Ellipsis
September 25, 2009
– Comments (71)
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September 18, 2009
Dear Pershing Square Investor:
The Pershing Square funds underperformed most major market indexes for the second quarter of
2009 while substantially outperforming most major market indexes for the year to date and since
inception as set forth below:
Based on the timing of our most recent quarterly letters, we have developed a deserved
reputation for tardiness in our quarterly communications. The previous sentence should have
been written with an “I” rather than “We” as I am the cause for these late communications. The
operations, finance, and IR teams deserve full credit for the timely distribution of performance
and capital account statements, which has given me cover for somewhat tardy quarterly letters.
Unlike every other function at Pershing Square, whether it is investment analysis, accounting/
finance, IR, technology, legal/compliance, or administration – all of which are team-driven – I
insist on personally writing our quarterly letters. Some firms outsource this important function,
but as the portfolio manager, I believe that you deserve to hear from me directly with no filter, at
least four times a year. Three of these communications historically have been quarterly letters
with the fourth being our annual dinner presentation.
The challenge with this approach is that I am always willing to defer the writing of the quarterly
letter in favor of spending the time required for an existing investment in the portfolio or for the
analysis of a promising new investment. I also don’t like to write unless I have something
significant to say and/or there have been material developments in the portfolio that we are
prepared to share in light of competitive or other considerations. As a result, these letters
occasionally get delayed, particularly, one might expect, in a year as interesting as this one. That
said, I am extremely sensitive to making sure that any material negative news is delivered
promptly.
What you can glean from these considerations is that in the future if your letter has not yet
arrived, in all likelihood it means that we are making progress with existing investments and/or
have identified a potential new situation(s) that is consuming our time and investment resources.
The good news is that the foregoing description reflects the current state of affairs. We like what
we own and we are carefully studying a number of potential opportunities that have
extraordinary potential.
Portfolio Update
During the quarter, most of our portfolio companies made significant operating and business
progress that contributed to stock price appreciation.
Portfolio Update
During the quarter, most of our portfolio companies made significant operating and business
progress that contributed to stock price appreciation.
EMC Corporation
Our second largest investment is our stake in EMC. We invested in EMC because of the high
quality nature of the company’s two principal business lines – the Information Infrastructure and
Virtual Infrastructure businesses – and our ability to acquire a position at a substantial discount
to our estimate of fair value.
Each of EMC’s Information Infrastructure’s three segments – Information Storage, Content
Management and Archiving, and RSA Information Security – leads the market in which it
competes. Because of the extremely high compound growth rate in data globally – estimated by
industry experts at 60+% per annum; (think saved YouTube videos and regulatory requirements
to preserve documents and data), we believe that demand for data storage over the long-term is
largely insensitive to the economy. As a result, we expect that EMC’s dominant market position
in Information Infrastructure will continue to allow it to generate growing, and predictable free
cash flow from new product sales, recurring maintenance and warranty revenues, and the sale of
consumables. The company also benefits because of its substantial operating leverage from
economies of scale, large barriers to entry, and economies of scope, where the breadth of the
company’s product offering is a significant competitive advantage.
EMC’s customers are diverse by industry and geography and enjoy efficiencies from
concentrating their infrastructure spending on a small number of market leading vendors such as
EMC. Its customers are also highly risk averse, as data storage is a critically important function
for regulatory and competitive reasons, and customers face significant costs if they switch to an
alternative vendor.
Information Infrastructure enjoys the benefits of both the inherent operating leverage of the
software business with the high switching costs of the hardware business. Because EMC’s
Information Infrastructure hardware is built from the assembly of components manufactured by
multiple, highly competitive, third-party suppliers, EMC does not suffer the inventory risk,
capital intensity, and supplier negotiating power of traditional hardware businesses.
EMC’s off-balance sheet assets include a large base of satisfied customers that are receptive to
additional offerings from EMC, and a sales force that is considered by many to be the best in the
information technology industry. Combined, these assets facilitate EMC’s expansion into
adjacent markets.
The rapid adoption of virtualization and cloud computing led by EMC’s 84% owned, publicly
traded VMware subsidiary – we are rapidly moving to a world in which you will simply rent
your computing power and storage from third parties and you will no longer have that noisy,
heat-generating, power-consuming box under your desk – increases the demand for EMC’s
offerings, while improving EMC’s opportunity to differentiate its offerings and maintain its
pricing.
VMware is driving a transformation of the information technology industry, and in that process
we expect it will capture large profits over time. We believe that the VMware can ultimately
enjoy a market position and economics similar to that enjoyed by Microsoft’s Windows x86
server and desktop operating system.
We attribute EMC’s substantial stock price appreciation in recent weeks to the market’s
recognition of a recently completed strategic acquisition, better-than-expected second quarter
operating performance, and the continued business progress of VMware.
We believe that EMC is undervalued on a sum-of-the-parts basis, and that the value of its two
core operating segments will continue to increase at an attractive rate.
General Growth Properties Inc.
On August 11th, Judge Gropper, the judge overseeing GGP’s bankruptcy, denied various motions
by secured creditors to dismiss the individual bankruptcy cases of the GGP property-owning
subsidiaries (the SPEs). The SPEs filed for bankruptcy along with GGP’s parent company so
that GGP could reorganize the entire enterprise in an efficient and cost effective manner.
Numerous secured creditors objected, arguing that the SPE bankruptcies were not in good faith
as the SPEs were supposed to be “bankruptcy remote,” and because their properties were
performing strongly, generating substantial cash flow and covering debt service with no evidence
of financial distress.
GGP argued that the directors of the SPEs had acted in good faith in putting the SPEs in
bankruptcy. They did so because they could not be confident, in light of the current state of the
real estate capital markets, that the SPEs could refinance their debt maturities as they come due
over the next several years, creating the risk of a future GGP bankruptcy.
Ruling in favor of GGP, Judge Gropper dismissed the creditors’ motions deciding that the
directors of each of the SPEs had acted in good faith. In his decision, the judge encouraged GGP
and its secured creditors to promptly negotiate an extension of maturities. The upshot of the
judge’s decision is that GGP should be able to successfully reorganize by extending the
maturities of its short-term debt.
Once maturity extensions of GGP’s mortgage debt are achieved, either consensually or through
litigation and court resolution, the company will work with its advisors to determine an
appropriate capital structure for the newly reorganized company. During the process, (1) the
enterprise value of the company will be determined by the court or by negotiation among the
unsecured creditors and equity holders, (2) the proportion of the company owned by current
common holders and unsecured creditors will be finalized, and (3) the company will thereafter
emerge from bankruptcy. Under the bankruptcy code, GGP’s unsecured creditors are entitled to
receive no more than the face amount of their claims plus accrued interest (although accrued
interest is often waived as part of a negotiation when unsecured creditors achieve par recoveries).
The balance of GGP’s value should inure to the benefit of the company’s shareholders. As a
result, the company’s valuation will likely play an important role in determining recoveries for
shareholders.
We believe the best comparable for GGP is Simon Properties, the largest U.S. shopping mall
REIT. While Simon is comparable to GGP in many ways, we believe that Simon stock may
currently trade at a discount to its intrinsic value because of the overhang of potential future
equity issuances that may be required to refund maturing debt obligations. At today’s stock price
of approximately $74, Simon trades a cap rate of approximately 7% using trailing 12-month net
operating income, a widely used measure of real estate value. If one were to apply Simon’s
current cap rate to GGP, it would give the company an enterprise value of $40 billion, implying a
stock price of $40 for GGP.
GGP stock has risen more than12-fold since we first began acquiring our position at 34 cents per
share on November 13th, and the unsecured debt we own has increased in value more than three
times over the same period. Over the same period, the risks to GGP bondholders and
shareholders have been reduced substantially, in our opinion, as the bankruptcy has progressed
and as the economy has shown signs that it may be exiting the recession. Despite this progress,
GGP is a highly leveraged company and there continues to be substantial uncertainty about the
potential outcomes for GGP security holders.
...
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(from here: Pershing Square Q2 2009 Investor Letter (pdf))
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