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August 13, 2014
Dear Pershing Square Investor:
The Pershing Square funds outperformed the major market indexes for the first and second
quarters of 2014 and since inception as set forth below
For the Quarter For the Quarter Year to Date
January 1 - March 31 April 1 - June 30 January 1 - June 30 Since Inception
Pershing Square, L.P. 01/01/04 - 06/30/14
Gross Return 13.8% 16.1% 32.1% 1199.1%
Net of All Fees 10.7% 12.9% 25.0% 626.7%
Pershing Square II, L.P. 01/01/05 - 06/30/14
Gross Return 13.7% 15.8% 31.7% 788.1%
Net of All Fees 10.7% 12.6% 24.6% 437.1%
Pershing Square International, Ltd. 01/01/05 - 06/30/14
Gross Return 14.3% 15.9% 32.5% 650.4%
Net of All Fees 11.1% 12.8% 25.3% 365.9%
Pershing Square Holdings, Ltd. 12/31/12 - 06/30/14
Gross Return 14.1% 16.0% 32.3% 49.6%
Net of All Fees 11.5% 13.4% 26.4% 38.5%
Indexes (including dividend reinvestment) 01/01/04 - 06/30/14
S&P 500 Index 1.8% 5.2% 7.1% 118.8%
NASDAQ Composite Index 0.8% 5.3% 6.2% 144.0%
Russell 1000 Index 2.0% 5.1% 7.3% 127.4%
Dow Jones Industrial Average -0.2% 2.8% 2.7% 110.3%
Reflections After Ten Years
We began investing capital January 1
, 2004 in partnership with a subsidiary of Leucadia
National Corporation which invested $50 million in Pershing Square, L.P. at our launch. At the
time of Leucadia’s investment, Gotham Partners did not have regulatory closure with respect to
the SEC’s and New York Attorney General’s MBIA-related investigations. Leucadia’s
investment, and most importantly, its imprimatur were critical to the successful launch of the
Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. Please see the
additional disclaimers and notes to performance results at the end of this letter.
firm. We will forever be indebted to Ian Cumming and Joe Steinberg, then Chairman and CEO
of Leucadia, who backed us when few others would. As a thank you gesture at the time, we
offered Leucadia a substantial minority interest in the management company for no additional
consideration, but they asked for nothing but good investment results in exchange for their
investment, and for that we are very grateful.
Returns Since Inception
Over the last ten and one-half years, we have generated net returns to our investors of 626.7% or
7.3 times day-one investor capital. Over the same period, the S&P 500, our principal
benchmark, as it has historically comprised most of our holdings, has returned 118.8% or about
2.2 times. Expressed as a compounded annual return, the funds have returned 21% net per
annum versus 8% for the S&P 500
. In a world in which investors are pleased to earn returns
that are one or two percentage points per annum above the S&P over 10-year periods, our
approximate 13 percentage point annual net margin over the index is notable.
We are proud of our record and how that record has been achieved. While our returns have been
strong, our downward volatility (the only kind of volatility investors really care about) has been
minimal. We have had two negative years in our history, 2008 when the funds declined 12% to
13%, and 2011, when the funds declined approximately 2%. While the S&P index is by design a
fully invested index, we have generated our returns with negative leverage, i.e., cash has
averaged 14% of invested capital since inception. Some might therefore criticize us for the
inefficient use of our balance sheet, for clearly the liquidity and nature of our holdings would
have allowed us to be more invested over time. Indeed, we could have comfortably supported a
modest amount of margin leverage without taking undue risk.
Because we are an active, control and influence-oriented investor, we have avoided being fully
invested because of the risk of investor redemptions. For example, during 2009, despite a
relatively strong 2008 and a 41% net return in 2009, we had to keep a substantial portion of our
assets in cash because of the large amount of investor redemptions we received. We will
hopefully begin to address this issue with the initial public offering of Pershing Square Holdings,
Ltd. (PSH), targeted for later this year, which will increase the amount of our capital that is
Our investment performance is particularly striking when one considers our compound annual
gross return of 27.7% for the past 10 and one-half years. This is a particularly large number in
light of our investment universe which is comprised of the largest and most well-covered
companies in the world – large cap North American equities – which according to the efficient
market hypothesis should not offer investors above-market returns. Our returns also reflect a
substantial drag from our historically large average cash position since inception. These results
beg the obvious question. Have our returns been a function of good investment analysis, or have
Returns are for Pershing Square, L.P., the Pershing Square fund with the longest track record. Past performance is
not necessarily indicative of future results. All investments involve risk including the loss of principal. Please see
the additional disclaimers and notes to performance results at the end of this letter.
our results been driven by a strategy that has a unique competitive advantage? The answer, we
believe, is both.
Corporate Control, Influence, and Control Premiums
Private equity investors pay large premiums for the right to control a portfolio company’s
governance, management, competitive strategy, operating strategy, capital allocation, and the
timing of exit. Despite having to pay control premiums, successful private equity investors have
earned attractive returns for their investors. The fact that opportunities exist for private equity
investors to pay substantial premiums and earn high returns is evidence that the companies that
they have acquired were not optimally managed and/or capitalized at the time of purchase.
If an investor can effect corporate change without having to pay a control premium – or better,
buy at a discount due to shareholder dissatisfaction – that investor would have an extraordinary
advantage. A rational investor is unlikely, however, to sell control at a discount. The good news
is that on occasion, minority stakes in high quality businesses can be purchased in the public
markets at a discount. These discounts principally arise because of two factors: shareholder
disaffection with management, and the short-term nature of large amounts of retail and
institutional investor capital which can often overreact to negative short-term corporate or macro
factors. Such an environment creates an opportunity for the proactive investor to buy a minority
stake in a public company and work to effect corporate change to create value on behalf of all
Why Shareholder Activism is Good for Corporate America
Activist investing is inherently healthy for the markets, particularly in a world where the
substantial majority of investment capital is indexed, in ETFs, or is explicitly or implicitly
passively managed. Prior to the arrival of shareholder activism, when shareholders were
disappointed with management, they had no choice but to sell because they had little if any
recourse. Today, they call a shareholder activist.
While not all shareholder activists have long-term, shareholder-oriented agendas, only those that
do are likely to have substantial influence because the activist can only succeed with majority
shareholder support. While the advisors to entrenched management teams have attempted to
limit the impact of activists with poison pills with decreasingly lower thresholds and attempts to
change the 13D rules, non-activist institutions have aggressively pushed back as they recognize
that shareholder activism is one of the few means they have to unlock value in a long-term
The popularity of activism as a strategy has increased due to the potential it offers for substantial
returns. In light of the attractive returns achieved and the growing number of participants, we are
often questioned about the sustainability of our strategy in an apparently more competitive
environment. The good news is that the opportunities for shareholder activism are only limited
to the extent all corporations optimize their business models, operations, and capital allocation
and become efficiently priced by the markets. We believe that corporate inefficiency and
security mispricing will continue for the foreseeable future and present a continued rich
opportunity set for Pershing Square. In light of our strategy’s high degree of concentration, our
approach to shareholder activism needs only a few opportunities each year to generate returns for
Our Strategy’s Structural and Competitive Advantages
As a large capitalization activist investor, we believe our strategy benefits from a large
opportunity set, sizeable barriers to entry, and limited competition.
We believe that the largest companies offer the most opportunity for corporate change because
they are typically held by passive shareholders and are too large to be vulnerable to private
equity buyouts. Large cap businesses are typically high quality companies, as they would not
typically achieve high valuations without substantial revenues, profits, and free cash flow. After
decades of high profits and cash flows, many large businesses become less disciplined about cost
control and capital allocation, and may otherwise lose focus. The number of large cap
companies is substantial, particularly when compared to a strategy which, due to its
concentration and long-term holding periods, requires that we identify only one or two new ideas
per year to generate attractive returns for our investors.
Large capitalization shareholder activism has the benefit of significant barriers to entry to
prevent large capital flows into the strategy. If one wishes to be a large cap activist, one has to
raise large amounts of capital, which is difficult for a start-up investment manager to achieve.
More significantly, the greatest barrier to entry for the strategy is the requirement that one build
reputational equity among the community of investors who represent the largest shareholders of
corporate America. It takes years to build a track record with institutions such that they are
willing to back an activist seeking control or substantial influence over a corporation. It takes
years of doing what we say we are going to do and strong investment performance to get the
institutional and retail backing required to effect change at large cap companies. Our large and
growing reputational equity will therefore remain a very significant moat for Pershing Square in
the future. One of our additional barriers to entry is less tangible, but no less significant. It is
best deemed creativity. Many of our most successful investments have been in situations and
used transaction structures that were previously unprecedented.
Doing large unprecedented transactions attracts attention, some number of detractors, and
enormous media and other public scrutiny. As we have said before, it requires a very thick and
calloused skin. It also requires some tolerance from our investors who are likely to read periodic
criticisms from those who resent our success and would like to see us fail, from our adversaries,
and from members of the media who are often not that well informed of the facts, or otherwise
fail to check so-called “facts” presented by our adversaries. We tolerate the enormous volumes
of press and the occasional attacks as a necessary and unfortunate evil of a high-profile activist
There are Those that Argue Shareholder Activism Must Be Stopped
A few have argued that shareholder activism should be stopped or curtailed. Notably, the
principal proponents of shutting down shareholder activism are not investors, but legal advisors
who “defend” companies from activists and profit from this activity. The anti-activists justify
their attacks against activism by conflating short-termism with activism. We are strongly in
agreement that short-termism is bad for the long-term health of companies and industries, but
successful shareholder activism is not short-termism. It is hard to argue that the changes we
have wrought at Canadian Pacific, General Growth, Air Products, McDonald’s, Fortune Brands,
Wendy’s, Howard Hughes, to name a few were those of a short-term investor. Our target
holding period of four or more years is certainly not short term, and has increased over time as
the quality of the managements and the businesses represented in our portfolio have improved.
Furthermore, the companies we have invested in, with extremely few exceptions,
continued to prosper even after we have exited, perhaps the best evidence of the long-term
successful nature of our approach and its contribution to corporate America.
Marty Lipton, of the Wachtell Lipton law firm, perhaps the strongest opponent of activism, has
argued that shareholder activists have an unfair advantage and therefore should be limited in how
much stock they can purchase before announcing their plans. He has called for revising the 13D
rules so that activist investors must stop their stake building at 5% of a target, and then
immediately alert the public of their plans.
The 13D Rules Work Effectively and Should Not Be Changed
While Marty Lipton argues that changes to the 13D rules will benefit long-term investors, the
only investors who would benefit from requiring activists to disclose earlier are those short-term,
price-sensitive investors who sell into the activist’s initial accumulation. Even in these cases,
these short-term investors only miss out on the increase in price between the activist’s cost and
the day-after pricing. If they chose to, these short-term investors could immediately repurchase
their shares and receive the benefit of any additional increase in value achieved by the activist’s
changes. The first day “pop” is often only a small percentage of the increase in value achieved
by a successful activist. In 26 out of 30 of our activist commitments the day-after price was still
a bargain price versus the ultimate price achieved from our involvement with a company.
Activism has a “public good” problem for the activist in that all of the other shareholders who
typically comprise 90% or more of a target can be considered free riders with none of the costs
or the illiquidity, and with all of the upside. The only investors who don’t materially benefit
from the activist’s involvement are those that sell out into the activist’s accumulation of its
toehold investment in the target, a stake which is typically less than 10% of shares outstanding.
And even those sellers benefit, since they are able to sell at a price that has likely increased as a
result of the activist’s purchases. The “public good” problem is a reasonable cost for the activist
to bear because it is typically the largest shareholder of the corporation.
Because activism comes with large costs, the largest of which is the opportunity cost of time, an
activist must be able to build a large enough stake to amortize his or her opportunity and other
costs. If the 13D rules were changed and required immediate disclosure at 5%, only those targets
where a 5% investment in dollars would justify the activist’s time would be suitable targets,
narrowing the activist investment universe, particularly for small and mid-cap activism. This
cost in reduced activism would be borne principally by the passive institutions and retail
We have discussed these three failures and disappointments at great length – JC Penney, Borders Group, and
Target. While Herbalife is still in the negative column, we are confident this investment will ultimately be a
investors who own the substantial majority of every corporation on the stock market. For this
reason, the last attempt to change the rules failed years ago as a large group of passive
institutions voiced their concerns about the public costs of a change in the 13D rules that were
designed to thwart shareholder activists.
The 13D rules were not designed to protect shareholders from shareholder activism but from
overnight changes in control of a corporation. The 13D rules (along with poison pills and
various state takeover statutes) have effectively solved this problem of the 1960s and have
prevented corporate theft of control occurring under the cover of darkness. The 13D rules,
however, were not designed nor intended to prevent a shareholder from lobbying for change at
an underperforming company. Attempts by conflicted legal advisors to change the rules to
benefit entrenched and underperforming managements put at risk our capitalist system and
should be strongly resisted by investors.
In recent years, the poison pill, a device originally designed to prevent acquisitions of control at
below fair value, has begun to be used to shutdown shareholder communication and activist
engagements. Corporate control does not shift when a new shareholder acquires 10%, 15% or
even 20% of a business, yet poison pills are increasingly being used by boards to stop activists
from acquiring more than 10% stakes in companies, with the threshold occasionally being
waived for certain favored passive institutions that are friends of management. Sotheby’s poison
pill is such a notable example. This is a very dangerous precedent for the future of our markets.
A hundred years ago, the Carnegies, J.P Morgans, and Rockefellers of the world were large
shareholders of corporations and acted like owners because it was their own money they were
investing. When their companies underperformed, they did not need shareholder activists
because they themselves replaced underperforming boards and managements to unlock value.
Why the Democratization and Passivity of Public Stock Ownership Must Be Balanced By
For the most part, majority interests in US public corporations are held by fiduciary institutions
which often have passive mandates by charter – they are index funds, ETFs etc. These
institutions do not usually have or permit the entrepreneurism required to be a shareholder
activist, or they are otherwise restricted from activism for business reasons.
We are often told by the largest passive institutions that they fear the loss of access to corporate
management or the withdrawal of 401k funds that they manage for corporate America if they
were to become activist investors. In other countries where shareholders for structural or other
reasons (think cross ownership and controlled corporations) are passive, and shareholder
activism is difficult if not impossible to execute – Japan being a notable example – corporations
and economies can underperform for a generation or more with no opportunity for improvement.
Shareholder activism is an essential free market solution for corporate underperformance which
does not require government intervention to succeed, and where the costs are borne by the
activist who can only be successful with majority shareholder support. It is difficult to conceive
of a better system. Investors should be wary of attempts to shut down shareholder activism
under the guise of “transparency,” “fairness,” “anti-short-termism” or other veiled attempts to
weaken shareholders’ ability to voice their concerns and arrest corporate underperformance.
The first and second quarter’s positive performance was driven by strong results across the
portfolio, led by Allergan, Canadian Pacific, Air Products, Platform Specialty Products, Beam,
Howard Hughes and the decline in Herbalife, among others. We discuss certain investments
below that have experienced material developments since our Annual Dinner last February.
Twenty-four years ago, I chose a seat in the upper deck (the so-called Sky Deck) of my business
school class and sat behind a fellow named Bill Doyle. Twenty-three years later, I convinced
Bill to join the Pershing Square team. Bill is an MIT and HBS grad who spent his first years after
business school at McKinsey, then Johnson & Johnson, and the last 10 or so years managing a
venture capital fund. I have personally invested in several of Bill’s prívate portfolio companies.
Bill is currently overseeing the management of a few of his remaining portfolio companies
including as Executive Chairman of an important cancer therapy company called Novocure. If
you know anyone who suffers from a deadly disease called Glioblastoma, a cancer of the brain,
call Bill at (212) 652-4033 and he will do his best to get the patient on Novocure’s therapy that
was recently FDA-approved for recurrent Glioblastoma, and is in Phase 3 trials for first-line
treatment. Additional trials are underway in pancreatic cancer and will begin soon in ovarian
cancer and non-small cell lung cancer. In light of Novocure’s importance to mankind and to its
investors (Novocure just raised $194 million at a $1.24 billion post-money valuation), we do not
yet have all of Bill’s time devoted to Pershing Square. Nonetheless, he has been quite productive
in his first year at Pershing Square.
Earlier this year, Bill introduced us to Mike Pearson, CEO of Valeant Pharmaceuticals. Bill
along with Jordan Rubin has led the research leading to our partnership with Valeant in its efforts
to merge with Allergan.
Why Mergers That Should Happen Don’t Happen
Many merger transactions that should happen between companies with a large degree of strategic
overlap and cost synergies don’t happen. While these transactions, properly executed, can create
enormous shareholder value, the senior management teams and boards of the target company
who often don’t survive the merger may reject such mergers due to what are euphemistically
called “social issues.” These social issues often include the desire of the target company CEO to
keep his job and its associated compensation, and the ancillary benefits of profile and power that
come with being in the “C suite” of a large public company.
The structure of most public companies’ compensation packages for senior management teams
contributes to this problem. In addition to annual base salaries and bonuses that are granted
based on management achieving “target” and “reach” levels of annual earnings performance,
CEOs are typically granted a certain dollar amount of restricted stock and options each year
based on the amounts that are granted to the CEOs of comparable companies. Because these
amounts are granted annually and valued based on the share prices at the time of grant, CEOs are
incentivized not to unlock the full potential of “their” businesses until shortly before they intend
to retire. If they work to unlock value too quickly, the strike prices of their annual option grants
will be higher than they would otherwise have been, and the number of shares underlying the
restricted stock and options they receive over time would be fewer than if the stock price had
remained lower during their tenure at the company.
Put simply, a CEO is incentivized to have his company’s stock price rise gradually enough to
keep his job, but not so quickly so the amount of options and restricted shares he receives each
year is maximized and granted each year at lower stock prices. Only until the CEO is ready to
retire, in the last year or so of his term is he now incentivized to unlock hidden value and
motivated to catalyze the sale of the company so he can receive additional accelerated change-of-
control and other benefits along with a control premium. While by no means do all CEOs behave
this way, traditional management compensation encourages such an approach.
Allergan’s management appears to be Exhibit A in this kind of behavior. While Allergan has
fabulous products with growing market appeal, it has been criticized for a decade by its
shareholders for its high expense levels (at 40% of revenues its historic overhead has been 12
percentage points higher than the average of its closest competitors), and wasteful and
unproductive early-stage R&D spending.
Allergan management’s sandbagging approach to running a business is best evidenced by
comparing Allergan’s 12% to 15% earnings growth guidance, that was expressed on the
company’s 2013 fourth quarter earnings conference call in February of this year, with
management’s statements, guidance, and new plan introduced after we and Valeant offered to
acquire the business on April 22
On May 12
, Allergan management held a conference call at which they increased February’s
12% to 15% earnings growth guidance to 20% per annum over the next five years. The increase
in earnings guidance was not due to the discovery of any new products or due to a projected
increase in revenues but rather magically appeared in response to the bid and is driven by a
planned gradual reduction in excess costs over the next five years.
Successive increases in our and Valeant’s bid for the company have elicited even stronger
predictions of superior performance from Allergan management. On July 21
announced its first large-scale restructuring with an expected $475 million of cost savings from a
13% overall reduction in personnel including a one-third reduction in the R&D workforce.
While one might have expected Allergan’s compensation committee to adjust management
compensation targets upwards in light of recent guidance; instead, the board has kept the existing
incentive plans in place and granted additional equity incentives including restricted stock and
options for management achieving the new earnings targets.
Management and the board have rejected the last increased offer which represents a more than
50% premium to Allergan’s unaffected stock price (at the time of the increase, the bid was worth
$181 per share), claiming that the bid “grossly undervalues Allergan.” We find this particularly
striking in light of the fact that management and board members sold $89 million of stock in the
first quarter before the bid was announced at an average price of $121.50 per share, including
$31 million of stock sales by the CEO. During the first quarter, the board also granted stock
options to management at $124 per share. Clearly, management found these prices fair as they
sold material amounts of stock. The board was similarly comfortable granting options with
strike prices at enormous discounts to Valeant’s offer, an offer that supposedly “grossly
undervalues” the company.
We Believe Allergan’s Board Has Breached Its Fiduciary Duty in Not Properly Examining
the Valeant Offer
Not only has the board rejected the bid, but we believe it has breached its fiduciary duty in not
observing its duty of care to properly evaluate the proposal. The bid is not an all-cash bid where
value can be easily assessed. Rather it is a cash and stock bid, with stock representing
approximately 60% of the consideration. Allergan shareholders will own 44% of the new, much
larger company which will benefit from Valeant’s estimate of $2.7 billion of cost synergies,
substantial revenue synergies, and Valeant management’s superior capital allocation approach.
Allergan has conveniently and inaccurately valued the Valeant bid by referencing today’s price
of Valeant which reflects uncertainty as to whether or not and when the transaction will close,
and a discount due to Allergan’s spurious headline-getting attacks on Valeant’s accounting,
business model, and strategy.
To its credit, Valeant has stayed above the fray and simply responded to these attacks by
providing increasingly detailed disclosures about its business. We have worked to advance the
transaction by meeting with shareholders, catalyzing Valeant to raise and improve its bid for the
company by our agreeing to take less cash consideration and more stock thereby delivering more
cash and current value to other Allergan shareholders, and by launching the process to call a
special meeting, which will allow other shareholders to voice their support for or against the
Notably, Allergan’s management and board have ignored their shareholders and made every
attempt to squelch or otherwise delay their shareholders from expressing their views on the
transaction. They have done so by putting in place a poison pill that restricts shareholders from
communicating with one another, imposing highly cumbersome bylaws with unique provisions
that discourage shareholders from participating in the calling of a special meeting, and limiting
any contact that shareholders may have with the board of directors, stating that the (conflicted)
Chairman/CEO is the only authorized party that can communicate with shareholders.
Allergan’s Recent Lawsuit
Allergan has used, as deemed by the media, “the scorchiest of scorched-earth” defenses,
including on August 1
suing Valeant, Pershing Square and me personally for securities fraud
and supposed abuse of the tender offer rules. While Allergan’s counsel Wachtell Lipton had
previously publicly stated in a memo to its clients (before they had been hired by Allergan) that
we had not violated the insider trading and tender offer laws (they did “flatter” us by calling us
“crafty”), they are now bringing spurious litigation in an attempt to delay the special meeting we
are working to call.
The lawsuit reads less like a brief and more like a public relations document referring to a “shell
company” (that is, the joint venture limited liability company that Valeant and we capitalized
with nearly $4 billion to buy Allergan stock), “secretive accumulations of stock through
antiquated 13D rules” (what sophisticated investor shares his investment ideas with the public
before implementing them?), and it makes various attacks on Valeant and Pershing Square
(including a quote from a January 2008 press report calling us short-term stock flippers).
With respect to the law, you should know that we and Valeant are well-versed in the takeover
and tender offer rules, that we are well advised (Pershing Square by Kirkland & Ellis, Valeant by
Sullivan & Cromwell and Skadden Arps), and that we have been meticulously careful in how we
have constructed and implemented this investment and transaction. Unfortunately, in America,
one can be sued by anyone for anything. In this case, Allergan’s board and management are
using shareholder funds to sue us to stop or delay a special meeting which will allow Allergan
shareholders to share their views on the Valeant transaction and to fix anti-shareholder bylaws
that serve to entrench management and the board.
Because of the poison pill and the bylaws, the special meeting itself is the only legal venue
where shareholders can vote to encourage the board to engage with Valeant, remove a majority
of Allergan’s directors, and vote to fix the bylaws. Shareholders can vote either way on each of
these issues so it is just as much a forum for Allergan to make its case against each of these
proposals as it is for us to seek support for them. Based on their scorched-earth attempts to stop
or delay the meeting, Allergan’s management and board appear to already know that their
shareholders do not support them. The special meeting will be a referendum on this board, the
Valeant deal, and Allergan’s independence. This board’s and management’s actions have made
clear that they do not want the meeting to be held.
We have recently received extremely strong support for the special meeting from ISS and Glass
Lewis, the two leading proxy advisory firms. As both of these firms are widely followed by
institutional investors, their support is a good leading indicator of the probability of success of
We believe that the owners of a corporation are better able than its board or management to
assess its value and whether or not the corporation should be sold or merged. Unlike Allergan’s
management and board, Allergan shareholders have the benefit of not being conflicted by
managements’ potential loss of receipt of stock options, restricted stock, salaries and bonuses,
and by the board members’ $400,000 or so of annual board fees in determining whether or not to
engage in negotiations with Valeant on a potential transaction.
We believe that Allergan’s senior management and board will go down in history as extremely
poor fiduciaries for their shareholders. In the meantime, we will continue to focus on getting a
transaction completed and maximizing the value of our investment.
Canadian Pacific (CP)
CP’s results continue to show remarkable progress on the transformation underway. The
extreme weather of the first quarter, which Hunter Harrison (CP’s CEO) described as “the worst
he has ever been through” in his five decades in the business, was the coldest in Canada in seven
decades and the third coldest in Chicago since records have been kept. The cold weather restricts
train length and speed and impairs efficiency. Despite these challenging winter conditions, first
quarter earnings per share increased 16% on 1% revenue growth for the quarter and a 380bps
improvement in CP’s operating ratio to 72.0%. CP quantified the EPS impact of the challenging
winter as $0.30-0.35 per share, which when excluded, would imply pro forma growth in EPS of
Second quarter results, with less impact from winter weather, better demonstrated CP’s
impressive performance. Earnings per share were 48% ahead of last year driven by revenue
growth of 12% and a 680 basis point improvement in its operating ratio to 65.1%. CP’s
impressive revenue growth was driven by strength in grain, crude, and coal. Operating expenses
grew just 2% despite revenue growth of 12% given CP’s continued operational productivity
enhancements. Net of higher stock-based compensation expense, driven by the rapid increase in
the share price, as well as a one-time adjustment to grain rates, the operating ratio would have
Despite the challenging weather conditions during the first quarter and part of the second quarter,
CP maintained its full-year guidance, which calls for 6% to 7% revenue growth, a 65% or lower
operating ratio, and 30% or greater EPS growth. The guidance for a 65% operating ratio, or 35%
EBIT margin, suggests that CP will hit its four-year margin target in just two years. Given the
rapid turnaround to date, which has exceeded all expectations, CP has announced that they will
have an analyst meeting on October 1st and 2nd in Westchester to announce new long-term
CP has continually stated its goal is to be the most efficient railway in North America in the near
term. Hitting such a target would take CP from worst to first in the industry. While the
operational turnaround is well underway, the next phase of the story – CP’s revenue acceleration
– is just coming into focus. As we argued during our proxy campaign, operational efficiency
goes hand-in-hand with timely and reliable service which translates into sustained share gains
and revenue growth.
On April 28
, we sold approximately 3.2 million shares of CP for portfolio construction reasons
and to provide liquidity for our Allergan investment. CP remains our second largest position in
the funds, and we remain the company’s largest investor. It is a high-quality business operated
by a best-in-class management team. We are delighted with the company’s progress to date.
Air Products and Chemicals, Inc. (APD)
We are pleased to report that Air Products hired Seifi Ghasemi, formerly Chairman and CEO of
Rockwood Holdings as its new CEO effective July 1st. We had previously proposed Seifi to the
board as part of our agreement with the company last September. Seifi is an industrial gas and
specialty chemicals industry veteran with a superb track record as an operator, capital allocator,
and long-term creator of shareholder value. At Rockwood he generated a 318% return for
shareholders since the company's IPO in August 2005, far exceeding the S&P 500 Index return
of 90% over the same period. His appointment as CEO was well received by investors, with Air
Products' share price appreciating 7.5% on the day of his appointment as CEO on June 18th.
While the CEO search took longer than investors would have preferred, Seifi has had the benefit
of the last nine months on the board to better understand Air Products from the inside, so this
time did not go wasted. On the Company's recent earnings call after just three weeks on the job,
he announced that the Company will outline its strategy and goals by mid-September with a
more detailed presentation to follow at an analyst day to be held in early 2015.
Air Products third quarter results showed modest improvement in the business, with underlying
sales growth of 4% and earnings per share growth of 7%. Guidance for the fiscal year ended
September 31, 2014 calls for EPS of $5.72 to 5.77 representing growth of 4% to 5%.
Investors and sell-side analysts are appropriately less focused on recent performance than the
longer-term opportunity at Air Products under Seifi's leadership. Seifi began the conference call
with a slide which stated his principal goal as CEO: "Create Shareholder Value.” He explained
that he believed Air Products had the people, technologies and geographic footprint to
significantly improve its performance and to regain its leadership position within the industry.
He emphasized that improvements in performance would be driven by decentralizing and
simplifying the organization and processes to drive productivity, increasing return hurdles for
growth capex investment, requiring greater accountability, and building a culture that is focused
on delivering results.
In many respects, we view Air Products as similar to our investment in Canadian Pacific given
the quality of the business, its reasonable valuation, and the significant opportunity for
improvement in performance to unlock material long-term value for shareholders. With Seifi in
place, we expect the long-awaited turnaround of Air Products to begin in earnest.
Since our discussion of HLF at the annual dinner in February, there have been a number of
materially positive developments which are confirmatory of our thesis.
On March 12
, HLF disclosed that it had received a Civil Investigative Demand (CID) from the
FTC. This is not simply an informal staff inquiry. Commencement of this type of proceeding
requires a preliminary staff examination of the facts and legal issues, an application to the full
Commission, and the majority vote of the Commissioners to initiate formal proceedings. This is
the most significant FTC action on MLMs and pyramids in over 35 years, and you can expect it
will entail a thorough examination of the practices of HLF.
According to press reports, the Department of Justice in the Southern District of New York and
the FBI have commenced criminal investigations of HLF. The Southern District is one of the
premier prosecution offices anywhere in the U.S. An investigation could include mail and wire
fraud, money laundering, tax evasion, false health claims, and RICO (Racketeer Influenced
Corrupt Organizations). A RICO investigation could look at the top distributors, many of whom
we have profiled on our website, and trace their coordinated, parallel illegal businesses, which
continue to be facilitated and promoted by HLF.
According to press reports, the Attorneys General of New York and Illinois have also indicated
that they are investigating Herbalife. These are two of the more aggressive and well-staffed
offices among the State AGs. New York has a very strong statute prohibiting pyramid
schemes. In early 2013, the Illinois AG, along with the FTC, co-prosecuted Fortune Hi-Tech
Marketing, shutting down this illegal pyramid scheme, a company which is remarkably similar to
In the wake of these regulatory developments, numerous shareholder suits have been filed or are
in the investigation stage, alleging that HLF violated securities laws by failing to adequately
disclose its practices and the fact that it is operating in violation of anti-pyramid and consumer
Our Nutrition Club Presentation
On July 18th, we announced through the media our upcoming presentation on Herbalife’s
nutrition club operations, an analysis that we completed after two years of intensive
investigations. At the time of first press reports of the upcoming event, Herbalife stock was
trading at approximately $65 share. On Monday July 21st, I phoned in to business television to
give a preview of the upcoming presentation and to promote attendance at the event, but
unnecessarily raised expectations for the presentation to extraordinary high levels.
In light of the hype, investors and the media came to the event perhaps expecting recordings of
the CEO acknowledging that he had been running a pyramid scheme, but instead were asked to
watch an extremely detailed three-hour presentation designed for regulators. The reaction was in
retrospect predictable. The stock price rose over the course of the day by 25%, back to slightly
above the levels of the prior week before the public announcement of the event. The increased
stock price contributed to the media and the press largely ignoring the presentation because the
market had “spoken.”
At the presentation, we explained that beginning when CEO Michael Johnson joined the
company in 2003, Herbalife’s U.S. sales had begun to decline and the company was running out
of potential victims who could afford the $3,000 buy-in to become a Supervisor, the level at
which Herbalife recruits earn the potential for royalties. In response, Johnson and other
members of Herbalife management devised a strategy to target the lowest income individuals in
the world, what Herbalife management labeled “The Bottom of the Pyramid,” as its new target
market for the so-called Herbalife “business opportunity.” These billions of new potential
victims are described in internal company documents as having an estimated collective buying
power of $13 trillion, an average of a few dollars per day.
Targeting “The Bottom of the Pyramid,” HLF management adopted and professionalized a
recruitment method developed in 2002 by an enterprising Herbalife distributor in Mexico. This
recruitment method involves so-called nutrition clubs where the poor attempt to qualify as HLF
supervisors (which requires a $3,000 investment in inventory) by paying $5 per day and
recruiting friends and family to do the same in a crude version of a “layaway” program. By
breaking down the purchase to $5 daily payments for a protein shake, tea and water, the $3,000
required buy-in becomes accessible for the poor. This recruitment process also drives
“consumption” of the product.
The nutrition club recruitment method was later “systematized” into so-called “training
programs” called “universities,” or “clubs” where these recruits would earn small rewards,
badges, and certificates for their purchases and unpaid work in the clubs, what we deem
“conscripted consumption,” in other words: they make shakes, clean toilets, and recruit others,
ultimately “graduating” in ceremonies when and if they achieve higher ranks in the scheme.
The consumption in nutrition clubs is not real retail consumption driven by consumer demand for
the products, but rather progress payments that are made by aspiring distributors as they attempt
to pursue the HLF “business opportunity.” Pyramid schemes are characterized by sales of
products to aspiring distributors driven by recruitment rather than true third-party demand for the
product. HLF’s nutrition clubs brilliantly conceal the distributor payments towards the business
opportunity as consumer demand. These fake customers have fooled Wall Street and the
regulators for years.
In summary, under Michael Johnson’s leadership, Herbalife developed systematic methods to
recruit the poor, preying on their interest in entrepreneurship, education, and the American
Dream by holding out the potential for these individuals to eventually earn $500,000 or more per
annum, a level of income achieved by fewer than 0.04% of Herbalife distributors. These
nutrition club training programs have been remarkably successful and now account for about 40
to 50 percent of Herbalife worldwide revenues and likely 100% or more of Herbalife profits.
As a result of our investigation, we are now able to explain and document to regulators that what
Herbalife management has deemed “daily consumption” at nutrition clubs, is in fact a low-
income, pyramid scheme concealed within the larger pyramid scheme, where the lower ticket
price enables the poor to aspire to achieve wealth through the Herbalife pyramid scheme.
Unfortunately, the outcomes for these aspiring recruits parallel those of the higher-income
victims of Herbalife. They spend countless unpaid hours striving to become money-making
entrepreneurs, ultimately stopping only when they have lost large amounts of their and their
families’ savings, and thousands of hours of uncompensated time, as their dreams inevitably turn
While the media and short-term investors seemed to ignore our presentation as evidenced by the
stock’s rebound that day, we did achieve our objective in increasing attendance. Nearly 30,000
logged on to the presentation including individuals from 154 countries, with more than 9,000
viewers remaining for the entire three hours. This compares to our previously highest-watched
webcast, our Herbalife China presentation, which had 1,100 viewers. Subsequently, the recorded
webcast presentation has been watched by tens of thousands of additional viewers including
regulators, Herbalife employees (174 logged on from HLF headquarters in California), and likely
thousands of Herbalife distributors from around the world.
While my overly promotional preview led to a public relations failure and a complete rebound in
the stock price that day, we were fortunate in having attracted a high degree of attention to the
webcast. Ultimately, all pyramid schemes collapse due to their running out of victims or
Substantially all of these so-called nutrition clubs are in violation of U.S. labor laws, minimum wage requirements,
and state sales tax collection requirements as well as state and local food-service regulations in addition to the anti-
pyramid laws of many states and the Federal government.
regulatory intervention. Publicity and transparency are the enemies of a confidence game. We
achieved both on a global scale over the last two weeks. While Herbalife has been successful in
what management calls “penetrating” the Latino community with this fraud, the close-knit nature
of the Latino community that has helped the scheme propagate may in fact assist in its collapse
as word spreads in this tight-knit community that Herbalife is a scam.
Herbalife’s Second Quarter Earnings
On July 28th, HLF announced second quarter earnings with both earnings and 2014 guidance
disappointing expectations. HLF’s reported earnings declined by 17% from $143.2 million to
$119.5 million year over year, and “adjusted” EPS increased only marginally (despite the
enormous share repurchases in the quarter) after adding back questionable charges including
regulatory costs of $8.0 million in the quarter defending the company from a “hedge fund
manager’s allegations,” an additional $5.1 million during the quarter in complying with the FTC
investigation, and non-cash interest expense associated with HLF’s convertible debt offering.
The size and growth of these regulatory and defense costs, we believe, are indicative of the
seriousness of the regulatory investigations of HLF that are underway.
HLF’s earnings report was notable in that North American volume points (a HLF measure of
unit growth) declined by 1%, South and Central America declined by 7%, and showed only
marginal growth in previous high growth areas like Asia Pacific and Mexico. The deceleration
in revenue and earnings growth is notable in that this was HLF’s first miss versus consensus
Unlike its competitors, Nu Skin, Tupperware and Avon, which are now using a more realistic 50
to 1 exchange rate to report their Venezuelan operations, HLF continues to use an “official” 10.6
to 1 rate in recognizing earnings and consolidating its Venezuelan assets. It is impossible to
convert material amounts of Bolivars to dollars other than in the black market where limited
amounts of currency can be exchanged at rates in excess of 70 to 1. If HLF had even used the
same 50 to 1 rates as its competitors, it would have reported an additional foreign exchange loss
of $109.5 million and a reduction in cash of $120.2 million. Given that Venezuela still accounts
for 4% of HLF’s total sales (i.e., over $200 million in run-rate revenues in Venezuela), a move to
the 50 to 1 exchange rate would result in $150+ million per year reduction in HLF revenues and
a materially negative impact on earnings.
HLF’s Balance Sheet and Credit Profile
Herbalife’s balance sheet has deteriorated dramatically since the end of last year when the
company had net cash on hand. At quarter end, the company had become substantially leveraged
with more than $2 billion of debt and reported cash of $774 million which overstates the
company’s true cash available to pay debt service. Only $124 million of this cash is available for
debt service. The balance is offshore, carried at artificial exchange rates (Venezuela) and will
otherwise require large tax payments to be brought to the U.S. to pay debt service. Furthermore,
HLF must continue amortizing its credit facility with $43.8 million in payments due before year
end, $100 million in 2015, and the remaining $750 million due upon the credit facility’s maturity
in March 2016. We believe the expiration of HLF’s credit facility is a potential catalyst as we
are skeptical that the company will be able to access the credit markets in order to refinance or
otherwise replace this facility.
Herbalife’s Stock Price Performance
In the aftermath of the earnings announcement, the stock lost all of the gains it had experienced
in the run-up following our July presentation and then some. Year to date, Herbalife stock price
has declined by over 33% from $78.70 to $52.09 per share. The decline was initially driven by
the announcement of the FTC’s investigation on March 12, 2014 as the bull case for its shares –
that government regulators would not take any action against the Company – was disproven.
Herbalife’s response to the government investigations was to continue its highly aggressive
accelerated stock buyback and eliminate its dividend, ostensibly to increase the amount of capital
for a buyback. The bulk of the buyback was completed as of June 30
– the company
repurchased $1.3 billion of its $1.6 billion buyback in the first half of this year representing more
than one-third of the market cap at current prices using the proceeds of a $1.15 billion
convertible offering and cash on hand.
With the company’s dramatically weakened balance sheet, its deteriorating business profile, and
the ongoing and highly active regulatory investigations (as evidenced by the company’s
disclosed costs to respond to these investigations), we believe that there is limited risk of a
sustained increase in HLF’s stock price from current levels, and much greater risk of regulatory
shutdown or reform along with further stock price declines.
Time and transparency are the friend of the great and honest business, and the enemy of a fraud.
With greater due diligence, we do not believe that any institution can own the stock.
We maintain a short stock and long put position in HLF. As the company has cancelled its
dividend and the interest cost of borrow has remained in the low single digits, our cost of carry
for this position has declined substantially. Our puts are principally over-the-counter contracts
that expire next year. We will extend their terms by paying additional premiums if it is
necessary to do so.
Platform Specialty Products (PAH)
PAH’s share price increased significantly this year as the market began to gain a better
understanding of the potential of PAH’s strategy to consolidate the specialty chemicals industry.
PAH is focused on acquiring asset-light, high-touch businesses, where returns on capital are high
and service and technical know-how are key elements of the customer’s purchasing decision.
In October of last year, PAH completed its first acquisition, the $1.8 billion purchase of
MacDermid Inc. On April 17
, PAH announced its second acquisition, the $1 billion purchase of
Chemtura AgroSciences (CAS) from the publicly traded company Chemtura. CAS is a leader in
the chemical formulation and coating of agricultural seeds, which help improve agricultural
productivity. CAS has an attractive growth profile due to its focus on agricultural productivity,
which is in increasing demand as the world’s nutritional demands are rising, while the amount of
land suitable for growing crops remains stagnant.
Although CAS operates in a different market segment than MacDermid, both have similar asset-
light, high-touch characteristics that arise from the use of complex chemical formulations. We
expect both businesses to serve as platforms for future transactions in their respective market
segments consistent with PAH’s announced strategy. We believe CAS is not only strategically
attractive for PAH, but also financially compelling. PAH announced that CAS, which is
expected to close later this year, will result in EPS accretion of ~35% prior to synergies.
In early August, Platform announced the $400mm acquisition of Agriphar, an agricultural
specialty chemicals company similar to CAS. Platform expects to achieve cost synergies of at
least 25% of Agriphar’s EBITDA and expects the acquisition to be more than 10% accretive to
Platform’s earnings per share.
Burger King Worldwide (BKW)
We view BKW as a high-quality franchised business model with significant international growth
opportunities. BKW’s nearly 100% franchised model allows it to expand its restaurant count
without deploying its own capital. Given the size of the new unit opportunity and business
structure, we believe that BKW can achieve a high rate of free cash flow growth over the long
term while simultaneously returning a high proportion of its earnings to shareholders.
BKW’s controlling shareholder, 3G, has installed a management team focused on operational
improvement and shareholder-friendly capital allocation. The powerful combination of a high
quality business and a highly talented management team should drive substantial revenue
growth, stronger operating profit growth, and even stronger earnings-per-share growth.
Consistent with our thesis, BKW continued to report strong earnings growth in the first half of
the year due to the combination of continued new unit expansion, an improvement in same-store
sales, a continued reduction in costs, and the benefit of an attractively leveraged balance sheet.
General Growth Properties (GGP)
On February 10, 2014, General Growth Properties, Inc. announced that it had repurchased over
27.6 million shares from affiliates of Pershing Square at $20.12 per share, for total consideration
of approximately $556 million. GGP currently trades at $23.80 per share. We sold stock back to
the company at management’s request rather than in a secondary offering because it was
advantageous to the company to retire shares at that price, and we were able to achieve a
comparable execution to that of a secondary offering.
With the block sale, we ended our more than five-year involvement with GGP, which began with
our joining the board, advising the company to declare bankruptcy, assisting it in restructuring its
debts, spinning out 34 real estate development assets into a new company (The Howard Hughes
Corporation), and raising over $6.8 billion in new equity to recapitalize GGP as it emerged from
bankruptcy. A company that had a market cap of less than $100 million on the day we
purchased our first shares is today a well-run, well-capitalized company with attractive prospects
for the future, and a market cap including the affiliate spinoffs of Howard Hughes and Rouse of
more than $30 billion.
We sold our shares in GGP at a fair price, but left money on the table for other investors as is our
custom. Our cost of capital is higher than that of other investors so they need not fear buying
from Pershing Square. Having a reputation for leaving money on the table has assisted us in
exiting large stakes in our portfolio companies over the years.
On May 1, 2014 the Suntory Holdings Limited closed its acquisition of Beam, Inc., ending our
nearly four-year investment in Fortune Brands and Beam, Inc. The transaction was the
culmination of our original investment thesis that a spin-off of Beam from Fortune Brands would
create significant value for shareholders. The Fortune Brands/Beam investment generated a 32%
annual internal rate of return over its life.
Proctor & Gamble (PG)
We exited our position in P&G over the course of the year, first by swapping our shares for
attractively priced options, and then in the second quarter, by selling the options outright. While
A.G. Lafley has begun to make progress reducing the complexity of the company by focusing it
on its core products and reducing costs, there is still much work to do. While we believe P&G
will be a good investment over time, we found better uses for the capital.
Beginning on August 18
, John Pinette will join as Director of Corporate
Communications. John has nearly two decades of experience managing internal and external
communications at leading companies including Microsoft in a variety of roles, Google as
Director of Communications (Asia) and most recently for Bill and Melinda Gates in the Gates
Family Office. John received his BA in Philosophy at St. Thomas College, his M.A. in Church
History and Theology at the University of Louvain (Belgium), and his J.C.L. in Cannon Law at
Gregorian University (Rome).
John will lead Pershing Square’s internal and external communications efforts, including
managing public relations, media, broad investor communications and Pershing Square events.
In June, the Investor Relations team welcomed two new members – Lou Kahl and Roman
Velikson. Lou has 12 years of investment industry experience as Senior Manager - Pension &
Investments at Pfizer, as a Director of Hedge Fund Research at Cliffwater and most recently as
Associate Partner, Liquid Alternatives Research at Hewitt EnnisKnupp. Lou earned his BA in
Economics at Villanova and his MBA at Penn State University.
Roman also has 12 years of experience in the investment industry. He spent five years at Morgan
Stanley in London, first in Equity Research Sales and later as Vice President – Capital
Introductions & Prime Brokerage Sales. He joins us from Goldman Sachs & Co where he was a
Vice President on the Capital Introduction team, working with non-U.S. hedge funds on their
capital raising activities in North America. Roman received his BA in Russian Language and
International Relations from the University of Wisconsin – Madison and his MBA from the
University of Chicago.
Roman and Lou bring a depth of experience and a breadth of new perspectives to our Investor
Relations team that will further enhance our ability to keep you informed. We are increasing the
size and experience of the investor relations team in advance of the PSH IPO.
In January, Lucy Kelly joined our technology team as Project Manager. Prior to joining Pershing
Square, she worked at Colliers ABR, Inc. Lucy had been consulting for Pershing Square for the
Please mark your calendar for the 3Q14 Investor Call which will be held on Monday October
20th at 11am EST.
Please feel free to contact the Investor Relations team or me if you have questions about any of
William A. Ackman
Additional Disclaimers and Notes to Performance Results The performance results of the Pershing Square funds
shown in this letter are presented on a gross and net-of-fees basis. Gross and net performance includes the
reinvestment of all dividends, interest, and capital gains, and reflect the deduction of, among other things, brokerage
commissions and administrative expenses. Net performance reflects the deduction of management fees and accrued
performance fee/allocation, if any. Performance fee for Pershing Square Holdings, Ltd. is 16%; performance
fee/allocation for each of Pershing Square, L.P., Pershing Square II, L.P. and Pershing Square International, Ltd. is
20%. All performance provided herein assumes an investor has been in each of the funds since its respective
inception date 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 stated
herein. Performance data for 2014 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 inception date for Pershing Square Holdings, Ltd. is
December 31, 2012. 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
well-known, 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.
General Disclaimers and Notes
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.
Any returns provided herein based on the change in a company’s share price is provided for illustrative purposes
only and is not an indication of future returns of the Pershing Square funds.
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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