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Hartch: US Bancorp, Baxter Look Cheap

Ryan Leggio

Leggio: This high quality businesses that you prefer are probably the cheapest areas of the U.S. equity market right now, that these values are kind of hiding in plain sight and one holding that you have Microsoft trades at close to 10% free cash flow to enterprise value yield. Yes, there is not a lot of growth there, but there is a dividend and certainly there is some growth, any explanation why these fantastic businesses, which will do well in inflationary and deflationary environments are so attractively priced right now?

Timothy Hartch: I don't want to speculate too much for why the market values particular companies at a low multiple, but I just think it's a great opportunity. We're very pleased to have Microsoft in the portfolio, trading at as you say, close to 10% free cash flow yield. We have other companies in the portfolio– in the 29 businesses, a number of them, which are low teens free cash flow yields. So, Waste Management, Baxter, which we've added, Walgreen, which we had trimmed, when it went up and now it come all the way back to under 30, also trading at very high free cash flow yield.

So, I think it's instead of speculating on why exactly in the negative sentiment that maybe surrounded individual companies, I just see it as an opportunity for our shareholders to own great businesses over a long time that are trading with a real significant discount. And I think in the case of Microsoft, there is so much speculation and people worried about certain changes, but the fact of the matter is, its still a dominant company and they have a lot of great technology, and we think it's a business that will certainly sustain it's current level of free cash flow and probably, as you say, grow it over time.

Leggio: And one name you recently picked up Baxter, can you talk a little bit about what attracted you to the company, where valuations stands and why you think at current valuations you really can protect shareholder capital?

Hartch: Well, Baxter is a good fit with our criteria, its recognized I believe generally as a very high quality business, but when you look at our specific criteria that we tried it for selecting our 29 businesses. We try to invest in companies that provide essential product and service and have a loyal customer base, and Baxter is a good example of that. The products it provides to treat hemophilia, and immune deficiency, as well as products in the renal area like dialysis. Those are have to have products that the patients rely on every day.

So, it's a very good fit from a qualitative perspective, management is excellent. Dave has done a good job over many years in terms of building the business and that's what we like. We like to have a business that we can participate in the growth of the business over many years. So, qualitatively, it's a very good fit, very high-quality business.

And then from a discount to intrinsic value, which is what drives our downside protection, as well as the upside opportunity. Its trading today at a low teens free cash flow multiple, which we view is very attractive, and it's also when we do a discount on intrinsic value. We would value it somewhere between 60 and 80 probably close to 70, and currently we are able to buy it in the low 40s. So, I think it's a perfect example of one of the 29 companies that we want to own.

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Leggio: Another name you've been adding to which is a longer holding in the portfolio is U.S. Bancorp, very high-quality franchise along with Wells Fargo. They both get a significant amount of revenues from fee-based business rather than just the spread business that some of the other banks get. Can you talk about what attracted you to U.S. Bancorp, over say Wells Fargo? And then also, why you prefer, U.S. Bancorp over say a Citigroup or a Bank of America, which look a lot cheaper on normalized earnings multiple, but maybe are a little bit more difficult to value?

Hartch: U.S. Bancorp is currently the only bank we own, so it's only bank in the 29 companies. So, it's certainly the bank that we have the most confidence in, and it's a large position, close to a top 10 position. When we look at a bank, we think one of the key value drivers, for one, if you are going to own a bank over a long-term is having deposit driven franchise, and U.S. Bancorp is of the large banks, it's probably the best example of a deposit driven franchise that creates value, that's how – because you don't have to pay as much for deposits.

Also, we're in a regulatory environment, which is very rough. I think one of the reasons we were able to buy Baxter is because of the regulatory challenges in healthcare. Same is true in financial services, there is lots of uncertainty and people are worried about the regulatory change. I think that's particularly difficult for a company like Citibank, which is the capital markets and a lot of the regulations will be focused on businesses like that.

And its going to affect all banks, but in particular those large money center banks. U.S. Bancorp in contrast is sort of the model that the regulators would like to have for a large bank in the sense its deposit driven, it also has very good credit quality and has done a very good job in terms of generating capital, there is a good capital base and their ability to produce high-levels of capital over time.

So, from our perspective it may not be trading at the lowest multiple of normalized earnings, but I think it's the safest bank and it also has enormous upside, when you look at it today from evaluation perspective.

Leggio: One of the themes that's been here at this conference are the real troubles in Europe and really in the periphery is that either helpful or concerning to any of your large portfolio holdings in aggregate?

Hartch: A number of our businesses have operations in Europe. Some of – a lot of our companies get 50% or more of their revenue from outside the U.S. Recently, I know there has been people concerned in the healthcare sector, company like DENTSPLY, they get 60% of its revenues from outside the U.S. and has significant presence in a country like Germany, but a meaningful throughout Europe and people are worried about reimbursement pressures in those areas.

So, I think it's certainly something we are following, but there is also great opportunities in emerging markets at the same time. So, a company like DENTSPLY that's the leader in the dental space has a huge opportunity in both Asia and Latin America, as well as even in Eastern Europe. So, I think there is certainly challenges, but it's often what creates the opportunity from evaluation perspective to buy these good businesses.

Leggio: Great, Tim. Thanks so much for joining us today.

Hartch: Thank you.

Leggio: And thank you for joining us. From the Morningstar Investment Conference, this is Ryan Leggio.