Friday, October 31, 2008

Bill Ackman's Ambitious Plans for Target

Yesterday's Wall Street Journal contained an article describing hedge fund manager William Ackman's ambitious plans to cajole the board and senior management of retailer Target Corp. into spinning its real estate into a separate REIT.

Ackman was stumping the plan on CNBC that morning, as well, assuring one and all that Target, as a tenant, would never default, so the REIT would be totally safe.

Here's what the Journal piece had to say about Ackman's plan,

"Mr. Ackman, whose Pershing Square Capital Management owns just under 10% of the Minneapolis-based retailer, says that Target has a huge real-estate company buried inside a retailer that isn't properly valued by the stock market. Target owns the land under 85% its 1,680 stores, the highest percentage of any retailer.

In a statement, Target said that it hadn't reached any conclusion on the proposal, but said its analysis of "similar ideas," conducted with advisers Goldman Sachs Group Inc., "raises serious concerns," including the validity of Mr. Ackman's assumptions about the valuation of Target and the separate REIT entity.

Target also said it is worried about the large expense of lease payments, which are subject to annual increases, plus the adverse effect the company believes the structure would have on its debt ratings, which presently stand at single-A. The retailer said it may respond to the plan "in the near future."

Other potential benefits to shareholders of a spinoff, he said, include a reduced tax burden for Target. A REIT is exempt from paying federal income taxes as long as it distributes 90% of its earnings to shareholders through dividends. For Target, foregoing those several hundred million dollars in taxes would boost cash flow and earnings, Mr. Ackman insisted.

He also argued that the combined values of Target and its REIT would likely be greater than Target's current market value because of the tax savings and the stability of Target as a tenant for the REIT.

If enacted, Mr. Ackman's proposal could cause debt-rating agencies to lower Target's credit ratings because of land transfers to the REIT, said Ee Lin See, a debt analyst with Credit Suisse."

As it happened, I ran into an old friend this morning at my fitness club. BW is a retired retail executive and consultant who spent his entire career in the business. I asked him if he had heard of Ackman's proposal. Not recalling his exact quote, I can paraphrase BW's response as follows,

'Yes, I read it in today's Journal. It's more grab and run. He'll drain the real estate value from Target, load it up with debt, and ruin it.'

Since I don't have operating experience in the sector, and BW does, I asked him, for argument's sake, how it was that a retailer could be so marginally profitable as to be driven into bankruptcy, over time, when forced to pay rent for land it now probably does not charge back for to each store.

BW explained the operating model for big box anchors like Target. Prior to ten years ago, he said, chains like Target were simply given the land beneath their stores by developers as an inducement to anchor a mall or shopping center. Such land, of course, has gained tremendously in value, albeit somewhat less so after the last twelve months.

Thus, he contended, all the major, older retailers operated without actually charging themselves for rent.

In response to my question about the effect of charging rent on Target's individual stores, BW did some quick math and estimated that a fair rent was roughly 3% of the total sales of a store, per year. He correctly estimated Target's gross margin to be roughly 35%. A quick look on Yahoo's page for Target gives a profit margin of about 4%.

Thus, adding rent into Target's cost base would, in fact, reduce its profitability quite a bit, on a percentage basis, from the current level.

So, essentially, Ackman is seeking to unlock and separately monetize years of real estate gains, while simultaneously making Target's operating model change to explicitly include the cost of leases in its income statement. Something it does not currently do. Nor, according to BW, do the other major retail chains so favored, as Target was, with gratis land for store locations.

Ackman would be able to reap gains from selling his fund's resulting REIT shares, and, then, also sell his fund's remaining Target operating company equity position, thus realizing instant profit from the underlying asset. It's a debatable question whether the new Target, stripped of low-cost land, would be as valuable over time. It might eventually lose as much, or more, than was monetized and siphoned out by the REIT.

I should also note that the Journal published a humorous piece in the past few days on this story involving a reporter who attended Ackman's New York presentation of the proposal.

Taken together- Ackman's CNBC appearance, the two Journal pieces and BW's comments- I find myself doubting that Ackman plans to continue holding Target equity in the proportion his fund currently does, statements on air notwithstanding.

This really does, as BW contends, look like the old 'lever them up and dump them' cash extraction of a classic leveraged buyout. And it appears that, rather than viewing their real estate as a passive accidental acquisition of no particular value to their operating model, Target's management realizes that it is, to the contrary, an important component of cost control.

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