Bill Ackman’s 2017 Annual Letter – ADP, QSR, MDLZ, HHC, CMG, FNMA/FMCC, Exiting Herbalife Short

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Automatic Data Processing (ADP)

  • Simple, predictable, FCF generative business that has underperformed its potential
  • Took an active approach to our investment in the company and ran a proxy contest to highlight the significant opportunity for improvement at the company
  • ADP’s management has committed to:
    • Enterprise Product Launch: ADP stated that it has an “upcoming” release of an Enterprise human capital management product which will enable ADP to stem and potentially reverse Enterprise market share losses
    • Accelerated Revenue Growth: after Employer Services’ organic revenue growth decelerates to ~2% to 4% this fiscal year, growth will reaccelerate to approximately 7% to 9% in the fiscal year beginning July 1, 2018, and will continue into fiscal year 2020 in order to achieve the company’s guidance of 6% to 7% organic growth over the next three fiscal years
    • Margin Improvement: ADP will increase operational profit margins by 500bps over the next three fiscal years despite a projected decline in operational profit in the first fiscal year
  • Company’s recently reported fiscal Q2 2018 results make clear that ADP continues to have a significant opportunity for improvement
    • While rising interest rates and tax reform are driving strong overall results and management’s increase in fiscal year EPS growth guidance to 12-13%, we were disappointed that the company’s organic operational growth in Employer Services remains weak, bookings growth of 6% remains modest in light of an easy comparison with last year, and management projects a 50bps decline in overall margins for the year
    • While we and other shareholders were not expecting material improvements in the first quarter since the proxy contest, investor expectations will grow substantially over the course of 2018
  • Pro forma for tax reform, ADP trades at 23x its fiscal year June 2019 EPS guidance, a reasonable price for a business of this quality and growth characteristics
  • Current valuation is below the valuation at which we initiated the position when considering the positive benefits of tax reform, rising interest rates, and modest organic growth which have outpaced the stock price increase
  • We believe that ADP stock is substantially undervalued if the company’s operations are optimized

Restaurant Brands International (QSR)

  • Continue to believe that QSR is a high-quality business that reflects our core investment principles and remains undervalued
  • In March 2017, QSR added Popeyes Louisiana Kitchen to existing brands Burger King and Tim Hortons, and showed significant progress in improving Popeyes’ cost structure
  • QSR exhibited net unit growth of 7% at Burger King and 3% at Tim Hortons. Company increased EBITDA margins by 300bps at Burger King and more than 1,500 bps at Popeyes; same store sales growth at Burger King increased by 3% which more than offset flat results at Tim Hortons
  • Despite QSR’s higher long-term growth potential compared to its peers, QSR currently trades at ~21x our estimate of 2018 FCF per share while peers trade at an average of ~24x FCF per share based on analyst estimates

Mondelez International (MDLZ)

  • Trades at less than 18x consensus estimates of 2018 EPS, a significant discount to both peer valuations and its historical average multiple despite its high business quality, secular growth potential, and substantial margin improvement opportunity
  • Unlike other large cap packaged food companies based in the US, MDLZ generates 75% of its sales overseas, including 40% in emerging markets, and 85% of its global sale from snacks
  • Company started to show good progress in accelerating revenue growth in 2017, with underlying organic revenue up 2% in the 2nd half after only 0.3% growth in the first half, and reported revenue growing 5% in the 2nd half after a 2% decline in the 1st half
  • Despite conservative guidance, we believe investor fears around a larger potential earnings “rebase” when Mr. Van de Put outlines his multi-year strategic plan at the end of the summer are unfounded given: 1) the substantial capital invested over the last several years to upgrade the manufacturing base and reduce product and procurement complexity; 2) a strong current portfolio of products, given the significant SKU rationalization over the last three years; 3) the healthy 9% of sales that the company currently invests in advertising and promotion, which is at the high end of its peer group given its scale; and 4) the fact that the 2018 margin goal of 17% is still materially below optimized levels

The Howard Hughes Corporation (HHC)

  • In 2017, HHC continued to make excellent progress across its portfolio
  • The Seaport District, one of HHC’s most valuable assets, is on track for its opening in the summer of 2018; ESPN recently signed a long-term lease for 19,000 sq.ft. to broadcast its daily shows from the Seaport which will bring greater visibility to this unique location
  • Also made progress with Ward Village in Hawaii where 93% of the company’s existing condo inventory has been sold or is under contract; Summerlin, HHC’s Las Vegas master planned community, had its fifth straight year with over $100 million in land sales
  • Has also achieved increased land sales at both its Bridgeland and Woodlands MPCs in Houston; HHC has 50 million sq.ft of remaining vertical development entitlements at its existing MPCs alone, which is greater than 10x the amount of development that HHC has executed since 2011
  • In January 2018, Pershing Square sold its common stock but increased its HHC total return swaps position, allowing PSH to maintain a more than 10% exposure to HHC

Chipotle (CMG)

  • On Feb 13, 2018, Chipotle announced that Brian Niccol would become the company’s new CEO and would be added to the board, effective March 5, 2018
  • Brian was most recently the CEO of Yum! Brands’ Taco Bell Division, where he was responsible for the highly successful turnaround of the business; under his leadership, Taco Bell successfully repositioned the brand as a lifestyle brand and launched numerous product initiatives, including the new breakfast daypart, the fastest growing daypart in the industry; he transformed Taco Bell into a social media leader and revolutionized its digital approach through mobile ordering and payment across their 7,000 restaurants
  • Prior to Taco Bell, Niccol held leadership roles at Pizza Hut, including VP of Strategy, CMO, and General Manager; Niccol began his career at Procter & Gamble where he spent 10 years in various brand management positions

Fannie Mae / Freddie Mac (FNMA/FMCC)

  • Following the 2016 presidential election, the prices of both stocks increased significantly as investors believed the likelihood of housing finance reform had increased as a result of the election
  • Those gains were largely retraced in 2017 due to: 1) an adverse court ruling in February 2017 in one of the GSE shareholder lawsuits against the federal government; 2) concerns that a rumored potential housing finance reform bill will contain provisions that are unfavorable for shareholders; 3) concerns that the Trump administration and Congress are now occupied with other agenda items delaying a potential resolution
  • For any proposal for housing finance reform to succeed, in our view, it will need to satisfy a number of conditions including:
    • Simplicity: the solution must be simple in order to ensure broad support and minimize systemic risk;
    • Visibility: in order to raise the enormous amount of required new private capital, investors must have visibility into the long-term earnings power of FNMA and FMCC;
    • Fair treatment: current investors in FNMA and FMCC must be treated fairly in order for new capital to be raised, as new investors will be highly skeptical as to how they will be treated if the ultimate outcome is poor for legacy shareholders
  • Although the momentum for reform is much stronger now than it was when we made our initial investment, several key points of debate remain as roadblocks to reform:
    • Feasibility and desirability of creating new competitors
    • Appropriate capital levels, rates of return and degree of regulation
    • Treatment of various classes of securities in Fannie and Freddie

Herbalife Short (HLF)

  • While we have been correct in our belief that Herbalife’s business fundamentals would deteriorate as earnings per share, revenue growth, and other measures of business performance weakened substantially since we initiated the investment, we underestimated Herbalife’s ability to access debt capital and use financial engineering which – coupled with Mr. Icahn’s share purchases to materially reduce the company’s free float – has driven share price appreciation
  • Reduction in free float is best evidenced by the cover page of Herbalife’s recently filed 10-K which reports 87.4 million shares outstanding of which only 22.7 million are held by non-affiliates of the issuer as of June 30, 2017
  • In light of the large number of shares that are held by index funds which are non-affiliates of the issuer, and the company’s recent announcement of another tender offer, it is not surprising that the shares have continued to increase substantially in price without regard to fundamental value as there is almost no supply of shares for sale from non-affiliates of the company
  • While we believe that deteriorating business fundamentals and a high valuation are a good recipe for an attractive short sale, technical factors are a critically important additional consideration
  • While we continue to believe our analysis of Herbalife’s business remains correct, the shares have become a highly risky short sale in light of the extremely limited free float, and as a result, we have exited this investment

Pershing Square 2017 Annual Letter 

Image Source: MarketWatch

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