U.S. hedge fund kicks the Tire

Date: Tuesday, July 4, 2006
Author: Lori McLeod, Financial Post

It has been a quiet month on the surface for Canadian Tire Corp. since New York hedge fund manager William Ackman stirred up a flurry of interest in the retailer.

But behind the scenes, a report on Canada's largest general goods chain by Mr. Ackman's firm, Pershing Square Capital Management, has been making the rounds at hedge fund and private equity firms, and it is generating a lot of discussion as to whether "The Tire" could really be worth nearly double its current trading price, as Mr. Ackman and his billion-dollar hedge fund have suggested.

Mr. Ackman, managing partner at Pershing, got things rolling after a speech at the annual Ira W. Sohn Investment Research Conference in New York, a charitable event mainly attended by hedge-fund professionals, where he highlighted Canadian Tire as one of his best investment ideas.

The stock traded almost eight times its average daily volume the next day, and gained almost 9% at one point during the session.

In an interview last month, Mr. Ackman said he owned "a lot" of the company's subordinate voting shares. Pershing's report dated May, 2006, said it started accumulating the shares recently.

Pershing's investment thesis revolves around four ideas that will drive the stock higher: sell Canadian Tire's credit card portfolio, sell some of its non-core real estate, do a sale leaseback of other real estate -- and to top it all off -- an income trust conversion.

This could result in a company valued at a whopping $129 per share, according to the report.

However, Canadian sell-side analysts don't believe there's much value hidden in the stock, and said the retailer is a better investment if it is kept whole, rather than broken up into parts.

"Canadian Tire ... is difficult for foreign investors to understand," CIBC World Markets analyst Perry Caicco said in a research note that argued the company is stronger in the long-term as a whole. "Like double-doubles, Mike Myers and CFL football, at first it doesn't make much sense. But after a while it hits -- this is a great business with a strong direction that the Canadian market values appropriately."

Mr. Caicco has a $68 price target on the stock, which doesn't leave much room for upside considering where the stock has been trading lately. It closed on Friday at $66.18, down 71 cents and just a little more than the $65.90 it closed at before Mr. Ackman's comments at the hedge fund event.

But while one New York hedge-fund manager quipped recently that most Americans think a double-double means "a hooker and a bottle of Scotch," Mr. Ackman probably isn't one of them.

He was instrumental in pushing Wendy's International Inc. to spin off Tim Hortons Inc. in an IPO that revitalized Wendy's depressed stock price.

Pershing uses parallels between Tim Hortons and Canadian Tire to back its latest Canadian investment -- both own substantial real estate assets, maintenance capital is the responsibility of their dealers or franchisees, and both have strong growth opportunities. The difference is that Canadian Tire is trading at 6.8 times Pershing's 2007 EBITDA (earnings before interest tax depreciation and amortization), while Tim Hortons is at 12.5 times.

Questions have been raised by analysts as to whether the Canadian retailer, which has been around for the better part of a century, would succumb to the views of an upstart New York hedge fund.

The issue is compounded by the fact that Martha and Owen Billes, the daughter and grandson, respectively, of Canadian Tire co-founder A.J. Billes, hold almost two-thirds voting control of the company.

"We believe Pershing's ability to affect change is overblown as ... Martha Billes has 61.4% voting control and is not likely to be pushed around by an outsider," Ryan Balgopal, analyst at Scotia Capital, said in a research note.

That said, Pershing isn't a fund that will sit back without voicing its views to Ms. Billes.

"Management is receptive to shareholder value enhancing initiatives," Pershing's report concluded, noting it has met with executives including recently appointed chief executive Tom Fauld.

A source said Pershing has a strong respect for and positive relationship with the company, although these compliments are often found in the language that comes before a battle between a company and its investors.

One of the biggest questions that comes up when the hedge funds come around is whether their suggestions for change are in the best interests of shareholders in the long run. In the case of Canadian Tire, the company's biggest institutional shareholder says "no."

"I think Canadian Tire has done a very fine job. It's a stock I own myself and have owned for 20 years or more. I think its a very fine company, they're doing extremely well," said Stephen Jarislowsky, chairman of $60-billion investment firm Jarislowsky, Fraser Ltd.

"Instead of unlocking value, why not just run a very good company? There are people that just want to make the stock go up and just want something tomorrow morning, I just don't see the point."

PERSHING SQUARE'S 'VALUE CREATION' OPTIONS FOR CANADIAN TIRE:

SALE OF CREDIT CARD PORTFOLIO

What is it?

Canada's second-largest MasterCard issuer, with $3.3-billion in managed receivables, expanding into loans, mortgages, home equity

Pershing's Opportunity

Sell to one of the major banks, which are willing

to pay a high premium on scarcity of remaining large portfolios

Estimated Impact on Stock Price

$19 per share

Con

Virtually all of Canadian Tire's receivables at the end of 2005 were from MasterCard accounts,

meaning a potential purchaser might pay a less lofty premium than the 30% Sears Canada got for its credit portfolio, according to a report by Scotia Capital analyst Ryan Balgopal

SALE LEASEBACK TRANSACTION ON CORE REAL ESTATE, AND SALE OF NON-CORE REAL ESTATE

What is it

Canadian Tire has large real estate holdings, including stores, distribution centres and non-core properties.

Pershing's Opportunity No. 1

Sell properties then lease them back from the buyer.

In January, Canadian Tire closed the sale of distribution centres in Brampton, Ont., and Calgary for $230-million to H&R REIT, then leased them back on 21-year renewable agreement.

Estimated Impact on Stock Price

$12 per share

Pershing's Opportunity No. 2

Sell off non-income-generating properties, including Toronto-area development projects. The company is already independently examining this option.

Impact on Stock Price

Approximately $4 per share

Con

Monetizing the real assets isn't a strong possibility, and would simply replace depreciation charges with rent payments that would dilute earnings. The company is continually remodeling and expanding, and needs to do so without having to regularly restructure property leases. -- Report by CIBC World Markets analyst Perry Caicco

INCOME TRUST CONVERSION

Pershing's Opportunity

Canadian Tire is a well-known brand with a strong retail following. It has stable real-estate and franchise-based cash flows and limited maintenance capital expenditures. However, a trust conversion would make more sense after some of the other transactions are completed.

Impact on Stock Price

$29 per share, assuming a 7% free cash flow yield and 90% free cash flow payout ratio.

Con

An income trust doesn't make sense for Canadian Tire's long-term growth strategy. A stock shouldn't always reflect the latest value and the desires of short-term investors. -- Stephen Jarislowsky, founder of Jarislowsky, Fraser Ltd., Canadian Tire's largest institutional investor and shareholder for more than 20 years.

GAS STATIONS

Pershing's opportunities

Sees the potential for Canadian Tire to sell or form a joint venture for Canadian Tire Petroleum. Owns and/or controls 259 gas stations across Canada, with fiscal 2005 revenues of $1.3-billion, but EBITDA of only $22-million and negative free cash flow.

Estimated Impact on Stock Price

None provided