Taking aim at Target
In one corner: An activist investor used to getting his way. In the other: A retail giant battling a slump. At stake: Target's board of directors - and possibly a whole lot more.
(Fortune Magazine) -- For a company that has made such beauty out of a simple bull's-eye, it is a painful irony: Target, the $65 billion retail giant, has itself become a target. Wielding the bow and arrow is William Ackman, the activist investor and founder of Pershing Square Capital Management, who sank $2 billion of his investors' money into the company back in 2007 - just before the global recession hit the fun- and fashion-loving Target shopper.
Now Ackman's investment, partly in options, is off 85%, and the company's own share price is down 41% from its July 2007 high, while rival Wal-Mart is up 3%. The relationship between the investor and his investment that was once a public lovefest is looking more like a bar brawl.
On March 17, Ackman launched a proxy battle for five of Target's board seats. He claims that the company's directors lack expertise in retailing, credit cards, and real estate -- all skill sets that would have helped it navigate the difficult economic climate.
"The deficit of experience on Target's board has contributed to the company's underperformance," writes Ackman in the letter he sent to shareholders.
Meanwhile Target's CEO, Gregg Steinhafel, has portrayed Ackman as a short-term investor who cares nothing for the company's core business and who launched the fight only because Target (TGT, Fortune 500) passed on his "risky and speculative" plan to spin off the company's real estate holdings.
The stakes are high, and not only because Target is one of the largest companies ever to be involved in a proxy fight. Regardless of who wins the vote at the annual meeting on May 28, Ackman's move against a widely respected company with no record of poor governance represents a new front in the world of shareholder activism, and one that any company should pay attention to.
Although directors of companies with worse records -- Citigroup, anyone? -- have been reelected, the fight at Target suggests that the days of the "trust me" boardroom are waning, and that costly struggles for control may become commonplace.
"Even companies that are well-regarded and that have managed to beat out almost every one of their competitors are not immune," says Greg Taxin, founder of proxy research firm Glass Lewis & Co. and now managing director of investment firm Spotlight Capital.
It is something of a surprise to see Target -- for so long retail's darling, with its steady management, fashion-forward products, and fresh design sense -- under attack. Just two years ago the company was expanding and being copied (unsuccessfully) by every other retailer, including rival Wal-Mart, which trailed it in same-store sales for four straight years. Between 1994, when CEO Robert Ulrich took over, and early 2008, the stock rose nearly eightfold, compared with 350% at Wal-Mart (WMT, Fortune 500).
But as Ulrich gave the reins to No. 2 Steinhafel, the "Expect more, pay less" slogan became at least half irrelevant. What had worked in an upturn no longer did as consumers began to shy away from Target's more aspirational merchandise in favor of Wal-Mart's dirt-cheap basics and wider food selection. Same-store sales for Target dropped 2.9% in 2008; Wal-Mart's increased 3.3%. Still, Target has slashed costs to the point that it can operate effectively on flat or even negative same-store sales, and many analysts think that makes it poised to rebound.
None of that has assuaged Ackman. The 43-year-old hedge fund investor, with a total of $4.8 billion under management, made the biggest bet of his already big-betting career on the company by creating a separate investment vehicle, Pershing Square IV, with only one stock in it: Target. On July 16, 2007, Ackman announced that he had accumulated a 9.8% position in Target, proclaiming it a great company whose stock would rise from $70 to more than $100.
The engaging and uber-confident Ackman, whose shock of white hair adds to his intensity, has long played in retail but is best known for shorting MBIA, which he bet against before the credit crisis, making over $1 billion. Target was something different: a company he believed in. It had, he told me in 2007, "the best retail operating management in the business." Steinhafel, a 30-year veteran who embodies Target's modest, insular culture (and who was about to be named CEO), said at the time that he welcomed the investment, although he looked tense when I asked him about Ackman's potential "suggestions."
Those suggestions came quickly -- no surprise to anyone who saw Ackman in action at Wendy's, where he persuaded the company to spin off Tim Horton's, or at McDonald's, where he pressed for a sale of the restaurants. He called on Target to do a share buyback and sell its credit card receivables, which, unlike most retailers, it owned entirely. He had for months been warning of the credit crunch, and in August 2007 proposed to Target that it sell the receivables to a bank in exchange for a guaranteed income stream and less risk. Target balked at first, in part because that business produced a third of the company's earnings growth. But in what both sides agree was a cordial series of meetings, Target eventually sold 47% of its receivables to J.P. Morgan Chase in May 2008.
Ackman proclaimed himself satisfied, although today he says he was actually disappointed. He was, in fact, correct about the credit, but not about the buybacks. Charge-offs have risen from 8.1% in March 2008 to 14.2% in March 2009; while Target bought stock back in the $50 range, it's now around $41. "It was better than doing nothing," he says of the credit sale. Plus, he had a bigger agenda.
Unlike most retailers, Target owns 85% of the ground under its stores - something that has given it a tremendous advantage in terms of growth. It can buy, sell, or expand at will, which in turn has helped the company gain share in the past.
But the real estate is also an asset that Ackman, the son of a real estate investor, says has never been properly valued. In May 2008, when the stock market was still booming and leverage still sexy, he proposed an IPO of the ground under the stores, creating a debt-free REIT that would earn the company a lot of cash but would also require it to pay regular rent in long-term ground leases. Steinhafel, he says, was intrigued. But after a review by Goldman Sachs, Target turned him down in September, citing a fear of affecting its credit rating and the uncertainty in the real estate market.
Suddenly that cozy relationship got chilly, says Steinhafel. "We had a constructive dialogue," he says. "We just didn't agree with his particular real estate proposal, and it was subsequent to that decision that he started the proxy contest."
By this time Steinhafel was under tremendous pressure, having taken over just as Target began to slump. But the pressure on Ackman was arguably worse: Although he had called the credit crisis, he failed to see how that would affect consumer spending.
Because of the leverage in his Target fund (he now owns 3.3% of the shares and another 4.5% in options), at its low in February his fund was down an astonishing 93%. Ackman was forced to publicly apologize, allow some angry investors (including the vocal Dan Loeb of Third Point) to close out their investments, and promise to waive fees for those who remained. He also put in $25 million of his own money (which he says has doubled since then, thanks to both his saber-rattling and the market's upturn), and in November made a revised proposal for what he called a TIP REIT, a spinoff of 20% of Target's land that would act like an inflation-protected security and that, he says, would avoid any credit or tax issues.
Although the security is indeed innovative, some doubt its value in the current environment. Says Hap Stein, CEO of Regency Centers, a shopping-center company that has Target as a tenant: "[The REIT] would make it difficult to do new developments, or to expand or renovate. It would be one thing if real estate values were high, but today it's like a non-fat decaf cappuccino -- why bother?"
Ackman says the REIT would let Target take advantage of bankrupt retailers' properties in this environment. He also says Stein is wrong because Target owns the buildings and there are no covenants in the ground lease that would affect building changes. In any case, the company rejected the new plan within two days. "I don't think they had time to adequately consider our revised proposal," Ackman says.
Saying no to Ackman is like taunting a bull with a red cloth: He gets more energized. He asked to join the board, along with another executive (Matthew Paull, who, it turned out, had a conflict because he sat on rival Best Buy's board). Leery of where this was going, the board said no, with nominations committee chairman Steven Sanger, former CEO of General Mills, saying he was "not authorized" to give Ackman an explanation.
Stung, Ackman announced he wanted to replace four directors up for reelection, plus Ulrich. The real issue, he now says, is governance and experience. "This proxy context is not about a deal," says Ackman. "It's about making sure the board is comprised of executives with relevant expertise to help guide and shape strategy going forward."
To convince investors that his slate is superior to Target's, Ackman has issued comparisons of each of his directors with one of theirs. Solomon Trujillo, CEO of Australian telecom company Telstra, for example, is faulted for not having any experience specific to Target's businesses, as compared with Michael Ashner, who runs Winthrop Realty Trust.
Ackman's biggest "get" is undoubtedly Jim Donald, who, prior to being axed from the CEO spot at Starbucks last year, turned around Pathmark and was the architect of Wal-Mart's move into food. Even Deutsche Bank Securities senior analyst Bill Dreher, who calls the fight "a waste of time and money," says that "where I sort of pricked up my ears was potentially being able to get Donald."
Target retorts that its directors are extremely well qualified, that Trujillo's technology experience is helpful, and that Ackman has attacked the board in "an effort to divert attention from Pershing's risky real estate agenda."
Though chosen by Ackman, the would-be directors are hardly your classic slate of yes-men. Interviews with each of them reveal not a unified bloc typical of proxy fights, but a collection of individuals, each with different reasons for wanting to serve. None but Ashner knew Ackman before last month, none is an investor in his funds, and each swears that he hasn't been asked for any kind of quid pro quo.
If people inside the Target camp are worried, they're not saying so. "Based on the amount of time we've spent with institutional shareholders, they continue to be very, very solid in their support," says Steinhafel.
Yet Target's actions suggest otherwise: Far from treating Ackman like a mere irritant, it is spending some $11 million to promote its own candidates -- money, Steinhafel notes, that would be better spent improving its business. "This is a very challenging economic environment," he says, "and it's unfortunate that we are having to invest our time in [fighting] a proxy contest."
The company is now describing its former friend as a short-term hedge fund manager in need of a quick fix and labels his options "derivatives" -- one of the curse words of 2009. Ackman fires back that the derivatives he owns are the same as the stock options executives have been granted -- and that he holds a lot more Target stock than the executive team itself, which holds only 0.3%. He says his board candidacy proves that he is in for the long haul, since he would no longer be able to actively trade the stock. And he acidly notes that Steinhafel sold over 200,000 shares just before Ackman announced his original purchase and hadn't bought more until March 18 -- the day after Ackman launched his fight.
Since then Ackman has been frantically jetting around the country, meeting with any investor he can, and he is hosting a "town hall" to introduce his slate on May 11. That is just what he needs to do, says investor Nelson Peltz, who won two of 12 seats at Heinz in 2004. "There is no shortcut," he says. "You have to spend a lot of time on the road and let them cross-examine you." Despite his hardball tactics in previous battles, Ackman now seems comfortable wrapping himself in the cloak of the little guy. "Why is it that an insular board gets to keep renewing the same guys year after year?"
Self-serving? Perhaps. Yet in this environment of discredited management, Ackman's push for new blood may strike a chord, says Spotlight Capital's Taxin. "The Target guys are going to face a harsh reality when they start talking to investors whose basic stance is going to be, 'Well, how does this harm the company? The stock's at 40: In 2007 it was at 70. Why should we stick with the team that did that to us?'"
Moreover, many institutional investors simply follow the recommendations of governance firms RiskMetrics (formerly ISS), Proxy Governance, and Glass Lewis. If Ackman is able to persuade the three firms -- particularly RiskMetrics, the largest -- to support him, he might have a shot at winning at least a few seats.
The likeliest outcome, say experienced proxy watchers, is some kind of face-saving settlement before the slate goes to a vote -- one in which perhaps Ackman and Donald end up on the board. At this point both sides are posturing. Target representatives set up a meeting with Pershing Square in early May, but nothing came of it.
Ackman remains confident; it is both his best and worst quality, says one banker who knows him. "We all have our Achilles' heel," he says. "Bill's is the absence of any doubt about his own opinion." But in the end, the opinions that will really matter are those of Target's other shareholders.