Greenlight Capital 3Q15 Letter: Still Long Sune, MU, CONSOLVW Staff
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The Greenlight Capital funds (the “Partnerships”) returned (14.3)%,1 net of fees and expenses, in the third quarter of 2015, bringing the year-to-date net return to (17.1)%. During the third quarter, the S&P 500 index returned (8.2)%, bringing the index’s year-to-date return to (5.3)%.
Given our results this quarter, this is a good time to discuss our process. First, we are value investors. This means that we buy what we believe are misunderstood companies at low valuations relative to their underlying assets and future cash flows. This involves spending many hours analyzing a company’s reported financial statements, then making adjustments to them based on our perception of the economics of the business.
Sometimes we determine that a listed or perceived asset is actually a liability; other times we find value that gets missed because the company has done a poor job explaining itself. We find that the more misunderstood a company is, the greater the likelihood of a dislocation between value and price, and the more we tend to like it.
Second, we run a concentrated portfolio. Our philosophy is to invest the most capital in ideas where we have the most conviction. The core of our process for both finding stocks and sizing our investments has not changed and has historically served us well.
Unfortunately, a good process does not prevent mistakes, nor does it guarantee good outcomes, especially on a short-term basis. Because we look for investments that have a healthy margin for error, a misjudgment of analysis is rarely a disaster. We don’t need much to go right in order to make money, and in many cases we can get a lot wrong and still break even. When we are very wrong, however, we are going to lose money. And although large losses don’t occur often, in a punitive environment we can have more than one in a short period of time.
With any large loss, we reassess the position to evaluate whether our thesis is busted or the losses are overblown. Depending on what we determine, we either add, hold, trim or exit. Sometimes, patience is in order and sometimes it’s not. Just as the summer began, we ran into significant problems in rapid succession in three of our largest positions. One has played itself out; the other two are still in their middle innings.
CONSOL Energy (CNX), SunEdison (SUNE) and Micron (MU) all performed abysmally this quarter. In the case of CNX and SUNE, the complicated financials that make these companies misunderstood are contributing to their declines. In both instances, a superficial financial analysis does not inspire confidence. It takes time, diligence, and possibly even some directed guidance for new investors to get up to speed. Lacking a strong incentive to dig through the numbers, some investors simply see a falling knife and look no further. This is what we see from here forward.
CNX is an Appalachia-based coal and natural gas production company. From its most recent high of $33.34 on May 8, the shares traded down gradually to $9.80, where they ended the quarter. There was no single moment where the shares fell sharply; it was essentially an orderly collapse. Yes, coal and natural gas prices both fell modestly during the decline. Yes, the company’s effort to bring its coal assets public in a separate vehicle was greeted coolly by the market. Yes, there is an oversupply of natural gas in the region, which has caused local realizations and quarterly earnings to fall below plan. We could have mitigated a portion of our loss by hedging natural gas, but with the price already near a historical low, we made the incorrect decision not to hedge the commodity risk.
However, CNX has had plenty of overlooked good news. The company went through a significant cost-cutting effort and cut its capital spending budget aggressively. In July it reported fantastic drilling results and a significant success at a test well in the Utica Shale. Ordinarily, the market responds favorably to positive drilling news. In the current environment, it has responded more like a child receiving socks as a birthday present, “Gee, just what I always wanted … more, cheap natural gas.” We believe the market has undue concern about the near-term prospects for Appalachian coal and natural gas, leading it to discount the company’s long-term resource value far beyond anything we anticipated.
CNX’s financials do not lend themselves to easy analysis. Right now, CNX is transitioning from one of the country’s biggest coal producers into a natural gas company. CNX’s financial statements combine both operations, which makes it challenging to properly analyze either of them. Gas analysts looking at CNX could see a low-cost, growing natural gas business with enormous resources combined with a worthless legacy coal business. Coal analysts aren’t looking at CNX – they’re looking for new jobs. Having dissected the financials, we see two businesses with significant upside.
Even at lower commodity prices, capital discipline, cost cutting and much more efficient drilling economics should enable CNX to be cash flow breakeven or better from here on out, which is a significant improvement from our original expectations of about $1 billion of cash burn through 2017. In 2016 we expect CNX to generate cash while growing its production and proved developed reserves. There are very few midsize energy companies achieving similar success. And yet, CNX trades as if it is at the cusp of financial distress. Of course, we wish we were entering the position now rather than at the higher prices we paid.
For the first part of the year SUNE was by far the fund’s biggest winner. The shares rallied from $19.51 to a peak of $32.13 on June 23 before collapsing to $7.18 by September 30. SUNE’s business is to develop solar and wind projects for major utilities and commercial customers that agree to buy the power over a very long term, often 20 years. These projects have purchase contracts from highly creditworthy counterparties and produce an average unlevered return on capital of 10% and 13% in developed and emerging markets, respectively. SUNE makes money by selling the projects at a premium to investors seeking safe, long-term income.
Given the low-rate environment, SUNE thought it could make even more money if it created its own related yield vehicles to buy the projects and dividend the income to shareholders. It created TerraForm Power (TERP) for its developed markets projects and TerraForm Global (GLBL) for its emerging markets projects. Initially this worked very well, and in July 2014, SUNE successfully brought TERP public. This July it brought GLBL public with much less success.
In the weeks before the GLBL initial public offering, SUNE was at its highs and we contemplated trimming the position. Since we expected the IPO would trigger a further advance in the shares, we decided against it. Around this same time, oil and gas prices renewed their declines, causing the values of energy master limited partnerships to justifiably fall. We believed that TERP and GLBL would not be impacted, as neither is subject to commodity risk. We were wrong. Because the SUNE yield vehicles were relatively new to investors, the market did not distinguish them from other energy dividend flow-through structures. In mid-July, TERP began falling along with the rest of the sector, taking SUNE with it. GLBL IPO’d at a big discount a week later and traded poorly in the aftermarket.
As GLBL and TERP continued to fall they effectively lost access to the capital markets, and SUNE collapsed as the market became worried that SUNE would not be able to sell its projects and could even run out of money. Ironically, the market judged SUNE’s rapidly growing and massive backlog of attractive projects to be a liability.
SUNE’s hard-to-decipher financial statements fed the stock collapse. SUNE consolidates both TERP and GLBL on its GAAP statements. The complicating result is two-fold: First, when SUNE sells a project to TERP or GLBL it bears the operating costs but doesn’t get to book the revenue from the sale. The result is the appearance of an operating loss. Second, TERP and GLBL use non-recourse project finance debt to fund the purchases and the debt appears on SUNE’s balance sheet. The result is that SUNE appears to be heavily levered and losing money. From a GAAP perspective that’s true, but from an economic perspective it is not. Nonetheless, this hasn’t stopped some wise guys from dubbing it “SunEnron”.
SUNE responded to the deteriorating environment by raising additional equity, finding third parties to buy its projects, and slowing its development pipeline. All of these actions have marginally lowered the company’s value, but have stabilized the situation. Taking into account the more conservative business plan, when we look through the complicated financials we believe that SUNE’s development business is poised to have economic earnings in 2016 of about $1.34 per share, assuming that TERP and GLBL do not regain access to the capital markets.
SUNE has additional value from its ownership of TERP and GLBL shares. During the panic, the market has fixated on the question of whether TERP and GLBL can access money cheaply enough to buy projects and grow their dividends. This is relevant insofar as it will determine whether they can be long-term buyers of SUNE’s projects, but we believe the market’s focus is too narrow.
The better question is: Do TERP and GLBL have the opportunity to buy projects at returns that exceed the risk? If they do, the capital markets would be wise to fund them. We believe the answer is a resounding “Yes.” A power plant with a long-term power purchase agreement is roughly equivalent to a secured lender. As the customers are strong credits, the ability to buy a portfolio of these projects at a 7% unlevered yield in developed markets and a 10% yield in emerging markets should be very attractive in the current income-starved environment, where 7-year A-rated corporate bonds yield less than 3.5%. We believe that once the market sorts through the mess, TERP and GLBL should recover and regain access to the capital markets. This would allow SUNE to realize substantial additional value.
MU was our biggest winner in 2014. Unfortunately, we overstayed our welcome and gave back much of those gains this year. The shares peaked at over $36 last December before collapsing to $14.98 on September 30. Our thesis has been that MU’s primary product, DRAM, has consolidated to three players, who are likely to create more industry profits compared to when DRAM production was highly fragmented.
The problem is that structural industry improvement doesn’t make DRAM less cyclical. The large capital requirements force participants to make large investments in anticipation of future demand. If the industry overestimates demand, it still makes sense to operate at full capacity and oversupply ensues. This year, demand came up short, DRAM prices collapsed, and despite our concerns about PC demand, we missed the turn of the cycle. Those PC demand worries led us to sell LAM Research and Marvell Technology at good prices prior to a sell-off in each security and we shorted (and subsequently covered) Best Buy, IBM and Intel. Although all of these moves helped, we underestimated the extent of MU’s exposure to the PC demand shortfall.
MU’s other business is flash memory or NAND. We anticipated a significant recovery in NAND this year that failed to materialize. MU is set to earn far less than we expected, and earnings will remain low until supply and demand come into balance.
Two other problems with our thesis have emerged. First, the Chinese have expressed interest in getting into DRAM. Our prior view was that the consolidated industry would not face new entrants. While the Chinese threat is distant, we judge it relevant. Second, MU announced a much more aggressive capital spending plan for NAND than we envisioned. While management believes that the extra investment will generate adequate returns, we are unconvinced. With separate problems clouding both the short-term and long-term, we determined that there is enough risk to the thesis to reduce the position. The three large problem positions tell only a part of the portfolio story. The trouble started toward the end of the second quarter. In early June we were up a little for the year, which wasn’t exciting, but we were about even with the market. We had noted it was hard to find things to buy. Then, between June 4 and August 18, we lost more than 14% (41 losing days and 13 winning days) in a flat market. It was a period where cheap stocks got cheaper and expensive stocks became ever dearer.
Notably, we suffered most of our losses prior to the market decline that commenced in late August. As the market fell, our portfolio performed only slightly worse than we would have expected. Our shorts fell almost as much as our longs and we lost only a little more than our net exposure during the correction.
The following table provides additional detail of what happened starting on June 4:
As both the environment and our performance have been challenging, we decided to try to swing a little less hard, so we reduced our gross exposure by about 30 points during the quarter. At the same time, we decided not to give up on promising investments. We looked at the entire portfolio and added, held, trimmed or exited depending on the strength of our thesis in conjunction with changing market prices. With the market and our long book cheaper, we decided to modestly increase our net long exposure with most of the change coming from short covering.
In addition to re-underwriting the existing portfolio, we also found two medium-sized new long ideas.
Michael Kors (KORS) designs, distributes and retails women’s accessories, footwear and apparel. KORS shares fell 25% after North American comparable store sales fell 5.8% in the March quarter. A distribution center shutdown led to a temporary halt in e-commerce, and the winter product line was repetitive, cooling customer interest. The market went from expecting ongoing earnings beats to worrying the company is a fad that has run its course. Both issues are now resolved, and the fall product line appears much improved. We believe KORS has multiple avenues of continued growth, including its international business and footwear. We established our position at an average price of $45.18, less than 9.5x March 2016 fiscal year earnings estimates net of the $4 per share in cash. We established a position in UIL Holdings (UIL) at an average price of $49.57 per share. UIL currently owns and operates several regulated utility assets in Connecticut and Massachusetts. In February, UIL announced that it was combining with Iberdrola USA, the U.S. division of Iberdrola, a large Spanish company with power and utility assets around the world. The Iberdrola USA business is currently made up of regulated utility assets in the Northeast, one of the largest wind energy portfolios in the U.S., and a wellregarded renewables development organization with a healthy pipeline of wind projects.
Upon closing, UIL shareholders will receive $10.50 per share in cash and one share in a new publicly listed entity which will comprise stable utility assets and a growing renewables business. The pro forma entity will be less levered than its peers with a large tax asset and attractive renewables cash flows that we believe are not fully reflected in the stock price today.
We also closed a number of positions during the quarter including:
- Citizens Financial Group (purchased at $22.36, sold at $26.28): Lowered 2016 guidance which defeated our thesis that there was upside to estimates.
- LAM Research (purchased at $54.07, sold at $75.30): We believed the cycle was peaking, putting 2016 estimates at risk.
- Spirit Aerosystems (purchased at $20.28, sold at $50.55): New management improved core margins, exited unprofitable development programs and initiated a stock buyback. This led to higher earnings and a higher multiple. We exited as the shares reached fair value.
- Intel (shorted at $34.23, covered at $29.28): We mitigated a portion of our long exposure to personal computers.
- Robert Half (shorted at $28.96, covered at $41.61): A multiyear short where the company generally performed better than we expected.
- St. Joe Company (shorted at $36.90, covered at $17.17): After being short for almost 10 years, we decided to declare victory and move on, even though the shares remain somewhat overvalued.
- U.S. Steel (shorted at $27.07, covered at $23.21): While we made money on this large short in a period where the S&P 500 rose substantially, we left a lot on the table by not covering the position very well, as the company ultimately achieved our bear case.
Some of you have already met our new Partner Relations Associate, Regan Gilbride, who joined us in August. Regan began her career at J.P. Morgan in the equity derivatives group, where she marketed structured products to registered investment advisors and broker-dealers. In 2010, she joined the Private Bank at J.P. Morgan as an investments specialist, providing customized investment solutions to high net worth individuals and families. More recently, she performed due diligence on the long/short equity hedge funds on J.P. Morgan’s private wealth platform. Regan graduated from Yale University in 2007 with a B.A. in Economics. She is a CFA charter holder.
Harry Greene joined Greenlight as a Research Analyst in October. Harry began his career in 2008 as a financial analyst with Goldman Sachs Investment Partners (GSIP), a clientfacing multi-strategy hedge fund at Goldman. In recent years at GSIP he was principally responsible for sourcing and evaluating special situation investments across equity and debt securities. Harry graduated from Yale University in 2008 with a B.A. in Economics and Mathematics. He was awarded the Richard U. Light Fellowship for Chinese language study and the Ronald Meltzer/Cornelia Awdziewicz Economic Award for his senior thesis on herding behavior among retail investors.
Welcome Regan and Harry. Go Bulldogs!
Alexandra Desbrow is currently on a sabbatical spending time with her family. Please direct all questions to Justin and Regan.
Also, we wish to thank everyone who participated in our third Greenlight Capital investor survey. We have not had a chance to analyze the findings yet, as the firm we hired is still tabulating the results. We plan to share the conclusions with you at our 20th annual partner meeting which will be held on January 19th at the American Museum of Natural History.
At quarter-end, the largest disclosed long positions in the Partnerships were Apple, CONSOL Energy, General Motors, gold, and Resona Holdings. The Partnerships had an average exposure of 91% long and 66% short.
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