By  on October 30, 2008

Activist investor William Ackman wants to separate Target Corp. from its real estate.

Ackman took his case to shareholders Wednesday and argued that the firm’s stores and the land on which they sit would be valued more by the markets if they were considered separately. The proposed spin-off, if approved by the company, would create the largest real estate investment trust in the country and the 62nd largest company in the S&P 500.

Target expressed concerns, but said it would continue to review Ackman’s proposal as investors drove the retailer’s stock up 5.7 percent to $40.72 on what was a down day for the markets overall. Ackman owns just less than 10 percent of Target through his Pershing Square Capital Management.

“What we have in mind is something that has not been done before,” Ackman said at an investor presentation in Midtown Manhattan, where he laid out the specifics of his plan.

Target owns about 95 percent of its stores and roughly 85 percent of the land under them, he said. By comparison, Macy’s Inc. owns 68 percent of its stores and Wal-Mart Stores Inc. owns 63 percent. Ackman said the land and the buildings of Target’s stores had a replacement value of about $39 billion, but the stock market only values them at about $13 billion. The investor’s plan to extract that value involves creating two closely related companies — the retail operations, which would own the stores, and a REIT that would own the land.

The REIT would lease the land back to Target for 75 years under one master lease that would be linked to the inflation rate.

Once the real estate arm is spun off, it would pay shareholders an estimated dividend of $8 billion, and enjoy the tax advantages and higher valuation of a REIT. Target also would gain about $200 million in free cash flow as it would not have to fund new land development or pay reduced taxes.

Ackman’s bottom line is a projected 74 percent increase in shareholder value, composed of Target the retailer at $32 a share and the REIT at $38 a share. After 12 months, he claimed, the two companies could further expand their market capitalization and rise to a collective share price of $83.

Of course, all of that depends on whether Target’s board accepts his plan and how shareholders ultimately respond to the unprecedented spin-off and a REIT with only one client. Ackman has been in talks with Target since May about his proposal and altered the plan in response to the retailer’s concerns.

The investor began meeting with management in summer 2007 about ways the company could improve its profitability. Since then, Target sold 47 percent of its credit card business to J.P. Morgan Chase & Co. and Ackman said he expects the company to spin off the rest of the credit business.

In taking his plan directly to shareholders, he is hoping other investors buy into the idea and ratchet up pressure on management.

Target on Wednesday said it had been evaluating Ackman’s ideas with the assistance of Goldman Sachs since May and had not yet reached a conclusion. The company had not seen the latest tweaks to the investor’s plan.

The retailer raised a number of concerns, including the validity of the assumptions behind the market valuations of the retailer and the REIT after the separation. The firm said it was concerned about “the reduction in Target’s financial flexibility due to the conveyance of valuable assets to the REIT and the large expense obligation created by the proposed lease payments, which are subject to annual increase.”

Target also is worried the rating on its debt would drop.

Ackman described the relationship between the two firms as similar to the symbiotic give-and-take between Pepsi and its bottlers. The REIT could use its weight to buy real estate for Target, cutting down on capital outlays as the chain expands. Target, though, would not be bound to use the REIT in its expansion; it could still buy the land itself.

One key innovation in the plan is in the retailer’s ownership of the stores. Should Target spin off the land under its stores, it would retain ownership and therefore the value of those buildings and the ability to rebuild or remodel as it saw fit.

There is a long history of activists trying to nudge managements into doing things to improve profitability. Dissident shareholders recently called for the ouster of Dillard’s Inc. chief executive officer William Dillard 2nd.

Ackman said his relationship with Target was not nearly as confrontational.

“This is nothing like the activist versus the company,” he said. “The company’s been very receptive to shareholders generally.”

And what if it doesn’t work?

“You can put the genie back in the bottle,” Ackman said, noting the two companies could merge again.

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