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Dear Pershing Square Investor: The funds generated strong performance for the third quarter and year-to-date as set forth below:1
For the Quarter July 1 - September 30 Year to Date January 1 - September 30 27.4% 23.8%
Pershing Square, L.P.
Gross Return Net of All Fees 14.4% 12.0%
Since Inception 01/01/04 - 09/30/09 348.2% 221.4% 01/01/05 - 09/30/09 214.5% 142.6% 01/01/05 - 09/30/09 187.5% 124.9% 01/01/04 - 09/30/09 6.8% 10.8% 9.4% 7.3%
Pershing Square II, L.P.
Gross Return Net of All Fees 16.6% 13.7% 27.9% 23.7%
Pershing Square International, Ltd.
Gross Return Net of All Fees 14.3% 11.4% 29.3% 25.0%
Indexes (including dividend reinvestment)
S&P 500 Index NASDAQ Composite Index Russell 1000 Index Dow Jones Industrial Average 15.6% 15.9% 16.0% 15.8% 19.3% 35.6% 21.1% 13.5%
Portfolio Update During the quarter, nearly all of our portfolio companies generated improved operating performance as the economy began to stabilize and corporate cost containment measures took effect. Because we do not believe that we have a competitive advantage in predicting short-term market or economic conditions, we generally choose to invest in businesses that will excel in almost any economic environment. Even so, given that our funds have investments which are generally more long than short; an improving economy will assist the funds’ performance. We expect, however, that investment selection, rather than macro factors or stock market movements, will continue to be the principal determinant of our performance as the substantial majority of our historic (and anticipated) profits have come from the narrowing of valuation
Past performance is not necessarily indicative of future results. Please see the additional disclaimers and notes to performance results at the end of this letter.
discrepancies between the prices we have paid for our investments (or received in shorting a security) and fair value. Below we have summarized General Growth Properties Inc. (“GGP”) and Target, two of last quarter’s most significant contributors to fund performance: General Growth Properties Inc. GGP was the largest contributor to fund performance during the quarter, and has continued to appreciate substantially during the fourth quarter. GGP’s unsecured debt is trading at or slightly below par, and its common stock is trading at approximately $7.60 per share, up more than 20 times from our initial purchase price. GGP’s bond and stock price performance have been driven by the company’s continued progress in bankruptcy court, increased valuations of REITs, recent reductions in shopping mall capitalization rates, and Simon Property Group’s public expressions of interest in acquiring the company. The most material development in the bankruptcy process occurred after the end of the quarter, when GGP announced an agreement with approximately $9.7 billion of its secured creditors to extend the maturities of their debts at an average interest rate of 5.35%. This agreement is subject to court approval and certain other conditions, and is anticipated to be consummated by year end. With $9.7 billion of the company’s secured creditors consensually agreeing to extend their maturities, it is likely, in Pershing Square’s view, that the balance of the company’s secured creditors will fall in line on similar terms rather than risk litigation in bankruptcy court. Yesterday, Fitch Ratings, which rates the GGP mortgage bonds and the special servicers who negotiated on their behalf, applauded the settlement by stating:
The successful resolution substantially alleviates the risk of rating downgrades for the transactions and illustrates the effectiveness of bankruptcy remote structures. Removing the loans from bankruptcy with their mortgages intact is an important test of the Special Purpose Entity structure, which is a key component in structured finance.
Fitch’s blessing for the terms of the extensions should further increase the likelihood that the other GGP secured creditors will choose to join the settlement. In fact, recent press reports have suggested that the GGP restructuring will likely become a model for other real estate mortgage extension negotiations that are underway as hundreds of billions of mortgages continue to mature without an active commercial mortgage market for these debts to be refinanced. Once GGP has extended the substantial majority of its secured debts, the company will be well positioned to emerge from bankruptcy as an independent company. Alternatively, it might be sold to a strategic buyer or a private equity firm, or a U.S., foreign or other investment consortium, if a sale would achieve a higher value for GGP stakeholders. Despite this dynamic, we believe the stock trades at a substantially lower valuation than Simon Property Group because many market participants and other analysts have incorrectly assumed that GGP’s unsecured creditors will meaningfully dilute shareholders’ ability to achieve a substantial recovery. GGP’s creditors are only entitled to a fixed claim equal to the face value of their obligations plus accrued interest. Any residual value above the company’s secured and unsecured creditors will inure entirely to the benefit of the company’s shareholders. As a result, proper stewardship of the recapitalization/sales process should allow the company to achieve full value for its common 2
stockholders. We expect that GGP will be the second or third largest REIT by market cap once it emerges from bankruptcy and will therefore be a must-own company for all of the various REIT funds and index portfolios. Thus, we believe an independent exit from bankruptcy will be feasible and could be achieved at high values. Alternatively, we believe that the bankruptcy process will create a once-in-a-lifetime opportunity for an outside investor to acquire a substantial minority, controlling, or 100% stake in one of only two high-quality national shopping mall platforms. The uniqueness of the asset, the fact that GGP’s largest competitor has publicly expressed interest in acquiring the company, and the fact that there are a sufficient number of well-capitalized potential buyers who will likely pursue the opportunity suggest that the bankruptcy auction process will be highly competitive. In light of the leveraged nature of the company’s balance sheet, each dollar per share of value is only approximately a 1% change in enterprise value. As a result, small changes in purchase price for the GGP enterprise in a competitive auction translate into outsized gains of incremental value for equity holders. While the company has made tremendous progress in bankruptcy, Chapter 11 is an inherently distracting and time-consuming process for any company, particularly one of the scale of GGP. While the company’s assets are of the highest quality and management and employees are extremely talented and highly motivated, competitor sniping and the distraction of bankruptcy inevitably lead to some degree of underperformance for any company in bankruptcy. While GGP has delivered solid results during the bankruptcy, we expect the company’s performance will materially improve after the company’s successful emergence. At that point, management will be reenergized and no longer distracted, and the company will be extremely well-positioned from a strategic and financial point of view. We believe that the combination of: (1) a unique and highly desirable company, (2) what will likely be a best-in-class capital structure of largely non-recourse, long-dated, fixed, low-cost leverage, (3) a competitive auction/capital raise process, and (4) the dynamics of the company’s leveraged equity structure create the potential for enormous value creation for GGP investors compared with current trading prices. That said, at present, there remain significant uncertainties about the potential outcomes for GGP security holders. As one of the largest equity owners of the company with representation on the company’s board of directors and as a substantial bond holder, we are well positioned to assist GGP in maximizing value for all of the company’s stakeholders.
Target Corporation We ran a proxy contest at Target, among other reasons, to improve the company’s corporate governance. In our recent investor letters, we expressed our belief that Target would take steps to make governance improvements before next year’s annual meeting. During the third quarter, Target announced that beginning in 2011, the company would eliminate its staggered board, requiring that all of its directors be elected annually. Most investors view staggered boards as an impediment to a change of control, although in Target’s case, the sheer scale of the business makes this consideration less meaningful. The real world benefit of an annually elected board is that it makes each director potentially subject to competition for his or her seat each year. 3
During the proxy contest, we were only able to challenge the incumbency of the one-third of Target’s board that was up for election at this year’s meeting which made it more difficult for us to impact the composition of the company’s board. We believe the likelihood of success in the contest would have been greater had our candidates faced the incumbent board’s weakest members, rather than simply those who were up for election by chance this past year. Beyond structural corporate defenses in election contests, prevailing U.S. proxy rules are an even greater impediment to a shareholder who wishes to challenge an existing board or any particular incumbent director. The practical requirement that shareholders vote on either the company proxy card or the challenger’s card makes it impossible for shareholders to pick and choose among directors from each group. If the SEC’s proposed rule requiring companies to give large, long-term owners the opportunity to propose directors on the company’s proxy card is adopted, this impediment should disappear. If staggered boards are eliminated and the universal ballot elements of the SEC’s proposed shareholder proxy access rule are enacted, we believe the resulting competition will help shift shareholders’ focus toward identifying and electing best-inclass directors, whether they are incumbents or shareholder nominees. When I began my investing career 17 years ago, I did not put enough emphasis on corporate governance as a consideration in selecting investments. As I have matured as an investor, I have come to appreciate how important corporate governance is to the future success or failure of an enterprise. While a legendary or powerful CEO can successfully lead a company even with a weak board, his or her probability of success will be enhanced materially with the right board and best practices. I attribute the bulk of responsibility for many business failures to board governance failures rather than management mistakes. We believe that Target’s increasing board accountability will inure to the benefit of its owners and other stakeholders over the long term. Going forward, we believe that there are several catalysts that should drive significant earnings growth for Target in 2010 and beyond. First, we believe that Target will begin to generate attractive sales growth as a result of (1) easier same-store-sales comparables in 2010; (2) an improved marketing campaign which appears to be resonating with consumers; (3) strong launches of private brands; and (4) a fresh-food expansion initiative entitled “P-Fresh” which is increasing shelf space dedicated to high frequency perishables in traditional general merchandise stores. P-Fresh stores are experiencing mid-single to double-digit sales growth, driving more frequent customer visits and generating incremental sales in other non-food categories. Target plans to roll out P-Fresh in over 20% of its store base in 2010 and will continue this rollout for several years. Since Target’s food offering will have lower prices than comparable offerings at traditional grocers, we believe that the company will enjoy significant market share gains and traffic increases. Second, we believe there is opportunity for margin expansion. Year-to-date, Target’s gross margins have held up well despite the mix impact of weak sales in high-margin, discretionary categories. Costs have been removed from the supply chain and inventory has been well managed. If consumers begin to increase purchases of high-margin discretionary products (apparel, home, etc.), gross margins could expand. In September, for the first time in many 4
quarters, comparable store sales growth in apparel outperformed the store average, suggesting a potential turn for Target’s apparel business. As regional retailers have closed stores and in some cases liquidated, we believe Target could benefit from market share gains in discretionary categories. As overall sales improve, we believe that Target will be able to leverage its fixed costs to improve profitability and generate accelerated earnings growth. Third, we think that Target’s credit card business could provide an earnings tailwind over the next 12-18 months. With charge-offs at a cyclically high ~14% of gross receivables in 2009E, Target’s credit card business is contributing little to the company’s current earnings. If chargeoffs were to normalize to the 9%- 10% range, Target should enjoy attractive earnings growth as its credit card segment approaches a more normalized level of profitability. In time, we expect that Target will sell its remaining interest in its credit card business, thereby diminishing credit and funding risk, while raising capital to be returned to shareholders or invested in the company. Based on these catalysts, we believe that Target is currently trading at approximately 11.0 to 12.0 times our range of estimates for 2011 earnings per share, a valuation we find compelling considering Target’s significant real estate ownership, its long-term opportunity to gain market share, its iconic brand, and increasingly dominant market position.
New Investments Nestle In June of this year, we initiated an investment in Nestle, the world’s largest food and beverage company. With an equity market capitalization of approximately $170 billion, Nestle owns an attractive portfolio of leading global food brands including Nescafe, Gerber, and Purina. Unlike many of its food and beverage competitors, Nestle has strong pricing power and limited private label competition across a substantial proportion of its product categories, including confectionary, baby foods, soluble coffee and pet foods. The next time you visit your local supermarket, notice the placement of Nestle brands – in supermarket parlance, they often “own the aisle,” a testament to their brand strength, value perception, and resonance with consumers. Beyond its strong global franchises, predictable free cash flow and unlevered capital structure, Nestle has attractive growth potential. In emerging markets, which we believe represent approximately 35% of the company’s sales and about 40% of its operating profits, Nestle is growing in the high-single to double-digits. In developed markets, Nestle is benefiting from retail brand consolidation which is allowing leading brands and private store brands to take share from second-tier brands. In addition to its attractive revenue growth potential, Nestle has a strong opportunity to increase operating margins through cost savings initiatives that should deliver roughly $1 billion of savings annually for the next several years. Nestle owns 52% of Alcon, the leading global eye care company, and 31% of L’Oreal, the global cosmetics company. In April of 2008, Nestle astutely negotiated the right to sell its stake in Alcon to Novartis at a 20.5% premium to the market price (capped at $181 per Alcon share) in a tax-free transaction beginning in January 2010. If Nestle were to exercise this put right at today’s price for Alcon, it would receive approximately $28 billion of cash, a substantial portion of which we expect would be used to fund the company’s sizable share repurchase program. 5
Corrections Corporation of America In the third quarter we established a position in Corrections Corporation of America (“CXW”), and have become the largest shareholder with approximately 9.5% of the shares outstanding. Corrections Corp is the nation’s largest private prison operator, which we believe trades at a meaningful discount to intrinsic value. We expect Corrections Corp to enjoy meaningful growth over the coming years. Publicly run prisons in the United States are currently operating in excess of capacity, and state budget pressures have put the construction of new prisons on hold. This supply/demand imbalance should drive more inmates into CXW facilities even if prison populations were to remain constant, although we expect them to continue to rise. Given that more than 80% of the costs in operating a prison are fixed, we anticipate higher occupancy at CXW facilities to translate into accelerating free cash flow per share growth. For more details regarding this investment, please see our presentation entitled “Prisons’ Dilemma” that was given at this year’s Value Investing Congress in New York, which we emailed to you on October 22nd.
Shorts, CDS and Net Exposure In our last letter, we indicated that we had identified more long investments this year than short opportunities. We also discussed why improving credit markets have made CDS investments less attractive, resulting in a substantial reduction in our CDS notional exposure. At the same time, our gross and net exposures have increased as we have put additional capital to work in our new (principally long) ideas. As a result, at the present time, the funds are 93% long and 9% short excluding our CDS positions. Because our long exposure is at the higher end of our historical range, we have been asked if our portfolio reflects a positive macro outlook, and whether we are at risk in the event of a double dip recession. A few reminders: We have never managed the funds to be so-called “market neutral,” nor have we attempted to mitigate (or take advantage of) the funds’ exposure to short-term market movements because we do not believe we have a competitive advantage in doing so. Rather, we invest our capital in a small number of situations which we believe have modest downside risk and substantial opportunities for profit. The modest downside risk comes from: (1) the identification of high quality businesses that are relatively immune to short-term macro factors and other extrinsic risks outside of our control, and (2) the fact that we have purchased our investments at prices which we believe to be a substantial discount to our assessment of intrinsic value. In addition, many of our investments have specific catalysts to unlock value – progress through bankruptcy, changes to capital structures, operating enhancements, a sale to a strategic buyer, and others – that make them somewhat less sensitive to overall stock market movements. Even so, if the stock market were suddenly to decline substantially, most of our long investments would likely decline in value. While some hedge fund investors mitigate their (often large) gross exposures through offsetting short positions that equal or approach the size of their long portfolio and result in a low net 6
exposure, this is not an approach with which we are comfortable. Despite our substantial net long exposure since inception, we have been able to generate high returns with modest downward volatility because of the inherent balance in our portfolio: The substantial majority of our assets are typically invested in high quality, well-capitalized businesses at substantial discounts to intrinsic value with catalysts for value creation. These long investments are typically balanced by short positions, principally expressed through credit default swaps, in highrisk, highly leveraged enterprises often with aggressive and/or fraudulent accounting and bad business models.
Operational Update During the quarter we completed the installation of Imagine, the core of our automated straightthrough processing system. Imagine has enabled us to meaningfully reduce the work load in our back office while improving compliance monitoring and error identification. We are in the initial phase of implementing a document and records management system, iManage. Courtney Leonardo has moved from Investor Relations to a new role in our legal department where she will manage the implementation and subsequent administration of this software. We recently finalized our prime brokerage documentation with UBS and transferred a portion of our main funds and substantially all of Pershing Square IV’s assets to UBS.
Annual Investor Dinner and Operational Due Diligence Meeting All investors should have received an invitation to our Annual Investor Dinner which will be held on January 28, 2010 at the New York Public Library. We are looking forward to seeing you there. We will also host an operational due diligence review several hours before the dinner for all investors who care to attend. We chose to separate the operational and investment discussions based on feedback from many of you. We believe that the operational due diligence meeting will provide a better forum for addressing specific questions you may have about our operations, and it will shorten the length of the evening program. Organizational Update We recently made two additions to the investor relations team. Ruth Wang joined us from Credit Suisse where she was an investment banking analyst in the Financial Institutions Group. Initially, Ruth has taken on Courtney Leonardo’s responsibilities in client administration; over time we expect she will make other important contributions to the team. Rosa Wilson joined in an administrative role after six years at Pequot Capital. In that our employees represent Pershing Square’s ultimate competitive advantage, we are delighted at the quality of personnel that we have been able to attract.
Please feel free to contact me or any member of the investor relations team if you have any further questions. Sincerely,
William A. Ackman
Additional Disclaimers and Notes to Performance Results The performance results shown on the first page of this letter are presented on a gross and net-offees basis and reflect the deduction of, among other things: management fees, brokerage commissions, administrative expenses, and accrued performance allocation, if any. Net performance includes the reinvestment of all dividends, interest, and capital gains; it assumes an investor that has been in the funds since their respective inception dates and participated in any “new issues.” Depending on the timing of a specific investment and participation in “new issues,” net performance for an individual investor may vary from the net performance as stated herein. Performance data for 2009 is estimated and unaudited. The inception date for Pershing Square, L.P. is January 1, 2004. The inception date for Pershing Square II, L.P. and Pershing Square International Ltd. is January 1, 2005. The performance data presented on the first page of this letter for the market indices under “since inception” is calculated from January 1, 2004. The market indices shown on the first page of this letter have been selected for purposes of comparing the performance of an investment in the Pershing Square funds with certain wellknown, broad-based equity benchmarks. The statistical data regarding the indices has been obtained from Bloomberg and the returns are calculated assuming all dividends are reinvested. The indices are not subject to any of the fees or expenses to which the funds are subject. The funds are not restricted to investing in those securities which comprise any of these indices, their performance may or may not correlate to any of these indices and it should not be considered a proxy for any of these indices. Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This letter is confidential and may not be distributed without the express written consent of Pershing Square Capital Management, L.P. and does not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential private offering memorandum. This letter contains information and analyses relating to some of the Pershing Square funds’ positions during the period reflected on the first page. Pershing Square may currently or in the future buy, sell, cover or otherwise change the form of its investment in the companies discussed in this letter for any reason. Pershing Square hereby disclaims any duty to provide any updates or changes to the information contained here including, without limitation, the manner or type of any Pershing Square investment.
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