Bill Ackman’s 3Q17 Letter: ADP, Chipotle, Fannie and Freddie, Herbalife Short, Mondelez

Smart Money

Pershing Square Capital Management 3Q17 Investor Letter, November 15, 2017

  • 3Q17 returns of -3.3% and YTD returns of -2.9% vs. S&P 500 returns of 4.5% and 17.2% for 3Q and YTD, respectively
  • Exited Air Products and Chemicals (APD), which delivered 104.7% over four and half years and Nomad Foods (NOMD) after an increase of 35% from our average cost in just over 2 years

Automatic Data Processing (ADP)

  • Simple, predictable, FCF generative business that has significantly underperformed its potential
  • As a conservatively financed, high-quality business in a sector with substantial positive growth, believe it has modest downside and if able to achieve its potential, offers substantial upside
  • Employer Services segment’s underperformance best demonstrated by 1) poor operating efficiency and subpar margins of 19% and 2) declining organic growth of 2-3% for FY 2018, with much of the revenue weakness due to company’s lack of a competitive offering in the enterprise segment which serves large companies
  • With a transformation focused on operational efficiency and technology leadership, believe that ADP can accelerate growth to 7% or more, in-line with, or better, than industry growth rates, while increasing margins from 19% to 35%
  • While we were not successful in gaining seats on ADP’s board this election cycle, our campaign over the past few months has informed ADP shareholders, the board, and management about the potential opportunities that exist to create significant shareholder value
  • In order to win the contest, ADP’s management and board pivoted their message to “we agree and we are already doing it” and made important commitments to shareholders and proxy advisory firms:
    • Accelerate revenue growth: growth will reaccelerate to ~7-9% in the FY beginning July 2018 and will continue into 2019 in order to achieve guidance of 6-7% organic growth over the next 3 fiscal years
    • Margin improvement: increase operational profit margins by 500-600bps over the next 3 fiscal years despite a projected decline in operational profit in the first fiscal year
    • Enterprise product launch: has an upcoming release of an Enterprise HCM product which will enable ADP to offer better service and recover Enterprise market share losses
  • Dynamic we have created by the proxy contest sets up a favorable risk-reward ratio for ADP shareholders. It is a quintessential example of how shareholder activism is supported to work
  • ADP is also potentially a large beneficiary of corporate tax reform as a reduction in US tax rates will boost ADP’s earnings and its market value by as much as 20%

Chipotle Mexican Grill (CMG)

  • While the last six months have been challenging, believe the company’s significant long-term growth opportunity is one of the most attractive in the industry
  • Management’s immediate focus has been on optimizing existing operations to allow its restaurants to deliver a consistently great guest experience
  • Near term operational initiatives include eliminating layers in the upper management ranks to redeploy more resources directly overseeing the restaurant operations, restructuring operations support, and improving the hiring process
  • Company launched all-natural queso nationwide on 9/12/17 and is currently testing several other menu additions
  • First major mobile app revamp in many years was launched on 11/6/17. The new app includes many features that make it easier for guests to order from Chipotle, including: 1) quicker reorder; 2) more precise customization of meals; 3) Apple and Android pay; and 4) ability to receive, store, and redeem Chipotle offers
  • Stock has been highly volatile – increasing to $499/share in May as sales trends improved and then declining more recently to a low of $263/share after a food safety incident in July in one store, and a below expectation quarter
    • Surprising degree of volatility for a company with substantial net cash position and no debt
    • Believe volatility driven by the fact that value of the company is highly dependent on investors’ estimates of future growth, average unit volumes, and store margins; when these estimates change, associated DCF calculations lead to widely varying estimates of intrinsic value
    • If the company begins to show progress on these metrics, we would expect the stock price to respond accordingly to the upside
  • Expect Chipotle will be a substantial beneficiary of lower US corporate taxes

Fannie Mae (FNMA) / Freddie Mac (FMCC)

  • Have been a number of favorable developments in the political and regulatory landscape regarding the GSEs and housing finance reform
    • RNC resolution made public on 9/13/17 that seeks to protect taxpayers by restoring safety and soundness to the GSEs, calls for Fannie and Freddie to be “permitted to rebuild equity capital,” and recognizes that Treasury can generate an estimated $100bn in additional cash profits by monetizing its warrants for 79.9% of each company’s common stock
    • A 9/13/17 letter from 6 Democratic Senators to the Treasury Secretary and FHFA Director requesting that the GSEs be permitted to build capital to prevent a future draw on Treasury’s line of credit
    • Testimony from FHFA Director to the House Financial Services Committee on 10/3/17 in which Director Watt outlined the extensive reforms that have taken place at the GSEs during their 9+ year conservatorship, stated that required minimum capital levels for Fannie and Freddie should be in the range of 2-3% and hinted at some form of initial capital retention in the coming months
    • Comments from Steve Mnuchin in mid-October that housing finance reform would be the next priority after tax reform, and that Fannie and Freddie would not be in conservatorship by the end of his initial 4-year term
  • Senator Corker, who has been one of the leading voices in Congress on housing finance reform for the last several years, will not seek re-election in 2018 and we believe that he would like to see this issue resolved before his retirement
    • He suggested that he will soon put forth new bipartisan legislation regarding housing finance reform, for which they should have the support of Secretary Mnuchin after the tax reform initiative concludes
  • In the meantime, intrinsic earnings power of both entities continues to increase, driven by growth and improved credit quality in their core single-family guarantee businesses
  • Current share prices do not reflect the significant momentum that continues to build for a bipartisan resolution of their status that would be highly profitable for the government and other shareholders, protect the taxpayer against future bailouts, and ensure that the dream of home ownership remains widely achievable for generations to come

Herbalife (HLF) Short

  • We have restructured our short position in Herbalife and our exposure is now represented entirely by put options (our loss is limited to the current market value of the puts)
  • Over the past several years, a number of events have occurred which would make any short seller optimistic about a short position in Herbalife:
    • Financial performance has deteriorated significantly
    • Despite the company having repurchased ~33% of outstanding shares since we shorted the stock, GAAP and adjusted EPS are down ~19% and ~16%, respectively
    • FTC settlement, which took effect on 5/25/17, appears to be severely impacting the company’s business: US sales for 2Q and 3Q were down 18% y/y and 3Q sales were down 9% sequentially compared to 2Q
    • Chinese government recently launched an investigation of multi-level marketing firms which operate in China – a market which represents about 20% of Herbalife’s revenues
    • Company has been subject to tremendous amount of criticism and negative public relations in the media, including from John Oliver and in the documentary film Betting on Zero
    • On 9/20/17, the company and its top distributors were sued in a class action complaint over alleged civil racketeering violations
  • Despite this deterioration in financial performance, adverse publicity, and negative regulatory and legal developments, Herbalife stock has remained at prices that we believe do not make sense from a fundamental investment point of view
  • Believe the elevated valuation can largely be explained due to technical factors, namely the stock’s substantially reduced free float, and the market’s perception, up until recently, that we would be forced to cover our large short position
  • We made the decision to convert our short position to put options because of reduced free float of the stock and to eliminate the incentive for market participants to attempt to squeeze us out of the position

Mondelez International (MDLZ)

  • Substantially undervalued given its high business quality, long-term secular growth potential – especially in emerging markets – and substantial opportunity to improve profit margins
    • Trades at 17x 2018E earnings, a discount to S&P 500 market multiple, for a business whose attributes are substantially better than the average company in the S&P 500
  • Global food peers such as Nestle and PepsiCo, and sweet snack-focused peers like Hershey currently trade at ~21x 2018E earnings, a nearly 25% premium to MDLZ
  • We expect this valuation gap to close over the coming quarters as investors gain further clarity around 3 concerns: 1) uncertainty regarding the US grocery landscape; 2) concerns about company’s growth potential; 3) apprehension regarding the upcoming CEO transition
  • 3Q17 performance reflects two inherent advantages in MDLZ’s portfolio: 1) only 25% of company’s sales are generated in the US and roughly 37% of its sales are in the faster-growing developing markets; 2) 85% of the company’s sales are in snacks which enjoy higher barriers to entry and superior long-term growth prospects vs. other packaged food categories
  • Expect company’s growth rate to accelerate further given tailwinds from 1) improving global macro environment, particularly in emerging markets; 2) weakening USD, 3) favorable near-term competitive dynamics in US cookies and crackers; 4) abatement of revenue headwinds from management’s historical actions to eliminate unprofitable, low-growth SKUs, and 5) significant opportunity to better utilize advertising and promotion, trade, and innovation investment to drive growth
  • Encouraged by management’s comments but have long been confident that a potential earnings “rebase” will not occur given: 1) substantial capital invested over the last several years to upgrade the manufacturing base and reduce product and procurement complexity; 2) strong current portfolio of products; 3) healthy 9% of sales that company invests in A&P; 4) fact that 2018 margin goals are still materially below optimized levels

Image Source: Bloomberg