Pershing Square Holdings, Ltd. (ticker: PSH:NA) today released Semiannual Financial Statements including its Investment Manager’s Report to Shareholders. The report can be found below.
Pershing Square Holdings 2016 Semiannual Report
Dear Pershing Square Holdings, Ltd. Shareholder,
Below we provide PSH’s performance since its inception. The period of the last twelve months has been the worst period of performance by a wide margin since the inception of the strategy on January 1, 2004. Performance has improved substantially in the last few weeks with significant progress at Valeant and increases in the value of other holdings bringing year-to-date performance through August 23, 2016 to -15.S%.
We recognize that the last twelve months have been extremely challenging for PSH investors. As the largest individual investors in PSH and in the private funds that are managed side by side with PSH, we have also borne substantial losses. We are working diligently to maximize the value of our existing holdings and to identify new opportunities for profitable investment. I am encouraged by our recent progress and look forward to updating you with additional developments as they occur.
In the following Portfolio Update section, we discuss each of our portfolio investments in detail. You will note that our portfolio companies are demonstrating strong and/or improving performance which has contributed to their recent stock price appreciation. In light of recent stock price appreciation and the existence of other potential investment opportunities, we have elected to sell a substantial portion of our investment in Zoetis and all of our investment in Canadian Pacific which, when combined with a portfolio sizing adjustment to Mondelez, has freed up a substantial amount of capital for new investments. As a result, the majority of the investment team’s time is currently being spent actively researching potential new commitments.
The progress noted in the Portfolio Update below has begun to be reflected in performance. From the bottom (March 15, 2016) when PSH was down 26.4% year to date, NAV per share has risen from $15.42 to $17.70 (August 23, 2016), a 14.8% increase bringing year-to-date performance to -15.5%. PSH’s stock price has underperformed the increase in NAV as the discount to NAV (currently 14.9%) has expanded slightly over that time period. We are cognizant of the substantial discount to NAV at which PSH trades, which we believe has been driven by a loss of confidence by some PSH investors as a result of events at Valeant. We expect that our recent progress at Valeant, further increases in NAV, coupled with the identification of one or more new investments will contribute to the closing of the discount.
Below are the attributions to gross performance of the portfolio of the Company through June 30, 2016.
Pershing Square Holdings – Portfolio Update
Air Products and Chemicals, Inc. (APD)
Air Products’ recent quarterly results marked the eighth straight quarter of double-digit EPS growth as APD continues its impressive transformation under CEO Seifi Ghasemi and his team.
APD’s fiscal year third quarter earnings per share of $1.92 were up 16% while currency-adjusted EPS growth was 19%. These impressive results were driven by currency-adjusted sales growth of 4% and operating margins which were up 340 basis points (bps) to 23.0%. Sales growth was driven by 4% volume growth, largely due to volume contributions from growth investments, and flat pricing. Margins increased across each major operating segment, including each region for industrial gases as well as the non-core Versum materials technology business. We believe this broad-based operating improvement is a testament to the cultural impact Seifi has had on APD along with the benefits of the company’s decentralized operating model which has empowered local operating executives to drive performance and unlock the company’s latent potential.
On the strength of these strong results and its near-term outlook, APD increased the lower end of its fiscal year earnings guidance by $0.05 to $7.45 to $7.55, which at the midpoint reflects 14% growth over the prior year despite modest foreign exchange headwinds.
While APD has made significant progress improving its operating margin from ~15.5% to ~23% since our investment, and now has a consolidated operating margin in-line with best-in-class peer Praxair, we believe that APD has additional opportunities to extract operating efficiencies. Adjusted for non-core businesses, APD’s industrial gas margins remain substantially below Praxair’s. Management has provided guidance which suggests that APD can extract $225 million of additional operating efficiencies over the next three years.
The company remains enthusiastic about the growth capex opportunities for large on-site air separation units and hydrogen facilities. businesses in which APD has strong leadership positions. Seifi and his team are disciplined about investing capital in growth capex projects that meet appropriate return hurdles.
Air Products’ plan to sell and spin off its non-core materials technology and electronics materials businesses is also progressing as planned. Subsequent to its announced spin off of these businesses as a newly formed company named Versum, the company announced the sale of the materials technology segment of the business to Evonik for 16 times EBITDA, a price that will yield an attractive ~12 times EBITDA net price for Air Products’ shareholders after the company pays taxes on the gain from the sale of this business. APD is proceeding with the planned spinoff of the remaining electronics materials business in the coming months. The electronics business, which produced FY 2015 sales and EBITDA of $1 billion and $302 million, respectively, is a leading provider of materials and delivery systems equipment to the semiconductor industry and has strong secular growth prospects due to the proliferation of consumer electronics devices around the world. The electronics business has meaningfully improved its operating margins and competitive positioning under CEO Guillermo Novo and his team, and is well positioned to be a successful independent company.
Overall, we expect APD to continue to deliver double-digit EPS growth for the next several years as it extracts additional cost efficiencies, brings on-stream growth capex projects, drives organic performance, and allocates capital to acquisitions, growth capex or the repurchases of its shares in a manner which maximizes returns for investors. We believe the company’s long-term outlook remains robust and its shares remain at a discount to their intrinsic value.
Fannie Mae (FNMA) / Freddie Mac (FMCC)
Fannie and Freddie’s underlying earnings progressed modestly in the second quarter as their core mortgage guarantee businesses improved due to an increase in the guarantee-fee rate and lower credit costs. Their non-core investment portfolios continued to be reduced, which is leading them to a safer and more capital-light business model. As in recent quarters, reported earnings remained volatile due to non-cash-accounting-based derivative losses in the non-core investment portfolio. As a result of the derivative losses and the continued Net Worth Sweep, the companies remain at risk of being required to draw capital from the Treasury, as a result of the requirement to pay dividends to Treasury under the Net Worth Sweep of more than $125 billion in excess of the original 10% dividend agreement. As the risk of capital draws from the Treasury increases, we believe that Congress will become increasingly focused on seeking a permanent resolution for Fannie and Freddie.
In the litigation, the government recently released additional documents which further support shareholder claims. From the documents, it is clear that high-level government officials were aware that the 08138 were expecting to become highly profitable just prior to the implementation of the Net Worth Sweep, which runs contrary to the government’s contemporaneous public statements that the GSEs were in a “death spiral.” In fact, private emails of key government officials show that the government intended to implement the Net Worth Sweep as a measure to prevent the GSEs from recapitalizing themselves and exiting conservatorship. Both of these points directly contradict key claims the government made on and after implementing the Net Worth Sweep and as a defense to the litigation. In addition, the courts rejected the government’s request to have individual lawsuits consolidated as a multi-district litigation and sent to Judge Lamberth. This allows each case to continue to proceed separately and be evaluated on its individual merits, which improves the likelihood of a favorable legal outcome for shareholders. We believe a new administration, which did not implement the Net Worth Sweep, will be more conducive to implementing a sensible resolution for Fannie and Freddie which benefits all stakeholders including tax payers, home owners and shareholders.
Herbalife Ltd. (HLF) Short
We have made substantial progress with our short position in Herbalife. On July 15, 2016, after a more than two-year investigation, the FTC found that Herbalife has been operating illegally, misleading consumers about the potential profitability of its so-called business opportunity, among other extremely critical findings. The FTC’s settlement with Herbalife avoided using the words “pyramid scheme” to describe its business, but found that the company had all of the hallmarks of other pyramid schemes it has prosecuted recently. The FTC’s findings confirm each of our principal allegations against the company.
The FTC stated that it chose to settle with Herbalife to avoid an extended period of litigation and to bring relief to consumers more rapidly. While Herbalife has to-date successfully spun the terms of the settlement as a victory for the company, the facts speak differently as the market appears to have recently begun to understand. While Herbalife stock rose more than 20% on the initial announcement of the settlement, it has declined since that time, and is now trading at approximately the same price as before the announcement.
Under the terms of the FTC settlement, the company is being required to totally restructure its business and compensate its distributors only for “profitable retail sales” to consumers who are not distributors pursuing the business opportunity (other than for a limited carve out for personal consumption of the product by distributors). In light of the fact that the FTC found little if any evidence of profitable retail sales, it is difficult to understand how the company can continue to motivate and recruit distributors to replace the more than 2,000,000 who quit each year when these aspiring distributors realize they cannot make money. As a result, we expect Herbalife to collapse as distributors leave as a result of the newly restructured compensation arrangements and required changes in marketing practices. While it is difficult to estimate a precise time frame for the company’s demise, we believe it will not be years. We have already described the Complaint and Settlement Agreement in detail during our July 20, 2016 conference call and presentation which is available on the PSH website, wwwpershingsguareholdings.com. In summary, the FTC findings make clear that Herbalife is a pyramid scheme.
A comparison of the FTC ’s findings about Herbalife with previous FTC pyramid scheme prosecutions reveals similar and often nearly identical language. The FTC Complaint alleged that Herbalife participants are “primarily compensated for successfully recruiting” new participants and not for selling products, the defining attribute of a pyramid scheme which has been alleged in each of the most recent FTC pyramid scheme cases. Exhibit I, which starts on page 32 of this report, compares the F TC’s allegations against Herbalife and other companies the FTC deemed to be pyramid schemes. Most notably, the count against Herbalife for Unfair Practices closely mirrors the Illegal Pyramid counts in previous cases. It is clear from Exhibit I that the FTC found Herbalife to be an illegal pyramid scheme and alleged the necessary findings to support that charge but, as part of the settlement, agreed to avoid using the phrase “pyramid scheme.” FTC Chairwoman Ramirez’s public comments corroborate this conclusion.
We believe the implementation of the Settlement Agreement – the most comprehensive business model reform required by the FTC against any multi-level marketing company – will cause Herbalife’s US. business to collapse and contribute to the eventual failure of the entire company. The settlement represents Herbalife’s agreement to engage in a “top to bottom”1 restructuring of its business model in the United States. Key elements include:
- Compensation to distributors is limited to verifiable, “Profitable Retail Sales””;
- Present compensation levels remain only if 80% or more of US. sales are verifiable, “Profitable Retail Sales”;
- At least two-thirds of rewards paid by Herbalife to distributors must be based on Profitable Retail Sales of Herbalife products that are tracked and verified;
- Qualification purchases are prohibited;
- Misleading income claims are prohibited; and
- An Independent Compliance Auditor will be hired to oversee compensation plan changes for a period of seven years.
Since the day of the FTC settlement announcement, Herbalife has orchestrated a coordinated media campaign to misrepresent the findings of the FTC and the inevitable business impact of the relief demanded by the FTC. On August 3, 2016, Herbalife reported its second quarter financial results. On the conference call, Herbalife management was consistently upbeat and bullish on the prospects for the business in the face of the FTC settlement, noting “these changes are good for our company,” and “we have the greatest confidence in our ability to comply with the agreement and continue to grow our business in the US. and around the world.” Management’s latest commentary is a continuation of prior misrepresentations.
Herbalife’s 1oQ provided revised disclosure pertaining to the FTC settlement and updated risk disclosures. It struck a more balanced, and at times cautionary, tone compared with management commentary on the call, noting that “there is no guarantee that we will be able to fully comply with the Consent Order,” and “[t]he impact of the Consent Order on our business could be significant.” All the same, the 100 reiterated that Herbalife “neither admitted nor denied the allegations in the FTC’s complaint”‘ in agreeing to the terms of the Consent Order,” and repeated the company line that “we do not believe the Consent Order changes our business model as a direct selling company.” The 100 included new language noting that the Consent Order does not prevent “other third-parties from bringing actions against us, whether in the form of other state, federal or foreign regulatory investigations or proceedings, or private litigation, any of which could lead to, among other things, monetary settlements, fines, penalties or injunctions.”
At a minimum, we believe the injunctive relief demanded by the FTC is likely to significantly weigh on Herbalife’s financial performance in the coming quarters. Moreover, we believe that the FTC complaint and settlement provide a roadmap for other state Attorneys General and regulators in 93 other countries around the world to seek similar relief and to enforce similar protections for their consumers.
Despite a bleak financial outlook, Herbalife is trading at ~13.5x the midpoint of management’s revised 2016 guidance ($4.50 to $4.80) or ~16 times 2016 guidance excluding certain items (which we believe are ongoing costs to the business but which Herbalife management inappropriately adds back). The implied multiple represents an even higher multiple of 2017 earnings, as Herbalife’s future earnings are likely to be significantly lower as changes to the business model reduce the company’s earnings power. These estimates exclude additional fines and/or the impact of additional injunctive relief that may arise from other regulatory agencies.
Herbalife stock price hit a recent high in the low $7os per share on the day of the settlement, but has declined to less than $62 currently. Putting aside the short case for Herbalife, it has become extremely difficult to comprehend the logic behind the bull case on Herbalife.
The bulls had believed that the FTC settlement would exonerate the company and otherwise not require any material changes to the company’s business practices. This is definitively false based on the FTC Settlement and Order. Second, the bulls believed that the company would announce a large leveraged recap at the time of a settlement. When pressed about buybacks on the recent earnings call, the CFO demurred and reminded investors about the maturity of its credit facility in March 2017 and the $1.15 billion out-of-the-money convertible debt issue which is due within three years. We do not believe that banks and/or bondholders are likely to be willing to provide a material amount of debt financing to Herbalife in light of the FTC findings, and without knowing the revenues, earnings, and cash flow implications of the F TC’s required business changes, which will not be fully implemented until May of next year.
Third, China, which has been the growth engine of the company in recent years, showed dramatically decelerated growth for the quarter calling into question its sustainability. Herbalife management stated that investors are likely to see “a significantly lower growth rate going forward” and that they do not believe China’s growth rate is “sustainable at the current levels.”
Fourth, long-only institutional investors appear to be exiting, with Fidelity, a long-time shareholder selling nearly 40% of its holdings as disclosed in its recently updated 13G filing. Fidelity will not be required to notify the market of additional sales until mid-November. Capital Research has also been a substantial seller. In light of the FTC ’s findings of wrongdoing, we do not believe that legitimate institutional investors will continue to own Herbalife. The substantial majority of other holders appear to be fast-money investors who we believe mistakenly bought on the announced settlement, betting on a buyback, when more than 50% of the float on that day changed hands at prices nearly 20% above current levels.
Lastly, at current prices it is difficult to make a compelling argument for owning Herbalife even if one does not believe it is a pyramid scheme. The stock trades at about a 50 percent multiple premium to legitimate supplement retailers like GNC, which, unlike Herbalife, is not being required to completely change the way it compensates its distributors as well as its marketing practices.
While it has been a long road, we see multiple paths to an eventually successful outcome with this investment.
See the full report below.