By Shawn Tully, editor-at-large
FORTUNE — Nelson Peltz is CEO and a founding partner of Trian Fund Management L.P., a multi-
billion dollar asset manager. Peltz (with longtime partners Peter May and Ed Garden) is renowned for his purchase of National Can in the 1980s and his spectacular rescue of Snapple. The firm typically buys large stakes in underperforming companies and then works closely with management to lower costs and burnish brands, a formula that has delivered big returns with Cadbury-Schweppes, Wendy’s and Heinz. Peltz is now applying his operational expertise at Tiffany and Legg Mason, which are welcoming his help, and a reluctant Family Dollar, which recently spurned Trian’s $7 billion leveraged buyout offer in February.
Fortune: We’ve seen a big increase in equity prices in the past several months. Is it harder to find bargains with valuations running so high?
Nelson Peltz: Clearly we like to see the lowest prices possible. But when all the companies we look at in North America and Europe are well run, we’ll have to close our doors. Until that time, we’ll see loads of opportunities despite the run-up in stock prices. Many companies simply aren’t living up to their potential and, as a result, are selling at low multiples of cash flow.
Those companies aren’t necessarily poorly run, but they do have lots of room for improvement. We need to steer clear of “value traps” in today’s market, where the price is relatively low, but it’s also unclear how to solve their problems. We invest where we can assemble a real plan to fix the company, and drive a major improvement in performance.
So the three key ingredients are, first, companies that sell at reduced multiples and, second, are clearly not living up to their potential, and third, where we can create a plan to substantially enhance their earnings.
We’re attracted to everything consumer. We like financial services where we aren’t taking balance sheet or credit risk. In financials, we like the fee-generating businesses rather than the banks. That’s why we invested in Legg Mason, a mutual fund company with a great future.
When we look at bank balance sheets, on the other hand, our eyes glaze over. We have no idea what’s in their balance sheets. When we examine a fee-driven financial company like Legg Mason, we understand what we’re looking at. They don’t have balance sheet or credit issues that are hard to comprehend, and where the outcome is highly unpredictable.
We’ve also seen an increase in M&A activity. How big has the change been? Are there more potential buyers for the types of companies you invest in than there were in 2009 and 2010?
The M&A market is just getting started. I’m surprised it hasn’t gotten hotter even faster. We all know the story about cash on corporate balance sheets. And the dollar is so darn weak that you’d think foreign players would be making lots of purchases in the U.S.
But potential acquirers still feel a sense of nervousness about the economy. Last week was a good example, with gold and silver cratering. Those types of sudden shocks add to the nervousness. But we’ll see more and more M&A activity in the months ahead.
Our portfolio is filled with companies with strategic value to potential acquirers. With Cadbury, the company developed a strategy that made its businesses both more profitable and more attractive to buyers. Management and the board knew they’d never get there unless a couple things happened. The company spun off Dr. Pepper. After Cadbury, the candy company, separated from Dr. Pepper, the soft drinks maker, Cadbury was able to substantially lower its debt load. The profits of Cadbury, the candy company, zoomed.
The transaction created $14 billion in additional value for shareholders. At the same time, the de-merger took the handcuffs off Dr Pepper’s management. They no longer were reporting back to London to get their decisions approved. Once their management was set free to put capital to work for the best returns, they took market share from Coke and Pepsi. That made Cadbury an extremely attractive merger candidate, and led to its purchase by Kraft (KFT).
As the Cadbury example shows, we believe for the most part that companies can heal themselves in the public markets. They don’t necessarily have to go private and take on six or seven times leverage to improve.
Look at Heinz (HNZ), Cadbury, Dr. Pepper, Legg Mason (LM), even Wendy’s (WEN). The evidence of improvement in these public companies is tangible. We’re not an activist, we’re a constructivist. The activists play the balance sheet by selling a division to buy back stock and leveraging the balance sheet and buying back more stock. Any MBA can do that. And most Wall Streeters do do that. We improve the earnings power of the company. Our background is in operations, not in Wall Street.
Trian stays concentrated in six to eight large investments. This resembles Buffett’s focused investing strategy versus a broad diversification approach. What’s the advantage of staying with a relatively small number of names?
As one of my partners says, diversification is for people who don’t have conviction. We can’t be brilliant about 50 companies. But we can be pretty smart about six or eight.
It takes a lot of time to do our research and write the White Papers that present our strategy for improving the company we’ve invested in. And we do it all from the outside. The company doesn’t know we’re an investor, because we’ve purchased 4.9%, so our stake is still undisclosed. We stay out of the public eye until we have the plan. When we first call management, it’s the first time they’ve heard of us. We tell them by working with us, we believe that by executing our operational plan your earnings and multiple will go up, and the world will be a better place.
The CEO is not thrilled when someone says I’m on the phone. But we have a ton of reputational capital from the institutions and mutual funds that own their shares. Those investors are often thrilled we are there, and tell management and the board. At Heinz, we launched a proxy fight and got two board seats. Today, the directors at Heinz are references for us, as are the board members of Tiffany (TIF) and former chairmen of Cadbury. When a company gets its first call, they’re usually upset. But once we talk to them, we tell them, ‘We’re not here to fire you. We see a great way to make your company more profitable.’
One of your most recent investments is Family Dollar, for which Trian made a $7 billion offer. You’ve been very successful with other types of retailers, but not in this space. Why do you like this company and this business? Must be a great deal judging from the premium.
Our relationship with management is much better than the press is saying. You have a great business here. In a pure vacuum you’d say few retailers have the record to match these guys. Family Dollar (FDO) has 20 years of same-store sales increases without interruption.
But three or four years ago, Family Dollar was the same size as Dollar General. One is from Tennessee, the other, Family Dollar, from Charlotte. They’re both doing 7,000 square-foot stores. Then KKR takes over Dollar General and takes it private. This is a backwater of retailing where the average sale is $10 to $15, and annual sales per store are $1 to $1.1 million. It takes a week to open a store. They have $150,000 worth of goods on the racks and another $150,000 in inventory, and they do 15% margins on that $1.1 million or so in sales.
So they don’t have a lot of competition. Wal-Mart doesn’t compete actively with a 7,000 square-foot store in B-location shopping centers that sells candy bars and milk. All of a sudden, Dollar General puts in hard-hitting retailers from the drug industry, and adds leverage. Then, looking at the EBITDA per square-foot and per employee—even with all the additional leverage—Dollar General leapfrogged Family Dollar, which had no debt and a pristine balance sheet.
We sent a letter to management recommending that they work to achieve the metrics of Dollar General. We’re not big leverage people, but they had too much cash. We felt they should open a lot more stores. They opened 150 last year, compared with 500 at Dollar General. So our view was, let’s get going here. America is waiting for you with the economy the way it is. They’ve attracted another strata of economic America. Now you find people who are little wealthier who find no shame in shopping at Family Dollar, or other dollar stores.
On the other end of the bargain-to-luxury spectrum is your stake in Tiffany. How are you helping Tiffany to broaden its appeal with new, more mainstream products?
We have a barbell approach to retail, since we’re in both Tiffany and Family Dollar. Management has a brand concept with an emphasis on expanding in China and other fast-growing foreign markets. Fifty percent of their sales are now abroad. They’re using the brand carefully and sparingly to change the paradigm for Tiffany. In the past, people went to Tiffany to buy an engagement ring or a present for someone else. It was not a place a woman would go to see what’s available for her. Or ask, what can I buy at Tiffany on my own, for myself?
Tiffany came out last September with a line of handbags, priced as low as $350. The price range meant they offered something for everyone. Now a woman has a reason to go in that store. They did tremendously well with the handbags. It was a rousing success. They did not risk the brand. Another important product is watches. Cartier sells $500 million watches and Tiffany did $50 million. So Tiffany did deals with Swatch, maker of Omega, and Breguet to design, market and sell watches. Before, Tiffany sold watches only in its own stores. Now Tiffany watches are sold in 1,500 stores.
What is your typical time frame for holding a stock?
We bought Heinz stock when its price was depressed, and when Heinz was paying an attractive dividend. Our model is designed to be safe. The risk-reward tradeoff is skewed towards safety. We like big dividend payers and investment grade companies. Those companies will not catch cold and die, and are not putting lots of leverage. We’re very proud of our relationship with Heinz after they initially rejected our plans.
I don’t set a time horizon for our investments, but if you look back over 25 years, we average just under three years as a major shareholder. In 2008, we set the clock back and stayed longer in our investments because the markets were so weak.
Trian made an investment in Legg Mason near the bottom of the market in 2009. Is Legg Mason’s value misunderstood by Wall Street?
Legg Mason’s structure is misunderstood by the market. Legg Mason has an affiliate model. They own 100% of their affiliates, which are investment managers such as Permal, Western Asset Management, and Royce. The parent company is paid a percentage of the revenues of those affiliates. The parent gets a fixed piece of the top line. The affiliates are responsible for all of their expenses. As revenues increase, it’s good for everyone.
It’s what we spend in corporate that largely determines the benefits for our shareholders. Legg Mason was spending too much money at corporate. After we made our investment, they announced $140 million in cost reductions over two years. That was in May of 2010, six months after I came on the board. They announced a $1 billion share buyback, and increased their dividend; Legg mason is a prodigious cash generator. They also have substantial tax credits that are a plus.
We understand why Legg Mason is misunderstood.