Longleaf Partners Fund 1Q15 Management Discussion

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Longleaf Partners

Longleaf Partners Fund management discussion for the first quarter ended March 31, 2015.

Longleaf Partners Fund declined 1.09% in the first quarter, trailing the S&P 500 Index’s 0.95% gain. While the Partners Fund has lagged the Index in the recent periods shown below, the Fund’s longer term outperformance over 15, 20, and 25 years reflects other stretches of falling behind the index followed by bursts of strong relative returns.

During the quarter the majority of our businesses had solid operating performance, coupled with value-accretive actions taken by our management partners. Many names were positive performers. Despite positive progress across the portfolio, the persistence of two broad headwinds – falling energy prices and U.S. dollar strength – weighed on returns. Our energy-related holdings were the largest return detractors and erased what otherwise was benchmark outperformance. We had positive local returns in our three European holdings, but the currency translation into U.S. dollars negatively impacted absolute and relative performance by 1.6%.

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Longleaf Partners Fund – Positive contributor

The Longleaf Partners Fund’s largest positive contributor, CK Hutchison (formerly Cheung Kong), announced its intention to merge with subsidiary HutchisonWhampoa and spin out the combined property company. This latest savvy move by founder and CEO Li Ka-shing should lessen the holding company discount on the stock as underlying business exposures are clarified and the spin off highlights the value of the combined property business. The stock gained 22% during the quarter. An independent valuer recently appraised CK Hutchison’s property business 48% higher than stated book.(1) The company’s high profile dramatic restructuring of a blue chip Asia conglomerate has the potential to unleash similar restructurings in the region. Fiber and networking company Level 3 Communications appreciated 9% after another strong quarter of margin and revenue growth. The integration with recently merged tw telecom is proceeding smoothly as the transaction enhances Level 3’s competitive positioning with a complementary product set and larger footprint. Level 3’s growth in its North American enterprise business remains solid as CEO Jeff Storey and his team invest in expanding its fiber network and portfolio of connected buildings.

Longleaf Partners Fund – Largest detractor

The largest detractor in the quarter was Chesapeake Energy, one of the largest producers of natural gas, natural gas liquids, and oil in the U.S., which declined 27%. The company reported lower-thanexpected price realizations and production in the fourth quarter. While the company cut 2015 budgeted capital expenditures (capex) over 40% versus 2014, the market was hoping for Chesapeake to balance lower cash flow with capex. The company maintains a flexible balance sheet, with $4 billion in cash and an additional $4 billion in an undrawn credit facility, which will allow CEO Doug Lawler to focus on driving the greatest value for shareholders for the long-term, either through the authorized $1 billion repurchase program, strategic acquisitions, or a combination of both.While our appraisal of the company has come down in the short-term with the collapse of oil and gas prices, the long-term thesis remains intact. Chesapeake’s second largest shareholder, Carl Icahn, recently increased his stake in Chesapeake by 10%, and Chairman Archie Dunham bought an additional $14million at quarter-end. During the quarter wemaintained our overall exposure to Chesapeake but switched half our position into options due to favorable pricing created by the panic and resulting volatility in energy markets. We also employed this approach to increase our exposure toMurphy. We viewed this as a rare opportunity to gainmore downside protection whilemaintaining the upside benefit of higher stock prices. The Chesapeake options accounted for more than half of that position’s decline in the quarter.

CONSOL Energy was down 17% on weak natural gas and coal prices. During the quarter the company reduced its capex budget and grew production strongly. The company is uniquely positioned to navigate these prices with low cost reserves and plans to monetize non-core assets, including the thermal coal master limited partnership (MLP) in mid-2015 and the met coal initial public offering (IPO) in late 2015. CONSOL is one of our most discounted holdings, and CEO Nick Deluliis expressed his agreement with a significant share repurchase announcement.

Longleaf Partners Fund – Added Positions

We added two new positions in the first quarter. Weakness in the Macau (China) gaming market provided the opportunity to purchaseWynn Resorts at a substantial discount to our appraisal. Wynn owns some of the world’s prime real estate through luxury gaming and hotel operations in Las Vegas and Macau as well as a future location outside Boston, Massachusetts. Through its 72% ownership of Wynn Macau, Wynn controls a gaming and hotel complex on the Macau peninsula and is completing an additional project in nearby Cotai. The company’sWynn and Encore casinos are among the most profitable in Vegas, with a prime location on the Strip. Steve Wynn has been a successful owneroperator who has made money for shareholders over a long period. We bought Google as fears around a slowdown in the company’s dominant search and display advertising business became over-discounted in the market.

Longleaf Partners Fund – Sold positions

We sold three successful investments in the quarter. Abbott, a global healthcare company, reached our appraisal, resulting in a 120% return over our 4-year holding period. We are extremely appreciative of the value that CEO Miles White built for shareholders during our ownership. Travelers, a leader in property and casualty insurance, also reached our appraised value. We made a 144% return over our 4+ year holding period. Jay Fishman is among the best operators and capital allocators in the industry, and his record at growing book value, even in challenging periods, greatly rewarded the Partners Fund’s shareholders. We sold Mondelez as price converged with our value. The stock returned 45% since our late 2012 purchase when Kraft spun out the global snacking and food brands, including Nabisco, Cadbury, and Trident, and renamed the company Mondelez. Although emerging market sales weakened, CEO Irene Rosenfeld preserved value per share through margin improvements, share repurchases, and value-accretive moves such as placing the coffee business in a joint venture with DE Master Blenders. This was our third successful investment in Nabisco’s brands. Each time we were able to purchase this juggernaut at a readily ascertainable discount, directly or through a larger company. We hope for another opportunity down the road.

We believe the Fund is well positioned for strong future relative performance. The price-to-value (P/V) ratio is in the mid-70s%, with cash at 4% when adjusted for options. We believe the portfolio is invested in high quality businesses with greater FCF yields and stronger future growth potential than the S&P 500 Index. Our management partners are taking actions to drive strong value growth and, in many cases, are creating catalysts for value recognition.

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