Vallourec (VLOUF) is a vertically integrated producer of branded premium seamless steel pipes and connections that have a variety of industrial purposes, the most important of which is for use in drilling for oil & gas, an application where the use of a strong, reliable pipe is critical. Although the company is headquartered and listed in France, it is truly a global enterprise with more than 70% of revenue generated outside of Europe. Revenue from oil and gas operations accounted for 61% of its total revenue in the last quarter. Vallourec's oil & gas segment sells seamless steel pipes and connections primarily for use in unconventional oil & gas plays in the U.S., as well as in deepwater projects throughout the world. These types of wells use considerably more seamless pipes and connections than traditional wells. More importantly, as new sources of oil and gas are in more difficult to drill locations, like deepwater offshore and unconventional shale, there is growth in demand for Vallourec's capabilities. For example, in 1990, deepwater offshore drilling was zero percent of global oil production. Today deepwater drilling produces roughly 5.5 million barrels of oil per day, and is projected to produce roughly 9 million barrels per day by 2020. Also, unconventional gas (shale) has grown rapidly in recent years, and today represents 23% of annual U.S. gas production. Vallourec has been in business for 100 years, and has a limited number of competitors in this niche business of high quality seamless pipes and connections. These products are designed to withstand the extreme temperature, pressure, and other factors related to more complex oil & gas drilling conditions and are protected by a multitude of patents and technical know-how. Vallourec's customers are keenly aware of the environmental risks and safety requirements for drilling, particularly offshore, and thus have a preference for high quality pipes and connections. The cost of these pipes and connections relative to the overall price to drill a well is very low. The price of the pipes provided by Vallourec is 5% to 10% of the total cost of an oilgas well, so there is little to be gained by switching to a cheaper pipe, but a lot to lose. Given the potential for catastrophic environmental disasters (and significant fines), it would not be rational for a drilling customer to scrimp on price for this most important, yet relatively inexpensive component of his or her well.

Facing higher costs in Europe, and with the potential to lower its production costs abroad, Vallourec recently embarked on a major expansion of its production facilities, adding new capacity in the U.S. and in Brazil. These facilities will allow Vallourec to produce its products locally, instead of producing and exporting from Europe. In May 2012, Vallourec's management made a number of announcements, including delays in qualification for the Brazilian plant and higher than expected capital expenditures to bring the U.S. plant on line. The stock sold off significantly and reached what we thought were quite attractive levels over the next month, eventually bottoming near two-thirds of book value. This caught our interest. We began building a position in our Funds in Vallourec at around 28 to 29 Euros per share in late June. At this price, we felt we were paying roughly 69% of the company's stated book value, 82% of tangible book value, and two-thirds of a conservative estimate of the company's intrinsic value. Given the rather concentrated nature of the seamless pipe industry, there were not a lot of comparable M&A deals to examine. However, in 2007, Tenaris, one of Vallourec's major competitors, acquired Hydril, a leading North American manufacturer of premium connections and pressure control products for 15 x EBIT. Consistent with our conservative appraisal policies, we used a lower multiple of 10 x 2013 EBIT to value Vallourec, and purchased shares at approximately two-thirds of that value.

Despite the delays in qualification and the higher than expected capital expenditures, we believe that both projects will ultimately be successful, particularly given the favorable outlook for unconventional shale plays and deepwater. Our evaluation of the business, specifically the connections business, leads us to believe that Vallourec's intrinsic value is greater than its stated book value. Although in the short term the company's legacy exposure to European manufacturing could weigh on the stock, we believe the long term prospects for Vallourec's oil & gas business are quite strong. It has a solid balance sheet with very little debt, which should allow it to weather near term disappointments that may arise. For investors such as ourselves, who are willing to look further out on the investment horizon for our returns, we felt we were being presented with an unusual pricing opportunity.

From Tweedy Browne's Investment Advisor's Letter and Semi-Annual Report.

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