Longleaf Partners Fund Management Discussion

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Also see Longleaf Partners Funds 2014 Letter: 2014 Reminiscent of the late 1990s

Longleaf Partners Fund finished the year up 4.92% after a 1.46% gain in the fourth quarter. These results fell below the S&P 500’s returns of 13.69% and 4.93% for the same periods. During the first half of the year, the Fund kept pace with the Index despite having a greater than 20% cash balance. In the second half of 2014, the Fund lagged the S&P 500’s advance largely due to our energy-related holdings, which were leading contributors in the first half but sold off with the sharp decline in oil prices. We are disappointed in the recent performance, but remain confident in the quality of our businesses and management partners in the portfolio. For the last five years, Longleaf Partners Fund exceeded our annual absolute return goal of inflation plus 10%, despite falling short of the Index. Over longer term periods of 15+ years shown below, the Fund surpassed the Index.

Longleaf Partners: Level 3 Communications

Fiber and networking company Level 3 Communications gained 49% and led the Fund’s performance for the year and the fourth quarter, up 8%. Level 3 provides critical infrastructure that connects businesses and consumers to the internet, allowing them to move voice, video and data. The company’s acquisition of tw telecom closed in the fourth quarter, significantly expanding its network reach in metropolitan markets and providing additional capacity to grow its enterprise customer base. Throughout the year, CEO Jeff Storey and his team delivered solid revenue growth, margin improvement, and higher free cash flow. The stock remains well below our value of its operating networks and non-earning dark fiber and conduit assets and is the Fund’s largest holding.

Longleaf Partners: FedEx

FedEx rose 22% for the year and 28% in the fourth quarter. The company expanded operating margins in its Express, Ground and Freight segments over the year and executed on profit improvement initiatives. EPS (earnings per share) grew as did our appraisal. The company repurchased close to 10% of its shares. FedEx moved to further entrench itself in Ground delivery through expansion capex and the acquisition of Genco, which handles reverse logistics for retailer returns. FedEx expects to benefit over the next year from a healthy U.S. economy and lower fuel prices, which improve the relative cost of faster delivery via planes at a premium versus slower shipping via boats.

Longleaf Partners: Berkshire Hathaway

Berkshire Hathaway appreciated 28% for the year after its fourth quarter gain of 10%. The company’s underlying operating businesses performed well. In insurance, GEICO revenues grew 10% driven 2/3 by units and 1/3 by pricing. Reinsurance endured no major catastrophes and some positive currency impact. BNSF grew 4% with gains in both volume and pricing. In the fourth quarter, Berkshire announced the acquisition of Duracell from Proctor & Gamble in a tax efficient exchange for appreciated Berkshire stock. The stock reached our appraisal, and we sold it. Berkshire rarely sells at enough of a discount to meet our criteria given its quality businesses and management, but we were able to purchase it for the second time in our history in 2012. The stock returned over 89% in our two year holding period.

Longleaf Partners: Cheung Kong

Hong Kong based conglomerate Cheung Kong gained 15% in the year. Over the course of 2014, results at most of the company’s operating divisions were strong. Additionally, management made several value-enhancing asset sales across multiple business lines at low cap rates and used proceeds to opportunistically reinvest in discounted infrastructure deals outside of Asia with double-digit IRRs (internal rates of return). Management also returned proceeds to shareholders in the form of dividends. Most recently, in a joint venture with Mitsubishi Corp, Cheung Kong bought an airplane leasing portfolio. With its strong balance sheet, Cheung Kong can take advantage of Hong Kong land banking opportunities if prices correct.

Longleaf Partners: Aon

For Aon, the world’s largest insurance broker and a leading benefits manager, increasing cash flow and healthy share repurchases helped our position gain 8% in the fourth quarter and 14% for the year. Aon’s private health care exchange business increased its scale, adding more than a dozen clients and aggressively growing the market. The company, led by CEO Greg Case, used $1.8 billion to repurchase almost 7% of shares in the first nine months of 2014, the highest amount since 2008. Aon authorized an additional repurchase plan of up to $6.1 billion, roughly 24% of outstanding shares.

Longleaf Partners: Performance detractors

Four of the five primary performance detractors for the year were energy-related businesses that sold off with the 49% decline in oil in the second half. Our investments do not reflect any special affinity for oil and gas. We own a select combination of companies – Chesapeake, Murphy Oil, CONSOL Energy, and Diamond Offshore via Loews – because we feel they have the asset bases, financial ability, and disciplined managements to reinvest in production at returns well above their costs of capital. Our management partners are controlling costs and making value additive divestitures. Our conservative appraisals use the lower of the marginal cost of production or the futures strip to price oil and gas. Because the strip has fallen below the marginal cost, we lowered our assumptions, but our adjustments were much smaller than the stock price declines. Over the next few years supply and demand should recalibrate and cause commodity prices to settle near the cost of production. The timing is unknown, but the upside from the current strip pricing combined with the proactive work of our CEO partners presents a compelling opportunity for long-term investors.

Chesapeake declined 21% for the full year and 14% in the fourth quarter. Since Chesapeake’s heavily vested Board took over in mid-2012, the company has delivered the balance sheet and improved production from its irreplaceable 12 +million net acres of oil and gas fields. CEO Doug Lawler is driving value recognition in ways he can control – selling assets at reasonable prices, reducing debt, and increasing operating efficiencies in both corporate and production activity. In the first half of the year, Chesapeake sold non-core acreage in Oklahoma, Texas, and Pennsylvania and spun-off its oilfield services business into Seventy-Seven Energy, which we sold. In the fourth quarter, Chesapeake closed the sale of Marcellus and Utica assets to Southwestern Energy for $5 billion. This amounted to roughly 8% of Chesapeake’s production for nearly half its market cap. Management announced plans to use $1 billion of the proceeds to repurchase the heavily discounted shares.

Despite being up 1% in the fourth quarter, Loews, the holding company owned and managed by the Tisch family, sold off with energy and was down 12% for the year. The company’s CNA insurance unit generated strong cash flow, but its stakes in energy companies Diamond Offshore (DO) and Boardwalk Pipelines Partners (BWP) declined 30% and 29% respectively. DO has the strongest balance sheet among drilling rig operators and should be able to upgrade its fleet cheaply as distressed sellers seek capital. BWP cut its dividend to invest in additional service points along its pipeline and expand its ability to transport gas from the northeastern U.S. Loews repurchased shares amounting to approximately 3.5% of the company and has substantial liquidity to take advantage of undervalued opportunities including additional shares.

Murphy was down 20% in the year after an 11% decline in the fourth quarter. CEO Roger Jenkins took actions to recognize value including selling a 30% stake in Malaysian assets at a price above our appraisal. Murphy also bought back shares in 2014 and has authorization for more. The sharp decline in oil prices most heavily affected Murphy’s ownership in Syncrude’s Canadian oil sands, which represented less than 15% of our appraisal before oil’s drop and less today.

CONSOL Energy dropped 11% in the fourth quarter and for the year in full. CONSOL’s management team took productive action to increase shareholder value despite a difficult coal and gas environment. In the second half of the year, Chairman Brett Harvey and CEO Nick Deluliis completed an IPO (initial public offering) for a midstream MLP (master limited partnership) at metrics above our appraisal. CONSOL most recently announced it would form an MLP to house its thermal coal business and form a subsidiary to own its metallurgical coal properties. These transactions should bring the value of its coal assets forward, improve the transparency into the value of these assets, and provide additional vehicles to access capital markets, while allowing the company to control the assets and realize synergies across its businesses. In addition, CONSOL authorized a share repurchase program for up to approximately 3.6% of the company.

Philips fell 18% in the year and 8% in the fourth quarter. The company faced a number of short-term challenges including a one-time pension payment, a temporary suspension of production at its Cleveland, OH-based medical imaging plant, slower emerging market demand, and foreign exchange headwinds. Currency translation from euros into U.S. dollars accounted for approximately half of the price decline. The stock price does not reflect the ongoing transformation of the company under CEO Frans Van Houten who has substantially improved operating margins and focused the company over his 3+ year tenure. Philips’ discounted share price provided management the opportunity to execute another massive €1.5 billion share repurchase. In 2014 Philips announced plans to sell or spin off its Lumiled and auto lighting businesses and to split into two companies: Lighting Solutions and HealthTech, which will be comprised of the current Healthcare and Consumer Lifestyle businesses. We applaud the split. The “conglomerate discount” should disappear as each business stands on its own and is easier to compare to more pure-play peers that trade at higher multiples. Separate reporting will commence in January 2015, and the split is expected to happen by 2016.

Longleaf Partners: New Positions

We initiated five new positions, all in the second half of the year. We bought Franklin Resources, McDonald’s, Scripps Networks, and Vivendi in the third quarter. In the fourth quarter, we bought agricultural equipment and commercial truck company CNH Industrial as weak U.S. corn and soybean prices weighed on farming-related companies. Our four exits each approached our appraisal values, including DirectTV and Vulcan Materials in the first quarter. As mentioned above, we sold Seventy-Seven Energy when it was spun out of Chesapeake and Berkshire Hathaway when it reached our appraisal.

The Fund started 2014 with 22% cash and ended the year with 13%. Helped by our new names, the price-to-value ratio (P/V) improved to the high-70s%. Our on-deck list of qualified new names remains challenged with deep discounts proving elusive. We continue to see more compelling opportunities outside of the U.S. where more economic uncertainty and weaker currencies are weighing on stocks. Our foreign-domiciled holdings are 25% of the portfolio with a maximum limit of 30%.

As the Fund’s largest shareholders, we are not pleased with our 2014 performance or the impact it had on longer periods. The return, however, does not adequately reflect the underlying progress our companies made during the year. We are confident that our portfolio of high quality, industry-leading companies and our management partners who are taking action to build shareholder value will reward our long-term partners.

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