In recent months, Pershing Square founder Bill Ackman has been increasing pressure on Target Corp. (TGT or the "Company"), attempting to supplant certain Board members. TGT investors have likely been following the situation very closely, given that shares of TGT have struggled since 2007. But before electing Ackman and his suggested members, investors should take a closer look at what Ackman originally proposed, before blindly electing his slate due to frustration with TGT's share price.
While TGT's Board is ripe for change, the Company is hardly worthy of significant activism. TGT is a great company that happens to compete with some other truly phenomenal companies in terms of operational efficiency. Companies like Wal-Mart Stores (WMT) and Costco (COST) are formidable competitors and critics have recently cited TGT's underperformance relative to WMT and COST as proof that a Board shake-up is warranted. This may be unfair to TGT because since 2004, TGT shares have basically returned the same as WMT.
If one reviews WMT's history over the past decade, WMT sold cheap products but offered little fashion appeal relative to TGT, which also sold more higher margin apparel and home-goods that had fashion appeal while being affordable. However, once the recession hit, absolute price mattered more across the board and WMT greatly benefited from this trend. WMT has succeeded because the recession played into its core strength of procuring goods for the lowest price. While the Company expanded its offerings, particularly in consumer electronics, many areas that critics harped on years ago, such as apparel, did not change meaningfully.
This is important for TGT investors to note because Ackman's activist route favors financial engineering which is unlikely to have any benefit on TGT except to expend fees on advisors. Unlike WMT, which benefited during the slowdown, TGT suffered due to its focus on home-goods and apparel. Home-goods for obvious reasons struggled, but TGT's apparel "moat" fell apart due to the recession. Tough times made many branded and mall-based retailers drop their apparel prices. Previously, branded apparel maintained higher price points than TGT's private label brands but in order to address slackening demand, branded retailers cut their prices where they fell into the price point of TGT's private label apparel. As a result, consumers could pay the same or even cheaper prices for branded apparel and "trade up" in terms of brand quality due to the price drops.
Ackman likely did not foresee these issues as he began his foray with TGT in 2007, raising roughly $2B in a separate fund to invest solely in TGT. This was a very smart move by Ackman because he had roughly $2B in call options invested in TGT in a fund separate from his flagship Pershing Square fund. Institutional investors must have been enamored by Ackman's marketing prowess because the strategy to raise a separate fund only benefited Ackman. If the TGT investment was successful, Ackman's reputation as an investor and activist would grow, not to mention massive personal returns stemming from a fund stuffed with high leverage call options. However, if the investment failed, as it has, the main Pershing Square fund's performance would not be impacted. This allowed Ackman's main fund to report a loss of about 12% for 2008 despite the TGT fund representing nearly 33-50% of Pershing Square's main fund when the TGT fund capital was first raised. For Ackman, this scenario is a case of Mohnish Pabrai's "Heads I Win, Tails I Don't Lose Much" scenario.
TGT investors may feel the need for change but before blindly electing Ackman's slate, it's important to review his proposal and more importantly ascertain where TGT would be if it elected his proposal. In 2007, Ackman suggested that TGT sell off its commercial real estate ("CRE") and use the proceeds to fund a massive stock buyback. He also suggested that TGT divest of its credit card business but the central aspect of his strategy was selling off TGT's CRE and funding a buyback. I was skeptical of this plan from the start and outlined the basics of its plan and why it was not very attractive. The plan was "Financial Engineering 101" and transparent enough that even a layman like myself could predict what his valuation target was.
However, the foundation of Ackman's proposal was to essentially sell one expensive asset in TGT's CRE to pay for another expensive asset in TGT's stock at the time. If Ackman's proposal was adopted, TGT would be worse off today than it currently is. In 2009, assuming TGT adopted Ackman's proposal. TGT would be saddled with above-market lease rates. This would be because TGT would have signed leases during the height of the CRE market, locking in 3-10 year leases at high lease rates. Many retailers in 2009 are able to renegotiate leases for significant drops relative to 2007 and 2008 rates as 3-10 year leases kick out. TGT would have been just one to two years into its lease agreements and would have been stuck paying above market lease rates. TGT competes with some of the strongest retailers in the world and would have had less financial flexibility in competing with them if Ackman's proposal was adopted. In return for these higher lease rates, TGT would have its Treasury account stuffed with TGT shares that it bought for $70+ if Ackman's plan was adopted. TGT investors should consider this when deciding on Ackman's slate as well as Ackman's previous activist campaigns.
Aside from TGT, Ackman is widely known for his activism with McDonald's Corp (MCD) in recent years. Ackman deserves credit for investing heavily in MCD when the stock was cheap but his activist efforts may arguably have been a distraction to MCD versus an actual benefit and value creation activity. As with TGT, Ackman proposed a real estate-based spin-off transaction where he suggested that MCD spin off its company-owned stores and use the proceeds to fund a leveraged share buyback. MCD did not enact this proposal and the stock performed fine because of operational and strategic initiatives, not financial engineering proposed by Ackman. The only difference between MCD and TGT is that Ackman grossly overpaid for TGT while he bought MCD at an attractive price and the bottom line is that no amount of financial engineering can make up for paying too much.
TGT's Board does not deserve a free ride by any means and should be altered to have greater investor representation, but Ackman's slate may not offer an attractive alternative. TGT is a generally well-run company and while activism works, the first thing is selecting the right opportunity. For nearly a decade, WMT stock has essentially done nothing but there is little done on the activist side. COST shares are down, in part related to some of the earnings growth being fueled by inflationary aspects, but there is little shareholder activism occurring there. Ackman is an intelligent investor but TGT investors nonetheless should consider his broader track record with TGT when considering his slate.