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Tech Stocks with David Einhorn’s New Short Criterion of 90% Downside

May 01, 2014 | About:

Holly LaFon

249 followers

David Einhorn (Trades, Portfolio) had a mediocre quarter one, dropping 1.5% while the S&P gained 1.2%, but he spies opportunities up ahead, according to his Greenlight Capital letter. One such is a short of a basket of technology stocks he believes are far overvalued and due for a correction, for which there is a precedent from the last tech bubble.

“Given the enormous stock price volatility, we decided to short a basket of bubble stocks,” he wrote in his letter. “A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to 'twice a silly price is not twice as silly' is that when the prices reconnect to traditional valuation methods, the de-rating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (CSCO) (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.”

Indicators of the current bubble he said are: rejection of conventional valuation methods, short-sellers being forced to cover due to losses and “huge first-day IPO pops for companies that have done little more than use the right buzzwords and attract the right venture capital.”

Fewer of these entities, which he deemed “cool kid” companies, may have large capitalizations and public enthusiasm than their tech bubble predecessors. Nevertheless, they are being incorrectly valued, he believes, and have significant room to fall. Einhorn’s criterion for selecting stocks for his short basket is that there be at least 90% downside for each stock, “if and when the market reapplies traditional valuations” to them.

Einhorn and his Greenlight team use a proprietary method to estimate their determination of their selected companies’ intrinsic value and did not specifically list any names of stocks they are actually shorting. But GuruFocus has found several tech companies that have more than 90% downside based on a discount cash flow (DCF) valuation calculation, for a good guess of which companies might have made his list, or at least are overvalued. If the market began valuing them with traditional analysis, their shares would cost far less.

Below are some tech stocks with more than 90% downside based on a DCF calculation of fair value, mainly found using this setting on the GuruFocus feature All-In-One Screener.

Netflix (NFLX)

Subscription-based Internet television company Netflix trades for $336.60 per share on Thursday, after investors traded the stock up 655% over the past five years. The company also has a high P/E ratio of 128.20, higher than 70% of the companies in the Global Specialty Retail industry, which has a median P/E of 18.2.

Founded in 1997, Netflix now has 48 million members – doubling its subscriber base since 2012 – spread across 40 countries and topped $1 billion in quarterly streaming revenue, as of the first quarter. Key contributors to the quarter’s success were higher domestic and international membership additions and season 2 of the popular series House of Cards. In 2013, the company completed its tenth consecutive year of annual revenue growth, from $501 million in 2004, to $4.38 billion in 2013.

Netflix’s net income also continued its growth streak, completing its fourth straight quarter of increases in quarter one, at $53 million, and projected to go higher to $69 million in quarter two. The company’s free cash flow has stayed in the high single-digits for the past three quarters.

Netflix has balance sheet cash of $1.7 billion and long-term debt of $900 million.

With recent earnings per share of $1.85 and a 14.7% 10-year growth rate, and five-star business predictability, the DCF calculator indicates Netflix has a fair value of $37.11 per share – an 819% margin of safety.

Amazon (AMZN)

Amazon’s share price has ballooned to $304.13 on Thursday, having been bid up 290% over the past five years. The company has a P/E ratio of 530.3, which surpasses 72% of the companies in the Global Specialty Retail industry.

While Amazon has grown revenue at the prodigious rate of 30.2% annually over the last 10 years, the company had lower earnings in the past two years than in the first two years of the decade, even reporting a loss of $39 million in 2012. The meager earnings numbers combined with a high share price has led to the astronomical P/E ratio.

Many Amazon investors argue, however, that the company’s relatively low earnings are due to the large among of funds it puts toward capital expenditures in expanding its shipping warehouse presence, and other new products and services such as grocery delivery and a TV set-top box. Once it completes this expansion, the remaining income will flow back into earnings, justifying the higher price, the thesis goes. In quarter one, operating expenses rose 23% over a year previously. For the second quarter, Amazon is expecting an operating loss between $455 million and $55 million, compared to income of $79 million a year previously, on an estimated 15% to 26% sales growth to between $18.1 billion and $19.8 billion.

If the market valued Amazon according to a DCF calculation with inputs of $0.59 earnings per share, a 10% forward 10-year growth rate and five-star business predictability, Amazon would have a share price of $8.70, for a 3440% margin of safety.

Einhorn noted Amazon in his letter as one of the companies hit hard during the previous Internet bubble, when it fell 93%.

Facebook (FB)

Foremost social media site Facebook Inc. held its IPO in May 2012, and has since been traded up almost 60%, to $61.11 per share on Thursday. Its P/E is 100.8, higher than 64% of companies in the Global Internet Content & Information industry, where the median P/E is 30.3.

Facebook has only four years of reported financials. For the quarter ended March 31, 2014, the company reported a 72% increase in revenue to $2.5 billion, compared to the first quarter a year prior, driven revenue from advertising, which reached $2.27 billion, an 82% increase. Facebook increased its ad revenue on News Feed adds on both mobile devices and personal computers, and raised the average price per ad by 118% during the quarter, and decreased the average number of ads by 17%.

Daily active users of Facebook continued to grow, up 21% year over year to 802 million.

Facebook also saw growth of 193% in net income year over year to $642 million, and has cash of $12.63 billion on its balance sheet, along with $922 million in free cash flow for the quarter.

A DCF calculation using $0.60 in earnings per share and assuming a 10% growth rate in the next 10 years would give Facebook stock a fair value of $8.85 per share, a margin of safety of 591%.

For more stocks that are overvalued based on a DCF calculation, use the GuruFocus All-In-One Screener here. This is a feature for Premium Members only. Not a Premium Member of GuruFocus? Try it free for 7 days here!


Rating: 4.5/5 (10 votes)

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Comments

johannes.bhakdi
Johannes.bhakdi - 2 months ago

Comparing the current market to the tech bubble in 2000 is inaccurate.

Let's look at fb, for example. It's earnings per share are actually 79 cents, and P/E is 77. Different from tech bubble stocks, it's growth is not hypothetical, but factual. It grows at 80% p.a. right now - in profits.

Assuming a 10% growth rate therefore defies the facts.

These people generated $600m in profits last quarter, and grow their profits at 10-20% PER QUARTER.

I think Einhorn is very generic in his assessment (probably for good reasons), there are clearly stocks that, under certain circumstances, could be viewed as bubbly - Netflix, LinkedIN, Twitter, Pandora - while others, like fb, Google, Apple, Microsoft could be viewed as undervalued.

I think this market is a stock-picker (or -shorter) market. There is huge downside potential for some, but betting against dramatic quarterly growth rates in profits could turn out to be a bad idea. As for Amazon, Bezoz behaves like a seed stage entrepreneur - it's up to the investors to decide if they want growth or profit. But he probably won't care. lol.

In the end, it's about understanding realistic TAM, actual growth rate, and the hard cash that changes hands in the corporate ecoystems. Based on this approach, Amazon, facebook, Apple, google, MS come out on top, the others maybe not.

Just mho.

HrZg
HrZg premium member - 2 months ago

In my opinion bold bet by Einhorn but could hold some water. Large cap companies with such high market assigned multiples (such as the ones above) pose a big threat to the market if they fail to deliver those 80% growth rates quarter after quarter. One company fails to deliver - ok - several fail to deliver and it is a big problem. One must think for how long can a large cap company grow at such a high rate. Maybe few can continue to grow so fast in the next three to five years, but can they all? Also, I think a lot of investors in these companies are buying the momentum without trying to think critically what the company will look like three to five years from now in order to arrive to the fair price now. I think this is a dangeorus pricing game where naive get hurt.

paulwitt
Paulwitt - 2 months ago

deleted

mungermice
Mungermice - 2 months ago

@Hrvoje.muhek1, yes that's the point also for me. Such irrational exuberance cannot be healthy for any investor, it's a field of speculators with high risk tolerance. In the history of stock market aggressive growth comes always to an end and that's common sense. A company cannot endless nearly doubling their profits. There's always a point of saturation when growth is slowing down and the risk that will happen is even higher on such rates today. To predict such rates for the next 5 oder 10 years is nonense. And when this happens the prize maybe is going even higher for a while because speculation has build a religion around a stock, think of a god who brings endless wealth. The history always showed the free fall of such overvaluation and the stock was faltering.

snowballbuilder
Snowballbuilder - 2 months ago

I think einhorn is right and his choise of shorting a basket of stock (probably quite the same stocks mentioned in klarman famuos and great "someday" ) will finally be right . I m not going to short any stock couse i m a long investor only , but if i ve to bet , i would bet , quite confident , that "someday" einhorn will be finally right.

kfh227
Kfh227 premium member - 2 months ago

it used to be said that bubbles occur every 30 years. The reason being that people that remember the last buble start retiring and dieing off.

With the tech bubble though, alot of young investors I know (I work in tech so I might be biased) only invest in tech and they have no idea what vluation is. Traditional bubbles were fueld by a wide range of ages. I wonder if this bubble is fueld by younger people.

vgm
Vgm - 2 months ago

Einhorn has now joined Klarman and Watsa in pointing up high valuations - some of which, let's be honest, are not that difficult to see. Watsa spent considerable ink discussing this in his latest AR, in part in defence of BBRY.

But, as Buffett pointed out a few days ago when asked about comments Einhorn had made on a tech bubble, the present situation is nothing like the tech craziness of the late 1990s. And Buffett repeated his view that there's no overall frothiness in the markets today, based on valuations.

Einhorn is a briliant investor but valuations can defy gravity (much) longer than anticipated. Some quite prominent observers have been predicting a crash of AMZN literally for years.

AlbertaSunwapta
AlbertaSunwapta - 2 months ago

If amazon has an incredible business model, I would guess there will be points the future where it's price falls back to earth and subsequent returns would look far more attractive than now. As van Den Berg (the younger one) said, 'the price you pay determines your return', however we must add that the combination of price and time held determines your rate of return.

vgm
Vgm - 2 months ago

In case anyone didn't see it, Einhorn discussed and clarified his tech strategy on Bloomberg: http://www.bloomberg.com/video/david-einhorn-on-tech-stocks-fed-policy-strategy-wby1QOW4RZWXEHAUuY8yEg.html

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