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Bill Ackman’s 1Q18 Letter: UTX, FNMA/FMCC, CMG, ADP, MDLZ

  • 1Q18 return of -8.2% vs. S&P 500 of -0.8%

United Technologies Corporation (UTX)

  • UTX is a leading industrial holding company which owns a number of high-quality businesses which benefit from favorable long-term growth trends and recurring long-term cash flows
  • Company operates in three distinct principal divisions: 1) Aerospace systems (UTAS) and engines (Pratt & Whitney); 2) Otis Elevator Company; and 3) Climate, Controls and Security
  • UTX is a market-leading provider of mission-critical aerospace systems and engines for commercial, military and business aircraft. Business can be best described by analogy to the razor blade business, in which initial sales of new equipment are sold at prices close to breakeven, but generate highly profitable aftermarket sales of spare parts and services that persist for decades
  • Aerospace business has significant barriers to entry due to the large upfront required investments in R&D and manufacturing, the long-term nature of the new product development cycle, and high switching costs due to stringent regulatory requirements and the IP-intensive nature of the products
  • Growing demand for global air travel should generate a strong tailwind for the aerospace business as a large number of new aircraft will be required to satisfy future passenger demand
  • UTX will shortly acquire Rockwell Collins, a leader in avionics systems which will further enhance UTAS’ competitive position by allowing it to compete in nearly all major aircraft sub-systems and provide a more integrated product offering
  • Pratt & Whitney is one of two large engine manufacturers in single-aisle, commercial aircraft, and the leading engine provider for military and small aircraft; Pratt & Whitney recently introduced its new engine platform, the geared turbofan (GTF), which provides material improvements in fuel efficiency and noise reduction versus competitive offerings; Pratt & Whitney’s profit margins should meaningfully expand as the GTF begins to generate lucrative aftermarket revenues
  • Otis is the leading elevator manufacturer and service provider with 30,000 technicians maintaining more than two million elevators; the elevator business benefits from global urbanization trends which support continued long-term growth of new elevator sales and servicing; large scale and highly dense route networks enable it to cost effectively and efficiently provide on-site service to its customers; while new elevator sales are modestly profitable, the liftetime value of an elevator sales comes primarily from the associated service contract, which is typically very long-term and highly profitable; more than 70% of Otis’ profits come from its service contracts, which represent a growing cash flow annuity as the installed base of elevators grows
  • UTX’s Climate, Controls and Security (CC&S) business is a market leader in HVAC, refrigeration and fire and security products and services; CC&S offers products under highly regarded brands including Carrier (HVAC), Transicold (refrigeration), Kidde (fire) and Chubb (security); Carrier is number one in HVAC in both the US residential and global commercial markets; refrigeration business sells solutions for global trucking, shipping, and retail, with growth driven by cold storage transportation in urban markets, and an increased focus on food safety in emerging markets; the fire and security division maintains market-leading positions in product sales due to the strength of its brands, and benefits from high barriers to entry due to the complexity of local regulatory codes and standards
  • UTX is currently trading at about 16x our estimate of this year’s earnings; this valuation is significantly below our estimate of the company’s underlying value based on the overall quality and future earnings growth potential of UTX’s operating subsidiaries
  • As each of these businesses has materially different capital requirements, competitive characteristics, and investor constituencies, we believe that they will be more likely to achieve fair value as independent companies

Fannie Mae (FNMA) / Freddie Mac (FMCC)

  • FNMA and FMCC reported modest underlying earnings growth in the first quarter, including improved fundaments in their core single-family guarantee businesses; after drawing funds from Treasury for the first time since 2012 earlier this year to fund one-time charges related to corporate tax reform, Fannie plans to resume dividend payments to Treasury this quarter while Freddie continues to rebuild its capital towards the $3bn limit for each entity that became effective at the start of the year
  • Absent a further change in policy from Treasury and FHFA, we would expect Freddie to resume dividend payments to the Treasury in the third quarter; while increasing the amount of capital each entity is allowed to hold from zero to $3 billion was a step in the right direction, current capital levels are still woefully inadequate in light of their more than $5 trillion of outstanding guarantees and other liabilities
  • Despite continued business progress and corporate tax reform which will materially enhance the GSE’s profitability, FNMA and FMCC’s common stock prices have declined about 50% YTD
    • We attribute this decline to investor frustration at the lack of progress on housing finance reform efforts in Congress, which seem to have stalled in the run-up to the midterm elections, and, we believe, forced selling from certain large investment firms that have recently begun to wind down their operations
  • Treasury Secretary Steven Mnuchin stated in late April that he would focus on housing finance reform after the elections in early 2019; the administration will soon have the ability to appoint a new director of the FHFA, FNMA and FMCC’s primary regulator, in January; since Congress has been unable to put forth a viable plan since conservatorship began nearly a decade ago, we believe it is increasingly likely that the administration and FHFA will soon take the lead on housing finance reform
  • We continue to believe that FNMA and FMCC offer a highly attractive potential reward relative to risk for the patient investor, particularly at current share prices, near their lowest since we made our investment in 2013

Chipotle (CMG)

  • Reported first quarter results on April 25th; results for ahead of consensus estimates for same-store sales, margins, and earnings; underlying same-store sales increased 2.7%, an acceleration from the prior two quarters driven by 6.2% average check growth and a 3.5% decline in transactions; restaurant margin was 19.5%, up nearly two percentage points from the prior year quarter, as decreased food costs and reduced marketing and promotional expenses as a percentage of sales, more than offset labor inflation and other cost increases
  • This quarter’s earnings call was the first time that the new CEO Brian Niccol publicly addressed investors; Brian shared his initial thoughts on the wealth of opportunities that he sees to improve CMG’s business and drive growth
    • Near term initiatives include a reallocation of marketing spend to more productive uses, implementation of a “test and learn” approach for new products and other initiatives, extended hours, and use of marketing and innovation to convert current downtimes into transaction-driving opportunities
    • Longer term opportunities may include breakfast, drive-throughs, and international expansion

Automatic Data Processing (ADP)

  • Reported a strong quarter driven by accelerated bookings growth and positive improvement in revenue retention; EPS increased 16% y-o-y, aided by 8% revenue growth and the reduction of its corporate tax rate
  • During our proxy contest with ADP last fall, company committed to achieving approximately $5.05 of EPS by FY 2020; since then, company has benefited from a number of extrinsic factors, not due to management actions, which should collectively boost FY 2020 EPS by 20%, or about $1 per share
    • These positive developments include corporate tax reform, the impact of rising interest rates on float income, and the upcoming adoption of a required accounting change, which should cause ADP’s earnings to more accurately reflect economic reality
    • Considered together, these factors should enable ADP to achieve a minimum of $6.25+ in EPS by 2020, nearly 25% more than the guidance provided by management last September
  • As consensus estimates for 2020 are only $5.63 per share, 10% below our minimum base estimate, we do not believe that ADP analysts and investors have fully considered the impact of these factors
  • We continue to believe that ADP’s potential is substantially greater than is reflected by its current guidance even when updated for the factors outlined above
  • Pro forma for the completion of mid-market migrations, we estimate that more than 60% of Employer Services revenue is now being generated by its small- and mid-market businesses which run on two next-generation platforms, Run and Workforce Now, which should eventually achieve SaaS margins of more than 40%

Mondelez International (MDLZ)

  • Reported first quarter earnings on May 1st; organic sales growth for the quarter was 2.4%, with over 70% of this increase driven by volume and product mix, and the balance from pricing
  • This was the third consecutive quarter with both organic sales growth in the 2-3% range, and a positive contribution from volume and product mix
  • All regions outside of North America posted solid growth, including 5.5% growth in emerging markets, which represent nearly 40% of the company’s sales; NA which accounts for less than 25% of sales, declined 1.8% in the quarter driven by ongoing weakness in gum, as well as transitory issues including inventory destocking at retailers, and poor supply chain execution
  • Operating profit margins expanded by 30bps to 16.7%, as a continued reduction in overhead costs more than offset a decline in gross margin driven by unfavorable product mix, higher commodity costs, and freight inflation in NA
  • Despite posting results that were in-line with or better than those of its key global and snack-focused peers in the quarter, MDLZ continues to trade at an unwarranted discount to both its peers and intrinsic value
  • MDLZ is currently trading at 15.5x forward earnings, which is a trough valuation for the company since the spin-off of Kraft Foods in October 2012, and a 25% discount to its average valuation multiple since then
  • We believe that MDLZ’s valuation gap should close as the company continues to report differentiated results over the coming quarters, and as investors gain more comfort with the new CEO who will reveal the results of the company’s strategic review at the end of the summer

Pershing Square Capital Management 1Q18 Letter, May 17, 2018

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

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