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Sequoia on the Case for Google

Google's value to users and advertisers, strong cash-flow generation, and current valuation are attractive, says Sequoia's David Poppe. Plus, Poppe outlines the case for newer fund holding Perrigo.

Mike Breen: You bought a stock, I believe in the last year, Google, which wouldn't fall into most typical value screens. It's a well-known company and actually not that expensive. Maybe you can talk about the small position you took in Google.

David Poppe: We are not technology investors, and so it is kind of out of the ordinary for us. It was a big leap into the unknown; but the more we looked at Google, we had some familiarity with the advertising business and marketing businesses, and the more we looked at it, the more it looked to us like a marketing business more than a technology business.

The search engine is extremely powerful. I think it's got about 65% market share. Microsoft has invested several billion dollars in Bing and not really been able to move Google's market share, so it looks like a defensible position to us. And it just creates an enormous amount of value, both, I think for the user, as somebody who does a Google search probably 30 times a day, but also for the advertiser.

It generates just enormous amounts of cash. We might be a little bit worried about how they'll allocate that capital over time; a lot of technology companies like to hold cash forever.

But it's extremely cash generative. The marketing benefit that it gives to buyers is very powerful, and it's not expensive. We looked at it, and it just did not seem expensive, particularly if you back out the cash--or give them any credit for the cash on the balance sheet--you start to get down to actually a pretty reasonable price for something that's still growing. You'll see people who are negative on Google; well it's only going to grow 15% from here.

Robert Goldfarb: Yeah, I think it was low-teens multiple, wasn't it…?

Poppe: It was low teens multiple…

Goldfarb: ...when you take out the cash. What's not to like?

Poppe: We looked at the huge amounts of cash and cash generation and the price, and it just seemed like this is something we need to work on.

Breen: There is a new holding that you added in the fall that I am not familiar with, I believe it's Perrigo.

Goldfarb: Perrigo.

Breen: Perrigo, just a small firm in the health-care space…

Poppe: Perrigo is really the dominant manufacturer of private label OTC drugs. So if you go buy aspirin or a cough syrup at Walgreens on the Walgreens brand, there is a good chance Perrigo made it, and we were really struck by the fact one, that their market share is so high. You would think that these would be commodity products, pretty easy to make. But there are a couple of things that are unique about it.

One, I think the packaging and the distribution is actually harder than the manufacturing. And they are very good at that--working with the retailer on packaging issues and marketing issues, part one. And part two, the fact is that the retailer doesn't make that much money on Tylenol, Bayer Aspirin or brand-name cough syrup, but they make a lot of money on the private-label product, and in this economy, we felt like the retailer's got a really strong incentive to promote private label; the consumer has got a really strong incentive to want to save some money by buying private label, and here is Perrigo with a huge market share in this business and should have some economic tailwinds behind it.

We like the management team. We like the fact that there are two or three or four pretty big drugs that can go private-label OTC in the future, like Omeprazole did when it went from being a prescription product to being an over-the-counter product, and you could make a private-label version of it. There are several more products like that coming out.

So we think they've got a good tailwind. In this kind of economy, we think the consumer benefits a lot from buying private label, and the retailers mostly like dealing with Perrigo and mostly earn a lot of money by dealing with Perrigo. So it seemed like a good fit.

Goldfarb: Yes, and what's unusual about Perrigo is that you would think that there would be a number two that would be fairly close, but there is not. In fact, I think the company that was number two went bankrupt.

So on each product they are not the sole source, but there is a competitor or more than one competitor. But they don't have the scale and the capabilities that Perrigo has, and when there is a conversion of a big product OTC, there might be seven new entrants, but Perrigo will get 70% or 75% share. So just vastly disproportionate to their [rivals].

Michael Breen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.