PSHZF - Pershing Square Holdings Ltd (PSHZF) Q1 2023 Earnings Call Transcript

2023-05-24 16:42:02 ET

Pershing Square Holdings Ltd (PSHZF)

Q1 2023 Earnings Conference Call

May 24, 2023, 11:00 ET

Company Participants

William Ackman - CEO & Portfolio Manager

Bharath Alamanda - Investment Analyst

Anthony Massaro - Investment Analyst

Ryan Israel - Partner

Feroz Qayyum - Investment Analyst

Manning Feng - Investment Analyst

Charles Korn - Investment Analyst

Ben Hakim - Partner

Conference Call Participants

Presentation

Operator

Welcome to the First Quarter 2023 Investor Call for Pershing Square [Operator Instructions]. It is now my pleasure to turn the call over to your host, Mr. William Ackman, CEO and Portfolio Manager.

William Ackman

Thank you, operator. So welcome to the Q1 Pershing Square Investor Conference Call. I always told to remind you about our legal disclaimer, which is available on our website and actually, my understanding has been delivered to all participants. We're going to talk about companies in our portfolio. Some of these companies, we are on the Board of Directors. But in each case, we're going to give Pershing Square's point of view, I would say, not the official if you will, point of view of the company. These are our opinions about the businesses in which we have an investment.

We cannot, as usual, comment on Pershing Square Holdings, we're unable to answer those questions. We did receive a significant number of questions with a lot of overlap. We'll do our best to cover those when we discuss individual and the answers when we discuss individual companies in the portfolio.

With year-to-date, we've had positive performance anywhere between 3.3% and 4.7% depending upon the fund through last night's close. That's, I'd say, a meaningful underperformance relative to the S&P, our closest benchmark, which was up 8.7% year-to-date. We don't particularly focus on our returns relative to the S&P in the short term, but we do consider it to be an important benchmark over the longer term. The nature of a concentrated portfolio is we are going to have periods of significant underperformance, but hopefully, more periods of significant outperformance, which has been our long-term history.

We are fully invested as of today, very limited cash resources included in those investments are some hedges, which we'll discuss in some detail, but we're going to begin first by talking about the portfolio and we're going to start with our investment in Alphabet, the holding company for Google and other assets. But why don't we start there? Bharath why don't you lead off with our new investment in Alphabet.

Bharath Alamanda

So Google to the company, we've studied and admired for a really long time. We think it's one of the world's great businesses with entry and incredibly strong network effects underpinning its core search franchise. We had an opportunity to initiate a position in the company earlier this year at a very attractive valuation as concerns around Google's competitive positioning in AI overshadowed the high-quality nature of its business and its strong growth prospects. So why do we like Google?

William Ackman

Just for the technical factors here, we have a position that you -- investors have seen the 13-F, actually, another 20% -- 20% to 25% larger. We own some of our Google positions for a forward contract and that does not appear in the 13-F. Our average cost was around $94 or $94.5 a share.

Bharath Alamanda

So just to summarize our investment thesis. One of the main reasons we like Google is they're a dominant leader in a rapidly growing digital ad market. Google has 85% plus share in search advertising and along with YouTube has approximately 50% share in the total digital ad market. And given higher improving ROIs and digital ads, we think we expect digital ads to continue taking share from traditional formats like TV and print and increasingly drive the total ad market to grow above its historical levels.

So for example, in the retail vertical, rising e-commerce penetration is catalyzing the migration of off-line customer acquisition costs like shelving fees and promotional spend into online ads. And with search and YouTube as 2 of the highest return and most resilient ad formats, Google is very well-positioned to benefit from the structural growth in digital ad intensity across the convertibles. And then likewise in its cloud business, Google is a top 3 player in a highly oligopolistic market that's still very much in the early stages of IT workloads migrating from on-premise to cloud and hybrid cloud solutions.

So these powerful secular tailwinds have enabled the company to grow revenue at a 20% annual growth rate over the last 5 years and should continue to support close to double-digit top line growth over the coming few years.

And then secondly, we think there's a significant margin opportunity at Google. Despite revenues nearly doubling since 2018, core Google margins are only 100 basis points higher. The company has recently committed to improving their cost discipline and as part of that, they announced a 6% reduction to their workforce. Given the fundamentally fixed cost nature and high incremental margins associated with their core search business, we believe Google should be able to deliver operating leverage while continuing to invest in AI. And moreover, Google's Cloud segment reached breakeven profitability for the first time this quarter and margin in that segment should continue inflecting higher, given peers like AWS enjoy nearly 30% EBIT margins.

And then thirdly, we really like that the company has a defensive balance sheet with a very attractive capital return program. So Google's cash position makes up about 8% of its market cap and the company is buying back about 4% of its shares on an annualized basis.

Despite these highly compelling attributes, we were able to initiate a position in the company at a very attractive valuation of only 16x forward earnings. That represents a meaningful discount to its historical mid-20s average trading multiple as concerns around AI perceived negative impact on Google Search business that weighed on its share price. We think those concerns vastly underestimate Google's position as a long-term structural AI winner for several key reasons.

So one, the company's incredible scale and the deeply ingrained consumer habit of googling gives them the largest distribution channels to roll out AI into search and their suite of consumer apps. Secondly, they have access to the highest quality training data for their AI models given their vast historical index of consumer queries and consumer behavior. And then lastly, Google has invested in AI for nearly a decade from their acquisition of the pioneering AI sort of deep mine in 2014, to developing proprietary TPU semiconductor chips, which are designed specifically for AI functions. Google has consistently prioritized and invested in AI and machine learning, far earlier than any of their peers or the current wave of emerging start-ups. And that AI leadership was clearly on display at the recently held developer conference, Google I/O Day.

During that event, the company unveiled its newest state-of-the-art large language model PaLM 2 and showcased a variety of big groundbreaking AI capabilities that will be made available to both consumers and Google Cloud customers. And for context, Google has 15 different products with over 500 million users each and 6 of those products have over 2 billion users each. And throughout its IOD keynote, the company demonstrated how AI is already deeply embedded in and will continue to enhance each one of those products in its ecosystem from features like Smart Compose that will automatically help you write e-mails in Gmail, the image editing and image generation in Google Photos.

And then most importantly, the company also introduced the integration of Generative AI in their core Google search product. So the vast majority of Google search queries that you do today already incorporate substantial elements of machine learning. And going forward, the company plans on serving results powered by Generative AI for queries where a chat like response can improve the consumer experience.

And as part of their demo, they also displayed how very context-rich ads can be seamlessly weaved into those generative AI search results. And more broadly, we think greater AI integration will only serve to improve the relevancy and convert it on ads and increased advertiser ROI and monetization.

So stepping back, we still believe we're in the very early days of AI development. Google's current valuation represents a fantastic opportunity to own one of the most advantaged scale players in AI with an unmatched business model and a very long runway for growth. The share price has appreciated by approximately 30% from our cost basis, but we still think there's tremendous upside from here, just given the high level of future earnings growth and the continued potential for the multiple to keep expanding.

William Ackman

I think what's interesting here, we're looking at the company, when you talk about earnings multiple, you're incorporating into the earnings, loss making, if you will, businesses, therefore, assigning kind of negative values to these other bets that have obviously some potential. The cloud business being only marginally profitable, but at this scale, Amazon's cloud business had meaningful profit suggesting that when they want, they're going to position to kind of generate real cash from that business. And in fact, they've had a large cash position, which we don't deduct from the enterprise value when we think about the price that we're paying for the company. So we think we're looking at it in a very conservative way and we think it's a secular winner in advertising and likely AI as well.

With that, let's go to Universal, which remains our largest position, although it shrunk in the last period, but maybe you can address that. So I guess the question for Ryan is how is the underlying business doing and apparently, that business is doing well. Ryan, just talk it down.

Ryan Israel

Sure. So the underlying business momentum really remains even ahead of what we initially thought when we entered into the transaction to buy the Universal shares just under 2 years ago. The company reported earnings last month, ensure that their revenue growth continues to be very close to a double-digit rate, which is actually a little bit ahead of our expectations. And even really ahead of the company's own algorithm that they unveiled just under 2 years ago at their Capital Markets Day, they talked about the long-term revenue growth would be a high single-digit rate and they would expand profit margins at about 100 basis points annually, yielding double-digit EBITDA growth.

The company has actually outperformed that in the last, really, almost 2 years and just step back, I think one of the reasons we remain so excited about the business and why the business has such momentum is really the fact that we view Universal as being an unbelievable business model that's really a royalty on the growth of music streaming. So we have this transition from a physical listening experience to effectively a digital experience where you have the ability to have on your smartphone, almost the vast majority of the 100 million songs that have ever been created and you pay only about $10 a month in order to listen to most of those songs and we think that's really the cheapest form of high-value entertainment you can find.

And so while there's about 500 million people who subscribe and pay to these services today, there's no reason why that over a long period of time shouldn't be up into the billions. And at the same time, given that the price point is so low relative to forms of other entertainment, whether it's live entertainment or video streaming, we think there are opportunities to improve the monetization, which Universal is really starting to scratch the surface on. So I think the current business results and momentum reflect that, and we think they're going to continue.

So the business itself is doing very well, but as you mentioned, the share price is not. The shares are down roughly 15% year-to-date. I think there's really 2 reasons for that. The first is sort of concerns about AI, which we actually think are misplaced.

We think AI has actually a very large opportunity, but I think the theory as to why people are concerned about AI in the marketplace is it really calls into the question, can you create music digitally through artificial intelligence and therefore, you don't need the key artists in Universal's position as a record label with those key artists. Maybe somewhat disintermediated as music can just be created by technology. And I think this fear grew because there were a few songs that were released in the style of some Universal music artists that were uploaded on a couple of platforms and very quickly got a lot of streams. And our perspective is actually that Universal has a very strong position defensively and legally to make sure that these types of illegal streams don't occur and they have the opportunity to use their copyrights and their intellectual property to really be on the leading edge of artificial intelligence.

So first, what we think about it is, if AI creates new music and it's not in the style of a Universal artist, that really just contributes to the proliferation of music on streaming platforms and one of the problems we've seen even before AI, where that was coming from independent artists was you can't break through the noise. Record labels are even more valuable now than they were in the past because in a world in which there are hundreds of thousands of uploads every single day, you need somebody of Universal stature to help you break through all of the noise and become recognized.

We think a lot of the AI that's not trained on Universal's intellectual property and copyright content is really going to contribute to the noise and ultimately, many people won't ever see it, they won't ever hear -- so that won't really be a threat. And for some of the songs that have already broken through, those songs were taken down very quickly because effectively, the models have been illegally trained on Universal's copyright and Universal is really the only one that has the right with their artists to be able to create any sort of AI on that property.

There's even a recent Supreme Court case that came down within the last week that really highlighted how when property is changed and effectively think what holds for AI, that models are trained on somebody else's copyright for commercial intent, that's an illegal activity. And I think one of the things that's very different now in a positive way than in the past, is platforms immediately took these things down. If you go back 7, 10 years ago, when there was a lot of illegal uploading of videos on whether it was YouTube or other services, it was a little bit more difficult to get them taken done quickly, but I think the company as well as the digital service providers have a much stronger partnership now. So I think it's going to be even easier to enforce those copyright protections. That's really kind of in the defensive nature of how it won't be a threat.

I think on the more positive side, the reason it's an opportunity is Universal owns a bunch of valuable IP. And so you can imagine a lot of situations in the future where there can be artists from their back catalog who are no longer living where AI might be able to create limited time hits, it would be very interesting for users to further kind of capture the fan imagination or even collaborations with existing artists and artists who are no longer performing.

So there are a lot of things that Universal can do with AI to create really unique, interesting fan experiences. And then just more broadly, I think one of the things we've understood from our work on Alphabet and other AI winners is the improvement for artificial intelligence to help targeting to provide more effective results for people at the moment they want based on their intention is really powerful.

So imagine that you are a very large Taylor Swift fan, will the ability of AI to help you find other artists that relate to Taylor Swift that you may have never thought about. So we think that AI in a variety of ways can be used both for Universal's own IP, but also just to help create a better fan experience over time. And all that should endure to the company's benefit. So that's the first concern that we had on the share price that we think is misplaced and it's actually an opportunity.

And the second really relates to this recently announced management compensation plan. So if you step back a few years ago, the company when it was a subsidiary of Vivendi, most of the -- all the compensation was in cash and there was an intention to replace some of that cash with equity to kind of better align the incentives of the senior management team, which we agree with. I think the market expectation though was that the cash compensation would roughly be offset dollar for dollar with the equity compensation. And what was announced recently was that there's actually going to be about $100 million more incremental equity awarded than the reduction in the cash. And that would result in sort of a mid-single-digit headwind to earnings growth from that larger than expected by the market compensation plan, which has been a reduction in some of the earnings estimates that analysts had for this year.

And then compounding that, there was also an increase in the tax rate from prior years that I don't think the market had expected, which was going to shave off a few more points of earnings growth. So I would say there has been sort of a concern about AI, which we disagree with. And then there has been, if you will, an incremental kind of headwind to the earnings per share, which is reduced estimates a little bit and is a reason why the share price is down, but I thought perhaps you want to add a few more thoughts on the compensation more broadly, Bill.

William Ackman

No. I think you covered it very well. I will say there -- not particularly well noticed, I would say, by the shareholder base, but a fairly significant announcement in that, the director who chaired the Compensation Committee was not re-appointed -- is not going to be re-appointed to the Board at the end of her term and that was a result of a vote of not just the unaffiliated shareholders, but 2 of the 3 large shareholders of the Board, including Pershing did vote against that member of the Board.

I think that has -- will have a longer-term beneficial effect in how the Board and the management think about compensation and making sure that management is compensated fairly and competitively and their interests are aligned with shareholders, but where those -- it's done in a measured, thoughtful way that the market can anticipate and build into where the shareholders win and the management wins alongside a success for the shareholders of the company. Why don't we go to Chipotle. Chipotle on the other hand, unlike Universal had a fairly spectacular start to the year. So update us Anthony.

Anthony Massaro

Thanks, Bill. So Chipotle stock is up about 50% year-to-date. It's really driven by 2 factors. The first is a market factor. So there has been a recovery of growth companies generally. The NASDAQ is up about 20% year-to-date, but the larger driver here is the company's idiosyncratic performance. So 30 points of the 50-point year-to-date increase really driven by strong results reported in Q1 at the end of April. Those results were exceptionally strong. They included same-store sales growth of about 11%, which was comprised of 10 points of pricing, 4 points of traffic growth, which was really notable following a couple of quarters of traffic declines and a 3-point headwind from mix.

A 4-year cumulative same-store sales, which is kind of cumulative growth since the pandemic began was over 46%. That's an industry-leading result. And this quarter really broke the bear case on Chipotle in 2 respects. So the first is that traffic started growing again following 2 quarters of declines and the second is that margins expanded meaningfully despite what has obviously been a significantly cost inflationary environment.

So I'll touch on each of those. First, traffic, why did that come back? Well, there are really 3 drivers of that. The first is better operations. So the first quarter was one of the best quarters in 5 years for both hourly and salaried turnover and that drove faster throughput. So the line in the store is moving faster, digital orders are more accurate.

They're more often on time and customers like that, they come back more often. Both sides of Chipotle's business grew in the first quarter. So the in-store business grew 23%, excuse me, and accounted for 60% of sales and the digital business grew 10% and accounted for the remaining 40% of sales. There's much more to come on the operations front going forward including a new clamshell grill that's currently in test in 10 restaurants. This grill reduces the chicken cooking time from 12 to 13 minutes to 3 minutes and it actually results in a better end product that's juicier. You can imagine what an unlock that will be for both the employees and customers.

Second driver of traffic growth is menu innovation. So there were 2 of them that were both popular with customers and operationally easy to execute that were launched in the first quarter. The first is the fajita quesadilla. This was really an order that was invented by a customer. So it was something that was going viral on TikTok, gaining a lot of popularity and customers were kind of jerry-rigging the digital menu to kind of order it and Chipotle just went ahead and added that as a permanent digital menu item. And it's entirely composed of existing ingredients, so it adds no complexity whatsoever to the restaurant. And this is really a great example of Chipotle's ability to basically crowdsource new products and launch them and drive incremental traffic and not introduce any additional complexity at all.

The second was a limited time offering that launched in mid-March. So it only had a small impact on the quarter, will have a larger impact on the second quarter. And that was chicken Chicken al pastor.This is a chicken with a spicier, more flavorful flavor profile, its pricing is only at a modest premium to the regular chicken. And based on results to date, it's on track to be the company's most successful limited time offering that's ever been launched.

The third factor that drove the traffic growth was strength across income cohorts. So higher income cohorts consumers continue to increase their purchase frequency, same as they did last quarter, but what really changed this quarter is that demand from lower income consumers actually improved versus the prior 6 months, which really highlights the great value that Chipotle offers for what you're paying.

The second segment of the bear case that was really kind of disproven with the first quarter was that margins expanded meaningfully. The company's powerful restaurant economic model is fully intact despite the inflation that they've experienced. So restaurant margins increased nearly 5 percentage points in the first quarter to 25.6%, while operating profit margins increased over 6 percentage points to just under 16%. This margin expansion reflects the benefit from price increases, which as I mentioned earlier, boosted same-store sales by 10 points in addition to operating leverage from traffic growth. The company has no plans for further pricing in 2023. They haven't taken any pricing this year at all and they don't plan to, unless inflation reaccelerates. The benefit they're getting from pricing is all from price increases that were taken last year. And I think -- we think that this should compare very favorably to peers who have taken or will take price increases this calendar year.

What's interesting on the margin front is the company's outperforming management's framework of 40% incremental margins. So the incremental margin was 54% in the first quarter and has been 45% on average over the last 4 quarters. And if you look at their old framework of kind of a $3 million AUV gets you a 27% margin, they're not far off from that. So the trailing 12-month margin in Q1 was about 25% on an AUV of $2.9 million. And I'd also point out that recall this business used to achieve 27% to 28% margins on average restaurant sales of $2.5 million before the food safety issues in 2015 and it's Pierre Taco Bell, which is the current CEO's Alma Mater, in 2022, achieved a restaurant margin of 28% on a much smaller AUV of $2.2 million.

William Ackman

Although I would say their food quality does not compare.

Anthony Massaro

Their food quality does not compare it. That's for sure. But my point being that -- this company, Chipotle and the CEO, Brian Niccol are no strangers to attractive economic models. So we expect more good news to come on that front going forward.

So despite a significant re-rating year-to-date, we believe Chipotle remains an extremely compelling long-term investment. So what's the bear case now? It's basically the multiple is high. We've heard that since we bought the stock at $400 in mid-2016, and we've heard it at every point along the way, but the stock is 5x since then. And why is that? Well, that's because this is a business that grows earnings rapidly. There's a long runway of mid-teens revenue growth, at least mid-teens ahead of us driven by 8% to 10% unit growth and at least mid-single-digit same-store sales. That last assumption, I think, is going to prove conservative. Current management has grown same-store sales at a 10% compound annual rate since 2018.

This management team has a 5-year plus track record of really outperforming expectations in many areas and I would finally note that our valuation does not take into account any upside levers from things like automation or AI, international growth beyond Canada, which can come in the form of franchising or company-operated expansion or additional day parts like breakfast. And we think all of these things are eventualities. So very excited to see what is in store for the future at Chipotle and turn it back to you, Bill.

William Ackman

Thank you, Anthony. Charles, why don't you update us on Lowe's. Interesting that they've reported the quarter, took down guidance and the stock went up. So what happened?

Charles Korn

Sure. Well, turning to a business that does not trade at a high multiple, which is kind of the essence of perhaps why the stock reacted favorably, we have Lowe's. I'm also first going to maybe just touch on macro because I think that's like the kind of the core of the debate on the stock today. And sort of it is the near-term outlook is fairly uncertain. And that's part of the reason why it's stock trading where it is, although we continue to believe that the long-term backdrop for this industry remains extremely favorable.

In the near term, what's happening kind of at present and you'll see this in the numbers, I'll talk through it is, comparable transactions for this industry have basically now round trip to 2019 levels. And yet industry-wide same-store sales are still elevated in the order of kind of 30-ish percentage points relative to the 2019 pre-COVID base and this is entirely due to an expansion in the average ticket. Now that itself is a combination of both mix and also price.

For the first time, we're now starting to see in 2023 some modest pressure to ticket, which was evident in Lowe's results this quarter, but this is overwhelmingly being driven by the flow-through of commodity deflation. So Lowe's basically passes through the cost of lumber and other building materials directly to its consumers. And so when you have lumber prices, which go from $1,200 per 1,000 square feet -- per 1,000 feet of board to $340, massively pressure sales. Notably, this dynamic is basically going to moderate over the coming quarters as they kind of lap into and roll over these price adjustment.

Now absent widespread deflation of retails, i.e., the MSRP of a lawn mower, a prospect we find highly unlikely. We believe that home improvement same-store sales should consolidate during the balance of the year near current levels. And yet, we remain very optimistic around the medium and long-term outlook for home improvement in the United States and some of the variables that drive that optimism include a historically old and aging housing stock. So the average home in the U.S. is now older than 40 years old. Increasingly, baby boomers are choosing to age in place until they reconfigure and remodel their homes to kind of support that decision.

Millennial cohorts are entering homeownership for the first time in large numbers. There is a widespread in well-debated national housing shortage and a general lack of new builder inventory. And then you have this kind of dynamic of some continued post COVID-19 hybrid work-from-home, which gives you incremental use cases and a higher asset utilization for your home, which should pressure the repair and remodel activity, which is required to support your home. And then yet you still have very high levels of home equity when compared to 2019. So we believe the combination of these variables creates a very attractive kind of medium-term outlook and long-term outlook for this industry.

Turning to Lowe's quarterly results specifically. Though the company reported negative same-store sales of 4.3%, which the pass-through of lumber deflation pressured sales by approximately 350 basis points and then a late arrival of spring, which is a critical selling season for Lowe's negatively impacted revenue by 175 basis points. So adjusting for those variables, same-store sales would have been up, but obviously, it did matter any impacted sales.

Operating profit margins expanded owing to strong expense control and the benefits of Lowe's enterprise-wide perpetual productivity initiative and taken together in reflecting the sale of Lowe's Canadian operations, which closed at year-end 2022. Adjusted operating profits declined 2%, but earnings grew 5% year-over-year as there was a 10% reduction in their share count. Lowe's bought back another $2.1 billion of stock this quarter and is on track to buy back roughly 7% of their market cap this year.

And as you alluded to, Bill, Lowe's moderated their full year guidance, reflecting some of these near-term market dynamics. Same-store sales are now projected to decline between 2% to 4% this year, which will be partially offset by operating margin expansion. And so earnings per share are likely to be roughly flattish this year or down low single digits, depending on specifically where they end up in their guidance range. And there are 2 interesting call-outs from this quarter, which I had highlight, which I think is part of the reason why the stock actually reacted favorably. So one is despite the headline same-store sales decline, Lowe's reported that comparable sales increased with their Pro customer base. This is roughly 25% of their revenue and that was despite 800 basis points of lumber-specific deflation that had customer base experience.

So looking through the lumber deflation, they're still growing same-store sales with the Pro customer base in the high single-digit range. That was over a 22% comparable growth last year, which is quite impressive. And this is a great indication that many of the operational initiatives that Marvin and his team have undertaken in recent years are bearing fruit and is clear evidence of share gain and unlocking the Pro productivity is critical to their long-term revenue productivity and margin aspirations. So this was a really positive data point in the quarter.

The other thing I would note is they announced that following a highly successful pilot program, they intend to expand their merchandise assortment at 300 rural store locations to include certain kind of farm and other kind of rural specific SKUs, which they believe will be well received by consumers. These rural locations had historically been viewed by the investor communication as a structural impediment of Lowe's achieving home...

William Ackman

You mean the investor community?

Charles Korn

Yes. Sorry if I said something else. Structural impediment of Lowe's achieving Home Depot-like revenue productivity and margins. They are viewed as kind of a weakness in their store base. And what's interesting is Lowe's for the first time kind of came out and said, no in fact, we view these stores as a competitive advantage for us and we believe that we have a unique opportunity here to drive incremental sales and profit growth in these locations, and they should help us achieve our long-term aspirations.

And so look, longer term, we continue to see line of sight for Lowe's to grow earnings off the current base at an accelerated rate as they close the revenue productivity gap and the margin percentage gap with their closest competitor targeting that kind of 15% margin over time, which will allow them to generate roughly $20 of earnings per share over time, which is roughly 50% higher than their current base of earnings and yet they continue to trade at approximately 14.5x forward earnings, which we view as a low valuation for a business of this quality and it is still a very substantial discount to its direct competitor, Home Depot, which trades in excess of 19x earnings.

William Ackman

One thing I think is always ignored interestingly when people look at retailers, the vast majority of retailers lease their stores, which create actually a lot more risk of obviously upward increasing rents, loss of control of good locations and Lowe's basically owns all of its own stores, which -- and that real estate is quite valuable. So when you think of a 14 multiple in the context of owning the real estate, it makes it an even cheaper story. Thanks for the summary. Feroz, Restaurant Brands.

Feroz Qayyum

Sure. So Restaurant Brands is making great progress in growing each of its brands while also turning around Burger King in the U.S. So Patrick Doyle has now been Executive Chairman for just about 6 months and under him, results are already starting to improve. In particular, one of the things that he's focused on is putting a renewed focus on franchisee profitability with specific medium-term targets by brand and compensation for many senior leaders also being tied to it.

So at Burger King in the U.S., the company reported its second consecutive quarter of improving same-store sales relative to pre-COVID levels, which are now up about 8%. This is despite being in the very early innings of its Reclaim the Flame program. So the company's only spent about $45 million of its $400 million program so far, meaning there is plenty of opportunity for it to recapture share as the program benefits start to kick in.

So far, that spend has been largely focused on advertising and some light touch remodels, but the larger intensive remodels will begin later this year. And as part of that effort, the company will optimize its store footprint. We'll close about 300 to 400 stores and transition more of its stores towards its better performing franchisees.

Given the improvements that have already been made and the building blocks for future improvement, we believe the company's target of improving franchisee level EBITDA to about $175,000 per store by next year is well within reach at which point the franchisees will take on some of the additional advertising burden. And look, the company doesn't need to look too far for a blueprint for success. It's international business at Burger King, which actually represents more than half the EBITDA is growing as well or better than all of its competitors with same-store sales that are up almost 30% relative to pre-COVID levels.

So the obvious question being, what is the difference between the international business and the U.S. business, well abroad, the stores are much newer. They're more efficient and Burger King has a much larger digital business. All efforts that the Reclaim the Flame plan will tackle in bringing to the U.S. as well.

Turning to Tims in Canada. That business has also continued to make improvements with its 11th consecutive quarter of improving same-store sales trends prior to pre-COVID levels, really every single quarter since COVID began. And over the last few years, that brand has undertaken a fairly dramatic effort to grow sales by improving their offering in the lunch and snacking day parts and extending their lead in the beverage category with innovations in cold beverage. Those efforts are finally paying off as afternoon foods and cold beverage sales are growing more than 20% currently.

And that abroad, Tims is also continuing to grow its brand. In particular, if you look at China, that now has more than 600 units really from a standing start a couple of years ago. And then if you look at other brands elsewhere, Popeyes and Firehouse are continuing to grow well with management starting to accelerate unit growth at both brands. Notably, Popeyes is now growing units at more than 10% a year as the higher AUVs have dramatically improved the unit economics of that business. We believe that's a great case study, an example of what QSR can actually achieve with Firehouse in the coming years as well.

So given the excitement around Patrick Doyle, new leadership, the improving business fundamentals, the share is actually now up 12% for the year. But given the opportunity for QSR brands to still catch up to their peers, in particular, in their home markets and a very long runway for unit growth internationally, we're still very excited about our investment at these prices.

William Ackman

Great. Look, I think it's great to have Patrick on board. But I think we've also talked as a team about how impressed we've been with Josh Kobza, who is the operating CEO of the business and we thought he did a great job on his first earnings call as CEO. So we think the team here is strong and deep in the company. Ryan, why don't you update us Hilton.

Ryan Israel

Sure. So Hilton really continues. It's just dramatic recovery from kind of the depths of COVID. And when the company reported results last month, they actually highlighted that their same-store sales metric, which they call RevPAR, 8% across the system ahead of where it was before COVID, which is really remarkable given that COVID just happened over 3 years ago. At the same time, their EBITDA is actually about a little over 30% above where it was pre-COVID, which really just reflects the fact that Hilton has grown its unit count significantly over the last 3 years, but also really reengineered its cost structure to become more efficient, which it did really during the depths of the COVID days and has been able to maintain that efficiency over time, but one of the things I think is really impressive in the near term is despite having improved beyond where it was pre-COVID, Hilton is still not back to the level of occupancy than it was prior to COVID.

And that's really because its core business customer is still returning to the road. And we actually think in the coming next several quarters, you're going to see an accelerated rate of growth as that occupancy trend tends to normalize to where it was before. So there's still more of an accelerated growth in the COVID recovery phase from Hilton to come over the coming quarters, which we're excited about, but I think longer term, again, one of the reasons why we like the business model so much is these royalty-based franchise or models are capital light.

And if you have the ability to grow, that can be one of the most valuable business models out there. And Hilton really is growing its unit count. Their target is about 6% to 7%. The rate that really grows in excess of a lot of the franchise concepts that we're familiar with and one of the reasons that they can achieve that, that I talked a little bit about now, is the ability just to create new brands from scratch, which isn't really something that even the other franchise concepts that we admire and certainly not as competitors are able to do and so there are 2 concepts that Hilton has recently introduced, I thought were worth discussing a little bit, just to highlight this opportunity and why we think Hilton can continue growing its unit count at such an elevated capital-light way for a long period of time.

The first concept they announced a little while ago called Spark. Spark is a really interesting development because it's basically at a premium economy segment, which is below the price point of any of Hilton's other brands. So it's not competitive with anything they do today, but it's actually one of the largest travel segments. And interestingly, because of the low price point, it often tends to be one of the more fragmented segments where there's a lot of independent owners and operators. And so there's a lot of people who go to these when they first start traveling and they have very bad experiences because the experiences can be incredibly inconsistent.

And so what Hilton is doing that we think is very smart here is in Spark, they're creating a conversion opportunity. So in an environment where it may be a little bit more difficult to get financing to build new projects, Hilton is coming up with project where it costs very little because you just need to spend a little bit of money to convert your existing hotel into something that meets Hilton's brand standards. They can provide a very consistent customer experience to what is today a very inconsistent customer experience and they're getting the largest funnel of travelers who are first starting to travel at the lowest price points that they can then over time, upsell into some of their higher-end products.

So we think this could be a very large opportunity over time and it's something that doesn't cost the company any capital in order to create and unlike some of their competitors, they don't need to go out and buy it, they can just build it. So we think that's very smart.

Another concept that they just talked about on the earnings call for the first time and really just released some more details over the last couple of days, is what's being called now Project H3, which is a very unique extended stay solution and this is really in response to kind of how flexible work arrangements are changing the travel and residential landscape. And so this product is a low-cost product that is really aimed at somebody who's going to stay in what they want to be in an apartment-like experience with the consistency of a hotel brand for more than 20 days. And there's really nothing else like it in the marketplace.

It is coming in again at a lower price point. It's not competitive with any of the other existing Hilton extended stays, which are really designed to be extended days of a week or 10 days, nothing this long term and this is something that the company talked about, but they already have over 300 development deals, even though they've just started talking about this in the last month.

And so we think it just really highlights these 2 concepts, the ability for the company to create new brands to power that unit growth, but also to do it in a very intelligent way, which really maximizes the network effects longer term for their entire customer base.

And so I just thought those were 2 things to highlight as to why we're so excited that the company can continue growing its units at a high rate, which we think will really help the company achieve kind of our internal estimates longer term of growing in the kind of mid-to-high teens earnings per share growth once they normalize from this rapid recovery from COVID. So we remain very excited about the company. While the shares were up about roughly 7% year-to-date, we actually believe the company is trading at one of the lower multiples it has over time. And actually, it's probably one of the most attractive kind of investment returns, we think we've seen from the company since really the last several years. So we're very excited about it.

William Ackman

So one of the -- it's an interesting analog to compare Restaurant Brands and Hilton, and we like obviously both businesses, but unique to Hilton is the ability to create brands, all of the Restaurant Brands were acquired. That, of course, limits the universe of things that you can do. Here we're limited by creativity, basically. And their ability to launch them with their credibility enables them to launch them with a lot of demand.

One question I would have I think our investors would want to know the answer to, the regional banking system, which has provided a lot of the financing, particularly for smaller real estate loans. I think of some of the extended stay or the Hilton kind of concepts in the U.S., what do the companies say about any impact -- potential impact on the unit development program?

Ryan Israel

Sure. I think it's a concern that may be out there that is weighing on the hotel industry in general because it certainly is the case that bank lending standards are getting tighter, it is becoming more difficult to finance a large variety of real estate projects right now. What I think makes Hilton unique and why they feel like they're more insulated than most is really 2 different things.

First, their brands are most financeable across the industry because they have such a high return, high margin profile, and they have such a just deep network of relationships with lenders and with developers. And so I think that if any project is not getting financed, Hilton will sort of be the last one that they're still willing to finance before they cut off is big. So I think that Hilton is very well insulated relative to the pressure of the industry in general.

The other thing that I think that's worth pointing out is that where Hilton's projects are, a lot of them tend to be at the more kind of meter, what they call upper scale. So lower price point, not the luxury property, not the high end ones. Those are the ones that would be the most difficult to finance in this market with the most risk. Hilton is really doing more consistent, high return and really lower cost hotels for their partners who are actually financing these things and those are easier, lower ticket items.

And then secondly, for example, if you think about Spark, which I just discussed, a lot of what Hilton does is actually conversion opportunities. So they have a very good balance between things that their partners need to build from the ground up, which in some respects will certainly be more impacted than they would have been when no money was free a few years ago, although we think they're still pretty well-insulated but a lot of their growth can come from conversions where people don't really need to go to a bank to have a loan because they're just making some more cosmetic-like changes that are very low cost. They may even be able to finance just out of their operations. And so we think that balance of new builds and conversion is something that will really help Hilton through to the extent that credit remains tight or continues to tighten over time.

William Ackman

Great. Ben, Howard Hughes?

Ben Hakim

Thanks, Bill. Howard Hughes has really now established itself as the country's premier owner and developer of large-scale master planned communities or MPCs. As we've talked about, these MPCs are located in sought-after a low cost, low tax and pro-business regions like Texas and Nevada, which continue to benefit from strong in-migration trends. But due to the macroeconomic uncertainty that has come with elevated interest rates, Howard Hughes has underperformed the market this year alongside and in line with the overall REIT sector.

However, we believe that Howard Hughes is uniquely advantaged business model is once again proving its resiliency throughout various market cycles. And as mortgage rates have stabilized this year, we've seen a positive shift in homebuyer sentiment. With supply of home resale inventory limited due to owners reluctance to sell and take on more expensive mortgages, there has been a resurgence in demand for newly built homes.

Homebuilder stocks have significantly outperformed this year as investors have come to appreciate this dynamic. In fact, Toll Brothers just reported this morning, and they had very strong commentary on the new home demand trend. Howard Hughes saw this trend in its own MPCs with a 120% sequential increase in new home sales compared to Q4 and only a 9% decrease compared to the elevated levels of Q1 last year. As a result, Howard Hughes expects to see strong residential land sales throughout this year and has guided for approximately $200 million of MPC earnings before taxes, which is in line with levels seen in 2017 and '18 prior to this period of outsized land and home sales post pandemic.

Howard Hughes has 30,000 acres of remaining land in its MPCs, which will provide ongoing cash flow generation for decades to come. In its income-producing operating assets segment, Howard Hughes' Q1 same-store net operating income grew by over 8% year-over-year. They experienced continued favorable leasing momentum across the portfolio with sequential improvement in overall leasing percentages across its core property types. This strong performance in a difficult leasing environment again shows the strength and desirability of Howard Hughes' communities.

In its Ward Village Hawaii development, Howard Hughes has 3 condo towers under construction and a fourth in pre-sale, all of which are nearly fully sold out at a record pace for the company. These 4 towers are expected to generate combined future revenues of nearly $2.5 billion between 2024 and in 2026 at a nearly 30% cash margin.

Given this continued strength and demand for its premium condo product, Howard Hughes announced the launch of its 11th condo tower, which is expected to commence pre-sales in late '23 and be delivered in 2027. So a steady pace of new condo home sales over the next few years.

At the Seaport in Downtown New York, revenues increased 27% in Q1 compared to the prior year due to the addition of the Jean-Georges operated Tin building. But it also came with continued losses as they attempt to ramp up the customer base and build customer loyalty. Tin Building achieved 7-day per week operations throughout Q1, which required some overstaffing to ensure the customer experience is stellar in the startup phase. But over the coming months, that you'd see intent to dial back that lever, which will hopefully result in better cash flows throughout the remainder of the year.

And from a balance sheet perspective, HHC ended up with $420 million of cash on hand. 100% of the company's debt is now fixed, capped or hedged with approximately 87% due in '26 or later. We would note, as we talked about the construction financing remains challenging but for Howard Hughes, that may just mean that they perhaps slightly later project or 2. And given that they own their own land, they have the luxury of being able to build whenever demand and financing is available.

And lastly, given our view of value at the company, Pershing Square has continued to purchase additional shares over the past year, increasing our ownership position to over 32% of the company.

William Ackman

I think Howard Hughes is a, I would say, a very long-term story with macro sensitivity, particularly in the short term in a market environment where people are looking to avoid risk. And the unfortunate nature of this business is the market tends to focus on whatever they think of the most concerning part of the portfolio and use that as a reason to knock the company. Homebuilder stocks are up a ton, our land sales are directly related to homebuilder outcome, yet our stock is -- Howard Hughes' stock is underperforming. We own a significant number of office assets. They're generally very well leased because they're inside our MPCs, but I think we're getting dinged there. But it's okay. Again, we take the long view and we're very happy to own more of the company at an attractive price.

Manning, Canadian Pacific, over the weekend, I read a new story about President of Mexico expropriating small railroad mine. I think that's contributing to some weakness in the stock. Maybe you can start there? And then why don't you talk about how the company is doing with Kansas City Southern.

Manning Feng

Yes, definitely. Thanks, Bill. So I'll definitely touch on Mexico. But maybe just for stepping back. A very exciting milestone happened in the first quarter at CP when it finally received regulatory approval from the Surface Transportation Board for its acquisition of Kansas City Southern. This transaction, as everyone may recall, has been in the works for nearly 2 years and we'd really like to congratulate Keith and the entire team for getting it over the finish line.

In the Surface Transportation Board's decision, it was extremely favorable for CP and the decision highlighted the many benefits of the transaction, which are also some of the reasons why we're so excited about the stock including increasing competition in the rail industry, creating new transportation options for shippers and reducing greenhouse gas emissions by shifting freight from truck to rail.

CP after receiving the green light from the government officially closed the acquisition on April 14 and renamed the combined company, CPKS, Canadian Pacific Kansas Southern. Although it has only been several weeks since officially merging, the team has really hit the ground running and already announced 2 major intermodal contract wins while focusing on integrating the 2 networks.

So now that the merger has closed, investor attention has shifted to both the integration of KCS as well as the new financial targets for the combined company. So in terms of the financial targets, management has a synergy target out there of USD 1 billion of EBITDA over 3 years post integration, but this target was last updated in August 2021, which was obviously prior to CP getting control of KCS. Since then, the pricing environment in the transportation industry has significantly improved not to mention that CP has identified many more synergy opportunities after getting to spend more than 1.5 years talking with customers and analyzing KCS' network in great detail.

So management is planning on updating these financial targets at their upcoming Investor Day in June, and we expect the new synergy target to be well in excess of the $1 billion prior number.

Bill, you mentioned Mexico. So I'll highlight a little bit. There's been several, I guess, recent events over the weekend that have contributed to weakness in the share price performance, weighed on investor sentiment, but in our opinion, actually do not impact the CPKC. So there's a little bit of background, there were headlines over the weekend that the Mexican government has expropriated a small section of railroad in Southern Mexico that is currently operated by Grupo Mexico, which is a large industrial company there. In Mexico, the railroads are owned by the government, but they are operated by private players exclusively via long-term concessions of the government grants. This railroad in particular, that was taken over by the government is really integral to the President's key infrastructure project, connecting the Gulf of Mexico to the Pacific Ocean and the Mexican government and Grupo Mexico have been in long-term negotiations over how to kind of make this project into fruition.

But talk, I think, fell-through over the weekend and the government went forward in top of the railroad. But I would note that the railroad is actually still operated by Grupo Mexico. It's still in operation today. And Grupo Mexico and the Mexican government are in active negotiations over the compensation and kind of the go-forward operations here.

The KCS situation is, in our opinion, completely different. KCS' network is in Northern Mexico. It has nothing to do with connecting the Gulf of Mexico into Pacific Ocean and infrastructure project at the prices of Mexico is very focused on. The KCS network, obviously, is cross-border with the U.S. and connects a lot of the Mexican industrial heartland to the very important U.S. market. So we think it would be extremely detrimental going to impact that. I'd also note that KCS' concession was recently extended to last until 2037, which we believe signals kind of the Mexican government's confidence in KCS and the CPKC combination.

I guess lastly, I'll note that the Mexican President, he's known as AMLO, he has 15 months left in his term and Mexico is a fully functioning democracy. So the President cannot kind of unilaterally take actions like this without consequences. The Mexican Supreme Court has already actively pushed back on many of his infrastructure projects where the government would perhaps be seen as overreaching private industry. So again, negative headlines, but again, we think this has nothing to do with CPKC and we remain really excited about the opportunities combining CP and KCS together, and we look forward to learning more at the June Investor Day.

William Ackman

Great. Anthony, any comments on Fannie-Freddie, would like to make?

Anthony Massaro

No. I guess that's a nice segue with expropriation, but no. No real updates. The entities are continuing to build capital.

William Ackman

Aren't we an active democracy?

Anthony Massaro

We are.

William Ackman

With just compensation for taking a product property?

Anthony Massaro

Well, we'll see. It's a long -- it will be a long runway here. But in the meantime, while we wait for kind of the eventual resolution, the entities are continuing to build capital. So they earned just under $6 billion combined in Q1. They have total capital of $103 billion on a GAAP basis or $85 billion excluding deferred tax assets, which they're not allowed to count towards regulatory capital. They need another $222 billion of capital. It will take about 8 years to reach that through retained earnings loans.

William Ackman

I don't think they actually need that. I think that...

Anthony Massaro

According to the latest higher capital standards.

William Ackman

Yes. That's right. What's interesting about Fannie-Freddie is I don't really know how to think about why the stock price is here versus any other stock price. It's -- it was a period of time where they weren't building any capital at all and the share price was 3x the current share price. And I think it's actually probably the most interesting play on who the next administration if President Trump is reelected, which is probably very good for Fannie-Freddie or any more conservative leaning administration, but don't let that affect your vote. Consider other factors.

Just thought I'd comment on -- actually, it's a quick question or there's a question from a shareholder -- investor about Fannie-Freddie with the Supreme Court decision in something called the Axon case, but we do not believe it is relevant to Fannie-Freddie and the anti-injunction provision that the Supreme Court basically is allowing the government to act without -- to take the actions that they deem necessary and that we are not in a position to challenge them. Our bet at this point is really based on the economic logic of Fannie and Freddie becoming independent companies once they are sufficiently capitalized, whether that's 8 years or whether there's some shorter period of time because the capital rules have changed or the business has raised capital in an IPO, but we do think that's the inevitable outcome. Interesting options representing a little under 1% of the portfolio.

I just want to comment on purchase for Spark Holdings. This is our, call it, SPAC 3.0 vehicle. It's been almost 1.5 years, I guess, probably more than 1.5 years. We've been working with the SEC, and we are getting close, but we're not quite there yet. We expect to make a revised filing, answering a few more questions to the government this -- hopefully, by the end of this week, we also are endeavoring to finish the various state approvals that are necessary. I best estimate of when we're in a position to actually start working on a transaction is really a July time frame, probably second week in July is probably the most I would say conservative, but again, this has taken a lot longer than we would expect. But we do think Spark is going to be a very interesting vehicle at a time when it's very challenging for a business to go public.

We think we'll have our -- we'll receive some interesting -- the phone will ring once people realize this entity is live and we believe it will be the most efficient way for someone to go public and have certainty on the transaction occurring, on price and a minimum capital raise of significance. And we think we do one and we'll set a kind of road map for what we can do going forward. So we're actually quite excited about it, although we're patiently excited because that's taking some time.

Briefly on hedges. Well, first of all, the elephant in the proverbial room are the debt ceiling talks that remain unresolved. I would say, our house view is that this is probably more likely than not lead to a default although you can't discount that kind of outcome. We do -- we don't think any of our individual businesses is materially affected by a government default or all well-financed companies that generate their own cash and have -- are conservatively financed, but it's just not a good for America moment and it could lead to a permanent increase in the cost of our debt. We do have a couple of interest rate related hedges on the kind of longer-term part of the curve. We do think 30-year borrowing rates in the United States government would certainly go up in the event of a default, on a persistent basis. So we didn't put that hedge in place initially for that reason, but it will serve a somewhat similar fact but we have no other sort of directly related hedges. We've looked at some alternatives, but the reward is not sufficiently asymmetric to justify the investment.

And again, there, we'd be only hedging opportunistically, i.e. with the goal of making a large profit having liquidity at the time when markets could be in disarray. We think it's the lower likelihood outcome, but we can't be certain.

With that, got about a minute left. Let's see if there's anything that we didn't yet cover that we're permitted to discuss in some of the questions. If there's anything new here of consequence. Actually, I think we've done a pretty good job of covering the questions. If you have further questions, please feel free to contact Tony Asnes or our ir@persq.com e-mail address and we'll get back to you promptly. So thank you for joining us for our first quarter conference call. Let's hope the government doesn't default and we'll know more certainly by the next call. Thank you.

Operator

Thank you, everyone. This concludes your conference call for today. You may now disconnect.

Question-and-Answer Session

End of Q&A

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Pershing Square Holdings Ltd (PSHZF) Q1 2023 Earnings Call Transcript