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David Einhorn’s 3Q17 Letter – Bubble Basket (Amazon, Tesla, Netflix), CAT short, GM, CNX, MYL, HPE, MU, TPX

Greenlight Capital 3Q17 Letter, October 24, 2017

Review

  • Returned 6.2%, net of fees, in 3Q17, bringing YTD return to 3.3% vs. S&P 500 of 4.5% and 14.2% for the quarter and YTD, respectively
  • Market remains very challenging for value investing as growth stocks have continued to outperform value stocks. Persistence of this dynamic leads to questions regarding whether value investing is a viable strategy. After years of running into the wind, we are left with no sense stronger than, “it will turn when it turns”
  • Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value
  • It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are just doing fine

Amazon

  • Earnings estimates had fallen over the prior few quarters
  • This quarter, revealed a much lower level of long-term structural profitability, causing consensus estimates for the next 5 years to drop by 40%, 22%, 18%, 14%, and 8%, respectively
  • Ordinarily, stocks trading at nosebleed multiples fall sharply when such a dramatic reassessment happens. Instead, Amazon fell less than 1% during the quarter
  • Just because Amazon can disrupt somebody else’s profit stream, doesn’t mean that Amazon earns that profit stream
  • For the moment, market disagrees and perhaps, simply being disruptive is enough

Tesla

  • Had an awful quarter both in its current results and future prospects
  • In response, shares fell almost 6% but believe it deserved much worse
  • Main near-term problems are poor demand for its legacy vehicles and manufacturing challenges for the new Model 3. Notably, TSLA dramatically reduced its gross margin assumption for the September quarter and publicly blamed ramp-up costs for the new Model 3 sedan
  • Company used the lower gross margin hurdle to offer incentives and to lower the cost of options on the Model S and Model X vehicles and even offered significant markdowns on showroom models
  • It is becoming clear that scale manufacturing is actually a skill. While the CEO makes bold claims about TSLA’s superior prowess, continued production shortfalls, defects and product recalls disprove him
  • Faces competition from established OEMs that have decades of scale manufacturing experience
  • Some of TSLA’s presumed market lead in areas like autonomous driving may more likely reflect TSLA’s willingness to put inadequately tested and dangerous products on the road rather than a true technological advantage

Netflix

  • Quarterly results beat expectations and the shares advanced 21%
  • Competition is heating up and media companies such as Disney will be removing their content from NFLX to compete directly
  • NFLX continues to accelerate its cash burn as it desperately tries to compensate for its inability to rely longer-term on licensed content
  • NFLX is incapable of dramatically changing the economics of stand-up comedy in favor of the comedians. Perhaps there really is a new paradigm for valuing equities and the joke is on us. Time will tell

CONSOL Energy

  • Continues to trade in a narrow range and recovered the loss from the prior quarter
  • Expect the separation between the coal and natural gas businesses to be completed this year and we are surprised that the shares have not re-rated much in anticipation of that event
  • Believe this position is particularly promising in the near-term as the market focuses on the new math
  • Notably, CNX announced its first share repurchase program in many years

GM

  • Advanced 16% as it continued to post strong results, closed the sale of its money-losing European business, and showed progress on its ‘Auto 2.0’ positioning
  • On September 13, GM’s finance subsidiary issued $1Bn of perpetual preferred stock. We were impressed that with minimal marketing, new security was priced to yield 5.75% and promptly traded to about 5.25%
  • Math on a sub-6% perpetual preferred security indicates our proposal was even more attractive than we had claimed

Caterpillar

  • Share rose 16% in the third quarter as the company raised earnings guidance for the year
  • This was the Company’s second straight “beat and raise” which has led analysts to conclude that CAT is entering a new upcycle
  • At its current share price, trades at 26x this year’s earnings, implying investors believe it is still well below mid-cycle earnings
  • We are skeptical. We continue to believe that the biggest drivers are mining, where the industry is plagued by overcapacity from the China-led super-cycle in steel production over the past decade; the energy sector, where oversupply is leading to materially slower investment; and construction, where we are already at or near the cycle peak
  • Some of CAT’s strength this year comes more from self-induced product shortages driven by all the factory closures it has made over the past several years in a frantic attempt to protect earnings as demand fell
  • Although dealers are not seeing much end-demand growth this year, they are double ordering equipment because they doubt CAT’s ability to fulfill orders in a timely fashion; believe this will result in higher costs and lower revenue for CAT

Mylan

  • Fell 19% as it suffered delays in new drug approvals and more rapid pricing degradation on existing products, which led to reduced guidance
  • P/E ratio is now 7x and 6x earnings next year
  • Believe that from here, estimates are likely to be achieved and possibly exceeded and we remain excited about the upside potential from MYL’s pipeline of complex generics

Hewlett Packard Enterprise (new long position)

  • Collection of enterprise hardware, services and software businesses spun off from HPE in 2015
  • To further unlock value, HPE spun off and sold its outsourced services and software businesses earlier this year
  • Today, HPE is an enterprise hardware business selling servers, storage and networking equipment, with very profitable maintenance and leasing operations
  • Purchased our position at $13.29 or 8x earnings. Earnings have been depressed by higher input costs and separation-related expenses, but HPE has an opportunity to significantly reduce its cost base
  • Believe the company has earnings power of $1.40 – $1.70 in the next few years

Micron (new long position)

  • When we purchased Micron several years ago, DRAM industry had consolidated from seven players down to three
  • Three participants (MU, Samsung, Hynix) seemed relatively satisfied with their market share and were content to grow capacity through technology upgrades in line with industry demand
  • Unfortunately, a combination of slower-than-expected demand growth from the PC market, along with faster-than-expected capacity growth from Samsung, led to steep pricing declines
  • At the same time, MU had difficulty integrating Elpida, the Japanese competitor it had acquired out of bankruptcy, and fell further behind on the cost curve
  • We chose to exit our position at mid-teens IRR which would have been much larger had we sold the stock at the cyclical top
  • A year and a half later, the situation looks quite different. Not only have MU’s investments in technology allowed it to improve its cost position, but its competitors have seen their progress slow
  • We are getting close to the physical limits of Moore’s Law as the latest DRAM chips are made up of layers of insulators and transistors that are just a handful of atoms in thickness
  • Industry capacity growth has therefore been slowing, while at the same time industry demand has improved
  • Though outlook for PC demand remains lousy, mobile phones and data center servers have much stronger prospects and are now 3x larger than the PC market as a source of DRAM demand
  • Advances in software need continually increasing amounts of DRAM to perform, a dynamic we expect to continue for some time
  • Company is now earning more than twice as much as it did at the peak of the last cycle and we re-entered the stock at $29.21
  • While DRAM will always be cyclical, believe investors are underappreciating the dynamics of current cycle and the long-term structural improvements in the industry

Tempur Sealy International (new long position)

  • Added at an average price of $56.11 per share
  • Manufactures and markets premium mattresses and bedding products under the Tempur-Pedic, Stearns & Foster, and Sealy brands
  • Early in 2017, shares fell precipitously after the company terminated its relationship with retailer Mattress Firm, its largest customer at 21% of sales
  • Believe that brand strength and customer loyalty will allow the company to recapture lost sales through other retailers and direct and online channels
  • Our work suggests that TPX earns significantly higher margins selling through other channels, as Mattress Firm had used its scale to negotiate large discounts from TPX
  • Bears argue that the growing willingness of consumers to buy mattresses online will erode TPX market share and pricing power. However, we note that TPX earns up to 2-3x as much profit on a mattress sold online as opposed to through a retail partner, TPX’s US direct business is arguably the fastest-growing bedding e-commerce business of any material size, and the Bed-in-a-Box products are a lower quality mattress sold at a lower price to address a different market segment
  • We see potential for TPX sales recapture and margin improvement to drive earnings to north of $6/share by 2019-2020, compared to consensus expectations of $4.05 in 2019

Image Source: Reuters

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