A Look at Ackman’s Plan for Target

Target Corporation (NYSE: TGT) shares are a bargain right now according to at least one activist investor - is it time for investors to jump onboard? Pershing Square’s William Ackman unveiled his plan to unlock value at the troubled retailer at a conference earlier this week in a move that could help Target shares rise substantially. The activist estimates that shares of Target could trade as high as $70 per share within the first year the plan was enacted.

Pershing Square estimates Target’s real estate portfolio to be worth around $39.1 billion. However, this value is clearly not reflected in the market where Target as a whole trades for just $28.97 billion. The activist recommended that Target spin-off its land assets into a real estate investment trust (REIT) that would own the land under Target’s stores. The discount retailer would then sign a 75-year lease for the land and would maintain ownership and control of its buildings.

Under the agreement, Target would own its buildings on 75-year ground leases that could be renewed while outsourcing its facilities management services. The REIT would lease the land to Target, provide facilities management services, and become Target’s exclusive land developer for the first two years and a preferred vendor thereafter. This means that future land purchases would be made through this entity for the first two years and they would have first option thereafter.

Pershing Square estimates that this transaction would substantially increase Target’s ahre price. Target’s $40 per share value now would have $7 per share added in incremental earnings generation, $17 per share added from the REIT’s multiple expansion, and $5 per share added from Target’s multiple expansion. This assumes that Target would trade at 14.2x earnings and the REIT would trade at 21.3x earnings, which are both conservative estimates given the new financials that these entities would possess.

Target is in a better position because of its improved free cash flow and financials. Store level return on invested capital would increase because of lower real estate costs as it would no longer have to finance acquisitions. This, combined with the elimination of the dividend (which will be transferred to the REIT), will result in substantially higher free cash flow and a more efficient capital strucutre that will allow its growth rates to exceed today’s rates to justify a higher multiple.

The REIT is unique in that it would be land-only and extremely secure with $20 billion in Target buildings available for re-possession upon default. The 75-year lease is also inflation-protected in that Target’s lease payments are coordinated with CPI and the payment dates are set to TIP payment dates. As a result, any discrepencies in valuation would be resolved through arbitrage between these two securities until it is eliminated. The size of the REIT will also make it a must-own security.

Pershing Square first initiated its investment in Target in April 2007 and now owns slightly less than 10% of the company. Since meeting with management in 2007, the hedge fund has enjoyed a very constructive relationship with the reatiler. Target recently raised some concerns, but is likely still reviewing the proposal. Investors interested in investing alongside Ackman, but awaiting approval by the company, may want to purchase LEAPS options in the meantime.

LEAPS options can be purchased for a fraction of the cost of purchasing Target shares outright and enable investors to own the rights to the stock at a set price for a year or more in the future. Assuming Pershing Square’s estimates were correct, investors can purchase a $60 January 2010 contract for just $3.80. This means that they would have the right to purchase 100 shares of Target at $60 for just $380 upfront (instead of $3,839 now). If shares hit $70, they would make $1,000 on their $380 investment - a return of nearly 300% compared to a return of just 82% purchasing the underlying without risking nearly $4,000.

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Is Expedia Ready to Take Off?

Expedia, Inc. (NDAQ: EXPE) shares surged higher after nearing a 52-week low while options also exhibited increased volatility. The online travel company is set to report its third quarter earnings on October 30th and expectations are mixed. Some analysts like Smith Barney have high expectations with a price target of $29, with oil prices on the decline. However, others aren’t so sure with consumer confidence hitting an all-time low last month.

Currently, Expedia is trading with a multiple of just 11x earnings and trading below book value with low debt. The company is also growing despite the economic downturn. Last quarter, Expedia announced a 16% increase in bookings and beat analyst estimates. The company’s total bookings came in at $5.93 billion with North American bookings increasing 10% and European bookings increasing 30%. Expedia intends to keep expanding its worlwide reach as well in response to the domestic slowdown.

Call options on the stock were also heavily traded in the November ‘08 calls at the $10 and $12.50 strikes. The volatility also suggests that the price will move more substantially in the near future. Investors interested in the long-term prospects of company may also want to look at purchasing long-term options as an alternative to buying the stock outright. Currently, the $12.50 January ‘11 calls are trading at $4.50 per contract.

Expedia is an online travel company, empowering business and leisure travelers with the tools and information they need to research, plan, book and experience travel. The company created a global marketplace used by a range of leisure and corporate travelers, offline retail travel agents and travel service providers. Expedia makes available, on a package basis, travel products and services provided by airlines, lodging properties, car rental companies and others.

Are Berkshire Shares on Sale?

Berkshire Hathaway (NYSE: BRK.A) shares continue to trend downward during the last few days, but some investors remain confident in the Oracle of Omaha Warren Buffett. The company currently trades with a price-earnings multiple of just 14.75x earnings after several questionable investments in the financial sector.

Buffett’s investment in Goldman Sachs (NYSE: GS) may have been poorly timed given the decline, but it was not your average investment. The billionaire received perpetual preferred stock that pays a 10% dividend as well as warrants for $5 billion of common stock at $115 per share. The strike price may be well above the current share price, but they do not expire for another five years.

Buffett also purchased a $3 billion stake in General Electric (NYSE: GE) via preferred shares with a 10% dividend along with the option to buy an additional $3 billion worth of common stock at $22.25 per share for the next five years. These warrants may also be lower than the current share price, but the terms of the deal are extended into the future.

These two companies could easily have found better terms elsewhere, but Warren Buffett’s status as an icon helped reassure other investors. The investments may also be trading lower right now, but the combination of a 10% dividend and long-term rights help ensure that the investments will pay off eventually.

It is also worth noting that Berkshire Hathaway B shares are trading at a discount to the A shares. The market capitalization of the B shares is around $163.88 billion versus A shares valuation of around $167.16 billion. This discrepency isn’t enough for a meaningful arbitrage play, but it does represent a good entry point for smaller investors to get involved.

AK Steel Takeover Rumors Persist

AK Steel Holding Corporation (NYSE: AKS) shares jumped higher Monday on renewed takeover chatter. The steel company has fallen sharply over the past few months to what Deutsche Bank calls “washed out” levels. With a price-earnings multiple of just 2.5x and a yield of 1.66%, many investors believe it could become a takeover target despite denials from potential suitors. Meanwhile, implied volatility in the stock’s options suggest a bet on large price movement in the future.

One potential suitor was German conglomorate ThyssenKrupp AG, which denied it was considering any offer Monday. The market had speculated that Germany’s largest steelmaker would make an offer for AK Steel at its low levels. The speculation even prompted a decline in ThyssenKrupp’s stock, which dropped 5.1% in the European session. This compares to AK Steel’s shares, which are trading higher by roughly the same amount in mid-day trading on the New York exchange.

AK Steel’s sharp drop can be traced back to a weak steel environment. Third quarter earnings for the firm jumped 74% as higherp rices for metals overcame weaker demand from the automotive and construction markets. However, the company cautioned that it sees reduced shipments in the fourth quarter and lower prices for steel amid lower demand. The company now sees deliveries of 1.4 million tons for an average selling price about 10% lower than third quarter levels.

AK Steel Holding Corporation is a producer of flat-rolled carbon, stainless and electrical steels and tubular products through its wholly owned subsidiary, AK Steel Corporation. The Company’s operations consist of seven steelmaking and finishing plants located in Indiana, Kentucky, Ohio and Pennsylvania that produce flat-rolled carbon steels, including coated, cold-rolled and hot-rolled products, and specialty stainless and electrical steels that are sold in slab, hot band, and sheet and strip form.

Investors Divided on Burlington’s Future

Burlington Northern Santa Fe Corporation (NYSE: BNI) is set to report earnings Thursday after-hours, but many investors don’t know what to expect. Competitors like CSX have beat expectations, but many remain skeptical on the industry’s outlook. Meanwhile, billionaire investor Warren Buffett continues to make bullish trades on the stock in a vote of confidence. This indecision is causing substantial volatility and pushing investors to extremes ahead of earnings tomorrow afternoon.

CSX Corporation reported strong earnings on Tuesday driven by a drop in energy costs and an effort to keep costs under control. Revenues increased 18% to nearly $3 billion while earnings per share from continuing operations skyrocketed 40% to $0.94 per share. Management pointed out that distributors are exploiting railroads to the advantage of their supply chains. This is good news in the short term with higher energy prices, but a macro slowdown could send shares lower in short order.

Warren Buffett’s Berkshire Hathaway also continues to sell puts against the large stock position that it has amassed in Burlington Northern Santa Fe. All of the puts carry an expiration of just two months after the sale. The strike prices are also getting lower to just $76 per share while the premium isn’t changing much. Buffett is basing the purchases on his famous motto: “Be fearful when others are being greedy, and be greedy when others are fearful.”

Many investors believe that Warren Buffett is helping to create a price floor at these levels and the move clearly demonstrates his confidence in the railroad. Investors looking to get involved in the upside without the cost of buying the expensive underlying shares may want to consider long-term LEAPS options. The January 2011 $80 calls are trading at just $17.30, which means investors can gain the right to purchase BNI shares anytime between now and January 2011 for just $1,840 per 100 shares.

Investors Divided on 3M’s Future

3M Company (NYSE: MMM) shares experienced elevated volatility as shares hover near a seven year low. MMM November option implied volatility of 45 is above its 26-week average of 30 according to Track Data. This suggests that larger price movement may be in the future. Investors are cearly divided as to the direction of the conglomorate with the stock falling sharply but analysts confident in the future of the firm.

3M Company beat its earnings expectations last quarter on strong international results, which bucked the negative trends dominating Wall Street. Sales came in a bit behind analyst estimates, but the company beat predictions on its bottom line. With American demand slowing, the company has relied on foreign markets to support its growth. Ultimately, the company lowered its outlook slightly, predicting 2008 earnings between $5.40 and $5.48 per share.

Analysts also remain extremely bullish on the stock. Goldman Sachs commented that, “the high-quality results from 3M this quarter were impressive on both what we saw and what we did not see.” However, investors may be more in tune with the CEO who noted that the company did see some signs of slowdown toward the end of the quarter in late September and noted that the current challenges will be a tough period for everyone. These contradictions are causing the volatility in the stock seen recently.

Investors betting on a turnaround at 3M may want to consider purchasing long-term call options. The January 2011 $60 callsare trading at just $10.40. This means that for $1,040 down, investors can have the right to purchase 3M stock anytime between now and January 2011 at $60 per share. So, if 3M were to rise to $75 per share, these options would have returned $1,500 or a 44.2% return on investment versus a 25% return on the $6,000 investment in the underlying.

Investors Show Mixed Sentiment on CarMax

CarMax Inc. (NYSE: KMX) shares traded sharply lower Tuesday, but some investors remain confident in the company. The virtual dealership continues to face difficulty in the used-vehicle market largely due to aggressive incentives from new-vehicle manufacturers. These declining values and ongoing weakness in the overall economy has hurt top-line growth while higher funding costs at the CarMax Auto Finance division is eroding margins at the bottom-line.

Analysts also remain bearish on CarMax’s future prospects. Pali Research maintained their “sell” rating on the company while reducing their price target to $8 per share. The analyst mentioned that there are concerns that need to be addressed related to the auto loan securitization potential of the company’s CAF division. As a result, the conditions for the company are likely to continue to be significantly challenging going forward.

Some investors remain confident in CarMax despite these short-term problems. CarMax remains the nation’s largest retailer of used cars and counts Warren Buffett among its shareholders, who owns a $302.2 million stake. Bulls believe that the problems facing the company are temporary with the underlying fundamentals remaining in tact. The company is also taking actions to reduce costs by cutting their work force and streamlining their operations.

Investors who are confident in CarMax’s future, but reluctant to commit a lot of capital may want to consider long-term options. The January 2011 calls may represent the best opportunity. For under $300, investors can purchase the right to acquire CarMax shares at $10 anytime between now and January 2011. That leaves a lot of room for a recovery and allows investors to risk only $300 or less on the bet instead of purchasing 100 shares for $1,000 at today’s prices.

Investors Confident in Kraft Turnaround

Kraft Foods Inc. (NYSE: KFT) may be trading near their 52-week lows, but investors remain confident in a turnaround. The food processing company should experience a boost from lower commodity prices and successful price hikes on much of its inventory. Meanwhile, billionaire investor Warren Buffett also holds a large $2.53 billion stake in the company that he purchased at higher prices, which gives many investors confidence in the value of the company.

Kraft Foods expects to experience cost savings from restructuring, lower commodity prices and economic conditions that encourage people to eat at home. Fast food competitors are being forced to raise their prices to cope with higher food costs, which should result in an exodus towards processed food offered by Kraft and others. Analysts have realized these trends with both UBS and Merill Lynch boosting their ratings on the stock.

Kraft Foods is also trading at a very reasonable valuation of 18x earnings while paying a healthy yield of 3.96 percent. This is very comparable to competitors like General Mills (GIS), despite the fact that Kraft pays a healthier dividend that should encourage a higher multiple. Many are expecting these financials to improve with future top and bottom line growth expected. Moreover, Buffett’s comments in his recent column in the New York Times added more confidence to the fire.

So, how can investors best take advantage of this value in Kraft Foods? Purchasing stock requires a lot of upfront cash while putting all the capital at risk. A better option may be to purchase long-term options on the stock, known as Longterm Equity Anticipation Securities or LEAPS. The January 2010 LEAPS represent some of the best deals. The $30 strikes are traidng at just $3.87 per contract while the $35 strikes are trading at $2.35 per contract.

Investors that believe Kraft is headed past $40 between now and January of 2010 may want to purchase the $35 strikes. The cost would be $235 to own the rights to 100 shares at $35 per share. So, if the stock did hit $40 per share, they would be able to immediately sell their position for $5 per share in profit, or $500, for an initial investment of just $235. This represents a 100%+ return compared to a 30% return gained by purchasing the underlying stock. Additionally, only $235 is at risk compared to $3,000 at risk seen purchasing the underlying stock.

Other Bidders Dry Up in Credit Crisis

Longs Drug Stores (LDG) shares dipped back down to their CVS Caremark Corporation (CVS) merger prices after a key activist admitted defeat in his bid to attract higher offers. Billionaire activist William Ackman revealed in a regulatory filing last week that he was unable to identify a higher bidder for the company. This is bad news for many arbiteurs that were holding out in hopes of a higher bid. CVS Caremark now has the acquisition guaranteed through a successful tender from the public.

“On September 11th, we wrote [the company] expressing our concern that a full process had not been completed to determine whether fair value had been achieved for Longs’ shareholders,” said Ackman in the filing. “Since that time, our advisors at Blackstone Group have canvassed the market for alternative transactions to the CVS $71.50 tender offer. Blackstone contacted a large number of potential parties and identified only one potential buyer, Walgreens, that expressed interest in purchasing the entire company.”

William Ackman and other investors initially opposed the deal before the global financial markets went into a tailspin and put a squeeze on available credit. The crisis ended up dragging down shares of many competing drug stores making CVS’ cash offer with secured financing the most attractive option. Other activists, like Advisory Research, also came around and agreed to tender its shares to CVS at the end of last week.

“We are disappointed that greater value could not be achieved,” said Ackman in closing. “Although clearly the opportunity cost of capital in the world has risen substantially since our efforts began over one month ago.” Ultimately, several buyers expressed interest in smaller pieces of the copany, including portions of the store base, RxAmerica and customer lists, but there were no other parties interested in making the full acquisition.

Shares of Longs Drug Stores are now trading just under CVS’ offer as the deal is set to be completed.

Options Investors Bet on AMAG

AMAG Pharmaceuticals, Inc. (AMAG) shares rallied last week after a large analyst firm recommended the stock. Grant Zeng of Zacks Investment Research wrote that the company’s iron replacement drug, Ferumoxytol, showed promising results in clinical trials and should ensure strong growth for AMAG in the coming years. The firm also reiterated its “buy” rating on the stock with a price target of $70 per share, which is well above the current trading price of $36.75 per share.

The upgrade also sparked heavy options trading on AMAG Pharmaceutical’s stock. Some 17,907 call options traded on Friday, which is more than 7x the average daily volume of 2,343 contracts. The majoity of the action was centered around the November $60 calls, but there was interest in the December calls as well. Some investors confident in AMAG Pharmaceutical’s upside and Zack’s investment research are LEAPS calls as an alternative to stock ownership.

The January $65 2010 LEAPS calls are the most popular with the $50 calls following close behind. The $65 calls are currently trading at just $8.10 a piece, which gives investors the right to 100 shares at $65 before January 2010 for just $810 down. This compares to the $6,500 down it would otherwise cost to establish a position that large. Unfortunately, the volatility in the stock may cause some to hesitate as the options are now more expensive.

AMAG Pharmaceuticals filed the NDA for Ferumoxytol in December 2007 and expects the FDA to approve the drug come early 2009. Clinical data on over 1,700 patients indicates an excellent safety profile with low incidents of heart problems. If approved, the drug would be a milestone for iron replacement therapy for anemia in chronic kidney disease while the drug could also be used as an imaging agent to aid in diagnosis.

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