Kraft Corporation (KFT)
After acquiring Cadbury earlier this year, Kraft is now the largest global snacks company with roughly 50% of its sales coming from highly branded confectionary, cookies and crackers. We continue to like the “new Kraft” for its underappreciated international growth opportunities, as Kraft leverages Cadbury’s well-established distribution network particularly in emerging markets. We also believe the company will significantly improve its profit margins, which are among the lowest of its peers.
Thus far, our thesis appears to be on track. Year to date, base Kraft EBIT margins (excluding corporate expense) are up from 14.8% to 15.4%. We believe margins will continue to increase in the coming quarters, particularly as the company delivers its expected $750 million of cost savings from the combined Kraft/Cadbury operations.
From a valuation perspective, based on the attractiveness of the categories in which Kraft participates, and its strong and growing emerging market presence, we think the stock is inexpensive at roughly 11x 2012 earnings.
We have reduced our investment in Kraft somewhat to raise capital for two new commitments, Fortune Brands and J.C. Penney, which we discuss further below. We sold not because we believe that Kraft is no longer an interesting investment – it remains a core holding of the funds – but rather because we believe that these new investments present an even more attractive use of capital.
We believe that Target is well positioned even if the U.S. economy remains weak. We expect that Target’s P-Fresh expansion program and its recently launched 5% off discount program for Target Visa and Red Card customers will drive increased sales and profitability for the company.
Target stock trades at about an approximate 8.5% projected free cash flow yield, a valuation which continues to be compelling. We remain one of Target’s largest shareholders even though, as with Kraft, we have recently reduced our exposure to raise capital for our J.C. Penney and Fortune Brands investments.
Citigroup reported solid earnings for the third quarter. The credit quality of Citi’s asset pool continues to improve and the wind down of Citi Holdings has progressed at a reasonable pace.
Other important developments include greater clarity on Basel III rule making which has allowed Citigroup to provide better visibility as to the timing, now targeted to be 2012, of the return of excess capital to shareholders. How and when Citi returns excess capital will likely have a material effect on long-term shareholder value. We believe that management is appropriately focused on this opportunity.
While Citi stock has appreciated substantially in recent weeks, it continues to trade at a discount to our estimate of fair value due to a number of factors, which include continued economic and regulatory uncertainty, and the technical overhang of the government’s sale of shares. We expect these issues will be resolved over the short term (in the case of the government’s stock sale) and the other issues over the intermediate term. In the meantime, we expect the bank to continue to generate substantial earnings which can be used to absorb remaining losses in its portfolio, while building additional capital for future distribution or investment.
ADP is a paradigm of a well-managed, stable, predictable, free-cash-flow-generative business.
The opportunity to acquire ADP at a discount to intrinsic value arose as ADP’s earnings and cash flow weakened with the economy. Retention rates and new business bookings declined substantially as recession-related pressures drove some ADP customers into liquidation, led to headcount reductions, and otherwise delayed new business. Lower average client fund balances coupled with low interest rates also contributed to weakness in ADP’s earnings.
We believe that ADP’s business performance has improved as evidenced by a substantial increase in customer retention rates and a sharp improvement in new business sales activity.
ADP should also continue to be a beneficiary of the stabilization and improvement of the economy. In the interim, ADP continues to wisely deploy capital in high-return acquisitions, substantial share repurchases, and dividends. Over the past five years, the company has repurchased more than 20% of its stock, made a number of intelligent acquisitions of complementary product offerings, while divesting non-core operations through sale or spinoff.
J.C. Penney (JCP)
As reported in our Schedule13D filed on October 8, during the third quarter and early in the fourth quarter, Pershing Square purchased stock and additional economic exposure totaling approximately 39.7 million shares, or approximately 16.8% of J.C. Penney.
We made this investment alongside Vornado Realty Trust, the publicly traded REIT led by Steve Roth and Michael Fascitelli. Vornado has also filed its own Schedule 13D on J.C. Penney in which it disclosed an approximate 9.9% ownership position. Vornado brings significant retail and real estate experience to this investment, and we look forward to consulting with them on strategic matters relating to the company.
After our 13D filing, the company hired Goldman Sachs and Barclays Capital as financial advisors, and on October 19, the day before our first meeting with J.C. Penney management, the company announced that its board had adopted a shareholder rights plan that would be triggered if, among other things, a person or group acquires at least 10% of its common stock.
Pershing Square’s and Vornado’s positions were grandfathered under the plan.
We were attracted to JCP because of its inexpensive valuation, strong brand name and assets, and well-deserved reputation for overseas sourcing, high quality systems, and large in-house brands. We purchased our holding at an average price of $25.28 per share, an enterprise valuation of 4.1x 2010 EBITDA (adjusted for excess cash and other saleable non-core assets), a low multiple of what we believe to be trough or near-trough pre-tax earnings. At yesterday’s closing share price of $30.80, JCP’s valuation has increased to 5.1 times EBITDA, a valuation that we continue to find attractive.
We believe there is significant potential for operational improvements at JCP which has underperformed its competitors including Kohl’s and other retailers. Trailing earnings are at cyclically depressed levels; margins have been squeezed and sales productivity is low, with sales per square foot now at 2002 levels. 2010 adjusted EBITDA is approximately 30% below its 2007 peak and EBIT margins have deteriorated by about 45%. As a result, there should be substantial operating leverage in a sales recovery, which should come from an improved economy and operational improvements if they can be achieved.
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