Bill Ackman’s Pershing Square Holdings annual report is now out – see the full letter below.
Pershing Square 2014 Letter
Allergan, Inc. (AGN)
In February of 2014, Pershing Square formed a joint venture with Valeant Pharmaceuticals International to pursue a merger between Valeant and Allergan. Allergan is a leading specialty drug company in aesthetics, dermatology and ophthalmology. Over the course of two months, the Pershing Square/Valeant joint venture acquired a 9.7% stake in Allergan at an average cost of $128 per share, which we deemed to be a fair price for the business, assuming no improvement in operations or a transaction.
Allergan had a strong track record of organic growth driven by a portfolio of market-leading products, including the fast-growing Botox franchise, but was not known to allocate capital efficiently or run its business cost effectively. Given the strategic overlap between Valeant and Allergan’s product portfolios, along with Valeant’s superior cost structure, operating model and capital allocation strategy, we believed that a merger between Valeant and Allergan had the potential to create enormous shareholder value.
On April 22nd, Valeant and Pershing Square announced an unsolicited offer to acquire Allergan for $161 per share, a 38% premium to Allergan’s unaffected stock price, and a takeover battle ensued with two price increases, litigation, two proxy contests, a war of words, and ultimately a transaction.
On November 17th, Allergan announced a merger with Actavis plc for cash and stock valued at ~$240 per share when the transaction closed on March 17th. Prior to closing, we hedged a substantial portion of the Actavis shares we would have received while electing to retain 1.35 million shares (held across all funds, ~500,000 are held in PSH) in the newly merged company which we consider to be undervalued and well managed.
Herbalife Ltd. (HLF) Short
We remain confident in our short thesis that HLF is an illegal pyramid scheme that will collapse or otherwise be shut down by regulators. The company’s business has continued to deteriorate as reflected by its substantially reduced forward earnings guidance for 2015.
Herbalife is doing its best to attack the messenger with a public relations campaign against Pershing Square. Ultimately, the facts will drive the outcome. We expect continued substantial business deterioration as the company is forced to reform its highly abusive and deceptive practices, or is shut down.
Air Products and Chemicals, Inc. (APD)
Air Products and Chemicals, Inc. has made meaningful progress since Seifi Ghasemi became CEO on July 1st of 2014. We believe that Seifi is the ideal leader to transform Air Products, and we applaud the Air Products Board for hiring Seifi as Chairman/CEO and supporting him in his efforts to improve the company.
Seifi’s announced goals are to increase EBIT margins from ~16% to ~22.5%, comparable to that of industry leader Praxair Inc. Air Products expects that half of this 650 basis point improvement will come from SG&A and overhead, and half from gains in productivity and operational efficiencies. Air Products was at the top of the industry two decades ago, and Seifi has stated that he believes there are no structural issues that should prevent the company from regaining its industry-leading performance.
Early results, including earnings announcements in October 2014 and January 2015, have been impressive. Earnings per share (EPS) have increased 13% and 16%, respectively in Seifi’s first two quarters as CEO. Operating margins are at the highest levels in nearly a decade, driven partially by reductions in SG&A of ~8% in the most recent quarter. With operating margins now at ~17.5%, Air Products has closed 150 basis points of its margin gap versus Praxair with remarkable rapidity. Air Products’ fiscal year 2015 guidance calls for EPS of $6.30-6.55, which represents growth of 10-13%despite foreign exchange headwinds.
Canadian Pacific Railway Limited (CP)
The remarkable transformation of Canadian Pacific continues under the leadership of Hunter Harrison and the reconstituted CP Board in 2014. Full-year EPS grew 32%, in spite of severe winter weather conditions in the first quarter of the year. In 2014, CP achieved an operating ratio of 64.7%, besting its four-year 65% operating ratio target just two years into the operating plan. On an annual basis, CP has risen from the least efficient Class I railroad to the third-best, and the improvements are continuing. This progress has been achieved while maintaining industry-leading safety performance. The drive to operational excellence is enhancing service and reliability, while lowering CP’s cost to serve its customers.
In October, CP held an analyst day to outline its revised multi-year plan. The company’s new four-yeartargets call for $10 billion of revenue by 2018, representing a 10.5% compound annual growth rate. This impressive revenue growth is driven by efficiencies and service-level improvements that permit CP to win business for which it historically could not compete.
CP’s announced revenue and margin goals translate into about $20 per share in earnings in 2018 including the impact of projected share repurchases. At the inception of our investment in 2011, CP earned $3.15 per share. The achievement of $20 per share in earnings would represent more than a six- fold increase in the earnings power of the business following the proxy contest and Hunter Harrison’s appointment as CEO. We believe CP remains an attractive investment led by a superlative management team.
Restaurant Brands International Inc. (RBI)
At the end of August, Burger King announced that it would acquire Tim Hortons, Canada’s leading quick- service restaurant (QSR) company, for $12 billion forming the newly renamed Restaurant Brands International (RBI). The transaction closed in December of 2014. Tim Hortons operates a 100% franchised business model with ~4,500 units. In Canada, where 80% of Tim Hortons’ restaurants are located, the company commands a market share which RBI estimates to be more than 40% of total QSR traffic and nearly 75% of QSR caffeinated beverages sales.
We believe the acquisition of Tim Hortons will create significant long-term value for RBI shareholders as executed by the company’s controlling shareholder, 3G Capital, which has an extremely strong track record of successful business transformations. In the four years that 3G has owned a controlling stake in RBI, the company has dramatically improved its operations, reduced its capital intensity, significantly grown its number of restaurants, and put in place an improved capital structure.
We believe the improvements that 3G has enacted at Burger King will serve as a template to create value in the Tim Hortons transaction. We believe there is substantial unit growth opportunity outside of Canada, and that under 3G’s leadership, Tim Hortons is well positioned to identify meaningful operations and capital efficiencies. The acquisition enhances Restaurant Brands’ medium and long-term EPS growth rate, andlong-term shareholder value.
Platform Specialty Products Corporation (PAH)
We believe that Platform Specialty Products has the opportunity to invest large amounts of capital at a high rate of return by acquiring a portfolio of specialty chemicals businesses that can operate more efficiently as part of a larger industry platform.
Platform’s business model of investment in asset-light, high-touch specialty chemical businesses is characterized by high margins, low capital intensity, and high switching-costs. Platform’s management team has a demonstrated record of value creation which benefits by an environment which is favorable for M&A activity.
In 2014, the company announced $5 billion in acquisitions in the agricultural chemicals industry by acquiring Chemtura AgroSolutions, Agriphar and Arysta LifeScience Limited. Agricultural chemicals are vital to increased food production, and are a key input to growing crop output to meet the rising demand for food worldwide. Agricultural chemicals have high barriers to entry, both from the need for intensive (and lengthy) research programs and the high hurdle of regulatory approval associated with any input in the food chain. With these acquisitions, we believe that Platform has assembled a leading global crop solutions business that offers a full product portfolio and diversity across crop varieties and geographies.
Zoetis Inc. (ZTS)
In November, Pershing Square announced an 8.5% stake in Zoetis, the world leader in branded animal healthcare products. Until 2013, Zoetis was a non-core subsidiary of Pfizer, whose primary business is human healthcare products. In January 2013, Pfizer completed an initial public offering of a 20% stake in Zoetis. The separation from Pfizer was completed in June 2013, when Pfizer split off its remaining 80% ownership to its shareholders.
The separation resulted in the creation of the only large, independent, publicly traded animal health company in the world. The company has a market capitalization of ~$24 billion and ~$5 billion in revenue.
Zoetis’ business model passes our high bar for business quality. Zoetis participates in markets with strong secular growth, driven by global increases in protein consumption, pet ownership, and the use of medicines to treat pets and livestock. As a result, the global animal health market has grown at an average of about 4% since 2008 and has experienced positive volume growth every year since 2003. Historically, Zoetis’ organic growth has exceeded the industry average.
Zoetis’ animal healthcare portfolio is highly durable. In 2014, ~80% of Zoetis’ revenue was derived from products that are not patent protected. Rather than rely on patents, which have a finite life, Zoetis’ business is driven by brand, market position, customer relationships and service, and other durable factors which have led to long product lifecycles.
One of the most important factors which contribute to the durability of Zoetis’ products is the small size of animal health products. Only about 20 products in the industry have sales exceeding $100 million, with the majority of products having sales significantly below this level. Gross margins of branded animal health products are lower than branded human health products. This combination of smaller products and lower gross margins has made it difficult for generic manufacturers to compete in the animal health market.
We have had a very positive dialogue with the board and management of the company. In February of 2015, Bill Doyle from our investment team joined the Zoetis Board of Directors. We expect the company to add an additional director shortly. We look forward to working with the board and management as along-term shareholder of Zoetis.
The Howard Hughes Corporation (HHC)
A little more than four years ago on November 10, 2010, HHC became a public company in a spinoff from General Growth Properties. At the time, there was considerable skepticism about the orphaned development assets that comprised HHC’s asset base. This was reflected in the company’s share price which closed at $36.90 that day. Since its launch as a public company shareholders have been rewarded with a four-fold increase in the company’s stock price.
In a short period of time, management designed and launched development or monetization plans for each of the company’s assets. HHC continues to create value converting its development-stage assets and vacant land into income-producing real estate and high-rise residential condominiums held for sale. We have not before seen a real estate company accomplish so much in so little time while maintaining superbly high quality execution along the way. Credit for this progress belongs to the extraordinary management team at HHC that is led by CEO David Weinreb and President Grant Herlitz, and a highlyshareholder-oriented, real-estate-savvy board of directors.
While the stock declined at the end of 2014 due to concerns about the decline in energy prices and its impact on the Houston assets held by the company, we viewed the market reaction as overdone and temporary. Since the beginning of 2015, the stock price has returned to near its all-time high.
We believe that HHC is well positioned to benefit from the housing recovery, and that over time, the intrinsic value of HHC will be easier for investors to assess as the company’s cash generation from stabilized income-producing assets increases.
Fannie Mae (FNMA) / Freddie Mac (FMCC)
Fannie Mae and Freddie Mac remain a critical piece of the U.S. mortgage market and we expect will serve as a core driver of the continuing housing recovery. In spite of much rhetoric about the desirability of replacing and shutting down Fannie and Freddie, we believe that there is no credible alternative to replace them. Consumers in the U.S. benefit enormously from the existence of the 30-year, prepayable, fixed-ratemortgage. As a result, we believe that Fannie and Freddie’s role is fundamental to the economy, and that ultimately, a renewed and recapitalized Fannie and Freddie is a far better alternative to any other.
Beginning in 2013, the U.S. Government began stripping all profits from Fannie and Freddie and sending them to the Treasury every quarter, in perpetuity. The Treasury unilaterally amended the 10% dividend rate on its senior preferred stock to a variable dividend equal to 100% of Fannie and Freddie’s future earnings and existing net worth. We view this net worth sweep as an unlawful taking of shareholders’ private property, and brought suit in District Court and in the U.S. Court of Federal Claims on behalf of common and preferred shareholders.
In September of 2014, the U.S. District Court for the District of Columbia dismissed shareholder lawsuits seeking to enjoin the net worth sweep undertaking by the government. We believe that much of the U.S. District Court ruling may ultimately be overturned on appeal.
The adverse court ruling resulted in a large decline in Fannie and Freddie’s respective share prices, which we used as an opportunity to purchase additional shares in both companies. We voluntarily withdrew our case in the U.S. District Court and are devoting our legal resources to reversing the Federal Government’s improper seizure of common shareholders’ property by prosecuting our Constitutional takings claims in the U.S. Court of Federal Claims.
In addition to our belief that the net worth sweep constitutes an unlawful taking under the U.S. Constitution, we believe that it is an untenable economic arrangement. By stripping Fannie and Freddie of the earnings that they could otherwise use to build capital, the Treasury is subjecting the U.S. taxpayer to grave risk during the next economic downturn.
We remain convinced that a reformed Fannie and Freddie is the only credible path to preserving widespread access to the 30-year, prepayable, fixed-rate mortgage at a reasonable cost. It is therefore essential that Fannie and Freddie build a sufficient level of capital through the retention of their earnings so they can continue to perform their vital function in the mortgage markets while limiting risk to the U.S. taxpayer. A reformed and well-capitalized Fannie and Freddie will accomplish the important policy objective of providing widespread and affordable access to mortgage credit for millions of Americans while, at the same time, delivering tremendous economic value to the U.S. taxpayer through Treasury’s ownership of warrants on 79.9% of Fannie and Freddie’s common stock.
While we remain confident in the prospects for Fannie and Freddie and believe our investment in their common shares will ultimately be worth a large multiple of current prices, the litigation is likely to continue for a protracted period before being resolved, unless the Administration, Treasury, Congress and other interested parties forge a consensual resolution. In light of the inherent uncertainty of the situation, our combined investment in the two companies represents about 3% of our capital at current market values.
During 2014, we exited our positions in Beam Inc. through a sale to Suntory Holdings, General Growth Properties, Inc. in a share sale to the company, and Procter & Gamble through open market sales.
Pershing Square 2014 Letter
As this is the first annual letter that will be read by the public Pershing Square Holdings, Ltd. investors as well as one that is read by investors who have been our partners for years, I thought it would be useful to provide an overview of our strategy as it has developed over the last eleven years.
In preparation for writing this letter, I re-read our investor letters since inception and highlighted the sections which I thought would be most useful to an understanding of Pershing Square. I often read the annual reports of companies in which we invest for the ten or more years preceding our investment as a way to understand the progress of a company and its strategy. To save you the effort of doing so for Pershing Square, later in this report, I have included excerpts from our previous letters organized by topic.Re-reading our investor letters was a useful exercise in that it has enabled me to better understand the development of our strategy over time.
While the core of our investment strategy remains unchanged, the growth of the firm, our increasing “reputational equity,” expanded relationships and experience have enabled us to intervene as an active investor differently from our approach in the past. In Pershing Square 1.0, we took substantial stakes and pushed for corporate changes which we believed would create shareholder value. Our holding periods were shorter. We achieved high rates of return, but required constant recycling of capital into new ideas. The changes we advocated were more structural and corporate than managerial and operating – think Wendy’s spinning off Tim Hortons, or Ceridian being sold to private equity.8 We proposed change from outside the board room as we did not generally become a member of the boards of target companies.
In retrospect, the development of our investment in General Growth Properties (GGP) represents the inception of Pershing Square 2.0. In GGP, I joined my first board since the inception of Pershing Square, more than five years after we launched the firm. At the inception of our GGP investment, our original strategy was a financial restructuring of the company in bankruptcy. From the perspective of the board of directors, we identified additional opportunities to create value which led to a recapitalization of GGP along with a change in management which we played a role in identifying.
It was the creation of The Howard Hughes Corporation (HHC) – which began as a spinoff of unrelated assets or businesses to unlock value – where we chose to take a much deeper approach. Unlike Tim Hortons, HHC did not actually exist at the time of our investment in GGP. We created HHC by assembling a pool of unrelated assets from GGP as a means to unlock the value of these principally non-income producing assets. Unlike in Wendy’s where we were advocating for the Tim Hortons spinoff from outside the boardroom, with HHC, we had the benefit and the responsibility of seeing it through.
By going beyond a financial restructuring and getting deeper into the creation of a new board and in the recruitment of management, we recognized the potential for greater board oversight to create substantiallonger-term value for Pershing Square and other stakeholders. HHC was not part of our original plan at the time of our initial investment in GGP. Since we created HHC from idea to launch, we had to help build a board of directors. As the largest stakeholder with more than a 25% stake in the new spinoff company, we ended up with the right to appoint one third of the board.
With these attributes came responsibility. I became chairman of HHC because there was no one else logical to serve in this role. We then hired a new management team led by David Weinreb and Grant Herlitz. While we had input into GGP’s new management team – we recommended Sandeep Mathrani for the job – at HHC, we identified and recruited the team and designed their compensation.
In retrospect, the transition from Pershing Square 1.0 to 2.0 was unplanned and largely organic. Our involvement with HHC led us to other deep engagements at J.C. Penney, Justice Holdings/Burger King (now Restaurant Brands International), Canadian Pacific, Air Products, Platform Specialty Products, and Zoetis. With one disappointing exception, J.C. Penney, Pershing Square 2.0’s track record of board engagements has been extremely strong. While our degree of engagement has varied, the approach is similar. Find a great business where there is an opportunity for management, operational, and/or governance improvements. Build a large stake at an attractive price. Work with management and the board to make necessary changes. Seek board representation for members of the Pershing Square team or affiliated or independent representatives that we identify.
While we give up some flexibility when joining a board, we have found that managements, boards, and Pershing Square benefit by our being present in the board room. CEOs often tell us that our involvement enables them to accelerate initiatives that they had previously advocated, but that the historic board was tentative about making out of concern with what the shareholders might think. With a large – and often the largest – shareholder represented on the board, who typically has the support of the majority of other owners, boards become more comfortable accelerating necessary change or making substantial new investments or acquisitions because they already have a shareholder sounding board in the board room.
As our typical investments today incorporate both structural and operational improvements, they offer more levers to create value. The combination of these initiatives has enabled us to earn larger multiples of capital over longer holding periods. GGP, which we recently exited, is the best and perhaps most extreme example. Our three current longest-standing holdings, HHC, CP, and Restaurant Brands have each appreciated multiple times since our initial investment. The balance of these commitments – Air Products, Platform Specialty Products, and Zoetis – are all off to strong starts since we got involved.
We do not believe it is necessary for us to have a board seat in these commitments if we are confident that the existing board already has appropriate shareholder representation, and a management team with exceptional operating and capital allocation discipline. Restaurant Brands, which is controlled by 3G, is a good such example. While the bulk of our capital is invested in Pershing Square 2.0-like commitments, we are still open to shorter-term commitments if the opportunity for profit relative to risk is large enough.
The benefits to our transition from Pershing Square 1.0 to 2.0 are significant. With reduced turnover in the portfolio, we can better understand our investments, reduce frictional costs, and continue to achieve high rates of return. Our reputational equity is also enhanced because as a longer-term investor, our recommendations for corporate change are more welcomed by the companies in which we invest and the major shareholders who own them.
Longer-term investing in high quality businesses is also more scalable than Pershing Square 1.0’s strategy. Once we are in a position of influence and own a high quality business run by able management who manages the business well and allocates free cash flow intelligently, absent excessive overvaluation or a substantially better use of capital, there are few good reasons to sell. It is essential though that these commitments have all of the above: high business quality, managerial and operating talent, and intelligent capital allocation for them to continue to generate high rates of return over the long term.
We believe that one of the biggest threats to the strategy has been the open-ended nature of our capital base. With the launch and increasing scale of PSH and a growing base of employee capital, our effective permanent capital base is quickly approaching a majority of our capital. When this is combined with loyal investors, relatively long-term contractual commitments in the private funds, and an active investor relations program, our capital base approaches the ideal of permanency. We took advantage of this increased permanency by being nearly 100% invested in our core activist strategy beginning last year. Our 2014 results benefited from not being diluted by our historic need to keep a large pool of assets in cash and liquid passive investments. We expect that the growing stability of our capital will continue to be an enormous competitive advantage for the strategy and for Pershing Square.
2014 was one of the strongest years in our history as measured by performance, net dollars of profits generated, as well as developments with respect to existing holdings and a new investment which should generate profits in future years. For a detailed review of the portfolio during 2014, please refer to the PSCM Annual Investor Update which is available on the Company’s website.
The IPO of Pershing Square Holdings was perhaps the most significant accomplishment of 2014 in light of its material strategic long-term benefits to our investment approach. None of 2014’s accomplishments could have been achieved without extraordinary contributions from every member of the Pershing Square team. Our finance, accounting, investor relations, legal and compliance, administrative, technology, and investment teams committed an enormous amount of time, insight, and energy to the IPO and listing of Pershing Square Holdings while simultaneously being responsible for their day jobs running the operations and investment oversight functions of Pershing Square.
Eleven years after our launch, the Pershing Square organization is functioning at its highest level of effectiveness ever. This is partly due to our extremely low turnover and the fact that most of us have worked together for more than five years and many of us for substantially longer. We are proud of our friendly, open, hard-working and family-oriented culture that has contributed greatly to our success, and that we have worked hard to preserve as the organization has grown. Long-term, our culture is likely to continue to be a key competitive advantage for the firm.
Over the next 10 or so pages, I have excerpted sections from the Pershing Square letters from inception to the present that cover our business model, investment strategy, risk management, valuation, hedging, trading, investor relations, and other topics that would be of interest to a new investor in Pershing Square. These excerpts are cited as originally written with any updates reflected within end brackets. You will note that there are de minimis updates, as even a decade later, our investment principles and philosophy are largely unchanged.
For new Pershing Square investors, we hope you find these principles useful in understanding what to expect from us going forward. For our longer-term investors, you may find the thoughts on the attached pages to be a helpful reminder of the key elements of our strategy.