To the Shareholders of Pershing Square Holdings, Ltd.:
In 2022, Pershing Square Holdings generated strong relative NAV performance of negative 8.8% versus negative 18.1% for our principal benchmark, the S&P 500 index.6 Our total shareholder return was negative 14.6%, as PSH’s discount to NAV widened by 4.9 percentage points, from 28.3% to 33.2%, during 2022.7
Investors who invested in Pershing Square, L.P. at its inception on January 1, 2004, and transferred their investment to PSH at its inception on December 31, 2012 (“Day One Investors”) have grown their equity investment at a 15.7% compounded annual rate over the last 19 years, compared with a 9.0% return had they invested in the S&P 500 during the same period. With the magic of compounding, our 15.7% compound annual NAV return translates into a cumulative total NAV return since inception of 1,557% versus 427% for the S&P 500 over the same period.8 In other words, Day One Investors have multiplied their equity investment by 16.6 times versus the 5.3 times multiple they would have achieved had they invested in a zero-fee S&P 500 index fund.
Using PSH’s stock price return rather than per-share NAV performance, Day One Investors have earned a 13.5% compounded return, an 11-times multiple of their original investment.9 This lower return reflects the 34% discount to NAV at which PSH’s stock currently trades.10 Our strong preference is for PSH’s shares to trade at or around intrinsic value for which we believe our NAV per share is a conservative estimate. With continued strong performance, we expect that PSH’s discount to NAV will narrow over time, and its NAV and market value returns will converge.
The Last Five Years
2022’s performance reflects a continuation of our strong absolute and relative performance over the last five years. Since the beginning of 2018, our NAV per share (including dividends) has more than tripled, up by 207% compared to 57% for the S&P 500 over the same period. We attribute this high degree of outperformance to our decision to refocus our investment strategy on the core principles that have driven our profitability since the inception of Pershing Square.
Beginning in late 2017, we returned to our roots as an investment-centric operation and made the strategic decision to stop raising capital for our open-ended hedge fund vehicles. Doing so allowed us to reduce the size of our organization and focus our resources on investing rather than the business of asset management, and the associated resource-intensive requirements of continually raising capital.
Over the last five years, PSH has generated a compound annual rate of return of 25.1%, even better than the results of our first nearly 12 years during which time we compounded investor capital at a 21% annual rate until July 2015, the beginning of a two-year period of substantial underperformance which we have previously described and analyzed in great detail.11
Over the last five years, we have been an enormous beneficiary of the increased stability of our capital as PSH now represents 87% of our assets under management, 26% of which is owned by affiliates of the investment manager12. Our private funds, which comprise 13% of our assets under management, also have highly stable capital as affiliates of the investment manager comprise 40% of their capital, with the balance held by long-term Pershing Square investors, many of whom have been partners and shareholders since our earliest days. With more than $3.2 billion of equity capital invested alongside our shareholders and other investors, we are well-aligned and highly incentivized to generate high long-term rates of return while carefully managing the risk of a permanent loss of capital.13
Stock Market Volatility is the Friend of the Long-term Investor
While our NAV declined by 8.8% in 2022, the volatility markets experienced in 2022 should set the stage for greater long-term outperformance for PSH. Last year, we made few portfolio changes other than with respect to the acquisition and/ or disposition of hedging instruments and the purchase and sale of Netflix which we have previously described in detail here. We prefer less rather than more investment-related activity as it is an indication that we have made good decisions about where to invest our capital for the long term. Constant turnover of the portfolio of a so-called long-term investment manager is generally an indication of poor investment decisions that had to be reconsidered.
We think of PSH as a vehicle by which one can own an indirect, proportionate interest in our underlying portfolio companies, cash, and hedges. While most of our portfolio companies share prices declined in 2022, they continued to generate strong business performance, increased earnings, and greater free cash flow per share. Our companies’ long-term prospects remain highly attractive, and we accordingly made minimal changes to our core equity holdings in 2022.
About half of our companies (or five of seven if we exclude Fannie and Freddie which are unable to repurchase shares) repurchased their own shares during the year thereby increasing our ownership without any additional investment from PSH. As a result of PSH’s and our companies’ share repurchase programs in 2022, our shareholders’ ‘look-through’ ownership of PSH’s underlying portfolio increased by 8.2%, half from PSH buybacks and the balance from share repurchase programs of our portfolio companies.14 If we are correct in our assessment of our companies’ future prospects, our increased ‘look-through’ ownership will amplify our returns in future years as our companies continue to increase in intrinsic value, which over the long term will be reflected in their share prices.
Share Repurchases and Our Discount to NAV
While a corporation’s persistent discount to its intrinsic value impairs its ability to raise low-cost equity capital and is a negative for shareholders who seek to sell in the short term, it can be a significant opportunity for long-term owners of PSH. We have no interest in raising equity capital, but relish the opportunity to buy back shares at 30+% discounts to NAV. We took advantage of the discount in 2022 by purchasing 8.3 million shares representing 4.1% of shares outstanding at an average price of $31.94 and a discount to NAV of 33%.
Since we began our share repurchase program on May 1, 2017, we have acquired 59.8 million shares or 25% of our shares outstanding at an average price of $18.80 and discount of 28%, which has added 1.2% per annum to our annual NAV returns since the inception of the program.
We intend to continue to opportunistically repurchase shares if it remains a good use of our capital relative to other opportunities. Our requirements for buying back shares include:
(1) we have substantial free cash available for purchases, and do not believe that we will be able to identify an attractive new investment in the then-current market environment,
(2) our existing holdings are trading at large discounts to their intrinsic value,
(3) the repurchase will not cause PSH to be overleveraged,
(4) the price paid is a very large discount to NAV, and
(5) we do not believe that further reductions in float will be counterproductive to our goal of causing PSH to trade at or around intrinsic value.
We continue to believe, and our experience to date has demonstrated, that even an aggressive share repurchase program will not cause the discount to narrow. That said, if the above criteria are met, share buybacks can be a useful and value-creating opportunistic tool for PSH.
We have not given up on addressing the wide discount at which our shares trade. We are continuing to consider potential transformational transactions that would enable PSH to become part of a U.S. listed company (which would not necessarily require that we give up our UK and Amsterdam listings and which would greatly increase the universe of investors who can own PSH). We are unable at this stage to estimate the probability or timing of achieving such a transaction, but we are considering a number of potential ideas at this time.
2022 In Review
2022 was characterized by a high degree of stock market volatility driven by aggressive global central bank interest rate increases, the war in Ukraine, and broad-based declines in nearly every asset class. In that the value of financial assets is based upon the present value of their future cash flows discounted back at an appropriate interest rate, broad based increases in interest rates combined with greater global risk and uncertainty caused discount rates to increase substantially and asset values to decline. In other words, higher required investment returns from investors lowered the price that investors were prepared to pay for financial assets, causing stock prices to decline.
Our equity holdings responded accordingly. Despite significant business progress in 2022 at each of our portfolio companies, the effect of higher discount rates for all but two of our companies overwhelmed their anticipated business progress, leading to stock price declines and mark-to-market losses for Pershing Square. Restaurant Brands and Canadian Pacific generated marginally positive total returns in 2022 as their business progress exceeded market expectations and overcame the downward impact on valuations from the rise in rates.15 Overall, our long-term equity portfolio generated a negative total return (including dividends) of 16.1% in 2022.16 In addition, PSH’s NAV declined by an additional 5.2% due to Netflix and losses in connection with the liquidation of Pershing Square Tontine Holdings, Ltd.17
Our losses on equities were offset somewhat by interest rate hedges, which contributed 14.3 percentage points of positive performance in 2022.18 These hedging gains, combined with our COVID-19 CDS hedges in February 2020, have been a highly material contributor over the last three years as they have generated approximately $5.3 billion in total hedging proceeds to date versus a cost of $446 million, the substantial majority of which have been redeployed in equities in a timely manner, which in turn have, in nearly all cases, increased substantially in value, further amplifying the benefits of our hedging gains.19
Why Did We Not Sell Equities in Light of Our Views on Interest Rates?
In light of our views on interest rates and their impact on equity values, why, you might ask, did we not sell or reduce our equity holdings in 2022? The answer is that our strategy is to maximize the growth in our long-term NAV per share which requires us to endure some amount of short-term, mark-to-market trading losses. We do not typically sell our core portfolio holdings even if we believe it is highly probable that they will decline in price in the short term, as long as our view of their long-term potential remains largely unchanged. We limit our short-term trading for this reason as doing otherwise will likely lead to lower long-term rates of return for Pershing Square due to several factors.
We are often one of the largest shareholders of our companies. Over time, we have built important, longstanding relationships with their management teams and boards, which have enabled us to be an influential shareholder. We believe our influence increases the probability of value-maximizing decisions being made by our portfolio companies while reducing the risk of value-destroying errors. Were we to constantly trade around our positions, we would have a less credible voice with management and other shareholders when advocating for strategic initiatives and corporate changes which have long-term implications.
Furthermore, large frictional costs are often incurred when acquiring and disposing of large holdings. To be successful as a short-term trader of large ownership stakes, we would have to successfully estimate how much a stock price will decline based on macro events, and then accurately predict what price we would have pay to repurchase the position. While our predictions about macro risks have been largely accurate, we cannot expect to always get it right. And even if we are correct in our macro assessments, it is far less knowable how and for how long the stock market and individual stocks might react to these events. A short-term trading program might enable us to avoid a small loss at the much larger cost of missing substantial stock price increases thereafter. As a result, we do not trade around our long-term holdings and generally only make adjustments in the size of positions to manage concentration risks in the portfolio.
Some have suggested that we should launch a macro fund so that investors who desire exposure to just our macro strategy would be able to directly participate in what has been a very high-performing strategy. The problem, however, with this approach is that we have only found macro investments that fit our requirements – namely a high degree of asymmetry and a high confidence level in the predicted outcome – to be episodically available. While we made large profits hedging the financial crisis in 2008, we made no material macro-related investments after the crisis until February 2020. While we have continued to identify interesting asymmetric macro investments over the past three years, there is no certainty that similar opportunities will present themselves in the future.
For the above reasons, we believe that our strategy of owning simple, predictable, free-cash-flow-generative, highly-durable and well-capitalized growth companies combined with occasional, opportunistic, asymmetric hedges will generate the highest, long-term rates of return for Pershing Square with the least amount of risk of a material permanent loss of capital. Our approach also has the benefit of being a better fit with our temperament, is less stress inducing, and much more time efficient. We therefore remain committed to this strategy that has served us well for nearly 20 years.
Market and Geopolitical Risks in 2023
We are operating in one of the most uncertain and risky environments in decades. As of the present moment, we are in the midst of what may be the early stages of a U.S. banking crisis with the potential for it to spread globally with Credit Suisse’s recent demise. Financial institutions are inextricably linked, and one large banking failure can ignite another and so on. This remains true even though some of the enormous derivative risks that almost took down the financial system during the crisis have been mitigated somewhat due to requirements for exchange trading of most derivatives. Banking is confidence sensitive. A run on deposits at one large bank, most recently Silicon Valley Bank (SVB), the 16th largest U.S. bank by assets, has the potential to spread to other financial institutions.
Until SVB failed, the vast majority of depositors did not concern themselves with the lack of deposit insurance for accounts above the FDIC-insured limits of $250,000. In reality, uninsured depositors are unsecured creditors of a bank which are at risk of loss in the event the bank were to fail. The events of the last few weeks made this manifestly clear as it was only a last-minute and apparently reluctant decision for the government to step in and guarantee uninsured deposits at SVB.
Now that uninsured depositors understand that there remains a risk that they will lose access to and/or have their deposits impaired, many businesses are rethinking their working capital management and investment strategies. This concern is compounded by the large increase in short-term interest rates. Since the financial crisis, there was little if any return offered on short-term funds, and depositors were therefore not particularly concerned about the yields, if any, they earned on deposits. The recent large increase in short-term rates has caused CFOs and corporate treasurers at all companies to become more disciplined about maximizing the yield they can earn on short-term cash. This will increase the cost of deposits for most banks, as they will have to be more competitive with money market accounts, putting pressure on bank’s net interest margins.
The U.S. economy relies on its large network of community and regional banks to provide access to debt capital, particularly for small and medium-sized companies that do not have access to the public capital markets. These banks also are major providers of real estate and construction loans as the large so-called systemically important banks have for the most part exited these lending categories other than for large capitalization, usually investment grade, corporate borrowers.
About 70% of commercial real estate bank loans are made by regional and smaller banks. There is a logic to this approach as real estate is inherently a local business, and a geographically proximate bank should be in a better position to assess the risks of local borrowers and the likelihood of their projects’ and business’ success. Increases in the cost of capital for regional banks will be passed along to their borrowers, and as a result fewer commercial real estate projects will be viable due to the higher cost of this capital. This will be a drag on the U.S. economy and will make it more difficult for existing real estate owners to refinance their debts when they come due, which will negatively impact real estate values further impairing bank balance sheets.
Our Approach to Cash Management
We have always taken a conservative approach to managing our cash as we have always been long-term skeptics of even highly-rated financial institutions, and on occasion, have profited from this skepticism. We therefore minimize the amount of cash we keep in banks to only what we need for daily liquidity purposes and sweep the balance into U.S. Treasury money market funds or into the direct purchase and ownership of short-term U.S. Treasurys. We are also highly selective as to which banks we do business with, keeping cash only at global systemically-important banks that we trust.
Sharing Our Views
Over the last couple of weeks, I took to Twitter to make the case for the FDIC – which insures deposits at U.S. banks with the proceeds of fees it charges to banks – to increase its current $250,000 per account limit. I recommended an immediate but temporary guarantee of all uninsured deposits to give time for the FDIC to update its current deposit guarantee system. I went public with my concerns and recommendations because I believe that the failure of Silvergate, SVB, and Signature Bank – the latter two within three days of each other – and the substantial declines in stock prices of the regional banks are putting our regional and community banking system at risk, which, as explained above, is a very important long-term driver of our economy.
PSH has obvious reasons to want the U.S. economy to be strong, as nearly every business, including the ones we own, is impacted by the deterioration of our economy. When we believe a mistake is being made by our government and/or regulators that will negatively impact our portfolio and the country by greatly damaging our economy and capitalist system, we believe it can be helpful to share our views.
While Twitter can be a maelstrom of negativity and criticism, it is a very efficient means to get the message out. Before Twitter, we would generally use the media, including appearances on business television and public presentations at conferences, to share our views about policy (Who’s Holding the Bag? was one of our most prescient).
We still, on occasion, use these more traditional forms of communication, but we like the ability to control our message without it being excerpted in a manner which could create a misleading impression, something we have occasionally experienced when relying on more traditional forms of media.
We have always been puzzled as to why market participants’ views are criticized by observers who claim that investors’ opinions are inherently conflicted, and therefore should be ignored. When we are seeking to understand the economy and market developments, we vastly prefer the opinion of thoughtful long-term investors over those of media commentators, academics, and other so-called disinterested observers. We would rather hear from active market participants who have capital at risk that coincide with their views, rather than ‘unconflicted’ pundits who suffer no economic cost when they get it wrong.
When it comes to our sharing our views about policy, our biggest conflict, if one were to call it one, is that we are large investors in businesses that benefit when the U.S. and global economies are strong. It is easier to profit as a long-term, long-only investor when a rising tide is lifting all boats.
The Banking Crisis
Since sharing our views on Twitter during this banking crisis could be perceived as having an impact on the short-term trading prices of bank securities, we elected to pass on any investment opportunities in banks, long or short, while sharing our views on what we believed the government should do. In our view, the failure to protect SVB depositors would have been a catastrophic policy error that would likely have led to massive runs on nearly every non-SIB bank by uninsured and even some insured depositors, and caused enormous damage to our economy. It would also likely have harmed U.S. competitiveness and our national defense in light of the tens of thousands of highly innovative technology companies that held large amounts of uninsured deposits at SVB.
As of this writing, the government has not fully adopted our recommendations as it has left open the question about what would happen to uninsured depositors at other institutions unless and until the regulators deem each future bank failure a systemically important one. We continue to believe that this individualized, bank-by-bank deposit guarantee approach is a policy mistake that will impair, potentially permanently, our network of regional banks by massively increasing their cost of capital and reducing their access to low-cost deposits.
Banking is a confidence sensitive business. The failure of three regional banks in a few weeks, including SVB with more than $200 billion of assets and $170 billion of deposits, and our regulators’ conflicting public statements, often from one day to the next about its support, or lack thereof, for depositors, have reduced investor, business, and consumer confidence in our banking system.
The uncertainty around how uninsured depositors will be treated is occurring at a time when the earnings power of regional and community banks is under pressure because of the increasing cost of their liabilities, declines in their share prices, and impairment in the value of their assets largely driven by the Federal Reserve’s increase in interest rates. The rise in rates has caused a decline in the value of banks’ fixed-rate securities and fixed-rate loan portfolios, which has occurred along with deterioration in their commercial real estate loan portfolios due to work-from-home’s and the pandemic’s impact particularly on office assets.
According to GAAP accounting, our banking system is nominally the best capitalized it has been in decades, but this is in large part due to the fact that banks are permitted to value a large portion of their assets, namely their so-called held to maturity (HTM) fixed-rate securities and loan portfolios, at amortized cost rather than market value, creating a misleading perception of banks’ true financial strength. Despite the fact that our accounting and regulatory regimes allow these assets to be carried at amortized cost, that does not make them more valuable than the price that would be realized if these assets had to be sold in the market.
There are reportedly ~$620 billion of mark-to-market losses on banks’ security portfolios that are not currently reflected on bank’s financial statements. If deposits continue to leave our regional banks and go to the larger systemically important banks and money market funds, regional banks will need to continue to borrow from the Federal Reserve banks through their “discount windows” and a newly created emergency program allowing banks to borrow against their HTM securities portfolios valued at amortized cost rather than market value.
While these Federal Reserve lending programs can help address the short-term liquidity needs of banks from deposits being withdrawn, they do so at a highly burdensome cost versus the near-zero interest rates that banks have been paying on deposits. They are a stop-gap, temporary solution to address short-term liquidity issues, but they do not solve the regional banks’ long-term funding needs and their cost of liabilities. We believe that uninsured deposits are likely to continue to leave regional banks unless and until an updated, systemwide deposit guarantee is introduced, and the sooner the better. Credit-related concerns of depositors are compounding deposit flight due to the substantially higher yields offered on money market funds, which will not abate even if all uninsured deposits are guaranteed. It is difficult for banks to get depositors to return once they have moved elsewhere and found acceptable, and likely higher-yielding, alternatives.
While we understand the concerns that some have raised about moral hazard risk due to government intervention, we think these concerns are misplaced. The banks’ managements and boards, and the shareholders and bondholders who mismanaged or failed to oversee the risks that led to their banks’ demise, have suffered severe outcomes including the complete destruction of shareholder and bondholder capital, the firing of management teams, the potential for significant civil and criminal liability, and enormous reputational damage.
No bank board or management team who has witnessed recent events will be inclined to take on more risk in the future simply because their depositors have not borne a loss. The opposite is much more likely to be true. Furthermore, a banking system that requires uninsured depositors to constantly assess their bank’s creditworthiness is not a viable one. We need a larger deposit guarantee regime, and we need it soon. The experience of the last three weeks of investing in banks will be seared upon the memories of bank investors for a generation or more. The longer this uncertainty continues, the higher their cost of capital and the less viable regional and smaller banks will be in the future to the detriment of our economy over the long term.
Geopolitical Risk and Artificial Intelligence
While the banking crisis is our most recent immediate concern, geopolitical risk remains highly elevated, higher than at any time perhaps in the last 50 years. North Korea continues to test ICBMs, China is building deeper ties to Russia including potentially supplying drones and other military assets while remaining intent on taking control of Taiwan, the war in Ukraine continues unabated without a foreseeable end, the U.S. is responding to attacks from Iran with ‘targeted’ responsive attacks, Israel is in the midst of a political crisis while being engaged in stopping Iran from obtaining nuclear capabilities, and the U.S. political system remains highly divisive with the threat of a potential default on our Treasury obligations looming, creating a highly uncertain and risky environment.
The recent launch of highly powerful Artificial Intelligence (AI) systems also creates considerable uncertainty about the future. While AI may be an extremely positive force for good, in the wrong hands, it can be a global threat. AI is likely to disrupt many businesses, including ones that until now seemed to have impenetrable moats. We are working diligently to understand the impact of AI on our companies, including how AI can be used in our own business, so that we better comprehend its short - and long-term implications.
While we have sought to hedge the potential economic risks from all of the above risks, there are no particularly good hedges. Our best protection against geopolitical risk is to own businesses that can survive the test of time, ones that are largely immune to the events that they or we cannot control. Since the beginning of the U.S. equity capital markets, certain great businesses have survived world wars, pandemics, periods of high levels of inflation, massive technological changes, the Great Depression, political divisiveness and civil unrest, and many thousands more have failed due to these stresses. The key to our strategy is identifying which companies have the widest economic and geopolitical moats, constantly stress testing these moats, and making sure our portfolio companies have fortress balance sheets that would enable them to manage through the inevitable risks of the modern world. Investment selection is our most important risk mitigation strategy in an uncertain world.
Pershing Square SPARC Holdings, Ltd. (SPARC)
On March 24th, we filed another, hopefully near-final, amendment to SPARC’s registration statement that we hope should address the minimal remaining comments that we have received from the SEC. To review, SPARC is an acquisition company, but without the drawbacks of conventional SPACs. Among other beneficial features, investors in SPARC do not need to invest any capital until we have identified a transaction, completed our due diligence, entered into a definitive agreement, had the transaction’s registration statement declared effective by the SEC, and obtained other required regulatory approvals. Once the transaction is ready to close, SPARC rights (SPARs) holders have 20 business days to decide whether to exercise their rights or sell them in the market.
The SPARs have a minimum exercise price of $10. We have the ability to increase the exercise price to the extent a transaction requires more capital. This will allow us to raise more capital if needed and greatly expand the universe of potential targets from ones that require $1.5 billion of capital (the amount raised at the $10 minimum SPAR exercise price and with the Sponsor’s minimum committed Forward Purchase Amount, assuming the exercise of all SPARs) to effectively unlimited amounts of capital. The Pershing Square funds will be investing a minimum of $250 million in SPARC’s transaction, and potentially substantially more depending upon the nature of the target, the terms of the transaction, and other factors.
The structure of SPARC effectively eliminates the time pressure on the Sponsor, as the SPARs have a 10-year term. Since we are not raising upfront capital, but rather are distributing SPARs to former Pershing Square Tontine Holdings, Ltd. shareholders and warrant holders, SPARC will have no underwriting fees, nor any shareholder warrants. The only dilutive security in SPARC’s structure is a 20% out-of-the-money warrant on 5.104% (4.95% for the Sponsor and 0.154% for advisory board members) of the newly merged company’s shares outstanding on a fully diluted basis, with the balance of the shares comprised entirely of common stock. At the launch of SPARC, these Sponsor Warrants will be purchased by PSH and the two Pershing Square private funds for their fair market value as determined by us in consultation with a nationally-recognized valuation firm, capital that will be used to fund the search for a target and to pay SPARC’s operating expenses.
In today’s extremely challenging equity capital markets environment, where few if any IPOs can be completed, SPARC’s ability to offer substantial transaction certainty, including a fixed transaction price and a guaranteed minimum amount of capital (the amount committed by the Sponsor) raised in a public offering, will make SPARC a highly attractive counterparty for private companies seeking to raise capital and go public. We expect the phone will start ringing shortly after our registration statement becomes effective and the SPARs are distributed to former Tontine investors.
We believe that a successful initial SPARC transaction will facilitate opportunities for future SPARCs. As such, we are hopeful that SPARC will play an important role in expanding our investment universe to include the acquisition of stakes in private companies on favorable terms.
2022 was a challenging year to be an investor in the capital markets. We have managed successfully through challenging periods like 2022 because Pershing Square was designed and built to be able to navigate the most extreme economic, investment, and geopolitical environments. This is largely due to the strength of our team. We are incredibly fortunate to come into work every day (we are not fans of work from home) alongside an extremely high functioning team in a beautiful and productive work environment. Our human assets represent substantially all of our productive capacity. We are an asset-light business where the talent walks out the door every day, so our success is largely a function of the culture we have built over nearly 20 years.
We have had minimal turnover at Pershing Square in the last five years since we made our strategic pivot. Limited turnover is highly unusual for an investment firm. The long-duration nature of the team is partially due to the fact that we do not have an “up or out” individualized culture. Pershing Square succeeds on the basis of the strength of the overall team, not because of one or two standalone superstars. We also value learning as much from our mistakes as from our successes. We carefully study our mistakes, both errors of commission and omission, and we share them publicly to keep you informed and to imprint them even deeper in our minds.
We have also learned to choose well when selecting new members of the team. Risk is greatly reduced when you work with colleagues with whom you have had the opportunity to build mutual trust over many years.
While it is difficult to predict the future in an uncertain world, we believe we are well positioned to generate high rates of return over the long term. Our confidence in our future prospects is based on the durability of our capital structure, the strength and well-aligned incentives of the team, our experience in identifying and helping to steward some of the best and most highly durable growth companies in the world, and our ability to continuously improve and learn from our mistakes.
None of the above would be possible without your support and long-term commitment for which we are extraordinarily grateful. There are few investment managers in the world that have been offered such an opportunity, and we will continue to work diligently to deliver the long-term results that such a commitment from our shareholders deserves.
William A. Ackman
Universal Music Group is the world’s leading music entertainment company and a high-quality, capital-light business that can be best thought of as a rapidly growing royalty on greater global consumption and monetization of music.
UMG has a decades-long runway for growth driven by increasing streaming penetration combined with the development of new services, platforms, and business models. At its inaugural Capital Markets Day in 2021, the company unveiled mid-term targets of high-single-digit revenue growth and mid-20s% EBITDA margins. Because of the rapid growth of streaming and the resurgence of vinyl (records) and merchandising, the company has vastly outperformed its own guidance with its revenue growth averaging 14% since its public offering in 2021. In 2022, UMG’s organic revenues and Adjusted EBITDA grew 12% as reported margins modestly declined due to lower-margin businesses returning to pre-COVID-19 levels.
We believe that the long-term outlook for UMG is excellent and that the company will continue to outperform its mid-term guidance. Music remains one of the lowest-cost, highest-value forms of entertainment. Since the launch of streaming services more than a decade ago, the monthly cost of a subscription plan had been flat at $10 until last year. In recent months, a number of the DSPs (digital service providers or streaming platforms) including Apple, Amazon and Deezer increased prices for their individual subscription plans in developed markets by 10% to $10.99 and by an even higher percentage for family and student plans. We believe that breaking the $10 barrier is a watershed moment, as other platforms will likely follow suit, and regular price increases will become the norm in the audio streaming industry as they are in the video streaming industry. At $10.99/month today (and less for a family plan on a per-person basis), one can listen to virtually any song ever recorded on any device, anywhere, anytime, at a value price.
While streaming helped revive the industry by convincing consumers to pay for music again, it also has its shortcomings. Many DSPs have become inundated with more than 100,000 tracks per day, many of which are low-quality, fraudulent, and/or 31-second tracks meant to game the system and divert royalties away from artists and songwriters. While more than 9 million artists have uploaded songs to Spotify, based on data shared by Spotify, only 2% of these artists have uploaded more than 10 songs and have more than 10,000 monthly users.
UMG is working directly with the DSPs to improve streaming’s economic model towards an “artist-centric” approach that gives more value to the artists that drive subscriber growth, engagement, and retention. While these changes may take time to be fully implemented, we believe that UMG will benefit from a greater share of streaming royalties due to its enormous breadth and depth in its artist roster. Similarly, while streaming led to broad adoption among consumers, a single price point for all consumers does not allow for customer segmentation. According to the BPI (an industry trade group), 15% of consumers account for 35% of all music spend, implying a significant opportunity for platforms and labels to better segment their customers and monetize superfans through targeted offerings.
At its current valuation, UMG’s attractive business characteristics and its long-term sustainable and robust earnings growth remain substantially undervalued. We believe that UMG also has further opportunities to improve its governance, investor relations and capital allocation as it builds experience as a public company, which should contribute to shareholder value creation.
Lowe’s is a high-quality business with significant long-term earnings growth potential underpinned by a superb management team that has been successfully executing a multi-faceted business transformation.
2022 presented a challenging macroeconomic backdrop which required Lowe’s to navigate commodity and retail price inflation along with the post-COVID-19 normalization of consumer purchase patterns. These challenges were further complicated by a shift in Lowe’s selling channels, with Do-It-Yourself (“DIY”) categories generating relatively weak results, offset by continued strength for projects requiring professional installation (the “Pro” business), a critical focus area for the company. Despite these headwinds, Lowe’s delivered strong financial results including nearly flat same-store-sales growth, revenue growth of 1%, operating profit growth of 5% (and an improved now 13.0% operating margin), and 15% growth in earnings-per-share, aided by a large share buyback program.
At present, the macroeconomic picture continues to create uncertainty about the short-term prospects of the home improvement business. The rapid rise of mortgage rates in 2022 combined with elevated home prices has meaningfully pressured homebuyer affordability. As a result, existing home sales have declined sharply in recent months. These factors have caused many market participants to become concerned that the home improvement sector is at risk of revenue and profit deterioration.
We are more constructive on the sector as its demand drivers tend to more closely correlate with home price appreciation, the age of the country’s housing stock, and consumers’ disposable income, all of which are predictive of future growth in demand. In addition, the national housing shortage, a lack of new builder inventory, continued post-COVID-19 hybrid work, high levels of home equity (vs. pre-COVID-19 levels), and continued strong Pro project backlogs should also continue to underpin home improvement market growth over the medium term. Furthermore, nearly two-thirds of Lowe’s revenue comes from non-deferrable repair and maintenance activity, which should be relatively unaffected by the macroeconomic environment.
In December, Lowe’s held its semiannual Analyst Day at which the company updated its medium-term targets to $520 sales per square foot (a low-teens percentage uplift from current levels), an operating margin target of 14.5%, with “line of sight” to 15% thereafter, and a targeted return on invested capital of 45%. If Lowe’s were to achieve these targets over the next several years, the company’s earnings would increase to more than $20 of earnings-per-share, or approximately 50% above current levels. In other words, the continued successful execution of Lowe’s business transformation should allow the company to generate accelerated earnings growth for the foreseeable future.
Notwithstanding our views on Lowe’s attractive long-term earnings outlook, Lowe’s currently trades at only 13.5 times forward earnings, a low valuation for a business of this quality, and a substantial discount to its direct competitor, Home Depot which trades at a price-earnings multiple of 18 times. We believe that Lowe’s current valuation reflects investors negative sentiment regarding the US housing market and incorporates the possibility of a greater than expected revenue decline. We are confident in management’s ability to execute and expect that Lowe’s will continue to generate high rates of return for shareholders as it continues its successful transformation.
Chipotle delivered another year of impressive results in 2022, expanding same-store sales and restaurant-level margins despite facing one of the highest inflationary environments on record.
During 2022, Chipotle grew same-store sales by 8%, or 31% from 2019 levels. While 2022 growth was driven by price increases to offset cost inflation, traffic is still up materially from 2019 levels as the company’s strong value proposition and menu innovations continue to resonate with customers. Chipotle offers high-quality and affordable food with a chicken entrée priced below $9 on average. This pricing remains a meaningful discount to alternatives from fast-casual competitors and represents tremendous value given Chipotle’s unrivaled use of wholesome ingredients, fresh preparation, customization, and convenience.
Chipotle’s attractive unit economic model remains firmly intact despite the inflationary environment. The company was one of the few businesses in the restaurant industry to expand margins in 2022, with restaurant-level margins up 130 basis points (bps) to 23.9%. Management has also highlighted the opportunity to further increase same-store sales and profitability by improving throughput in the near term.
The company’s growth runway remains robust. In North America, management estimates its potential to more than double its restaurant count to 7,000 over time by adding small-town locations and focusing on the high-performing Chipotlane digital drive-thru format, which represents over 80% of new store openings and is currently only 18% of the store base.
In addition to new restaurants in North America, Chipotle’s many growth opportunities include menu innovation such as the recently launched chicken al pastor, loyalty program enhancements, and eventually international store growth and a breakfast offering.
QSR’s franchised business model is a high-quality, capital-light, growing annuity that generates high-margin brand royalty fees from its four leading concepts: Burger King, Tim Hortons, Popeyes, and Firehouse Subs.
In November, Patrick Doyle, the legendary CEO who led Domino’s Pizza’s turnaround, joined as Executive Chairman. Under his tenure, Domino’s became the #1 pizza company by doubling systemwide sales and franchisee profitability driving a 23-fold increase in its share price over eight years. We believe that Patrick can accelerate growth at QSR and help the company achieve its full potential. He has purchased $30 million of QSR shares in the open market and has accepted a compensation arrangement that is entirely tied to QSR’s share price. QSR also recently promoted Josh Kobza to CEO, who will help execute on Patrick’s strategic vision in his new role.
QSR is continuing to make progress in positioning each of its brands for sustainable, long-term growth. To reinvigorate growth at Burger King in the U.S., the company launched a $400 million program to “reclaim the flame,” which includes $150 million in advertising and digital investments and $250 million in modernizing its restaurants. While the program was only recently launched, Burger King U.S.’s performance has started to improve, with the most recent quarter’s same-store sales 4% above pre-COVID-19 levels. Tim Hortons Canada has also improved to 9% same-store sales above pre-COVID-19 levels, despite Canada’s reopening significantly trailing the U.S. Meanwhile, Burger King International, Popeyes and Firehouse continue to generate strong same-store sales relative to pre-COVID-19 levels, with results that are in-line or above their peers.
We believe that QSR’s franchised-based royalty model is particularly attractive in today’s inflationary environment as the company’s revenues benefit as its franchisees increase prices, while the company’s cost structure is generally not subject to the same degree of inflationary pressures. QSR can continue to grow its business with minimal capital required as its franchisees open new units. Despite idiosyncratic issues in certain countries, QSR’s unit growth has returned to its historic mid-single-digit growth rate and is poised for an acceleration this year. As a result of its improving same-store sales coupled with strong unit growth, QSR’s earnings are now greater than prior to COVID-19 and are increasing at an attractive rate.
Despite improved brand performance and continued strong unit growth, QSR still trades at a wide discount to both its intrinsic value and its peers, which have lower long-term growth potential. As each of its brands return to sustainable growth, QSR’s share price should more accurately reflect our views of its business fundamentals over time. In light of higher interest rates and to increase its financial flexibility, the company is currently reducing leverage rather than share repurchases. We expect the company to return to repurchasing shares once it has reached its leverage target.
Hilton is a high-quality, asset-light, high-margin business with significant long-term growth potential. Over the past three years, management has done a remarkable job of navigating through the COVID-19 pandemic. In the third quarter of 2022, HLT’s revenue per room (“RevPAR”), the industry metric for same-store sales, surpassed 2019 levels for the first time. 2022 benefited from the strength of domestic leisure travel occasions – as consumers’ post-COVID-19 spending shifted from goods to services – and the continued recovery of business transient and group travel.
Hilton’s RevPAR has now surpassed 2019 even though occupancy has not yet fully recovered. RevPAR growth has been supported by an increase in average daily rate (“ADR”), resulting from strong consumer demand, a positive mix-shift from large corporations to small and medium-sized businesses, and broad inflationary pressures throughout 2022. Average daily rates have stabilized 10% to 15% above 2019 levels (representing 3-4% compound annual growth) while occupancy continues to improve as business travel occasions normalize, which should support current RevPAR levels. These factors, combined with an easy comparison from first-half 2022, position Hilton for a year of above-trend RevPAR growth in 2023.
Over the medium-term, Hilton will benefit from continued strong growth from non-RevPAR fee earnings (e.g., Hilton Grand Vacations royalty fees, Hilton Honors American Express card program) and the acceleration of net unit growth back to Hilton’s historical 6% to 7% growth algorithm, aided in part by organic new brand development (notably, the recently announced Spark by Hilton). Strong revenue growth combined with Hilton’s excellent cost control, high incremental margins, and its substantial capital return program should drive robust earnings growth for the foreseeable future.
Despite Hilton’s unique business model and attractive long-term earnings algorithm, the stock remains attractively priced at approximately 24 times forward earnings. We find Hilton’s valuation to be compelling given its industry-leading competitive position, superb management team, attractive long-term net unit growth algorithm, and best-in-class capital return policy.
HHC’s uniquely advantaged business model of owning master planned communities (“MPCs”) drove robust performance in 2022 amidst a challenging macroeconomic backdrop.
As mortgage rates rose throughout the year, the relative affordability of HHC’s MPCs remained highly attractive to prospective homebuyers. HHC’s MPCs are well-located in low cost-of-living, low-tax states like Texas and Nevada, which continue to benefit from significant in-migration. Despite a slowdown in the broader housing market, HHC’s land sales were supported by strong pricing growth and resilient volume. Average land sale price per acre increased 32% in 2022, reflecting supply-demand imbalances and historically low homebuilder lot inventories in HHC’s MPC metro-areas (Houston, Las Vegas, and Phoenix).
In its income-producing operating assets, NOI grew 6% in 2022 driven by an increase in rental rates and a steady recovery in leasing back to pre-pandemic levels. In Ward Village, the company’s condo development in Hawaii, the company continues to experience strong condo sales. HHC’s tenth and latest luxury condo tower is already 73% pre-sold despite having launched sales in September. During 2022, HHC repurchased approximately 8% of its shares funded by robust cash flow generation and proceeds from non-core asset sales.
HHC remains well insulated from the impact of rising interest rates and volatility in the capital markets. As of Q4 2022, substantially all of the company’s debt is either fixed rate or hedged and approximately 87% of debt is due in 2026 or later. HHC recently completed $1 billion in financings, extending its weighted-average debt maturity to six years. Additionally, the company’s ability to self-fund future development with cash flow generated internally from land sales and operating assets mitigates its reliance on external financing.
Pershing Square has owned HHC since its spinoff from General Growth Properties in 2010. In 2022, we purchased an additional 2.3 million shares of the company at an average price of $72 per share, which we view as a significant discount to the company’s intrinsic value. The recent purchases increase Pershing Square’s ownership of the company to 32%. HHC’s portfolio of well-located land and high-quality operating assets should deliver resilient long-term value creation throughout various market cycles.
CP is a highly attractive, inflation-protected business led by a best-in-class management team that operates in an oligopolistic industry with significant barriers to entry. Together with Kansas City Southern (“KCS”), CP is starting the next chapter of its unique growth story.
On March 15, 2023, CP received regulatory approval from the Surface Transportation Board for its acquisition of KCS. This transformational merger creates the only single-line railroad connecting Canada, the United States, and Mexico, leading to many new transportation options for shippers and greatly enhancing CP-KCS’ competitiveness.
As the world moves towards de-globalization, we expect CP-KCS will be a key beneficiary of increased North American nearshoring and USMCA investment. The combined company will also foster a more environmentally friendly and safer North American supply chain by shifting approximately 64,000 trucks annually from the road to rail and expanding CP’s industry-leading safety practices. As a result of the many benefits, we believe the KCS acquisition will generate meaningful revenue and cost synergies and drive double-digit earnings growth.
Despite CP’s acquisition of KCS and favorable outlook, CP continues to trade at a discount to its intrinsic value and its closest peer, Canadian National. We believe that the successful integration of KCS will be an important catalyst for share price appreciation in the years to come.
Fannie Mae and Freddie Mac remain valuable perpetual options on the companies’ exit from conservatorship. Adverse court rulings have effectively ended shareholder litigation. The Supreme Court denied certiorari in their Court of Federal Claims litigation (the “Takings Cases”) on January 9th, 2023, which follows the June 2021 Supreme Court ruling in the Collins litigation that found the Third Amendment to the PSPAs to be authorized under the HERA statute. On March 1, 2023, Pershing Square dropped its remaining claims in the Takings Cases as we did not see a viable path forward.
We continue to believe that the economic and political rationale for Fannie and Freddie’s independence remains intact. Both entities continue to build capital through retained earnings which has increased their combined capital to $97 billion approaching a fortress-level of capital. We believe that it is simply a matter of when, not if, that Fannie and Freddie will be released from conservatorship.
As discussed in detail in the 2022 Semiannual Financial Statements, we exited our investments in Netflix, Dominos, and Pershing Square Tontine Holdings.