The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (25 page)

In mid-July of that year, Pershing submitted a proposal recommending the spin-off of Horton, the sale of a large portion of the company’s restaurants to franchisees, and a share repurchase program. Despite his 10 percent ownership in the company, Wendy’s refused to discuss Ackman’s recommendations with him. “The CEO would not even meet with us.”

So Pershing Square hired Blackstone to write the equivalent of what some investors might call a fairness opinion. “We hired Blackstone to do an analysis of what Wendy’s would be worth if they implemented our plan.” We sent the Blackstone analysis to the board and filed it publicly in our 13D,” says Ackman.

Six weeks later, Wendy’s announced that it would sell 15 to 18 percent of Tim Horton’s in a tax-free spin-off during the first quarter of 2006.

In December 2005, Trian Partners, led by Nelson Peltz, Peter May, and Ed Garden, followed Pershing and announced that it had bought a significant equity position in Wendy’s. Trian also issued its own “white paper,” suggesting the company should spin off of all of Tim Horton’s as soon as practicable, sell-off ancillary brands like Baja Fresh and Café Express, improve margins at Wendy’s standalone restaurants through significant cost reductions and prudent revenue growth, and rethink previously announced strategic initiatives. Trian would later appoint representatives to the Wendy’s board in early 2006 about the time Wendy’s CEO was fired by the board.

In November 2006, it was reported that Ackman had liquidated his Wendy’s stake. From Ackman’s initiation in Wendy’s in mid-April 2005 to liquidation, Wendy’s stock appreciated from $38 to about $71.

“Wendy’s was a really good investment for us, making the fund a few hundred million, which was sizable as a percent of our total assets at the time,” says Ackman. “Wendy’s set us up for McDonald’s.”

Making Cents at McDonald’s

In the late 1990s, Ackman’s Gotham Partners owned a small stake in McDonald’s and started looking into how the company could operate more efficiently. In the second half of 2005, Ackman invested in McDonald’s again, this time with a more involved plan. He viewed McDonald’s as three separate entities: a franchising operation (representing 75 percent of McDonald’s restaurants); a restaurant operation (company restaurant ownership of remaining 25 percent); and a real estate business (land ownership of nearly 37 percent of all restaurants and 59 percent of all buildings).

He would pick up with McDonald’s where he left off with Wendy’s and began building an equity position initially through options. His principal goal was to convince McDonald’s to sell or spin off its company-operated stores to the more entrepreneurial franchisees, who would materially improve the operating performance of the restaurants. This would have the additional benefit of improving the quality of McDonald’s earnings and cash flow as the assets that remained at McDonald’s would generate cash from rent and a franchise royalty stream from the franchisees.

“McDonald’s is what we call a brand royalty company, similar to what we worked to create at Wendy’s,” says Ackman. “The company collects about 4 percent of the gross revenues from franchisees for the brand name and franchise rights and about 9 to 10 percent in rent,” says Ackman. “When we initially attempted to convince the company that selling restaurants to franchisees would be a good idea, the push back was that the restaurants were profitable. Because McDonald’s owned the real estate and did not charge itself rent or franchise fees, the company’s operated stores appeared to be much more profitable than they were in reality.”

“Owning 13 to 14 percent of the gross revenues of every McDonald’s in the world is one of the greatest annuity streams of all time,” says Ackman. “Every time someone buys a Coke, McDonald’s get 14 cents right off the top. It’s an even better business than Coke. The problem was that McDonald’s had
‘deworsified’
their business by buying out a lot of retiring franchisees in the earlier years, so at the time of our investment they owned almost 30 percent of the restaurants. McDonald’s argued that it was important for them to have skin in the game by owning restaurants alongside their franchisees.

“The best franchisers in the world own very few restaurants. I would argue that Subway is one of the best franchisors because they don’t have to own any of their stores. The deal is a good one for the franchisee. And the franchisees are doing a good job. There’s little reason for a well-run franchisor to own any restaurants because the business of operating a restaurant is not nearly as attractive as the business of collecting a royalty in exchange for a brand,” says Ackman.

“We wanted McDonald’s to become more of a brand royalty company. We went to McDonald’s and we said, ‘Look, the entire business is trading at a discount to the sum of the parts comprised of the franchise business, the real estate business—together what we deemed the ‘brand royalty business’—and the company-operated business known internally as McOpCo. And the mistake you’re making is that the real business you want to be in is the brand royalty business, not the restaurant business. And the reaction to us was, ‘Well, you know, we’re earning a lot of money in our restaurant business. We make high- to mid-teens margins.’ We pointed out to them that they weren’t charging themselves rent or a franchise fee. And once you took off 4 percent in franchise fees and 8 or 9 percent in rent, and an allocation of corporate overhead and capital expenditures, they weren’t making any money operating restaurants.”

“So we said, ‘Look, if you sell these to the franchisees, you’ll collect the 14 percent royalty premium, and the franchisees will do a better job operating the stores which will grow the top line on which you get a royalty. The untold secret of McDonald’s is that when you sell a restaurant to a franchisee, sales typically go up a lot because the franchisees do a much better job managing the store.’ ”

“Now, McDonald’s didn’t like being told what to do by a hedge fund in New York and they tried to shut us down,” says Ackman. So a week after McDonald’s rejected Ackman’s updated proposal in November 2005, Pershing hosted a conference for McDonald’s shareholders to discuss potential options for the company. Ackman also flipped burgers at a McDonald’s with his eldest daughter to learn more about the business and to gain credibility with the franchisees.

In mid-January 2006, three months after Pershing’s original proposal and two months after its rejection, he revised his plan to include the sale of 20 percent of McOpCo in an initial public offering (IPO); the use of the IPO funds along with existing cash to accelerate store expansion in China and Russia; tripling the dividend to $2 per share, retiring all unsecured debt and expanding the share repurchase program; refranchising 1,000 stores in mature markets over the next two to three years; and providing more disclosure about the financial performance of company-owned stores.

McDonald’s publicly rejected Ackman’s second proposal, but, ultimately, the company quietly capitulated by beginning a process of selling restaurants to franchisees.

“They didn’t do it as quickly as we would have wanted but nonetheless the stock doubled over two years. That’s a big move for a large cap company. The company has continued to improve its operating and financial performance to this day.”

Borders and Target: A Couple of Clunkers

In November 2006, Pershing built an 11 percent stake in Borders, saying its shares were undervalued and could rise to $36 from $23.92. Ackman said at the time that fears of the threat from online retailer
Amazon.com
were “exaggerated.” Looking back, “We were wrong. We did our best to save the company, but it still failed,” says Ackman as his investment in the bookstore chain shriveled.

Calling it “the best retailer in the world,” in April 2007 Ackman began buying shares of Target Corporation for about $54 a share. Because of the size of the company, Ackman had raised a separate coinvestment vehicle totaling $2 billion from a group of other hedge funds and Pershing Square investors. While the main Pershing Square funds operated without leverage, Pershing’s coinvestment vehicles were leveraged single-stock funds that used options, margin, and total return swap leverage to enhance their returns. The first three coinvestment funds had generated high returns for investors as they coinvested with the main Pershing fund in Sears Roebuck, Wendy’s, and McDonald’s.

Pershing’s stake in Target, in its main funds and its fourth coinvestment fund, comprised of a combination of options and common stock, topped out at 9.97 percent of the company. Shortly after building its stake, in August 2007, Ackman met with Target CEO Greg Steinhafel and CFO Doug Scovanner to present his proposal for Target to sell its nearly $8 billion of credit card receivables, to transfer the risk of this business from the company, with the proceeds to be reinvested in the business and in share repurchases.

Initially, Target appeared to be heading in the right direction. In September 2007, Target announced it would review ownership alternatives for credit card receivables; later, it announced that it would buy $10 billion of its shares over three years. By May 2008, it announced a $3.6 billion sale of less than half of the credit card receivables to J. P. Morgan Chase. Unfortunately, Target had ignored the most important part of Pershing’s advice. The credit card transaction left Target with effectively all of the credit risk of the business, and half the funding risk.

While Ackman was disappointed with the transaction, he continued to press forward with a more extensive overhaul of the retailer.

Zeroing in on Target

In May of 2008, Ackman presented Target with a plan to create a publicly traded REIT that he believed would be valued at about $37 a share within a year. The Target REIT would own the land under every Target store, which would be triple net leased back to Target for 75 years. The lease rent would rise by the consumer price index and be payable twice yearly. The structure created a debt-free REIT, which would generate an extremely safe stream of growing dividends that was designed by Pershing to look as close as possible to a Treasury Inflation Protected Security; hence, Pershing named the company TIP REIT.

Pershing believed the benefits to Target from the transaction were substantial. It would allow Target to retain control over all of its buildings so it could maintain the flexibility of opening, closing, modifying, and moving stores while monetizing the large embedded value of its well-located real estate portfolio, a value that approximated 75 percent of the market value of the company.

Pershing’s TIP REIT was initially well received by Target’s senior management and its adviser Goldman Sachs. In September 2008, Target’s board considered the potential REIT transaction. Unfortunately for Pershing, the Target board met shortly after Fannie, Freddie, AIG, and Lehman failed, and the board did not have any appetite for what looked like a financial engineering transaction.

Rejected by the company, Ackman decided to go public with his TIP REIT proposal in a town hall format. Shortly after its November 2008 presentation, Target summarily rejected Pershing’s proposal, citing a number of concerns. A few weeks later Ackman made a second public presentation attempting to address Target reservations about the plan, but which Target again rejected. Then, after having bought back $5 billion of stock over the prior year on November 17th, Target suspended its share buyback program. The stock closed at $31.68, down substantially from Pershing Square’s more than $50 purchase price.

In February 2009, Ackman privately sought a board seat for himself and Matt Paull, the retired CFO of McDonald’s who had joined Pershing Square’s advisory board. As the stock market neared a bottom in March 2009, Target stock dropped to $25 per share as investors ran for the exits from retail stocks and the company’s large credit card business, which Pershing had pushed the company to sell.

Pershing’s leveraged Target coinvestment fund suffered with the decline in the stock. At the stock market low, the Target-only fund had declined by 93 percent leaving investors with mark to market losses of $1.86 billion.

In light of the severe losses, a number of the investors in the fund pushed for the right to exit despite the fund’s several-year remaining lock up. While Ackman told these investors that it was not a good time to sell, he offered everyone who wanted to exit the opportunity to do so, and committed personal capital to buy out exiting investors. Because he believed the opportunity to buy out investors was an attractive one, he offered all investors in the fund the opportunity to do so, although few went along. He also waived fees for all of the investors who elected to stay in the fund. Most significantly, he gave every investor in the Target-only fund a credit for any losses incurred that they could use against any future gains in the Pershing Square main funds. This so-called loss carry-forward meant that the fund investors wouldn’t pay any incentive fees on their main fund investment until they recouped the Target-only fund losses.

By March 2009, Ackman decided to push for a slate of five candidates, including himself, arguing for a 13-member board. Target rejected Ackman’s proposed slate, saying it supported reelecting the four directors on its 12-member board. Both sides made their case to shareholders in more than 20 regulatory filings but at the May 28 annual shareholder meeting, Ackman’s slate lost.