Pershing Square Q3 Letter to Investors - Compliments Berkowitz and Brookfield - Updates Major Positions
General Growth Properties Inc.
GGP emerged from bankruptcy on November 9 and distributed shares in The Howard Hughes
Corporation (HHC) to old GGP shareholders including Pershing Square. The company
subsequently launched an offering of new GGP shares. The proceeds are to be used to “claw
back” a portion of the shares from Pershing Square, the Fairholme Funds, and Texas Teachers
that were purchased on November 9 at $10.00 per share ($10.25 for Texas Teachers), and any
remaining funds will be used for general corporate purposes.
On November 15, the offering was priced at $14.75 per share. Net of the claw back shares, we
acquired an additional 46 or 48 million shares (depending on whether the greenshoe is exercised)
of new GGP for $10.00 per share that traded at $14.31 per share as of yesterday’s close. In
connection with the offering, we also lent GGP $350 million at 6% interest which will shortly be
repaid from the proceeds of the offering. We are pleased to note that GGP stock initially
purchased for 34 cents per share in November of 2008 (and at an average price of less than $1.00
per share) now trades for more than $18.00 per share including the shares received in the HHC
spinoff. We no longer own any old GGP bonds, having sold and/or exchanged the debt to fulfill
our equity commitment to the company.
Prior to the offering, GGP hired Sandeep Mathrani, the Executive Vice President of Vornado
Realty Trust’s retail real estate division, as CEO. He will join the company full time on January
1, 2011. We met Sandeep years ago, having previously shared the 29th floor of 888 Seventh
Avenue with Vornado’s retail group. We hold Sandeep in extremely high regard and had
recommended him to the GGP search committee. We expect that Sandeep will prove to be a
superb leader for GGP as it works to improve its operational performance. We will also benefit
from the oversight of Brookfield Asset Management, led by Bruce Flatt, its CEO, who will serve
as Chairman of GGP, and Cyrus Madon and Ric Clark, two Brookfield managing directors, who
will also serve on the board.
Now that the transaction has closed and we have no more deal issues to negotiate with
Brookfield, we can speak with candor about our colleagues at Brookfield without weakening our
negotiating position. I have known Bruce Flatt since the 1990s, but had never worked on a
transaction with him. Bruce and his team proved to be extraordinary transaction participants in
consummating an extremely complicated deal. While the original deal was struck in March of
this year, the transaction was amended numerous times to accommodate bankruptcy, tax, and
other issues. In each instance, Brookfield worked in good faith to optimize a transaction for the
collective benefit of all parties and never used its negotiating leverage to extract concessions that
would have been inconsistent with the original transaction it shook hands on many months
earlier. Brookfield always worked to expand the pie for the benefit of all, and for that we, and
the other shareholders of GGP, are extremely grateful.
Bruce Berkowitz of Fairholme Capital was the other key participant in the GGP recapitalization
without whom we would have been materially worse off. While Bruce is not well known in the
hedge fund community, he is the star of the mutual fund world, with his fund recently named US
Equity Mutual Fund of the decade. Bruce manages approximately $20 billion in a highly
concentrated fashion. At a critical juncture in the transaction, when GGP was subject to a
competitive take-under bid from Simon Properties, Bruce stepped up with a $2.7 billion
commitment that provided the remaining capital necessary to guarantee GGP’s bankruptcy
emergence. Bruce and his partner Charlie Fernandez have been exemplary transaction partners
in the recapitalization, calling us early on to offer support and then later making an ironclad,
multi-billion dollar commitment that we knew GGP could rely on, long before the papers were
finalized. Fairholme’s commitment remained firm despite the enormous economic and capital
As part of the recapitalization, we obtained the right to appoint a director to the GGP board. We
chose to forgo that right and instead allow the Blackstone Group to appoint John Schreiber in
lieu of a Pershing Square representative because he is an extremely experienced retail real estate
investor who will best represent the interests of all shareholders. We no longer believe that our
involvement on the GGP board is necessary for the long-term success of this investment. We
have worked closely with Blackstone for many years and, in particular, with members of their
real estate private equity group, Jon Gray and A.J. Agarwal. In light of our comfort with
Blackstone and their combined $500 million investment in GGP and HHC, we believe they will
be a highly value-added co-investor.
It is important to mention the critical role that GGP’s senior management, led by Adam Metz and
Tom Nolan, played in overseeing the company during this challenging period. They, along with
a motivated and talented workforce, and the superb legal and bankruptcy advisors at Weil
Gotshal, Kirkland & Ellis, Miller Buckfire, UBS, and AlixPartners, accomplished what many
have come to regard as the most successful bankruptcy restructuring of all time.
We must also mention the remarkable work of the GGP Equity Committee and the sage advice
of its counsel Saul Ewing and financial advisor Cantor Fitzgerald. Our small legal team at
Sullivan & Cromwell did a superb job representing our interests, including in negotiations with
the talented lawyers at Willkie Farr, who served as Brookfield’s counsel. We are delighted to
have worked alongside such an outstanding group of principals and professionals on this
Looking ahead, we continue to believe the superregional mall business and GGP in particular
will be attractive investments over the long term. Furthermore, GGP possesses certain unique
attributes that should allow it to outperform its competitors over the intermediate term. GGP is
underearning its potential because a substantial amount of its space is currently leased on a shortterm basis at below-market terms, and occupancy costs, particularly for its best assets, are
meaningfully lower than its competitors’, providing the potential for significant increases in net
operating income. In addition, as a result of the bankruptcy negotiations, a large percentage of
GGP’s secured mortgage indebtedness is prepayable without penalty. As rates have continued to
decline since these mortgages were restructured, the opportunity may exist to refinance at
significantly lower rates, which could have a meaningfully positive impact on GGP shareholder
value. We look forward to a reenergized GGP tackling these opportunities. Combined, these
attributes should allow GGP’s NOI and FFO growth to exceed that of other mall REITs, and
despite the recent run up in GGP’s share price, it continues to trade at a substantial discount to its
relevant peer group.
We continue to maintain a short position in the REIT index and certain REIT equities which
mitigate, to some extent, our exposure to overall REIT valuations. We expect that GGP will
outperform its competitors and the REIT index as a whole because of its unique attributes.
Howard Hughes Corporation
As part of the recapitalization, we received a distribution of HHC stock and committed an
additional $58 million of capital, which along with investments from Brookfield, Fairholme, and
Blackstone cumulatively totaled $250 million. In connection with this commitment, we received
seven-year warrants to purchase HHC stock at $50 per share. Our combined economic stake in
the company including stock, warrants, and cash-settled total return swaps represents
approximately 28% of shares outstanding.
We have the right to appoint three directors to the company as long as we maintain a 17.5% or
greater economic stake in the company. We have appointed Allen Model, a member of Pershing
Square’s advisory board, and Gary Krow, formerly the President of Comdata, a subsidiary of
Ceridian Corporation, to represent our interests. I have joined the board as the company’s
As part of the restructuring of GGP, the company contributed to HHC its redevelopment assets,
its master planned community portfolio, and certain other properties whose cash flows were not
reflective of their potential value. We designed the restructuring of GGP to incorporate the HHC
spinoff because we believed that these assets would be attributed little, if any, value if they
remained within GGP, and more appropriately valued in the spinoff company.
The market appears to have begun to recognize the value inherent in HHC’s portfolio as it trades
as of yesterday’s close at $40.30 per share, an enterprise value of $1.8 billion, net of the $250
million equity investment from new investors. This ‘found’ value inures solely to the benefit of
pre-emergence GGP shareholders, meaningfully improving their recoveries.
We are in the process of hiring a senior management team for HHC and hope to accomplish this
critical objective shortly. In the interim, the company is overseen by affiliates of Brookfield and
TPMC, a Dallas-based private real estate investment firm. We are excited by the potential to
create a business backed by this unique portfolio of assets owned by a well-capitalized public
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
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.
Corrections Corporation of America
Corrections Corp was a significant contributor to performance during the quarter as the stock
rose 29.4% on the announcement of several key contract wins including a 1,200 bed contract
with the U.S. Marshals Service for its California City facility, a build-to-suit contract with the
state of Georgia for 1,150 beds, and its assumption of the management of two new facilities in
Florida. CCA and its existing inventory of empty beds will be the beneficiaries of the
combination of rising prison populations, overcrowded public facilities, and a lack of new prison
builds by either the federal or state governments.
The company has been an aggressive buyer of its own stock, repurchasing more than 5% of its
shares since the beginning of the year. As a result of the recent contract wins and its stock
repurchase activity, CXW recently increased its guidance for 2010 free cash flow per share. The
company now trades at an approximate 9% free cash flow yield, which we find attractive.
Peter Cooper Village/Stuyvesant Town
We were unsuccessful in New York Supreme Court defeating litigation brought by CWCapital,
the special servicer for Stuyvesant Town’s first mortgage lender. Our efforts to obtain an
expedited appeal were similarly unsuccessful. As a result, we were confronted with the choice
of pursuing the litigation in the New York Supreme Court and the Appellate Division over the
next few years, or alternatively negotiating a settlement with CWCapital.
We had the benefit, in our view, of being right on the law, and ultimately having a reasonable
probability of success on appeal. Our senior mezzanine claims were also valuable to the first
mortgagee due to several factors: (1) if the first mortgagee were to foreclose on the property, it
would have to pay approximately $120 million in New York State and City transfer taxes and
then a similar level of transfer taxes on the subsequent sale to a new owner, (2) by foreclosing its
lien, the lender would lose the ability to assign its mortgage to a new buyer, foregoing the
opportunity to avoid a 2.8% mortgage recording tax, an additional approximate $60 million or
more of frictional cost, and furthermore, (3) the securitization trusts, once they foreclose their
mortgage, may be limited in their ability to provide seller financing to a buyer of the property by
restructuring its existing mortgage, likely reducing the proceeds realized on a sale.
As a result of these factors, we were in a relatively strong bargaining position with CWCapital
despite the loss of litigation and the subordinate nature of our claims. We weighed the relative
merits of settling the litigation versus pursuing our claims, and concluded that the return-oninvested-brain-damage calculation weighed strongly in favor of a settlement. We subsequently
negotiated the sale of our loans to the first mortgage lender at our partnership’s original purchase
price of $45 million (our share was 77.5% of this amount) and we folded the tent.
I have learned from prior experience that sometimes the better part of valor in an investment
situation is to move on. Onward.
In October, we successfully exited our Landry’s investment. We received $24.50 per share in
this management led buyout, approximately 66% above our average cost of $14.78 per share.
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.
Fortune Brands is a conglomerate, an amalgamation of three distinct businesses. The largest
business unit based on operating profit is Spirits, a subsidiary which owns leading brands such as
Jim Beam and Maker’s Mark bourbons, Sauza tequila, and Courvoisier cognac. We believe that
Spirits is one of the great consumer categories given its strong and sustainable profit margins,
high barriers to entry, economic resiliency, and limited exposure to mass merchants. The second
most profitable division is Home & Security which includes brands such as Moen faucets,
Artistokraft cabinets, Therma-Tru doors, Simonton windows, and Master Lock security products.
Home & Security has reduced its cost structure and gained significant share in the downturn; we
think the business is extremely well positioned for a rebound. Finally, Fortune’s Golf subsidiary
owns best-in-class brands including Titleist and FootJoy.
In July, we began accumulating shares in the company when the stock price was approximately
$41 per share. Today, we own approximately 11% of the outstanding shares at an average
purchase price of approximately $46 per share as compared to Fortune’s current share price of
$57.40 as of yesterday’s close. Despite the 40% increase in stock price since we first established
our position, we believe there is substantially greater value that can be realized.
On November 4th, we met with Fortune Brands senior management to share our thinking on the