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.

Dana Telsey v. Warren Buffett on Wal-Mart

Yesterday on one of CNBC's morning programs, retail analyst Dana Telsey gave a wonderfully informed, sensible analysis of Target as preferential to Wal-Mart. It happened to coincide with an excellent interview of the company's leaders in that day's Wall Street Journal.

As is often done, the network placed a Wal-Mart booster opposite Ms. Telsey. All he could really do, though, was reiterate that he hoped Wal-Mart CEO Lee Scott might be fired by year's end, leading the stock to be 'value priced' for some sort of hoped-for turnaround.

As it happens, Warren Buffett had recently (perhaps at his Berkshire Hathaway annual meeting last weekend?) proclaimed himself a buyer of Wal-mart stock.

Thus, Mark Haines of CNBC ceaselessly hectored Dana Telsey with comments like, 'so you think Buffett's wrong,' and 'so you're disagreeing with Buffett' throughout pauses in her remarks.

Hey, Buffett has made his share of mistakes- US Air and Salomon Brothers, to name a few. I believe Mark Haines is wrong to deify the guy. In fact, yesterday on CNBC, one critic described Buffett as basically over the hill, with less-than-stellar recent returns.

He characterized the current search for a new CIO as essentially much ado about nothing, counseling viewers to find the 'next Warren Buffett.' With many billions of dollars to allocate, the commentator (I wish I could recall his name) rather irreverently, but, I believe, correctly suggested that Buffett isn't the same as he was when he was younger, with less money to invest, and that his successor will be unlikely to keep the assets around for long.

With that in mind, I pulled the Yahoo-sourced chart on the left (please click on chart to see a larger version) comparing Berkshire vs. the S&P500 for the past five year. The firm appears to pay no dividends on its stock. Thus, this price chart is essentially a picture of total returns as well. Frankly, I was stunned at what I saw. Berkshire has not significantly outperformed the index over the entire period. For most of the years, it tracks nearly on top of the S&P, with a less pronounced dip in 2002, and a less pronounced rise in 2004. Lately, it's paced the index. Not exactly the kind of return performance that would draw attention, were it any other company than the one Buffett operates.

Back to Target vs. Buffett's pick, Wal-Mart. Dana Telsey noted that a buy of Wal-Mart is for turnaround, but that Target is poised to perform much better. On that note, the Journal interview revealed a stunningly smart, confident team of executives who don't look at their business as cost-cutting discount retail, but, rather, designer-brand and unique-retail experience marketing to selected customers.

Furthermore, they regularly take a common consumer problem and make it part of "The Big Idea" contest. To quote the article, Michael Francis, EVP of Marketing said,

"I challenge my team to solve a problem or see things a new way. We've done everything from what's the next consumable product that we would like to repackage to what product in your pantry frustrates you the most. The winner gets a cash prize, recognition and sometimes we create the product or campaign.

I have people who are brilliant all over the country and they feed in ideas on a regular basis. I probably have about a dozen of them- trend people, movie people, advertising people. We pay them. And we get monthly missives- emails or letters.....it's people who we trust, who we know have the right taste level, who understand our brand."

On that subject of brand, CEO Bob Ulrich said,

"We created the whole trend of designers making products for discounters, starting with architect Michael Graves in 1999....These things keep evolving. You can't just be unique in one category. You can't be really mundane in small electrics if you're trying to be innovative in textiles. You can't be really forward in linens and beat down in shoes, so you have to start to get more consistency across the board....our guests, who are on average about 20% more affluent, more highly educated, come from more sophisticated areas."

And, again, Michael Francis, on brand advertising and promotion,

"I don't want to be on a billboard along some freeway in some dense metropolitan area. I want to be where there is a smart, sophisticated audience, who's experiencing that venue for reasons other than brand awareness......(the buzz is) a powerful, powerful component of what we do. Buzz has had an astonishingly important ability to amplify our entire marketing message."

What struck me about these comments in the Journal interview is how much Target's management and strategy is about consumer needs satisfaction and problem solution, not just logistical cost-cutting. They practice a flair for dramatic, exciting retailing that Wal-Mart never had. So when the latter saturated its market segment, going upmarket, as I wrote in a post in late 2005, was very difficult, if not impossible (as I predicted). Target, on the other hand, has kept a finger on the pulse of its more upscale market segment, and continued to give them reasons to return to its stores.

Thus, as the Yahoo-source price chart for Target, Wal-Mart and the S&P500 on the left shows, Target has outperformed Wal-Mart over the past five years. However, even Target has not quite surpassed the index, which explains why it's not on my equity portfolio selection lists. Further, Target seemed to be experiencing similar performance pattern as Wal-mart up until late 2004, when it finally deviated from Wal-Mart's downward path, and began to soar. Still, in those two years, Target has only just would have outpeformed the index.

So, personally, I'd side with Telsey, although Target is not in my selection list. I've seen Telsey for years on retail and luxury beat, and she appears to know her stuff. Combining Buffett's recent performance, and the pictures of Target's and Wal-Mart's recent performances, along with information about Target's more consumer-focused strategy, I would be inclined to back Dana Telsey's prediction that Target will continue to outperform Wal-Mart in the years ahead.