Monday, 27 August 2012

Bill Ackman's True Genius: Hyper-Alignment

Anyone who follows Bill Ackman's investment career can see that he is a great investor.  If you had bought GGP when he did at $0.40, you would have made more than 80x your original investment in a little over three years (including the current market value of the HHC and RSE spinoffs). Of course, opportunities like that rarely come along, and I certainly don't expect Ackman's or any investor's future picks to yield such results. Furthermore, Ackman is not right 100% of the time, as can be seen in some of his retail mishaps such as Target and Borders.

One aspect of Ackman's activist approach that I believe is widely overlooked is his creation of a system to align CEOs he hires into companies. I have discussed this method of Ackman's in an earlier post, so this may sound a little repetitive to those who previously read it. The reason why I think his true genius is on display through the technique of having the incoming CEOs invest in warrants is that, when the writing is on the wall in a few years, I believe we will see the benefits in the stock prices of Howard Hughes Corp. and JCPenney.  So how, you may ask, does this intangible factor guarantee success? The answer is that it doesn't. But given the importance I place on having a good management team in place, if you give me a great CEO and further have incentives in place that amplify his long-term up- and down-side, you have my close attention for at least a few hours!

Howard Hughes Corp. Warrants - Purchase Terms
  • Weinreb and Herlitz ("W&H") bought 2.7m warrants for $17m, or ~$6.30 per warrant on Nov. 19, 2010
  • Strike price is $42.23 (closing price on 11/19/2010)
  • Breakeven price is therefore $48.53 ($6.30 + $42.23)
  • 7-year life; if share price is not at least $48.53 by Nov. 19, 2017, Weinreb and Herlitz stand to lose 100% of their $17m investment
My take on this: At the current price of $65.39, W&H are already beyond their breakeven price by $17.16 or $46 million (272% gross return!!). It is true that both are technically safe as long as the housing recovery keeps trudging along and nothing too adverse happens.  One must wonder then what incentive either manager has to continue working hard prior to the warrant expiries.  Well, for one thing, the warrant terms are such that they "are not exercisable for six years except in the event of a change of control, termination of the executive without cause, or the separation of the executive from the company for good reason. In addition, for the first six years of the warrants’ term, each executive is prohibited from selling, hedging, or otherwise reducing his net long exposure to the shares underlying the warrants."  The only phrasing in the above terms that makes me queasy is "separation of the executive from the company for good reason".  But chances are that, if for example, Bill Ackman ever wanted to get rid of W&H, by that point the couple would have failed and their warrants out of the money anyway. 

I believe W&H will continue to do their best to surface value by Nov. 2017 because of the leveraged upside both still have from this vantage point.  If they are able to build the value of the company to $100 (my intrinsic value estimate for HHC), this would mean a $139m profit [(100-48.53) x 2.7] or a 817% gross return.

Thus far, management has been quietly working away on advancing developments at the South Street Seaport, Riverwalk Marketplace, Columbia MPC, Bridgeland MPC, Woodlands MPC, and the Ward Centers in Honolulu. My bet is that W&H will really pick up the steam in 2015, and by 2017 we will have seen various value realization moves (e.g. spin off a segment, sell partial interests for more than people expect).  Don't forget that you also have Bill Ackman, the financial engineer of all financial engineers, to ensure than as much value by then is surfaced.

J.C. Penney Warrants - Purchase Terms
  • Ron Johnson bought 7.257m warrants for $50m, or ~$6.89 per warrant in June 2011
  • Strike price is $29.92 and breakeven price is therefore $36.81 ($6.89 + $29.92)
  • 7.5-year life; if share price is not at least $36.81 by December 2018, Johnson will lose 100% of his $50m investment
  • The warrants cannot be sold or hedged for the first six years of their term
My take: Just to get to Ron Johnson's breakeven price on his investment, an investor today would experience a 49% gross return (36.81/24.65).  To me, this is the riskier bet as the thesis depends on Johnson's turnaround strategy playing out successfully. Unless an investor is 100% that his/her downside is protected by the real estate value of the stores, there exists a possible binary outcome.  That is why I have committed only a small portion of my portfolio to this name.  Still, Johnson's fortitude in executing the turnaround (e.g. not caving in after a terrible quarter and reverting back to coupons) suggests that he is running JCP like a private company, which is the purpose of the executive subscribed warrants: setting the CEO's eyes on the long-term prize rather than quarter-to-quarter targets.

Key Takeaways
  • Executive Subscribed Warrants are a great tool to align the long-term interests of management
  • Under this incentive, the CEO must build value over the next six years or risk losing his entire investment
    • Implications: He is much less likely to make decisions for the short term
    • Evidence: JCP going against grain of giving back in to couponing to meet quarterly expectations
  • Okay, so what if this system is a success? What happens after the 6th-7th year? How is the CEO aligned after this point when the stock is up several hundred percent?
    • Answer: I don't, but for the next several years you can bet the CEO will do everything he can to surface value.
  • I don't expect this system can be done for every company, so therefore it is not the answer to alignment problems at most companies
    • Answer: That is very true. For this warrant system to work, (1) a competent CEO with the financial means to invest a convincing sum must be available, (2) the company must be undervalued and thus be perceived as a great investment by the incoming CEO.  So we should not expect to see this implemented well too often. However, if other activist investors do copy Ackman's approach, close attention should be paid to the opportunity.
Disclosure: I currently own positions in all the stocks mentioned above: HHC, GGP, RSE, JCP