Pershing Square Capital Management letter for the third quarter ended September 30, 2016.
The performance of Pershing Square Holdings, Ltd. is set forth below1.
Pershing Square Capital Management Third Quarter Performance Attribution
Investments that contributed or detracted at least 50 basis points to gross performance for the quarter are outlined below1,2:
The chart above shows the performance of Pershing Square, L.P., our longest standing fund which launched at the inception of the firm on January 1, 2004. The substantial decline in performance from August 2015 through March 31, 2016 is largely due to Valeant’s decline, which affected PSH’s performance as well. While year-to-date performance for PSH remains negative, the fund’s performance turned positive in the second quarter, and in the third quarter, and the fourth quarter to date. This is despite the continued decline in Valeant’s stock price, as our other holdings have appreciated substantially. Valeant now represents approximately 5% of the fund’s capital.
From inception of the strategy, investors have achieved a six-fold multiple of invested capital, a 14.9% annual compound return, which compares favorably with the S&P 500, which has generated a 158% cumulative return and a 7.6% annual compound return over the same period. While this is a good result, it is below our long-term goals and not much solace to PSH investors who joined us in recent years.
Since the beginning of the year, we have worked to achieve a number of key business objectives to improve both short-term and long-term performance. These objectives have included: (1) exiting certain portfolio investments to free up capital for new opportunities, (2) identifying new investments, (3) assisting our portfolio companies in executing their strategies, (4) obtaining board representation at Valeant and assisting the company in a turnaround, and (5) putting in place a long-term compensation arrangement for long standing Pershing Square employees. We have made substantial progress on all of the above objectives. This progress is partially reflected in the fund’s 18.4% NAV performance since the fund bottomed on March 31, 2016 versus 8.3% for the S&P 500 over the same period, but more significantly in the business progress and developments in the balance of the portfolio which we discuss in greater detail below (although PSH’s share price performance has underperformed its NAV performance as the discount to NAV has widened substantially, which we also discuss below).
Over the past two quarters, we have exited our investments in Canadian Pacific and Zoetis, two highly successful activist engagements that have contributed substantially to our profits over the years. While we consider both to be high quality businesses run by extremely able management teams, we harvested these investments to free up capital for new commitments.
Canadian Pacific Railway Limited (CP)
In our August 26, 2016 Investor letter we reported the sale of our remaining 9.8 million shares of CP on August 4, 2016, approximately five years from the inception of the investment. During the course of our investment, CP’s share price increased nearly four times, its operating performance went from worst to nearly tied for first with Canadian National, and its credit rating improved from a weak Baa-/BBB- to a strong Baa+/BBB+. While critics often accuse activists of being short-term investors focused primarily on stock buybacks and dividends, CP is a paradigmatic example of the long-term sustainable business performance enhancements and shareholder value creation we have achieved in our core activist holdings.
Zoetis Inc. (ZTS)
On November 9th we sold our last shares of Zoetis, about two years after we publicly announced an 8.5% ownership stake. Despite the high quality nature of the business and its strong management team, we sold to redeploy the capital in certain new investments.
We purchased our stake in Zoetis at an average cost of approximately $37 per share. Shortly thereafter, we met with the Zoetis management to learn more about the company and to discuss our views on potential initiatives to create shareholder value. On February 4, 2015, Zoetis agreed to add then-Pershing Square investment team member (and healthcare industry veteran) Bill Doyle and Actavis Executive Chairman Paul Bisaro to the board on April 13, 2015.
Over the course of our ownership, ZTS developed and implemented a number of value-enhancing initiatives including restructuring its supply chain, pursuing organic revenue growth opportunities while reducing costs, and setting a goal of increasing operating margins from ~25% in 2014 to ~34% by 2017. Zoetis outperformed each of these objectives during our ownership.
We sold our remaining shares of Zoetis on November 9th. During our more than two-year ownership, Zoetis generated a total shareholder return of 58%.
We have publicly disclosed one of our new investments – Chipotle Mexican Grill – which we describe in greater detail below. We have yet to disclose the second investment in which we have built a half-sized position, as the accumulation of additional shares has been disrupted by the recent increase in its stock price.
Chipotle Mexican Grill (CMG)
On September 6th, we announced a 9.9% stake in Chipotle Mexican Grill which we purchased at an average price of $405 per share. Chipotle has built a superb brand pioneering the “fast casual” restaurant industry with the success of its outstanding product offering, unique culture and powerful economic model. We have followed the business for years, noting how it has disrupted the fast food industry with its high quality, delicious and customizable hot meals that are prepared quickly and sold at affordable prices. The company has been significantly negatively impacted by food safety issues beginning in the fourth quarter of 2015 which caused a peak decline in average unit sales of 36%. In response, the company has implemented best-in-class food safety protocols over the past year, and worked to win back lost customers. While traffic and sales have begun to recover, average unit volumes are still 19% below peak levels.
We have always believed that a good time to buy a great business is when it is in temporary trouble. While Chipotle’s reputation has been bruised, we think that with the passage of time and improved marketing, technology and governance initiatives, the business will not only recover but become much stronger. Chipotle’s sales recovery will be neither smooth nor predictable over the next few quarters; yet, we believe that all of the key drivers of Chipotle’s powerful economic moat and long-term success remain intact. These drivers include:
- A strong and relevant brand built by visionary leadership
- A differentiated product offering with a highly attractive value proposition
- Substantial scale in the fast casual industry and first-mover advantage in real estate
- Strong unit economics and extremely high returns on capital, driven by a well-honed model that facilitates best-in-class throughput
- Enormous growth opportunities including new units and operating enhancements such as mobile ordering and catering
The Chipotle brand was developed by founder Steve Ells with the philosophy that food served fast does not have to be a traditional “fast-food” experience. This vision later evolved into an ambition to change the way the world thinks about and eats fast