Rail, retail: Ackman's activist investments
The founder of Pershing Square Capital Management outlines his goals for Canadian Pacific and JC Penney.
This week, the founder of Pershing Square Capital Management and activist investor issued a letter outlining the state of his current deals, including the retailer and the railroad, which are now almost 40% of his highly concentrated portfolio.
Once a retailer of bland, low-priced fashions and housewares, J.C. Penney (JCP) got a jolt when Ackman acquired over 17% of it in 2010 to 2011 and vowed to effect a "transformation" that would deliver outsized returns. This week, Ackman's letter containing an explanation of his steps at J.C. Penney coincided with the stock's dip to a 52-week low on decreased sales. Ackman's success with JCP seems to hinge on whether customers will return to its new and improved version after the transition period, now in its early stages.
Prior to Ackman's entrance, J.C. Penney's model was becoming outdated and its top line was sliding: Revenues dipped from $19.9 billion in 2007 to $17.6 billion in 2010.
By 2010, the company's comparable same-store sales and total net sales actually grew modestly, as several changes were already underway. For instance, J.C. Penney opened 76 Sephora stores within stores and launched the Liz Claiborne brand. In the first quarter of 2012, JCP opened 17 more Sephoras inside Penney stores, bringing the total to 325 locations and two new department stores. The company also discontinued its catalog print media and closed down its catalog outlet stores.
Ackman wants to attract other vendors to the retailer through its revamped brand and cheaper rents and openings costs. "By building out new shops which generate substantially higher sales per square foot, JCP should be able to greatly increase its overall sales per square foot and profitability," Ackman said in his letter.
The biggest problem, however, has been with the company's promotional strategy. Ackman and J.C. Penney CEO Ron Johnson did away with the company's numerous discounts. Instead, they rolled out a "Fair and Square" pricing strategy that divided pricing into three types: everyday, month-long and best or lowest prices.
The problem with this strategy is that the meaning is not always clear. In fact, lack of success educating consumers about it led to an 18.9% decline in sales in the first quarter. The company was then forced to make deeper markdowns to move accumulated seasonal inventory.
If the company does a better job familiarizing consumers with the pricing plan, sales could pick up in the second quarter, making the stock's price dip temporary. But if management does not acknowledge the mistake, it could prolong the stock price depression. Ackman addressed the issue in his letter, saying, "Ron and the rest of the JCP team are working hard to fix the marketing and messaging, and we are confident that they will get it right."
Thus far, Ackman's efforts to raise the quality of merchandise and streamline the store's discount strategy has driven some customers from the stores. Yet he believes that when the transformation is complete, the store will appeal to more customers than before.
His vision for the store (which he compares to a mall in his letter) is: "With time and some changes, the marketing message for the property will be better understood, old customers who left will return, and a large base of new customers, who hadn't shopped at the property before, will start shopping because they are attracted by the new tenants and the more attractive and compelling shopping experience. The mall will become the most attractive place to shop in the market because each month two to three new stores will be opening which will create news and a reason for existing and new customers to shop in the mall."
Even if sales return and affirm the long-term profitability of a JCP investment, Ackman still expects more volatility in the stock in the near term.
Control of Canadian Pacific Railway (CP), the second-largest railway in Canada, is now in Ackman's hands. As he says in his letter, the vast majority of shareholders welcomed him and his six board nominees in May, while the chairman and CEO received the fewest votes and resigned.
Ackman's task is to turn around a company whose revenues and earnings have grown little in recent years. Revenue was $4.4 billion in 2005 and $4.8 billion in 2010. Earnings over that period went from $448 million to $563 million. Free cash flow fell to a loss in 2010 and 2011.The company lags the industry in several measures. For instance, it has a net margin of 12.6%, lower than the industry's 16%; the return on equity (trailing 12 months) is 13.9% compared to 17.2%; and debt to equity is 1.0 compared to 0.8.
Ackman believes almost all of the railroad's issues are related to operations. The operating ratio -- the company's operating expenses as a percentage of revenue -- is a key measurement for a railway's efficiency. Canadian Pacific had been working toward lowering its operating ratio to between 70 and 72% by 2014. Canadian National (CNI), its closest competitor, has already decreased its operating ratio to 63.5% in 2011. Of all large railroads, only Canadian Pacific failed to improve its operating ratio materially since 2003, according to Morningstar.
The more efficient Canadian National trades for $80.81 a share on Thursday, compared to $70.97 for Canadian Pacific. If Ackman's new board can similarly streamline the company, investors stand to realize substantial upside. It may prove difficult to do, as workers at CP have gone on strike recently after cost-cutting measures included reducing post-retirement benefits by 40%.
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