From Pershing Square's Q2 Letter to Investors released August 20
We believe our activist track record, both long and short, is the best of any activist investor of which we are aware.
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We have had three failures on the long side: Borders Group, Target, and J.C. Penney. Clearly, retail has not been our strong suit, and this is duly noted.
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While the story of our investment in J.C. Penney is not yet over, our initial CEO candidate was unsuccessful, the Company?s intrinsic value has been impaired, and as of August 16, 2013, the stock trades at a more than 40% discount to our average cost.
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Investing is a probabilistic business. For every commitment of capital we make, we compare our estimation of the likelihood of success with the probability of failure. We then assess how much we can make in a successful outcome with our best estimate of what we can lose in an unsuccessful outcome. We are willing to take more risk in a situation that offers more reward.
We have historically described J.C. Penney as a higher-risk, higher-potential-reward investment. We bought stock in the Company at a price we deemed to be attractive, and we assisted the board in recruiting someone whom we believed to be the best potential retail CEO in America, Ron Johnson. Ron went to work attempting to transform the Company into a more productive and more profitable retailer. We were publicly and privately supportive of Ron while he attempted to transform J.C. Penney.
It is difficult for a CEO to succeed, particularly in a turnaround or business transformation, without major shareholder and board support. Our public support of Ron caused the media to conclude erroneously that we were controlling the decision making at the Company despite the fact that we had only one seat on J.C. Penney?s 11-person board. All of the board?s decisions with respect to replacing Mike Ullman and hiring Ron were unanimous.
Had Ron Johnson?s plans been successful in driving traffic and sales, we would have likely made many multiples of our investment. When Ron?s strategy failed to generate profitable sales and led to large revenue declines and losses, we and the rest of the board concluded that a change in management was necessary.
The board brought back Mike Ullman as an interim CEO. We were unable to attract a long-term CEO at the time we replaced Ron because the Company needed capital and the CEO candidates we approached would not come on board without the Company having adequate financial resources.
We worked to protect our investment by assisting the Company in raising $2.25 billion of low-cost capital to shore up the balance sheet and give the Company running room to return to profitability. I became Chairman of the Finance Committee in order to lead this effort, and with two other members of our investment team who were on site in Plano for four weeks worked closely with the J.C. Penney finance team and the Company?s advisors in executing this financing.
Mike Ullman has worked hard to reverse some of the changes that contributed to the Company?s sales decline. Our understanding when Mike was hired as an interim CEO was that the board would immediately seek to recruit a long-term CEO for the business. When the search process was not launched for several months, Mike settled in as a longer-term CEO and began to make a series of material changes in personnel and operations that were not consistent with the actions of a typical interim CEO. We also began to have concerns about capital investment plans, cost control, inventory management, and the business planning process.
In recent weeks, when we felt that these concerns were not adequately being addressed and we could not make progress addressing them privately with the board, we raised our concerns publicly with two open letters to the board. We did so because of our fiduciary duty to the shareholders of the Company, and to protect our investment.
In his 1993 letter to shareholders, Warren Buffett addressed the issue of what a director should do if he believes that a Company is heading in a materially wrong direction and he cannot convince the rest of the board of the merit of his concern:
[A] director who sees something he doesn't like should attempt to persuade the other directors of his views. If he is successful, the board will have the muscle to make the appropriate change. Suppose, though, that the unhappy director can't get other directors to agree with him. He should then feel free to make his views known to the absentee owners. Directors seldom do that, of course. The temperament of many directors would in fact be incompatible with critical behavior of that sort. But I see nothing improper in such actions, assuming the issues are serious. Naturally, the complaining director can expect a vigorous rebuttal from the unpersuaded directors, a prospect that should discourage the dissenter from pursuing trivial or non-rational causes. [Source: Berkshire Hathaway 1993 Annual Report.]
Sharing our concerns publicly has the benefit of focusing all constituents inside and outside the Company on these issues. This increases the probability these concerns will be addressed. The downside of going public as a director is that it makes it more difficult to work with the board going forward. It also risks creating a media circus that can be distracting to the Company.
Having achieved our objectives of publicly elevating these issues and in order to minimize continued disruption, I tendered my resignation from the board as part of an agreement whereby the Company would add Ron Tysoe, an experienced retail financial executive to the board, and one additional director with relevant expertise whom we expect will be named shortly. We retain the contractual right to appoint an additional director to the board.
The benefit of our influence over our portfolio companies is that when unexpected negative events occur, we can take steps to mitigate our risk, and are not therefore beholden to the status quo. While there is substantial upside if J.C. Penney?s business turns, there continues to be risk at J.C. Penney. That risk has been somewhat ameliorated by the additional liquidity the Company has obtained through the financing and the renewed focus the Company will have on managing cash and costs while it works to bring back traffic and sales.
If J.C. Penney is able to return sales to the levels of recent years, generate historical levels of gross margins and maintain the SG&A reductions achieved by prior management, the stock should rise substantially from current levels. We believe these objectives are achievable, but how much time they will take is more difficult to determine. The Company?s recently announced second quarter earnings report has shown some early indications that the Company may be recovering.
While many of you have asked what our plans are for this holding, as with our other investments, we do not disclose in advance what we intend to do in the future for obvious reasons. After our failed proxy contest at Target, we held our investment for more than 19 months until the price rose to a level where we found better uses for capital. We may choose to exit J.C. Penney after more or less time depending on developments at the Company, the stock price, and the availability of other investment opportunities.
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Our sixth active short investment is Herbalife. To date, we have a substantial mark-to-market loss on this position. We do not, however, consider Herbalife to be a failed investment despite these losses. In the short term, the market is an indicator of what the majority of participants who are invested in Herbalife believe. The facts and fundamentals will ultimately determine whether or not we are correct. Our job is to find situations where the market assessment of value materially differs from reality. We believe that Herbalife was a good short sale at our cost, and an even better one at current values and in light of recent developments.
Follows many pages recapping why Ackman thinks HLF is a great short at his cost and at current prices