contingencies – approximately one-third of the company’s market cap is in net cash. How cheap are the shares, trading now at just under ¥7,800? INVESTMENT SNAPSHOT Fanuc (Tokyo: 6954:JP) Business: Global manufacturer of factory automation systems and equipment, including computerized numerically controlled equipment, servo motors and robotics. Share Information (@6/30/09, Exchange Rate: $1 = ¥95.915): Price ¥7,760 52-Week Range ¥4,800 – ¥10,800 Dividend Yield 1.8% Market Cap ¥1.86 trillion FANUC HISTORY 15000 12000 9000 6000 3000 June 30, 2009 MM: Stripping out the cash, you’re paying around ¥5,000 per share for the operating business, which has generated in the best times more than ¥600 in earnings per share. If you normalize that to ¥450-500 per share, you’re only paying 10-11x EPS. On normalized EBIT, the multiple is around 7x. That’s a very conservative price to pay for a business with dominant market share and excellent growth prospects, which in more normal times could be expected to trade at closer to 15x EBIT. There’s a need for this technology over time, evidenced by the fact that each successive peak in Fanuc’s earnings power over the last few cycles has been substantially higher than the prior one. There’s no reason this business can’t earn ¥1,000 per share at some point. THE BOTTOM LINE The market’s short-term focus is undervaluing the company’s potential to translate leading market positions and key intellectual property into strong profit growth as the global economy mends, says Matt McLennan. At a reasonable multiple of 15x his estimate of the company’s normalized EBIT, the shares would be worth twice their current value. Sources: Company reports, other publicly available information Financials (FY2008) Revenue ¥468.40 billion Operating Profit Margin 40.5% Net Profit Margin 27.1% Valuation Metrics (Current Price vs. TTM): FANUC S&P 500 P/E 16.6 35.4 2007 2008 2009 www.valueinvestorinsight.com 15000 12000 9000 6000 3000 INVESTOR INSIGHT: First Eagle If we were growth investors, we’d be out there looking at the penetration of CNC systems in China ten years out and then trying to figure out how much Fanuc would benefit from that. We don’t have to make those types of precise forecasts – the stock is currently cheap based on what they’ve already demonstrated they can do. How would you characterize management’s concern for shareholders? MM: On the surface, Fanuc seems like the prototypical company that people rightly complain about: too much cash on the balance sheet, no external directors, not much interaction with the Street. On the other hand, though, you have an extremely experienced management team that has built a very strong culture and that takes a generational view in how they do things. The mission is for the company to live forever, but at the same time they’ve shown a clear ability to produce high cash flow through the cycle. If we can buy into a company like that at the right price, that’s very appealing to us. Staying in Japan, explain your interest in pharmaceutical company Astellas [4503:JP]. MM: Astellas isn’t one of the betterknown global pharmaceutical companies – it is the product of a merger five years ago between Yamanouchi Pharmaceutical and Fujisawa Healthcare – but it generates nearly ¥1 trillion in annual revenue [approximately $10 billion] from a portfolio of 18 drugs, with particular strength in immunology and urology. It has the largest salesforce in Japan, distributing drugs there for others, including Lipitor for Pfizer. The company also has a large newproduct pipeline, with 18 molecules that are in either Phase 2 or Phase 3 testing. Roughly half of the pipeline drugs are focused on areas in which the company already has a large presence, but the rest target new areas like diabetes and cardiovascular treatment. Value Investor Insight 5
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