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Bill Ackman’s 2Q18 Letter: ADP, CMG, LOW, UTX, MDLZ, FNMA/FMCC

  • YTD performance, through August 7th, has increased to 12.7% compared with 8.1% for the S&P 500 and 1.3% for the FTSE 250 over the same period

Automatic Data Processing (ADP)

  • At the Analyst Day, company committed to achieving 7% to 9% revenue growth and pre-tax operating margins of 23% to 25% by FY 2021
  • New margin targets imply annual EPS growth of 16% to 19% over the next three fiscal years, with a 2021 earnings target of approximately $7/share
  • Fiscal Q4 results were strong, evidenced by accelerating y-o-y booking growth (18%), robust top-line growth (8% as reported, 6% organic growth) and significant margin expansion; EPS was up 39% y-o-y, helped by 400bps of net-economic margin expansion and the benefits of corporate tax reform
  • Company introduced FY 2019 guidance:
    • Projected economic revenue growth of 5% to 7%, continued operational margin expansion, and increased float income, with EPS projected to grow 13% to 15% over FY 2018
    • Based on current guidance, ADP should realize $5.12 to $5.21 of adjusted EPS for FY 2019
  • CFO Jan Siegmund announced that he would be leaving the company when a replacement is identified. We believe the hiring of a new CFO with operational expertise in executing business transformations would be well received by shareholders

Chipotle (CMG)

  • To enable the organization to deliver on its new strategy, management is undertaking a people and culture transformation with the aim of making the company more disciplined, results-focused, and “scrappy”
  • Initial stages of this transformation include the establishment of a new corporate headquarters in Southern California and the closure of the Denver and NY offices, the elimination of two management layers to streamline decision-making, and the addition of experienced external talent in marketing, menu, digital, analytics, and human resources
  • Company will shift its marketing from an inefficient field-based, promotion-driven approach to a centralized strategy that aims to elevate Chipotle from a food brand to a purpose-driven lifestyle brand
  • In Q2, same-store sales increased 3.3%, an improvement from the prior quarter, driven by 5.1% average check growth and a 1.8% decline in transactions
  • Management raised outlook for full year same-store sales growth from low-single digits growth to low to mid-single digits growth
  • Restaurant margins were 19.7%, up nearly one percentage point from prior year quarter, as decreased food costs as a % of sales more than offset wage inflation
  • Digital sales grew 32%, up from 20% in Q1, and now account for 10.3% of total sales. Delivery sales quadrupled in the quarter as the company launched a new national partnership with 3rd party delivery provider, DoorDash, and added the ability to order delivery in the Chipotle mobile app

Lowe’s Companies (LOW)

  • Leading US home improvement retailer with an advantaged business model in a category that is positioned for continued growth. Home improvement category operates as an oligopoly, and Lowe’s significant market presence results in a scale advantage that allows it to be a convenient and low-cost provider of home improvement products across its more than 2,000 stores and fully integrated mobile and online platform
  • Lowe’s has strong future growth prospects as continued growth of the housing market should drive home improvement spending over next several years. Increasing repair and maintenance requirements of the aging US housing stock should contribute to sales growth over the longer term
  • We have avoided investing in retail for nearly five years, but we believe the home improvement category is well insulated from the threat of online competitors, as a significant amount of the company’s products are either difficult and/or expensive to ship due to their size, regulatory constraints, installation requirements or are uneconomic to ship due to the combination of their low price point and heavy weight
  • We previously invested in Lowe’s in 2011 due to our belief that the market did not appreciate the rapid earnings growth that would likely result from an improvement in the housing market following the financial crisis. Shortly after we initiated our investment in 2011, the stock price appreciated significantly, and we exited our position to allocate elsewhere
    • While earnings and share price continued to increase thereafter, since that time, Lowe’s has materially underperformed its closest competitor, Home Depot
  • In response to growing shareholder dissatisfaction earlier this year, Lowe’s appointed 3 new directors to its board, and announced a search for a new CEO
  • After appreciating 15% from our cost, Lowe’s currently trades at ~18x our estimate of this year’s earnings, which do not yet reflect any impact from the management change
    • Home Depot trades at more than 21x analyst estimates of this year’s earnings, as the market has rewarded the company’s historically strong execution with a premium multiple
  • There is large upside potential to Lowe’s if it can narrow the performance gap with Home Depot as it is likely that closing the performance gap will cause the market to reward the company with an increased multiple on higher earnings that reflect the company’s underlying business quality and growth potential

United Technologies Corporation (UTX)

  • Second quarter earnings showed strong organic revenue growth of 6%, led by growth in the aerospace businesses of 10%; organic revenue growth has been above 5% for the last four consecutive quarters
  • Company raised its guidance for 2018 EPS for the second time this year. UTX now expects full year organic revenue growth of between 5-6% and EPS growth of 7-9%
  • Despite significant profit growth in its aerospace businesses, UTX’s operating profit was roughly flat compared with the prior year due to a decline in earnings from the commercial businesses
    • In the aerospace businesses, UTAS organic revenues increased 8% and operating profits grew 17%; Pratt & Whitney organic revenues increased 12% and operating profit grew 8% due to the initial losses associated with the ramp-up of the GTF engine program
    • In its commercial businesses, CC&S organic revenues grew 4% but operating profit was flat as input costs and new product investments increased; Otis organic revenues grew 3% but operating profit declined 11%, partly due to continued price and mix pressure in China and one-time costs
  • Divergent performance of the aerospace and commercial businesses further reinforces the logic of a business separation of UTX’s subsidiaries, as the strength in the aerospace business is not being appropriately reflected in UTX’s stock price, which trades at only 16 to 17x our estimate of this year’s earnings
  • Greg Hayes (CEO) stated on the earnings call that “all options are on the table” to maximize long-term shareholder value including a three-way split of the company and/or potential business divestitures

Mondelez (MDLZ)

  • Underlying organic sales growth was approximately 2% excluding a net benefit from lapping volume declines related to a cyberattack in the prior year quarter and one-time items
  • Volume and product mix contributed 50 bps to underlying growth, with the balance from pricing
  • Global sales growth for the snacks categories has improved approximately 2% in 2017 to just over 3% in the first half of this year
  • Company attributed the gap between 3% growth of its categories and its 2% underlying organic growth to share losses in their Brazil and US gum businesses, as well as an inventory trade reduction in US cookies and crackers that should be transitory
  • Operating profit margin expanded by 130 bps to 16.7%, driven by a 60 bps improvement in gross margin due to productivity savings, volume leverage, and lower input costs, as well as a 70 bps reduction in overhead costs as a % of sales due to continued implementation of zero-based budgeting
  • Management raised full year organic sales growth guidance from an increase of 1% to 2% to the high end of that range, and reiterated guidance for a 17% operating profit margin including an increase in gross margin, and double-digit EPS growth on a constant-currency basis

Fannie Mae (FNMA) / Freddie Mac (FMCC)

  • Guarantee fees charged on newly issued mortgage backed securities continued to increase along with the size of their guarantee portfolios, while underlying credit losses remained modest
  • Both enterprises have now increased their capital reserves to the $3bn per entity limit imposed by Treasury in December, and plan to pay a combined $6.1bn in dividends to Treasury under the net worth sweep by September 30th
  • Treasury will have received a total of $286bn in dividends on its Senior Preferred Stock investment, which is $94bn more than its cumulative cash investment of $191bn
    • This represents an annualized cash-on-cash return to the government of nearly 11%, above the bargained for 10% interest rate
    • This return reflects no value for Treasury’s warrants to purchase 79.9% of the common stock of both entities, which we believe should be worth in excess of $150bn in Fannie and Freddie exit conservatorship and are recapitalized
  • In June, FHFA released draft proposed capital rules for the enterprises that would apply once they exit conservatorship. Overall, we are encouraged that FHFA is soliciting feedback from market participants regarding adequate capital levels for the entities, which have been near zero since conservatorship began nearly a decade ago
  • In order to raise the large amount of private capital that will eventually be needed to recapitalize the enterprises, we believe that all final capital rules should avoid complexity and procyclicality, as well as balance the requirement for a fortress balance sheet with the need to deliver market returns to investors, and affordable mortgage rates to customers
  • We expect housing finance reform efforts to resume in earnest after midterm elections in November

Pershing Square Letter to Shareholders 2Q18

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

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