With Bill Ackman's Pershing Square increasingly becoming a levered bet on the fate of Valeant, which moments ago, ahead of its investor day, cut both its revenue and profit forecasts for both the quarter and the full year as follows:
Q4 2015 Revised Guidance
- Total Revenues previously $3.25 - $3.45 billion now $2.7 - $2.8 billion
- Adjusted EPS* previously $4.00 - $4.20 now $2.55 -$2.65
- Adjusted Cash Flow from Operations* previously greater than $1.0 billion, now greater than $600 million
Full Year 2015 Revised Guidance
- Total Revenue previously $11.0 - $11.2 billion now $10.4 -$10.5 billion
- Adjusted EPS* previously $11.67 - $11.87 now $10.23 -$10.33
- Adjusted Cash Flow from Operations* previously greater than $3.35 billion, now greater than $2.95 billion
... overnight the silver-haired manager released a letter with an appropriate warning: "If the year finishes with our portfolio holdings at or around current values, 2015 will be the worst performance year in Pershing Square’s history, even worse than 2008 during the financial crisis when the funds declined by 12% to 13%. You might therefore find it surprising that we believe that 2015 has been a good year for our portfolio companies."
He then, rhetorically asks, "how can this be?"
Here is his full answer from his December 15 letter to investors:
We have often described our strategy as the implementation of a private equity approach to the public markets – with nearly all of the control-oriented benefits of private equity without the negatives, i.e., the requirement to pay large premiums for control, the necessity of using large amount of leverage in order to win competitive auctions, and the inherent illiquidity of private investments.
In light of the liquidity of our publicly traded portfolio, we receive a minute-by-minute indication of the market value of our holdings. Over the long-term, the portfolio’s mark-tomarket value is by far the most appropriate measure of our success. In the short term, however, it can create a misleading perception of our progress.
While we certainly observe and monitor the daily prices of our holdings, our principal focus is the underlying business progress of our portfolio companies and their changes in intrinsic value, which we determine largely based on our assessment of the discounted cash flows we expect them to generate over time. By this measure, we believe that the intrinsic value of the portfolio increased materially over the course of the year. Growth in the intrinsic value of our holdings is the most important determinant of our long-term success.
While we believe that the portfolio’s intrinsic value increased, the mark-to-market value of our portfolio has declined substantially since the beginning of the year. As a result of this divergence, we believe that the Pershing Square funds are trading at perhaps the greatest discount to their intrinsic value that we have seen since the inception of the firm.
With a large and growing divergence between intrinsic value and market value, the stability of our capital becomes an even more important factor in our long-term success. In recent years, we have made material improvements to the stability of our capital. With the launch of Pershing Square Holdings, Ltd. (PSH), substantial growth in employee investments in the funds, and the $1.0 billion bond offering by PSH, nearly half of our capital is effectively permanent. The balance of our funds is also quite stable as the substantial majority of our private funds has one-eighth per quarter liquidity and is held by investors (other than several new investors who joined in the last year), who have made large profits over many years of investment in Pershing Square.
Despite the substantial decline in the funds’ performance from August to the present, our net redemptions were nominal at $39 million or 0.2% of capital for the third quarter, and $13 million or 0.1% in the fourth quarter. As a result, we have not been forced to raise cash as the portfolio declined, but have been able to be opportunistic. The recent substantial increase in our economic exposure to Valeant at recent lows in the stock is a good such example.
As the largest investors in the funds, we viscerally experience the mark-to-market decline in the portfolio along with our investors. That said, we believe it is a useful exercise to think about the Pershing Square portfolio as if it were comprised of private companies. If our holdings were solely private companies, one would be focused almost exclusively on the companies’ underlying business progress. Judged on this basis, the companies that represent the substantial majority of our capital have delivered strong year-to-date results which have contributed to significant increases in their intrinsic values. As you will read in the detailed summaries of each investment below – Mondelez, Valeant, Air Products, Canadian Pacific, Zoetis, Howard Hughes, and Restaurant Brands – all have reported strong results, and we expect them to continue to do so. The company we are short, Herbalife, reported poor results, substantially reduced earnings guidance for 2016, and large quarter-on-quarter increases in regulatory defense costs.
Platform Specialty Products which represents a small portion of the portfolio (currently 3.5%, at peak valuation, 6.3%), generated results that were below our expectations due to execution issues, foreign currency effects, as well as other factors specific to certain of its business units. While disappointing, we view these factors as generally short-term in nature and addressable over the short to intermediate term.
In summary, we believe the portfolio increased in intrinsic value over the course of the year while substantially declining in market value. We much prefer growth in intrinsic value than short-term increases in market value without corresponding progress in intrinsic value. Market value declines during periods of intrinsic value growth create opportunities for long-term profits, as our funds and our portfolio companies are able to purchase shares at attractive valuations.
You might be surprised to see Valeant on our list of companies whose intrinsic value increased this year in light of the controversy around Valeant’s specialty pharmacy distribution channel, regulatory subpoenas, and drug pricing. When we first began acquiring our stake in Valeant for approximately $160 per share (our initial position’s average cost was $196), analyst cash earnings estimates for 2016 were $11.89 per share. Over the course of the year, Valeant made a number of small acquisitions in addition to its large opportunistic purchase of Salix. The result of these transactions and the related synergies increased our estimates for cash earnings to about $15.90 per share for 2016 and larger amounts in later years, substantially increasing our estimate of Valeant’s intrinsic value.
When Valeant’s specialty pharmacy (Philidor) and drug pricing controversies came to light, we assessed the impact of these developments on future revenues, earnings and cash flows. While we believe that 2016 cash earnings will likely be somewhat lower than our initial estimate, we do not believe that Valeant’s long-term earnings prospects have materially changed. While there remains uncertainty with respect to Valeant’s business, we believe the company’s business value has grown considerably since our initial investment despite recent negative developments, unfavorable press, some reputational damage, and short-term disruption to the company’s distribution of dermatology products.
Had Valeant been a private company, we believe that the controversy surrounding its specialty pharmacy and drug pricing issues would not have been as newsworthy nor perceived as material to the company’s intrinsic value. As a public company, Valeant’s stock price precipitous decline gave credence to the short sellers’ attacks on the company, and the corresponding media coverage caused some reputational damage. That said, we believe the impact on intrinsic value will ultimately be modest and the reputational damage can be mitigated. Valeant has begun to address these reputational issues with greater transparency and responsiveness to short seller attacks and inaccurate press, and will continue to do so at an analyst day tomorrow where senior management will spend more than four hours with investors and analysts.
In summary, while it is important to monitor mark-to-market developments in the short term, growth in long-term intrinsic value will ultimately be determinative of our success or failure. To paraphrase Benjamin Graham, in the short term, the market is a voting machine, representing the short-term whims of investors. Over the long term, the market is a weighing machine when market prices become a better representative of intrinsic value. While we cannot guarantee returns, we can guarantee that we will implement an investment strategy and process that we believe will continue to lead to long-term attractive rates of return.
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More in the full letter below
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