Bill Ackman’s 2Q17 Letter – ADP, Chipotle, Fannie & Freddie, Herbalife Short, Hilton Exit

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Pershing Square Interim Financial Report (Six Months Ended 6/30/17), August 17, 2017

  • 6/30/17 YTD returns of -2.3% vs. S&P 500 9.3%

Automatic Data Processing (ADP) – New Investment

  • Classic Pershing Square investment – simple, predictable, FCF generative business that has underperformed its potential
  • As a conservatively financed, capital-light business with long-term customer relationships in a sector with positive growth, believe it has modest downside
  • Believe that ADP is one of the highest quality businesses we have owned and one which offers an enormous opportunity for operational improvement
  • It has been 5 years since the inception of our investment in Canadian Pacific, where we had to wage a proxy contest to obtain board seats in a long-term activist portfolio holding
    • As in CP, we approached ADP and offered to share privately our due diligence and analysis with the board to see if we could work together to unlock value for all shareholders
    • Learned from experience that often the greatest opportunities for profit exist at companies that are the most resistant to and threated by change
  • Now appears that the board is willing to engage – has recently asked to interview our board candidates and offered to meet with us on 9/5/17

Chipotle Mexican Grill (CMG) – Portfolio Update

  • Made significant progress in improving its business and driving a sales recovery since early 2016
  • Suffered a setback in mid-July in the form of a norovirus incident at a single restaurant in VA
    • Norovirus is a common and highly contagious illness affecting nearly 20 million Americans each year and is unrelated to Chipotle’s food supply chain
    • Incident in Virginia was the result of a failure in one restaurant to comply with procedures used to minimize the risk of a norovirus outbreak
  • Despite the setback, Chipotle has taken a number of significant steps since Pershing Square’s initial investment
    • Dismantling of the co-CEO structure and the appointment of Steve Ells as sole CEO
    • Major board refresh that reconstituted half of the current board with new directors
    • Renewed focus on simplifying operations and delivering an excellent guest experience which has led to improvements in key performance metrics
    • Strengthening of the leadership team with additions of a proven restaurant operations executive from Arby’s and a seasoned communications executive with over 20 years of public affairs experience at Yum! Brands
    • Opening of the Chipotle NEXT Kitchen to explore the operational impact of potential menu innovation
  • Made our investment in Chipotle anticipating that the sales recovery would be neither smooth nor predictable but with a belief that the key drivers of Chipotle’s powerful economic moat and long-term success would remain intact
  • Continue to believe there is an enormous long-term growth opportunity for Chipotle given: 1) significant potential to drive sales per restaurant higher through mobile and digital ordering, menu innovation, catering, and improved operations; 2) opportunity to expand its vastly underpenetrated restaurant base in the US; and 3) considerable potential to build the brand internationally

Fannie Mae (FNMA) / Freddie Mac (FMCC) – Portfolio Update

  • Both stocks have fallen ~30% YTD, trading modestly above our average purchase prices of nearly 4 years ago despite substantial increases in intrinsic value since that time
  • Believe consensus view in Congress and the White house is that the 30-year prepayable fixed rate mortgage, which is the bedrock of middle-class housing values and affordability, is essential for the economy and the American people, and would not exist without Fannie and Freddie
  • Growing consensus that US government must play a role as a catastrophic guarantor for the housing financing system and that the private sector should pay a market-based fee for that support
  • Government would like the private sector to invest a large amount of capital in a first loss position to protect the government’s guarantee from ever being called upon
  • Believe there is a growing consensus that the simplest and lowest risk solution to address each of these key considerations is the reform and restructuring of Fannie and Freddie supported by a large capital raise from the private sector and retained earnings of the 2 companies
  • No new investor will invest in Fannie and Freddie unless historic investors are protected from, and compensated for, the expropriation of profits from the 2 companies that took place with the CF sweep transaction that has swept more than $270bn of profits from Fannie and Freddie since the crisis
  • Completing the largest capital raise in history in a newly restructured Fannie and Freddie will not be achievable unless and until investors in the companies are treated fairly and receive commitments that the extra-legal action of the past will be reversed and not reoccur
  • Since government and taxpayers own 79.9% of the common stocks of both companies, interests of shareholders and government are largely aligned
  • Fannie and Freddie offer one of the few potential opportunities for political compromise in the current political environment as a resolution could generate tens of billions of dollars for taxpayers and reduce the risk of future government outlays

Herbalife (HLF) – Short

  • On 8/14/17, Chinese media outlets reported that Chinese government has launched an investigation and crackdown on multi-level marketing and pyramid selling companies
    • HLF updated its risk-factor disclosures in its 1Q 10Q, adding new language about regulatory risk in China (China is 20% of HLF’s revenues)
  • Q2 results were disappointing to HLF investors and analysts from a top line perspective as volume declined 8% y-o-y
    • North America -18%, South & Central America -9%, Mexico -1% and APAC -1%, partially offset by growing in EMEA +4% and China +5%
  • Expect the US business to continue to suffer as distributors attempt to comply with the new restrictive elements of the FTC consent order, with the full impact more evident in Q3 and thereafter
    • Other regions of the world remain weak including major markets such as China, South Korea, Brazil, and Mexico
  • During Q2, HLF stock increased after the company announced a large share buyback despite a reduction in guidance and substantial insider selling
  • HLF continues to trade at a high valuation multiple particularly when compared to its actual GAAP earnings
    • Investors appear to have accepted the company’s non-GAAP EPS metric which excludes interest expense on its $1.15bn substantially out-of-the-money convertible note that is due in 2019
    • Also adds back expenses related to regulatory inquiries, related to FTC settlement implementation and related to challenges to the company’s business model
  • Expect continued business deterioration and ongoing regulatory and public relations issues for the company, which should lead to further stock price declines – this is likely to be compounded by aggressive buyback program

Hilton Worldwide Holdings (HLT) – Exited Position

  • Exited Hilton at a 32% profit versus our cost over an 11-month holding period
  • Hilton is an asset-light, high-margin, fee-based business that primarily franchises and manages hotel properties under more than a dozen hotel brands
  • Organically established an industry-leading global pipeline of franchised hotel rooms
  • Extensive and growing network of brands and properties offers a significant and self-reinforcing value proposition to both guests and hotel owners, which creates a strong competitive moat around the business
  • In the summer of 2016, announced it would spin off its owned hotel and timeshare businesses which we believed would highlight the significant value of its remaining franchised and management business
  • Believed that two key investor concerns were weighing on the share price: a potential downturn in the lodging cycle and the potential competitive threat from Airbnb
  • In the beginning of 2017, Hilton spun off its owned hotel and timeshare businesses. After the spin, share price began a steady upward ascent as the company continued to report strong business performance and initiated a meaningful share repurchase program
  • Hilton embodied many of the characteristics that we have identified in other successful investments: a high-quality business with a significant opportunity for capital-light growth, a best-in-class management team, sponsorship from a well-regarded sponsor (Blackstone), and a built-in catalyst, the spinoffs, to unlock shareholder value

Mondelez International (MDLZ) – Portfolio Update

  • Underlying sales growth was essentially flat excluding the impact of a global cyberattack in late June that disrupted the systems of a number of large corporations including MDLZ
    • Europe delivered its 5th consecutive quarter of volume growth
    • Many emerging markets including India, Mexico, and Southeast Asia grew strongly while others such as Brazil and Middle East continued to suffer from macro conditions
    • North America sales declined – optimistic that this will turn to growth in 2H17 driven by new product launches as well as retail shelf space gains in the biscuits category
  • Operating profit margins expanded in the second quarter to 15.8%; YTD margins of 16.3%
    • Management remains committed to its 2018 profit margin target of 17-18%
  • Announced that Dirk Van de Put, current President and CEO of McCain Foods would succeed Irene Rosenfeld as CEO in November
  • Mondelez is one of the few large cap food companies with strong visibility to grow both revenues and earnings for the foreseeable future – with MDLZ trading at ~18x 2018E earnings, believe that market is significantly discounting the company’s earnings growth potential and its strategic appeal in a consolidating industry

The Howard Hughes Corporation (HHC) – Portfolio Update

  • Continues to make steady progress across its 3 business lines – Operating Assets, Strategic Developments and Master Planned Communities
  • Operating Asset portfolio: increased its projected stabilized net operating income target to $245 million
  • Strategic Development segment: sold an additional 65 condo units at Ward Village in Hawaii during 1H17, increasing the % of total units closed or under contract at its 4 condo towers to 85%
  • In its MPCs, will likely generate over $100 million in land sales at Summerlin for the 5th year in a row. Land sales are increasing in Houston as market is showing signs of a rebound as crude prices have stabilized
  • Refinanced its existing bonds with a new $800 million bond issuance in a positive NPV transaction, saving 150 bps in interest and extending the maturity date by 3.5 years
    • Subsequently closed an incremental $200 million bond add-on at a YTW of less than 5%
  • Now has $660 million of cash on its balance sheet which will allow it to finance its remaining development projects without the need to raise additional equity capital
  • David Weinreb, HHC’s CEO, sold some of his expiring warrants, exercised warrants to purchase $50 million common stock and agreed to purchase $50 million in new warrants from the company which he is restricted from selling or hedging for the next 5 years
    • One of the largest investment commitments that we have seen by a management team

Air Products and Chemicals (APD) – Portfolio Update

  • EPS grew 15% for Fiscal Q3 driven by 8% revenue growth from increased volumes and 90 bps of margin expansion
  • Revenue growth was driven by organic growth and contributions from new plants coming on stream
  • Margin performance reflects continued operating efficiencies – management has stated that they have more work to do on productivity and that they continue to see productivity opportunities
  • Foreign currency headwinds have been a material drag in recent years but expect this dynamic will start to become a modest tailwind assuming that rates stay at current levels
  • Continues to bring on stream growth capex projects including large facilities in India and China
    • Growth capex continues to drive meaningful increases in cash flow despite significantly reduced capex budgets as new projects benefit from the capable underwriting of CEO and his team
  • One of the largest catalysts for further value creation remains the use of company’s excess capital. Currently has ~$5Bn of investment capital, comprised of cash and leverage capacity
    • Management expects this amount to grow to $8Bn over the coming 3 years as company generates annual cash flow of ~$1Bn before growth capex and after dividends

Restaurant Brands International (QSR) – Portfolio Update

  • Delievered strong net unit growth at each of its three brands and significantly improved Popeyes’ cost structure in its first full quarter of ownership
  • Same-store-sales growth was mixed as Burger King returned to growth and Tim Hortons results modestly declined
  • Net units grew 6%, the highest rate in several years, reflecting strong growth across all of the brands
  • Announced an agreement with an existing Burger King franchisee to develop Tim Hortons in Spain, which represents the brand’s 4th international development agreement
  • Also continued to reduce costs, most notably at Popeyes, where margins increased by nearly 1,500 bps

Platform Specialty Products (PAH) – Portfolio Update

  • Organic revenue increased 2% as Performance Solutions grew 6% and Ag Solutions declined 2%
    • Growth in Performance Solutions was due primarily to the positive results of the electronics business and strength in its industrial business
    • Modest decline in Ag Solutions resulted from poor weather in Eastern Europe and restructuring of its business in Africa
  • Organic EBITDA increased 8% due to strong results in both segments
    • Performance Solutions EBITDA grew 7% due to revenue growth and ongoing cost synergies from Alent acquisition
    • Ag Solutions EBITDA grew 9% in spite of the decline in revenue due to increased sales of higher-margin products and continued cost reductions in the business
  • As a result of interest savings from the company’s recent debt refinancing and its leveraged capital structure, EPS grew roughly 25%

Nomad Foods (NOMD) – Portfolio Update

  • Iconic brands and core categories in each of its markets which management has dubbed Must-Win-Battles are key drivers of performance
  • Italy, the UK, and Germany, company’s big 3 markets and the core of the legacy Iglo business, are all now back on solid footing with the new strategy in place
  • Raised its guidance for the year – expects to achieve mid-to-high single digit growth in underlying EBITDA, the result of low single-digit like-for-like revenue growth, continued cost controls and synergies from the Findus acquisition
  • Completed a favorable debt refinancing that extended its maturities from 2020 to 2024 and will generate €14 million of annual cash interest savings

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

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