Greenlight Capital Q2 letter has just been sent to investors, a copy of which was reviewed by ValueWalk. Below is the full letter, check back soon for further coverage any analysis.
Charlie Munger’s Cancer Surgery Formula
The Greenlight Capital funds (the “Partnerships”) returned 7.9%,1 net of fees and expenses, in the second quarter of 2014, bringing the year to date net return to 6.4%. During the second quarter, the S&P 500 index returned 5.2%, bringing the index year-todate return to 7.1%.
Greenlight Capital’s long portfolio contribution
Our long portfolio contributed 14% to our gross return, a strong absolute and relative performance. We made large gains in:
Micron Technology, Inc. (NASDAQ:MU) ($23.66 to $32.95): The spike in DRAM prices from last year turned out not to be a blip and earnings continued to exceed expectations. We believe consensus earnings estimates remain too low, positioning the company for further earnings surprises and multiple expansion.
Apple Inc. (NASDAQ:AAPL) ($76.68 to $92.93): Investors’ 2013 fears that AAPL had saturated the market and its best days were behind it proved unfounded as 130 million people became first-time iOS customers in the last year. Last quarter, AAPL’s EPS grew 15% and the forecast is for more of the same. Importantly, AAPL also increased its share repurchase authorization by $30 billion to $90 billion. Concurrently, AAPL also announced a seven for one stock split. AAPL remains inexpensive at about 11x earnings net of cash.
Greenlight Capital also gains in SUNE, ATC and OIS
We also made significant gains in:
Sunedison Inc (NYSE:SUNE) ($18.84 to $22.60): In May, SUNE completed the IPO of its semiconductor division. SUNE’s yieldco, TerraForm Power (TERP), completed its IPO in July. SUNE completed several solar portfolio acquisitions and disclosed an attractive incentive distribution rights structure that should allow it to enjoy additional value from TERP over time.
Altice SA (AMS:ATC) (€32.34 to €50.88): As we discussed in our last letter, ATC’s 40% owned subsidiary Numericable will buy French competitor SFR to form the second largest telecommunications company in a consolidating market; it also announced its intention to cut more costs and the ability to finance the acquisition at a lower cost than anticipated.
Resona Holdings Inc (TYO:8308) (¥499 to ¥590): Earnings came in slightly above expectations and capital ratios improved materially due to the transition to international accounting standards. This supports the bank’s announced plan to repurchase the government’s equity stake.
Oil States International, Inc. (NYSE:OIS) ($98.60 to $114.15) / Civeo Corp (NYSE:CVEO): OIS completed the spinoff of its legacy accommodations segment, now called Civeo (CVEO). The combined OIS/CVEO share price appreciated as investors re-rated the two businesses closer to their respective fair values. The shares ended the quarter at $114.15 on an old OIS-equivalent basis.
The short portfolio lost a bit less than the market despite a rash of takeover activity that infected a number of positions. Costly takeovers of our shorts appear to be a cyclical phenomenon: We went from 1996-2003 without incurring a single material loss due to a takeover. Then in 2006-2007 we had a number of our shorts taken over in rapid succession, the most costly being Medtronic’s $4.2 billion acquisition of Kyphon at a 32% premium over Kyphon’s already lofty share price. In reviewing historical takeovers of our shorts where we lost money, almost none proved to be good deals for the acquirers.
Things got quieter again for a few years but now takeover season has returned and is again causing losses in our short portfolio. Companies we are short often have serious problems of which the boards and management are probably aware. This makes them more eager than usual to sell at any sort of premium. The prospective buyers ought to discover these problems during due diligence, which should make them walk away. But in the current environment, debt financing is so inexpensive that acquirers can pay premiums and have the deals be accretive to EPS, making them more willing to overlook or ignore any problems they discover.
Takeover season has returned and in a new twist, the buyers’ stock prices are also advancing in response to announced deals, enabling companies, including some of our shorts, to see gains as acquirers – even of other troubled companies. Here are a number of examples that have affected us:
Safeway (SWY) is a deteriorating supermarket chain. In 2008, SWY completed a large remodeling program that failed to adequately lift sales and profits, leaving SWY competitively stuck between Whole Foods on the high end and Walmart on the low end. SWY’s revenues and profits are in decline and SWY has no apparent means of reversing those trends. SWY also has a large off-balance sheet liability to multiemployer pension plans or MEPPs. The disclosure around the MEPPs is hard to analyze, but we have done a thorough job and believe it is approximately an $8 billion unrecognized liability. Though SWY claims that our figures are too high, we have discussed our analysis with management and still believe we are correct. Nonetheless, Albertsons has agreed to purchase SWY for about $10 billion or 17x SWY’s deteriorating EBIT. We don’t know how Albertsons views the MEPP issue.
Martin Marietta Materials (MLM) produces aggregates for the construction industry. The company has missed analyst estimates in 17 of the last 26 quarters, which has led to continuous erosion of earnings estimates. From 2009 to 2013, the company earned between $2.03 and $2.61 per share annually, excluding one-time expenses. Once upon a time, MLM was expected to earn $8 per share this year. Current estimates stand around $3.75. In January, MLM agreed to acquire cement, aggregates and concrete maker, Texas Industries (TXI) for $2.7 billion. TXI appears to be an even worse business, with negative EBIT each year from FY 2010 through FY 2013. However, MLM issued a proxy statement presenting a management forecast (prayer?) that implies post-merger EPS of $12+ in 2018. The market chose to ignore MLM’s long history of missing its forecasts, and its shares advanced more than 20% since January when it announced the acquisition.
Lorillard (LO) makes cigarettes. Over 80% of its profits come from menthol-flavored cigarettes, which were banned in Europe earlier this year. The FDA is six years into evaluating whether to regulate menthol flavoring, and may decide to ban it here, as well. The FDA is due to announce its findings any day now or, perhaps, any year now. This risk did not stop Reynolds American (RAI) from agreeing to acquire LO for $68 per share – a sizable premium to the $48 that LO traded at in February before word of the deal leaked. We suspect that RAI is willing to accept the menthol risk on the theory that in for a penny, in for a pound.
Questcor Pharmaceuticals (QCOR) makes one product, H.P. Acthar Gel, an off-patent drug approved in 1952 for 19 different diseases only two of which have clinical studies demonstrating safety and efficacy. The laundry list of problems and risks that this company faces could fill a lengthy PowerPoint presentation. We won’t review them in detail here, as many of them have received substantial attention in the national media. There are ongoing criminal investigations against the company; there have been a large number of adverse patient experiences including a number of deaths; large commercial payers including Aetna, Cigna and UnitedHealthcare have recently moved to limit reimbursement of the drug (if Medicare follows suit, it will be a real problem); and the FDA is reviewing lab reports that indicate that H.P. (which stands for highly purified) Acthar Gel does not actually include any highly purified Acthar, but rather deamidated Acthar, a degraded form of the drug that is a different chemical compound than is indicated on H.P. Acthar’s label.
Nonetheless, in April, Mallinckrodt Pharmaceuticals (MNK) agreed to purchase QCOR for $5.6 billion. Given that MNK does not pay taxes and can debt finance the acquisition cheaply, the acquisition will be massively accretive to MNK’s earnings – provided nothing bad happens to QCOR. After the deal was announced, we purchased a medium-sized stake in MNK at an average price of $63.17. Subsequently, we spoke with MNK’s CEO and ascertained that he is blowing smoke over his evaluation of the many risks facing H.P. Acthar Gel. Most notably, he said that a biological test, rather than a chemical test, is the proper way to evaluate the activity of the drug. We believe this misses the point since QCOR has
admitted that H.P. Acthar Gel only contains deamidated Acthar, which is not the compound indicated on the FDA-approved label, and is therefore an untested, unapproved drug. We have since disposed of our MNK stock at an average price of $76.09. Given that QCOR is larger than MNK, and MNK is going to lever-up to buy QCOR, we believe that MNK is setting itself up to be a very attractive short sale candidate if the merger is completed. Our QCOR short was the only significant loser in the portfolio in the quarter, advancing from $64.93 to $92.49 per share.
Finally, there is Keurig Green Mountain (GMCR). We will again keep our thoughts about GMCR and Coca Cola’s minority investment (with rumors of a possible takeover) to ourselves.
We made a medium-sized new investment in Lam Research (LRCX), a maker of semi-conductor capital equipment. As transistors get smaller and smaller, the conversion of semiconductor designs into working chips becomes more difficult. The solution, known as “multi-patterning”, involves running each layer of the chip through the manufacturing line multiple times, etching away the excess material until the chip works properly. This forces chip manufacturers to buy more of LRCX’s etchers and deposition tools for each manufacturing line. We purchased the position at an average price of $54.07 representing 7x our calendar 2015 earnings estimate, net of cash on the balance sheet. LRCX ended the quarter at $67.58.
In our last quarterly letter, we wrote about the bubble in momentum stocks, most of which are in the technology sector. The media latched onto a single sentence embedded in a lengthy discussion about ‘cool kid’ stocks and suggested that we were declaring all technology stocks to be in a bubble. Nothing could be further from the truth. Many of our largest long positions are in technology, and we are not holding them with a cynical view that we want to play a bubble. We believe that stocks including Apple, Lam Research, Marvell Technology and Micron Technology have strong prospects and are undervalued.
At the same time, there are a number of tech stocks that are caught up in a smaller version of the 1999-2000 internet bubble, and as we mentioned, we created a bubble basket to short them. At this year’s Sohn Investment Conference in May, David presented athenahealth (ATHN), a healthcare IT company, as an example of a bubble basket stock. In response to our assertion that the shares are absurdly overvalued, CEO Jonathan Bush summed things up perfectly a few days after the conference when he told Bloomberg TV, “And those who buy our stock should not be sort of bottom [line] watching value investors. They should be people who dream of a health care cloud.” At Greenlight, dreams do not form the basis of investment theses.
The notable positions closed during the quarter were Aspen Insurance Holdings (AHL; +17% compounded return), where our thesis of improved ROEs, better capital returns, and corresponding multiple expansion played out over our multi- year holding period, and Rite Aid (RAD; +215% compounded return), where our thesis of sales and profits turning higher played out and the shares reached fair value.
Things were quiet on the operations side. We have no developments to share.
At quarter-end, the largest disclosed long positions in the Partnerships were Apple, gold, Marvell Technology, Micron Technology, Resona Holdings and SunEdison. The Partnerships had an average exposure of 115% long and 71% short.
“Sometimes the questions are complicated and the answers are simple.”
— Dr. Seuss
Greenlight Capital, Inc.