Case Study: Whole Foods Markets (WFM)

One material event to note this quarter is Amazon's pending acquisition of Whole Foods Market (WFM). Recall in my 2015 Annual Letter I mentioned purchasing WFM which, at that time, had declined from a high of over $65 per share in 2013 by more than half¹. Our cost basis was ~$30, which at the time reflected a fair-ish 13x multiple on cash flows ex-store expansion costs.

Shares were relatively range-bound for over a year, but things started heating up in 2017 Q2 after Jana Partners, an activist hedge fund, took a big stake and pressed aggressively for changes. On June 16th, Amazon announced a $42 per share bid for WFM, netting us a 40% gain. Annualized return over our roughly 18 month holding period was a satisfactory 25%.

WFM chart for the duration of our holding period. Things heated up in Q2 after Jana took a big stake.

The only pimple here was that WFM was never larger than a 2-3% position across our accounts. However, I harbor no regrets in not making it larger. It is always with hindsight that one laments not betting everything on black after the roulette wheel deposits the pinball on black. My analysis of WFM was that it traded at a fair price at around $30/share but possessed a platinum brand that would eventually be unlocked, whether through organic growth or M&A. Had shares traded down to sub-$25, we likely would have owned more, but alas, we settled for making not-as-much money. First world problems.

What’s more interesting is that very few people anticipated a strategic merger between these dance partners. Most of the chatter surrounded the possibility of Krogers or Albertsons or even Wal-Mart being the eventual acquirers of Whole Foods. The fact that Amazon, the online behemoth, is paying $13.7 billion, over ten times more than their next largest acquisition², for a footprint of brick & mortar stores across the nation is a hint that traditional retail is in fact not dead. Physical spaces that are well-designed and offer visceral pleasures are alive and well. It is the sloppier ones, the ones with poor product selections, with run-down facades, with demoralized underpaid staff that are doomed³. In the past, they were able to survive because despite being unpleasant to shop at, there were few other choices to buy what you wanted/needed without driving excessive distances. Now, there’s Amazon, and they’re taking their promise of customer delights to a physical store near you.

And so what’s going on is beyond the blasé “online shopping is killing retail” narrative. It is the very idea of capitalism encapsulated in a nutshell: increase productivity or make way for those who can, the ultimate winner being the consumer, who no longer have to suffer the indignities of poor parking layouts or sour-faced customer service reps or waste time driving between stores just to find a particular size in stock and can instead get it all with just 1-Click and then spend all that newfound free time going to places that are pleasant and stimulating and offer experiences that enrich the mind and soul. It’s not about online vs. offline. It’s about better vs. worse. It’s about progress.

“There are many advantages to a customer-centric approach, but here’s the big one: customers are always beautifully, wonderfully dissatisfied, even when they report being happy and business is great. Even when they don’t yet know it, customers want something better, and your desire to delight customers will drive you to invent on their behalf.”

-Jeffrey P. Bezos, 2016 Letter to Amazon Shareholders

_____________________________________

¹Yes, finally a case study in which we profited from!
²http://fortune.com/2017/06/16/amazon-buys-whole-foods-stock/
³I’m thinking of a chain that starts with an ‘S’ and ends with an ‘ears’

Case Study: Valeant Pharmaceuticals

Those that follow financial news on a regular basis can skip this post as I wager there has not been a name more covered than Valeant in the business press since 2015. Sorry to pile on.

Valeant is a pharma company that, until 2015, was thought to have struck gold in pioneering a new business model. It is the erstwhile brainchild of J. Michael Pearson, who took over as CEO in 2010 with the idea of acquiring rather than developing drugs. The thesis: R&D of new drugs is inefficient and unpredictable. Instead, build a platform to market and distribute and then buy up drugs that have already been developed and approved. And as icing on the cake, relocate to Canada to lower the effective tax rate from 25% to 5%.

This worked like a miracle in the early years. Revenues went from $1 billion to $8 billion by 2014, driven by dozens upon dozens of acquisitions in that span. VRX went from $15/share to over $200. At its peak, it was Canada’s most valuable company.

But the rule of thumb in finance is: there is never anything new under the sun. An acquisition oriented growth strategy relies on two prongs: 1.) affordable financing, and 2.) affordable targets. Thanks to the financial crisis, interest rates were at a generational low, so Valeant was able to issue debt with abandon. And as their stock rose, they were able to supplement their shopping spree with equity. The second prong proved to be a problem as they grew ever larger. To move the needle, they needed bigger acquisitions. By 2014, there were only a few targets large enough, and none of them were keen on selling out – at least not at a price anywhere near a bargain.

Mr. Pearson’s solution was novel: team up with a large hedge fund to hunt together. Enter William A. Ackman’s Pershing Square Capital, who in 2014 took a large stake in Botox-maker Allergan and pledged to vote his stake in favor of a hostile $50 billion Valeant takeover. To make a long story short, Allergan fought tooth and nail, and escaped Valeant by wooing a white knight in Actavis to acquire them instead for $66 billion.

Meanwhile, Mr. Ackman took home over $2 billion in profits from his Allergan trade. Pershing Square Capital finished 2014 up 40%. What happens next will form the moral of the story: he rolled his entire Allergan profit into VRX.

Valeant’s consolation prize in the wake of Allergan’s rejection was a $10 billion acquisition of Salix. By then, Valeant’s balance sheet had become bloated with debt. Less than $6 billion in equity was supporting almost $50 billion in total assets. And into this highly levered entity Mr. Ackman invested almost 20% of Pershing Square’s capital.

Almost everything went wrong subsequently. Valeant was discovered to be using extremely aggressive, borderline illegal tactics in pushing their drugs. They were also jacking up the prices on their drugs after acquiring them, sometimes as much as 10 times their original price, raising the ire of Congress and Presidential candidates. Charlie Munger accused them of being deeply immoral. As their stock began to collapse amidst intense public scrutiny, they lost their currency to do acquisitions; nobody wanted to be acquired by Valeant anymore anyway. Doctors began pulling back on prescribing their drugs.

VRX has since crumpled from $260/share down to $10. There is serious doubt whether they will survive their $1.8 billion of annual interest payments. Mike Pearson has been ousted as CEO, and Mr. Ackman, a man with an unquestionably high IQ and nearly unlimited resources, sold his shares last month at the bottom for a $3 billion loss. And it’s not just Mr. Ackman. Scores of brilliant fund managers had piled into VRX, even the venerable Buffett-endorsed Sequoia Fund.

***

As a fellow investor, it’s bad form (and possibly bad karma) to revel in too much schadenfreude. Things can and will go wrong all the time. Management can be dishonest, government can conspire against our interests, consumer tastes can change on a whim. If you’re in the business long enough, you’re not really doing your job unless you have a few deep scars. There are just too many factors out of our control. But what we can control is our buy/sell judgment. Not just whether to buy/sell but how much to buy/sell.

And so the lesson of leverage for us is: look-through. One may be adding implicit leverage to one’s portfolio by investing too much in companies aggressive with debt. If Valeant had been more modestly levered, their survivability would not be in doubt and their stock would still retain significant value (although it probably would not have gone stratospheric earlier either). There would have been more margin of safety, which, in the complex and uncertain world we live in, should be a virtue we strive for.

“I don't have any advice for young people who want to get rich. Basically, I think the desire to get rich fast is pretty dangerous. My own system was to get rich slow. It protracts a rather pleasant process. After all, if you get rich fast all you can do is be robbed by your own employees your yacht and so forth. Whereas if you get rich slow you amuse yourself over a lifetime.”

-Charles T. Munger, 2015 Daily Journal Annual Meeting 

2016 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.