Oak Value Comments on Purchases: Qualcomm and Vulcan Materials; and Sales: Activision Blizzard, Diageo, ITT Education, Medtronic, and Monsanto

Recent Purchases

Qualcomm – We initiated a position in Qualcomm during the quarter. Qualcomm is a pioneer and innovator in creating and enabling technologies for wireless communications. With over 10,000 patents and a leading market share, we view Qualcomm as a tollbooth on the expansion of wireless adoption and its increased technological capabilities around the globe. Though the lion’s share of the company’s revenues are derived from the manufacture and sale of chipsets for wireless devices, Qualcomm’s profits are disproportionately derived from the royalties and license revenues of its intellectual property portfolio.


The company’s original technology leadership position was based on code division multiple access technology (“CDMA”), a key communications standard used in wireless networks. Qualcomm has leveraged this CDMA expertise into the semiconductor market, where it is a key supplier of chips to wireless handset makers, and generates royalty revenue by licensing its intellectual property. CDMA is one of the two main wireless standards currently used by the telecommunications industry around the globe. Qualcomm has accomplished a veritable “lock” on CDMA standards and subsequently developed technology that enables them to advance not only CDMA but also GSM (the 2^nd technology standard). This expansion and adoption of 3G and 4G technologies for CDMA and GSM broadens the opportunity set for Qualcomm and significantly expands its worldwide addressable market opportunity.


Increasing needs for speed, efficiency, and bandwidth to deliver wireless voice, video, and data have converged to accelerate the adoption of these advanced technologies. In many markets around the world, the reach and efficiency of wireless communications is bypassing wired communications. Exponential growth in a number of emerging markets should represent significant opportunities for Qualcomm to deliver technology either directly through its manufactured chipsets or through the licensing of its technology. With a full spectrum of protected intellectual property, Qualcomm is capable of facilitating wireless communication in devices that are designed and priced to match the needs and resources of the end markets. In our opinion, Qualcomm’s ability to create devices that target the entire economic spectrum for their customers is a solid competitive advantage. The company has demonstrated its ability to provide technology for the explosive unit growth of entry-level products on one end of the spectrum and significantly advanced functional and technical capabilities on the other end of the spectrum. While high unit volumes in lower priced devices may appear to be a steepening of a declining price curve, the company’s focus on expansion of the overall market by increasing wireless adoption is at the core of its strategy.


The transition from 2G to 3G standards is one of the fastest growing wireless technologies adoptions in mature and emerging markets. Qualcomm’s 3G platform represents approximately 30% of the overall handset market and it is growing at an annual rate of 20-25%. We believe underpenetrated emerging markets such as China, India, and Brazil will extend Qualcomm’s growth cycle.


The royalty/licensing model is a highly profitable and extremely scalable revenue model that drives the types of structural and economic advantages that we seek. The licensing arrangements with handset makers allow the firm to collect approximately 3-4% of the total sales price of each handset unit sold. For Qualcomm, this model generates operating margins in excess of 80%. Given our view that the long-term secular growth rate for adoption of smart phones and wireless devices in general is quite high, we believe the future for Qualcomm is relatively predictable. The company also manufactures and sells chipsets to the producers of end-user devices. Though this business is far less profitable than the licensing business, it still produces operating margins in excess of 20%. Most companies would be ecstatic if their least profitable business still produced such operating results.


Our research of Qualcomm spans the better part of the last decade as we have followed the evolution of its business model and the end markets it serves. The company has achieved outstanding growth and profitability in recent years, but it experienced a near term setback last year because of the economic downturn. Sales have remained pressured this year somewhat due to softer pricing for handsets. Consequently, we believe there is a disconnect between the company’s long-term growth prospects and its current share price. While the decline in the average selling price for handsets has caused investor concern, we expect the continued strength in demand will more than compensate for this


decline. With nearly $19B of cash on hand, the strength of Qualcomm’s balance sheet is a testament to the cash generating power of its business. The company utilizes the cash for buybacks, dividends, and acquisitions. Qualcomm has bought back more than $12.9B of stock over the last 5 years and we expect these activities to continue in the future. Moreover, it spends more than $2B each year on research and development. In our view, Qualcomm possesses attractive competitive, structural and economic advantages and the company management clearly demonstrates an understanding of the significance of these advantages. After years of patiently watching and waiting, we were recently given the opportunity to buy shares of this company at an attractive valuation.


Vulcan Materials – Vulcan Materials is the largest aggregates producer in the U.S. Based in Birmingham, AL, the company produces construction aggregates, crushed stone, sand and gravel, asphalt, concrete and cement. Aggregates are essential to virtually all types of construction, including residential, commercial, and infrastructure but are especially important to highway construction. The company’s operational footprint is primarily in the regions of the country with the strongest prospects for long-term economic and population growth—the Southeast, the Southwest, and the Mid-Atlantic.


While volumes in the aggregates business are correlated to general economic and construction activity, the competitive and structural dynamics of the industry have historically supported an inflation-plus pricing environment. As the country’s largest aggregates provider, Vulcan has a diversified national footprint, with key representation in very large markets. Nearly half of the nation’s population growth in the next ten years is projected in Vulcan’s top five revenue states. With permitted and operating quarries in many of the country’s key growth markets, we believe Vulcan will benefit from high barriers to entry, above average growth opportunities and attractive economics as volumes stand to recover significantly in the years ahead. After years of analysis, we concluded that these longer-term competitive and structural dynamics supported our assessment of Vulcan as an advantaged business.


Because of the low value-to-weight ratio, the aggregates business is largely a local business. Most aggregates are consumed within a relatively small radius of where they are quarried. Markets that are accessible by rail or barge do provide some opportunity for cross-market competition, but this activity is somewhat limited by the availability of local aggregate supply and the relative cost of transportation. In most local markets, the aggregates business tends to function as an oligopoly with just a few, and in many cases only two, primary providers. Additionally, the aggregates quarry business is large, loud, and dirty. Permits to build new quarries have become increasingly difficult to obtain due to strict regulations and the “not in my back yard” view of many communities. Finally, pricing power for aggregates in the U.S. has tended to be sustainable over time, with no decline in any year since 1970. The number of aggregates operations in the U.S. has grown only 7% during the last 35 years while aggregates demand has increased by 80%. In past economic downturns, industry participants maintained pricing power even as shipment volumes fell.


Volumes for the industry and for Vulcan have declined significantly in the last couple of years while pricing has held up very well. Our outlook for Vulcan is constructive. The need for continued investment in the country’s transportation infrastructure has been widely publicized as a significant portion of the bridges and highways in the U.S. are overdue for resurfacing and/or replacement. We view this need as the foundation for our “base case” growth scenario for Vulcan. The current funding for the Highway Bill is the highest in history and sets a solid base of expectations for future aggregates demand. Additionally, much of the funding from the federal stimulus bill that was passed in 2009 will actually be spent in 2010 and 2011. Though Vulcan’s products are also used in residential and commercial construction, these activities are less aggregate-intensive than infrastructure and transportation construction projects.


We continue to monitor residential and commercial building activities, as they represent incremental demand for Vulcan’s products, but in our opinion, it is far too early to include a meaningful recovery of these volumes in future expectations for the company.


From a business model standpoint, Vulcan possesses certain characteristics that we have found in other resource or capacity rich holdings such as Republic Services (landfills) and Chesapeake Energy (shale gas reserves). Significant upfront capital commitment and regulatory requirements serve as significant barriers to entry for these businesses. Low marginal production costs support attractive operating margins and provide for significant operating leverage with modest unit volume increases. Vulcan is an efficient operator focused on producing cash operating earnings. The company’s balance sheet carries more debt than many of the Fund’s portfolio holdings, but this is primarily due to its purchase of Florida Rock in 2007. The Florida Rock acquisition was an important strategic move for the company, but the timing was less than ideal. We expect the retirement of debt to be a primary objective for the company in the coming years. Having waited and watched for several years, we initiated the Fund’s position in Vulcan during the quarter with the expectation that the company will continue to benefit from significant competitive and structural advantages and that these advantages will be apparent in the economics that will come with increased volumes.


Recent Sales


Activision Blizzard – We sold the Fund’s position in Activision Blizzard during the quarter to fund our purchase of Qualcomm. Both companies are technology related entities and very well positioned in their respective competitive landscape. Activision, like most of our portfolio companies, maintains an enviable balance sheet – which we believe provides them with ample resources to grow and expand their entertainment-oriented franchise in the future. While Activision remains, in our view, a very good company and one we may revisit at another time, we simply found Qualcomm to be a more compelling portfolio opportunity.


Diageo – Diageo is an advantaged business that generates significant free cash flow. The company has announced a strategic realignment to step up its investment in marketing and innovation in order to drive top line trends in their more mature markets. With the prospects of Europe remaining weaker for some time, we were faced with the reality that Diageo’s growth opportunities are likely to be somewhat muted for the next couple of years and that the costs of this realignment will weigh on the company’s profitability until it reaches scale and productivity. Diageo is an outstanding company and a leader in its industry. We will continue to monitor the company’s progress. Meanwhile, we believe the Fund portfolio will be better served with this capital allocated to other opportunities.


ITT Education – We eliminated the final remnants of the Fund’s position in ITT Education during the quarter as the regulatory scrutiny of the “for-profit” education companies continues to overshadow the entire industry. This pressure is particularly critical for ITT Education in that the potential requirements around gainful employment could have an adverse effect on the company’s profitability and growth prospects. We chose to manage the Fund’s exposure to this particular risk by eliminating the ITT Education position and maintaining the Apollo Education position, where we believe the potential implications of additional regulation will be less onerous.


Medtronic –Medtronic continues to demonstrate growth and profitability as an overall company – yet the mix of the business is still at least 1/3 represented by the Cardiac Rhythm Management (ICDs) segment. Medtronic continues to spend aggressively to develop new products. While we are confident that the company will successfully commercialize its R&D pipeline over time, we have concluded that the timeline for this realization has been extended. In searching for sources of funding to continue to build the Fund’s exposure to Teva Pharmaceutical, we eliminated the Medtronic position.


Monsanto – Our ownership of Monsanto was not nearly as long or as profitable as we expected when we initiated the position last fall. In summary, we were just too early in our pursuit of this company and underestimated the potential business shifts that were transpiring for Monsanto. Over the past year, a dramatic decline in Monsanto’s Round Up (glyphosate) gross profits punished their earnings and outlook. While we anticipated a re-set in this business and believed we had appropriately sized the exposure, the impact was far greater and more damaging to the company’s results than we expected. We continue to be attracted to the agrichemical industry and in particular to Monsanto’s leadership position in the development of genetically modified seeds. We will watch and monitor the company closely as they work through their current issues.