David Einhorn (Trades, Portfolio) of Greenlight Capital is a famous value investor who is short Tesla (TSLA, Financial) and Netflix (NFLX, Financial), among other names. He is long company's like Brighthouse Financial (BHF, Financial) and Chemours (CC, Financial). In his latest letter, he talked about all four ideas. This is a review of his commentary and any emphasis is by me. In between quotes, I’ll offer context for his remarks.Â
Einhorn’s thesis on Brighthouse, a provider of annuity and life insurance products, revolves around the market misunderstanding the nature of its accounting. The market is misreading earnings that are impacted by interest rate hedges. He explains it like this:
"...In the early part of the year and again in June, management added to its interest rate hedges and purchased cheap options that protected the balance sheet through the subsequent interest rate declines. Usually, when an advertised bear case doesn’t come to fruition, the stock tends to soar. Relative to BHF’s $4 billion market cap, the $400 million capital build when the market had expected a large loss ought to have had a large positive impact on the share price. In this case, the market yawned. The glass-half-empty crowd concluded that if the hedges generated gains in a falling rate environment, those gains would probably be reversed if rates went back up."
Einhorn's analysis leads him to believe the company is very cheap at 9t times enterprise value to Ebitda or 0.25 times book value. He fears it will take time for the market to notice:
"As one analyst put it in his summary of the quarter, 'we do not expect there to be many buyers for this name despite a seemingly cheap valuation and reasonably good earnings results.'”
However, great investments need a catalyst, something that unlocks value. Einhorn believes, in this case, that’s the buyback program:
"...with the stock in the doldrums, BHF continued its aggressive buyback program, repurchasing nearly 3% of outstanding shares in May and June alone, and management collectively purchased nearly $1 million worth of shares on the open market after the earnings report in August."
Insiders have indeed been buying in quantity. The buying is also spread out across executives, which is a good sign as well.
"We have been negative about NFLX for a long time, as the company has yet to demonstrate a profitable business model. While NFLX has grown subscribers and revenues, cash costs have grown even faster. This year the company projects to burn a stunning $3.5 billion on just $20 billion of revenue."
Einhorn criticizes the business model, which may surprise many people as competitors are copying it and Netflix is the dominant over-the-top platform. However, Einhorn makes interesting points and is well aware of Netflix's position and its history:
"In its early years, NFLX created a niche by licensing cheap content and growing its subscriber base with a low-priced, value offering that aggregated hundreds of popular titles owned by major studios. That arbitrage has gone away as the cost of licensed content has soared, competition has intensified and traditional studios are pulling their libraries from NFLX to launch their own streaming services. It appears to us that the value creation from streaming video on demand has gone to stand-up comics and the owners of perennially popular shows like Friends, The Office and South Park."
This is obviously true and considered by the market with most notably Disney (DIS) really stepping up its game. Einhorn believes Netflix tries to deal with the problem of not being able to license content cheaply anymore through content creation. But Einhorn can’t really find examples of Netflix shows where viewership is durable and that have become a real franchise:
"When was the last time you heard anyone mention watching House of Cards? More generally, NFLX structures its site to emphasize new releases and popular licensed content while library content requires an effort to watch. And yet, NFLX amortizes its content over up to 10 years, inflating GAAP margins by deferring expense recognition."Â
Here he gets at the heart of the matter. Netflix basically capitalizes its content spending and amortizes it over a decade. If you do that by spending $10 billion on shows this year, it will appear as if you’ve spent only $1 billion. If whatever you are buying isn’t really worth much beyond year two, you will ultimately not be able to sustain that content spending.
"How and why does something like that deserve a multiple-year accounting life? We believe that management’s approach to expense recognition renders NFLX’s GAAP financials nearly meaningless. The point is that NFLX needs to maintain a constant stream of popular new content in order to sustain, let alone grow, its subscriber base. Thus, the cash burn of over $3 billion (which NFLX promises will improve “slowly” and “gradually”) better reflects the business economics than do its GAAP financials."
Einhorn is convinced Netflix will continue to lose money over the coming years. Historically, the market is judging Netflix primarily on subscriber growth. But things are changing:
"...NFLX’s domestic subscriber growth has slowed sharply in 2019. Unsurprisingly, NFLX – as is its custom – announced that it will no longer guide to the number of U.S. subscribers. International subscriber growth also appears to have peaked. At the same time, NFLX has begun offering heavily discounted “mobile-only” plans in some emerging markets."
Einhorn is not just skeptical of subscriber growth but also of pricing power. A potentially toxic combination:
"Bulls forecast ever-higher international prices (from roughly $9.50 per month currently to $14-15 per month or higher over the next decade), but that math breaks down as NFLX increasingly relies on $3-4 monthly subscriptions in low-income countries like India and Malaysia to maintain the global subscriber growth narrative.
Of further note, in its most recent 10-Q, NFLX adjusted its description of its pricing plans by changing one rather important word. The filing now says, “We expect that from time to time the prices of our membership plans in each country may change (from increase) and we may occasionally test other plan and price variations.” With a disclosure like that, the NFLX story of unmitigated pricing power for years to come has to be called into question."
Einhorn is skeptical that Netflix will ultimately work out with $8 billion in debt against $23 billion of content on the balance sheet. In his view, $23 billion greatly overvalues the value of said content. He is also skeptical of the market’s willingness to fund a company with durable negative cash flows and at about 6 times sales.
Einhorn has something of a battle going on with Elon Musk. Musk once sent him a box of shorts, but Einhorn is not kidding anymore. The gloves have come off a few letters ago and he’s punishing:
"...TSLA appears to continue to spin positive PR ahead of the safety and fair treatment of its customers. For example, in August Walmart sued TSLA because its solar panels were catching on fire. Rather than warn its solar customers when TSLA became aware of the fire risk, TSLA allegedly created Project Titan – a covert program to replace the defective components while staying out of the news."
For a few weeks, this seemed to stir things up, but then the market moved on and, for now, this doesn’t seem to be of concern to longs. After the publicity, it also looked like Walmart (WMT, Financial) and Tesla came to an understanding at least to a degree.
"Similarly, in response to a series of car battery fires, instead of recalling the batteries, TSLA appears to have quietly issued a “software update” to the battery management system that has a side effect of reducing battery range. TSLA has chosen not to warn or compensate its customers for the decreased performance."
It looks like this has now incited an NHTSA probe.
"Finally, to the surprise of nobody, documents in TSLA’s SolarCity litigation unsealed in September showed that Elon Musk knowingly orchestrated a significant fraud by arranging the $2.6 billion acquisition at a time when SolarCity was insolvent. Musk and his family had a huge conflict of interest, but rather than properly recusing himself, Musk initiated the transaction and drove the process."
"SolarCity was so cash-strapped, it was trying to delay payments to vendors after parts were delivered and the vendors had recognized the revenue; SolarCity could not raise any funds at reasonable rates from third parties; and Musk engineered the unveiling of the Solar Roof tile to convince TSLA’s shareholders to approve the deal, even though the product did not exist at the time. As was the case with Musk’s extraordinary “funding secured” tweet last year, we believe this level of trampling of standard processes of corporate governance, ignoring methods to deal with related party transactions and self-dealing should lead to substantial consequences. For now, the accepted reality appears to be that Elon Musk is above the law."
Einhorn seems to expect the above events will ultimately have important consequences for Tesla or its CEO. Musk already stepped down from the chairman position due to an earlier settlement with the Securities and Exchange Commission. At least for now, Tesla remains the largest U.S. car company.
Disclosure: Short Tesla.
Read more here:
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