Presentation on Canadian Tire Corp. by William A. Ackman, Pershing Square Capital Management, L.P. Given May 23, 2006 at The Ira W. Sohn Investment Research Conference in New York City. This edited transcript is reprinted with Mr. Ackman s permission and that of the conference organizers. To see the PowerPoint presentation that accompanied this speech, please click here. Bill Ackman: The company I ll be discussing today is Canadian Tire. It trades on the Toronto Exchange, with a market cap of $5.4 billion and an enterprise value of $6.3 billion. It closed today a little under $66 per share. [Note: The shares closed on August 16 at $69.55.] It looks conventionally cheap, 6.8x EBITDA and 13.5x next year s earnings, but that s really just the beginning of the story. There are four components to the business. The bulk of the business is Canadian Tire retail, probably one of the best-known brands in Canada an 84-year-old business, a fabulous brand. It s perceived to be a retail company, but in reality, it s really a real estate company and a franchise business, and the characteristics of this business are very different than a traditional retailer. They have a financial services subsidiary that s grown tremendously in the last five years, with a $3.3 billion portfolio and about 5% of the Canadian credit-card market, making it the second-largest credit-card issuer. They have a business they bought for $100 million called Mark s Work Wearhouse, which did $84 million of EBITDA last year. That s over a three-year period of time since their acquisition, so they re pretty good at making acquisitions. That s a specialty retailer, fabulous same-store sales growth. And then there s Canadian Tire Petroleum, which is kind of the weakest part of the puzzle, but which has significant asset value. They own about 58% of their locations and they pump about twice as much gas per location as any of the other independents or major oil companies in the market. What s interesting is because of the company s business model, earnings significantly understate the company s free cash flow per share, adjusted for maintenance capital expenditures. The company trades at about a 10% earnings yield at the current stock price. If you look at the stock-price chart and it doesn t look like the kind of chart we normally get excited about, in that it seems like we re late to the party what s interesting is that the business value s grown at a much faster rate than the stock
price. We ve been buying the stock we bought more today. We ve been an active buyer over, really, the last 45 days, and I wish the conference were a couple weeks out so we could buy a little bit more. It s still very, very cheap. I m going to take you through each of the component parts of the company. The first, the retail business, accounts for about 2/3 of the overall EBITDA. There are 462 general merchandise stores. It s called Canadian Tire, but the business is about half home-related, kind of everything from small appliances, to towels, to other things you buy for the home. Auto is about 25% percent of the business. It s the biggest auto retailer in Canada, and they ve also got hardware and sporting goods and leisure. In the Canadian Tire retail business they also have a business they started a few years ago called PartSource, which is almost an entirely franchised business, modeled very much after AutoZone for the serious do-it-yourself customer. CTC owns 75% of their locations, land and building, and the balance is basically long term leaseholds, so, economically, they own pretty much all of their real estate. What we like about it and what we find interesting and what accounts for the company s superb sort of cash flow characteristics is that the business model s really that of a franchise company. Now, you wouldn t be able to tell this by looking at their income statement. The income statement shows revenues, expenses, operating income, interest, taxes, and net income. That s all you get from the company, but, in reality, there s a huge rental stream. They get about 4% of the gross revenues of every store, and then they sell their inventory to the store at a profit. The best kind of model for this business is really Tim Hortons. Instead of selling tires, Tim Hortons gets a percentage of the revenues and they sell donuts to their stores. These guys sell tires and other such things through the stores, but the economics are very, very similar. The dealer is responsible for all the maintenance cap ex for the store, responsible for all the capital to build out the store the lightning fixtures, the cash registers all the employees. All that Canadian Tire does, basically, is own the real estate. They help the guy market. They share the marketing expenses and they build a system. The Canadian Tire dealers are kind of legendary in their communities. They re local millionaires and very few dealers own more than one store. It s a great business model because the dealer is obviously very focused on the economics of their store because they really own the business, and the way the model works is Canadian Tire basically sells the inventory at a markup to the dealer. The dealers are only really allowed to buy from Canadian Tire and the profit above the markup is the dealer s profit so if someone walks out the door with a wrench, that comes out of the dealer s pocket, and the dealer s just obviously very focused on driving sales. That dealer, of course, has all the inventory risk in the business, and, again, this is not readily apparent by just looking at the company s financials.
Again, here s the comparison with Tim Hortons. This is 100% franchise model, versus Tim Hortons at 97%. In both companies maintenance cap ex is the responsibility of the franchisee or the dealer as opposed to the company, you have very entrepreneurial people running the business, there are very significant real estate assets actually, more real estate assets in Canadian Tire than Tim Hortons and there are very significant growth opportunities. Canadian Tire is in the process of reconfiguring and expanding their stores. They have excess real estate in almost all of their locations, with a very high-return, low-risk expansion strategy. With all this, Canadian Tire trades at 6.8x EBITDA, while Tim Hortons trades at 12.5x EBITDA. There s more. They also own significant excess real estate that s not employed in their business, including a 4 million-square-foot site in downtown Toronto, a 1 million-square-foot site, and a 300,000 square-foot site. We learned recently they had put those sites on the market after getting full entitlement, and now is great time to sell real estate in Toronto. Those assets are not generating income. They are material, and we ll take you through what we think they re worth. In addition to that, they ve got 20-odd other real estate holdings of significant value when you have a company that s been around for 84 years in Canada, they picked the best location in all the various communities and, over time, built up a fabulous real estate portfolio. With respect to the petroleum business this is really gas-station business they own 58% of the real estate, so, again, we see significant assets there. EBITDA growth has in the last couple of years been in the low- to mid-teens in the Canadian Tire retail business. It s not a high organic growth concept from here maybe 3% same-store sales but they ve just begun a dramatic acceleration of the growth after testing a concept of expanding their stores by 20% to see what the results were. They ve been having such dramatically positive results in the tests that they ve decided to accelerate that expansion. That s made the analysts negative on the stock because in the short term it hurts same-store sales it s very disruptive to be rebuilding a store but that has provided the buying opportunity since the beginning of the year. Another opportunity they have is they currently source most of their supplies in North America. They re just beginning to buy in Asia, and there s a significant opportunity just from better managing the supply chain. Financial services is probably the company s most valuable business on a multiple basis. They started out with a private-label card business they ve had since the 1960s. They switched to a MasterCard product and they turned almost all their customers, 95%, from the private label card to MasterCard. That s allowed for very significant growth in receivables. They re actually very good at pricing credit and figuring out who is a good risk. They intentionally have 5-6%
charge-offs and it allows them to grow a very profitable business. They re now expanding into other products, like home equity loans, mortgages, other kinds of term loans. In addition, with the credit card, they have a kind of AAA automotive-assistance business, which has a fabulous high return on capital and is very, very profitable. They don t break out the economics, but we ve been able to come up with some numbers. They have a warranty and credit business a business that Buffet is in with his insurance operation which I think is a fabulous business. People pay a premium every month to have insurance so that in case they die someone pays their bills. Receivables are growing at about a 21% compound rate. That s driven largely by average account balances. As they switch from private label to MasterCard, they ve been able to get their customers to put more money on the card. They also offer what they call Canadian Tire Money, which is a points program that allows people to actually get more on money that they spend in the company s stores. That drives incremental sales and is part of the Canadian heritage. Annual EBITDA growth has been 18% for the financial business and it s become, obviously, a very material part of Canadian Tire. As a consolidated part of the company, though, it trades at only 6.8x EBITDA. The opportunity in this business is to take average balances from $1,619 per card to $2,450, which is the market average, and we re confident they re going to get there. They have not yet issued a gold card and they re now going to start doing gold and platinum cards. Let s talk now about Mark s Work Wearhouse. It has 334 specialty apparel stores. They ve expanded it into kind of casual work wear. It s 75% private label, which is probably the highest percentage of private label of any retailer I ve ever seen. Obviously, the result is that this is an incredibly profitable retailer. They paid $112 million for the business. They didn t report what the EBITDA was when they bought it. The first year they owned it, it did $34 million in EBITDA. Last year it did $82 million. You ll see where the growth has come from, it s come from same-store sales growth. This is an incredible, fabulous specialty retailer hidden in Canadian Tire. It, too, is available for 6.8 times EBITDA. They re now expanding into women s uniforms and healthcare markets. They re adding square footage. This is a very attractive concept on a stand-alone basis and we think this would trade at a meaningfully higher multiple as a spin-off.
Okay, let s talk about petroleum. Petroleum is kind of the underperformer. They own 260 gas stations. This has been a very difficult business for them in the last few years. They sort of had to commit to a price with the refiners and Imperial Oils of the world, and they ve not been able to fully pass that along to the customer. This business has been a negative in terms of returns, but it has very significant asset value, primarily driven by real estate. They ve begun to build out 7-Eleven type stores, which have been successful, with car washes and other ways to generate incremental returns, but, again, this business would be worth a lot more either to someone else or in a joint venture with someone else. Now, the reason they own it is because it s a great brand opportunity for them. They have the Canadian Tire name on 260 gas stations. They give you Canadian Tire money when you use your credit card and they give you little promotions to go and spend money at the stores, so I understand the strategic reason. But we think there s an opportunity to joint venture this with an integrated oil company or somehow extract the capital they have invested, which is significant. Overall, here s how we think about the business, which, again, trades at only 6.8x EBITDA. Just looking at the Canadian Tire part of the business, it s the cheapest real estate franchise business of which we are aware in the world. They proved the Canadian Tire retail expansion worked, and it s a great management team. They decided, You know what? We re going to accelerate the rollout of this even though it s going to hurt earnings in the short term. It really hasn t earnings were up 35% in the first quarter. They have great growth opportunities in the credit business and Mark s Work Wearhouse. This is a very shareholdefriendly management team with a great history in terms of execution. The embedded options, as we see them, in terms of creating value include monetization of the credit-card portfolio, a sale leaseback of core real estate, a sale of the higher, better-use properties, and a Canadian income trust conversion. Monetizing the credit card portfolio what we re talking about here is not a sale of the business but rather getting a cheaper funding source. The company has traditionally financed themselves in this business by doing securitizations of the receivables, but banks obviously have a lot more economies of scale in this business and there have been very large prices paid for credit-card receivables in what amount to joint ventures. In these deals the retailer gets to keep all the growth in the business, gets to retain a very substantial cash flow stream typically something close to what they were generating in EBITDA before they sold the receivable pool and plus they take capital out of the business. We think the company should pursue a transaction like this. Sears Canada pursued a very accretive transaction like this recently. Kohl s completed one very recently. Such a deal would allow them to take, we think, about $1.3 billion in capital out of the business, retaining a very substantial growth annuity. That capital could then be returned to shareholders.
Just to give you an idea of what the economics looked like to a seller, Sears Canada basically sold its credit-card portfolio, adjusted for the revenue stream that they got to keep, at about a 27x multiple of EBITDA. Again, you can buy all of Canadian Tire for 6.8 times. What does this do for the stock? Assuming a 20% premium to the book value of the receivables which is a significant discount to the Sears Canada receivables, and we don t think that these receivables are worth less than Sears Canada s and assuming you pay full taxes on the sale, it s a 30% uplift in the stock just from a monetization of the credit-card portfolio. Now let s look at a sale leaseback of core real estate. The company recently did a sale leaseback of two of their distribution centers for $230 million. That s something in the mid-5% cap-rate range. If you assume a 7% cap rate on deals for other core real estate, you re looking at about a 48% uplift in the stock from the incremental benefits of the credit card portfolio and the sale leaseback of real estate. Then, you ve got the potential outright sale of three development sites. We think at least two of these are on the market now. These are, at the most, guesstimates because of the size and uniqueness of the sites, it s difficult to tell what they re worth. I think, reasonably conservatively, that $400 million is a decent number after tax, which is $4 per share. We could be wrong, but it does not have a material effect on the ultimate valuation. By the way, in our assessments of the incremental value creation, we re not assuming a share buyback. We like that management has begun to shed some of these excess assets that don t generate cash. An obvious use for the capital they generate is a share buyback, but we re basically assuming those proceeds either sit on the balance sheet or they are dividended back to shareholders. If the company were to buy back stock with the proceeds, it s incrementally accretive. The last opportunity for them and this is one where we think, actually, today is not the right time is a Canadian income trust conversion. In an income trust conversion, basically, you eliminate corporate tax. It s sort of the equivalent of a corporate real estate investment trust, and because of the stability of the assets the real estate assets, the franchise businesses, the minimal capital intensity you can convert Canadian Tire into what would be a yield security using pretty conservative assumptions based on today s cash flows. We estimate that would create an incremental $29 in share value that idea just sort of sits out there, so we think that helps create a floor on the valuation. Add it all together and we arrive at a potential value that is a 98% premium to where the stock trades today. We like that this is a low leverage company and you have an opportunity to double your money. It trades at 6.8x EBITDA. It s a 10% free cash flow yield on your investment right now. They have excess real
estate assets. If you look at each of the component parts of the business the retail business, financial services, Mark s Work Wearhouse, even the petroleum business each of these businesses is worth a very substantial premium to where the company trades when consolidated together. So there are obviously several ways to make money here. We ve met with management. The new CEO has been in place now for three weeks and he s very receptive to shareholder value enhancing alternatives. That doesn t mean they ll do everything we suggest, but we think this is a very shareholder-oriented management team. Management and the dealers own 15% of the outstanding shares, which is also something that s not publicly reported, so we think their incentives are aligned with ours. Thank you very much.