Pershing Square Annual Report: Chipotle, Herbalife, Valeant, et al.

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Pershing Square Holdings 2016 Annual Report, March 28, 2017

Chipotle (CMG)

  • On 9/6/16, announced a 9.9% stake in CMG which was purchased at an average of $405 per share
  • Company has been significantly negatively impacted by food safety issues beginning in the fourth quarter of 2015 which caused a peak decline in average unit sales of 36%
    • While traffic and sales have begun to recover, average unit volumes were still 19% below peak levels as of 4Q16
  • Reputation has been bruised but think that with the passage of time and improved operations, marketing, technology, and governance initiatives, the business will not only recover but become stronger
  • Limited global macroeconomic sensitivity and foreign currency exposure, simple business model with limited non-GAAP earnings adjustments, high effective tax rate of nearly 40% (beneficiary in the event of US corporate tax reform), and unlevered balance sheet with strong net cash position
  • Key drivers of CMG’s powerful economic moat and long-term success:
    • Strong and relevant brand built by visionary leadership
    • Differentiated product offering with a highly attractive value proposition
    • Substantial scale in the fast casual industry and first-mover advantage in real estate
    • Strong unit economics and extremely high returns on capital, driven by a well-honed model that facilitates best-in-class throughput
    • Enormous growth opportunities including new units and operating enhancements such as mobile ordering and catering
  • Strong brand:
    • Brand developed by founder Steve Ells with the philosophy that food served fast does not have to be a traditional “fast-food” experience
    • Company grew from one restaurant to more than 2,200 relying primarily on customer word of mouth, supplemented by non-traditional marketing techniques including digital and social media, owned content, and local events
  • Differentiated product offering:
    • As part of our research, compared CMG’s customer value proposition to those of fast casual, quick service, and casual dining competitors across 6 metrics: food quality, taste, in-store experience, customization ability, speed, and value
    • Superlative quality, engages customers, allows exact customization, facilitates the fastest throughput, product price point offers value
    • Other concepts can successfully compete on one or more of these attributes but few are able to replicate the Chipotle offering at comparable price points at scale
  • Enormous growth opportunity:
    • Average unit volumes ~$2.5 million, among the highest in the industry despite only serving two day-parts and limited store hours (i.e. 11 hrs vs. as much as 24 hrs)
    • Initiatives such as mobile and digital ordering as well as catering will drive an accelerated rate of same-store sales growth for the foreseeable future, incremental to the impact of recovering lost customers
    • Returns on capital for new units remain compelling even at today’s lower sales level; management believes US can ultimately support more than double the current store base
  • Food safety:
    • Company has done an excellent job of reducing the risk of another incident while maintaining the quality and taste
  • Management and Board developments:
    • On 12/12/16, CMG named Steve Ells sole CEO concurrent with resignation of former co-CEO Monty Moran
    • Announced a renewed focus on delivering excellent guest experience and removing unnecessary complexity from restaurant operations
    • On 12/16/16, announced a board refresh in which 4 new directors were named including Pershing Square partner and investment team member, Ali Namvar, and Pershing Square advisory board member and former McDonald’s CFO Matthew Paull
    • On 3/17/17, company announced that four incumbent directors will not stand for election at the upcoming annual meeting; new board will have 8 members including the 4 recent appointees

Herbalife (HLF) Short

  • On 7/15/16, FTC filed a Complaint against HLF and simultaneously entered into a Stipulation to Entry of Order for Permanent Injunction and Monetary Judgment; select assertions by the FTC include that:
    • HLF does not offer participants a viable retail-based business opportunity
    • HLF’s business model primarily compensated members for recruiting new distributors to purchase product, not for selling product at retail
    • Participants’ wholesale purchases from HLF are primarily a payment to participate in a business opportunity that rewards recruiting at the expense of retail sales
    • Overwhelmingly majority of distributors who attempt to retail the product make little or no net income, or even lose money, from retailing the product
  • In November 2016, HLF announced that Michael Johnson will transition to Executive Chairman at which point Rich Goudis, the current COO, will take over as CEO
  • Believe John Oliver’s Last Week Tonight segment on multi-level marketing with a focus on HLF and recent theatrical release of “Betting on Zero” will continue to shape public narrative and highlight the tremendous harm HLF has and continues to inflict upon millions of Americans
  • Operating results in 2016 were disappointing to long investors as mid-single-digit topline organic growth was negatively impacted by significant FX headwinds causing sales to be relatively unchanged versus 2015; organic growth decelerated across most regions (China, notably, posted a 6% organic decline in Q4)
    • Management guided to 4-7% 2017 constant currency revenue growth and currency neutral EPS growth of -13% to -5%
  • In February 2017, HLF disclosed a new investigation by the SEC and Department of Justice related to anti-corruption compliance in China (China is 19% of revenue)
  • Pyramid schemes are confidence games – newly disclosed SEC/DOJ corruption probe, CEO departure, declining earnings, deteriorating popular perception of Herbalife will likely impair distributor confidence
  • Remain short Herbalife because we believe its intrinsic value is meaningfully below the current share price and believe the stock should eventually decline to zero

Why We Sold Valeant

  • At the time of sale, VRX position represented 3% of the portfolio; if the stock price increased even very substantially, impact on overall performance would have been modest and would not compensate for the HR and substantial mindshare that this investment had and would have continued to consume if we had remained a shareholder
  • Valeant has made significant progress and we expect management to continue to do so but there is still a lot of work to be done
  • Clearly, our investment in Valeant was a huge mistake
  • Highly acquisitive nature of VRX required flawless capital allocation and operational execution and therefore, a larger than normal degree of reliance on management; we misjudged the prior management team
  • Few important reminders from this experience:
    • Management’s historic ability to deploy capital in acquisitions and earn high rates of return is not a sufficiently durable asset that one can assign material value in assessing the intrinsic value of a business
    • Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control and the existence of these factors is a highly important consideration in position sizing
    • A management team with a superb long-term investment record is still capable of making significant mistakes
    • A large stock price decline can destroy substantial amounts of intrinsic value due to its effects on morale, retention and recruitment, and the perception and reputation of a company

Air Products and Chemicals (APD)

  • Continued to make progress on its transformation under Seifi Ghasemi as its CEO
  • Operating margins improved, increasing 400 bps to 23.1% in 2016; this improvement drove a 14% increase in EPS, exceeding the high end of guidance despite 3% FX headwinds
  • APD executed spinoff and sale transactions for its non-core electronic materials and performance materials businesses
    • Company now has minimal net debt with cash on hand and leverage capacity totaling ~$5B
    • Expect management to invest this capital wisely for core industrial gas assets
  • In January, issued 1Q17 results, which showed 9% growth in EPS; announcement included a reduction in fiscal year 2017 guidance by $0.25 ($0.05 of this is related to core industrial gases business with remainder driven by spin-related accounting adjustments, FX movements, and lower sales of equipment)
  • Investment thesis is not predicated on improvements in economic growth but any improvements in growth should improve organic volume and pricing trends in its merchant business
  • Believe the upside in APD remains significant – extremely high-quality, reasonably priced and run by outstanding management

Fannie Mae (FNMA) / Freddie Mac (FMCC)

  • Fannie and Freddie have historically been, and continue to be, essential in allowing for widespread access to the 30-year fixed rate mortgage at a reasonable cost
  • The new administration has the willingness and ability to make the necessary changes to Fannie and Freddie’s business model to preserve widespread access to 30-year-fixed-rate mortgage
    • Steve Mnuchin, a mortgage market expert, made public comments that highlight his desire to reform Fannie and Freddie
  • 2016 shareholder returns were 138% and 131% respectively; in the first two months of 2017, share prices have declined nearly 25% after a ruling in the appellate court upheld most of the original rulings of the DC District Court in September 2014
    • We think the market overreacted to the recent ruling
  • Believe Fannie and Freddie offer a compelling risk-reward as there are various scenarios which will generate a many-fold multiple from current levels
  • Total loss is possible but believe the probability is relatively modest and has become lower in the new political environment

The Howard Hughes Corporation (HHC)

  • Despite a more than three-fold increase over the last six years, remains undervalued in our view
  • Continued to make meaningful progress in 2016 to enhance the value of its key assets
    • In its operating asset segment, net operating income grew to $135 million or $156 million annualizing Q4 NOI, from $118 million in 2015
    • Management increased its projected stabilized 2020 NOI to $232 million from $219 million
  • While share price performance has been impressive since spin-off, price has been flat in the last three years
    • HHC story and value proposition is complicated by the vast development potential that cannot be estimated by simply applying a multiple to existing cash flows
    • HHC recently started conducting quarterly earning conference calls and taking a more proactive approach to investor and analyst outreach

Mondelez International (MDLZ)

  • Despite owning some of the best brands in the industry, has among the lowest profit margins in large cap packaged food, presenting a meaningful opportunity to increase efficiency that management is currently addressing
  • Made good progress:
    • Operating profit margins expanded by 220 bps to 15.3%
    • Remains committed to its 2018 margins of 17-18%
  • While consolidation in packaged foods could represent an opportunity for MDLZ, believe the business is an attractive investment assuming no contribution from M&A

Nomad Foods (NOMD)

  • Recent results have been disappointing as revenue trends have been weak
    • Management team believes this has been caused by legacy strategic decisions to focus on new product development at the expense of company’s core offerings
    • Redirected resources behind company’s core offerings
    • Initial results have been encouraging
  • While top-line trends are improving, management team continues to control and reduce costs while extracting synergies from its Findus acquisition
  • Stock currently trades at 9.5x FCF guidance, a valuation we find attractive

Platform Specialty Products Corporation (PAH)

  • Solidified its core leadership team including CEO and Ag President
  • Returned to positive organic growth despite continued softness in its end markets, delivered on synergies, and improved capital structure through an equity issuance and debt refinancing
  • Despite positive progress, share price declined 23.5% in 2016; in the first two months of 2017, appreciated 34%, more than offsetting the decline in 2016

Restaurant Brands International (QSR)

  • Company’s controlling shareholder 3G installed an excellent management team and created a unique and impactful performance culture, compensation system, and business process
  • Highly scalable and replicable operating strategy can be applied to potential future acquisition opportunities
  • In 2016, 16% organic EBITDA growth and 45% EPS growth
  • In February 2017, announced the acquisition of Popeyes Louisiana Kitchen – believe QSR will be able to improve cost structure and accelerate growth in new units

Exited Canadian Pacific Railway (CP)

  • Sold remaining shares in 2016 after approximately 5 years from inception of the investment
  • During the hold period, price increased 4x, operating performance went from worst to nearly tied with first with Canadian National, and credit rating improved from Baa-/BBB- to a strong Baa+/BBB+
  • Total return including dividends was 318.9%

Exited Zoetis (ZTS)

  • Sold remaining shares in 2016 about two years after announcing ownership stake
  • Despite the high quality business, sold to redeploy the capital in certain new investments
  • Over the course of our ownership, ZTS developed and implemented value-enhancing initiatives including restructuring its supply chain, pursuing organic growth opportunities while reducing costs, and setting a goal of increasing margins from 25% to 34% – ZTS outperformed each of these objectives during our ownership
  • Total return including dividends of 57.9%

Pershing Square Capital Management is an activist hedge fund founded by Bill Ackman in 2004. 

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