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Einhorn - Q1 '12 Letter to Partners

Einhorn - Q1 '12 Letter to Partners

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Published by: AAOI2 on May 30, 2012
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 2 Grand Central Tower 
140 East 45
th
Street, 24
th
Floor 
New York, NY 10017Phone: 212-973-1900
Fax 212-973-9219
www.greenlightcapital.com
May 29, 2012Dear Partner:
The Greenlight Capital funds (the “Partnerships”) returned 6.8%
1
, net of fees and expenses, inthe first quarter of 2012.In the first quarter, the market rose steadily with eleven weeks of gains and only two weeksof trivial losses. In its relentless climb, the market took nearly every stock in our portfoliosalong with it, resulting in profits on the long side and losses on the short side. In aggregate,the longs advanced more than the market and the shorts advanced less than the market, so wegenerated positive alpha on both sides of the balance sheet.During the presentation at our annual Partners’ Dinner, we talked about a number of stocksthat have suffered multiple compression, where businesses have performed nicely, but havenot seen a corresponding uplift in their share price. Apple (AAPL) is the clearest example of this. In 2011, AAPL’s revenue grew 66% and earnings per share grew 78%. Both of thesegrowth rates greatly exceeded market expectations and even our own expectations, whichwere considerably more optimistic than consensus. Nonetheless, the stock appreciated byonly 25%. As a result of this mismatch, AAPL’s P/E multiple compressed by about one third.Several other names in our portfolio including General Motors (GM), Microsoft (MSFT),Delphi (DLPH) and Arkema (France: AKE) also suffered multiple compression in 2011. Thistrend reversed in the first quarter, with all of these companies enjoying rising share prices thatreflect both current earnings performance and some P/E multiple catch-up from last year. None of our long portfolio investments have recovered with as much fanfare as AAPL, whichsurged from $405 to $600 per share in the quarter, bringing its P/E back to where it was at theend of 2010. Yet not everyone agrees that AAPL’s stock price is merely playing catch-up toits fundamentals. Some see the stock surge as a bubble, while others go so far as to mock thatAAPL is its own asset class.Here are some of the common concerns we have heard:1.
 
Too many hedge funds own AAPL.2.
 
If AAPL’s share price doubles, it will have a $1 trillion market capitalization, andeveryone knows there can be no such thing as a $1 trillion company.
1
 
Source: Greenlight Capital. Please refer to information contained in the disclosures at the end of the letter.
 
Page 2
 
3.
 
Motorola, Research in Motion and Nokia were all market leaders that proved unable tohold onto their dominant positions and healthy margins; this too will be AAPL’s fate.4.
 
AAPL can’t possibly maintain its current hyper-growth trajectory.Let’s address these one at a time:1.
 
Too many funds.
It’s not clear what the objection is here. We suppose the worry isthat there is a herd mentality among hedge funds, and that when one fund sells, therecould be a cascade of hedge funds selling shares and the stock price will collapse.Moreover, if everyone already owns AAPL, who is left to buy it? Collectively, hedgefunds currently hold less than 5%
2
of AAPL’s outstanding shares, and no hedge fundranks among the top 40 holders of the stock. The average hedge fund has less than2%
2
of its equity assets in AAPL versus AAPL’s 4% weighting in the S&P 500, whichmeans hedge funds are actually underweight AAPL.2.
 
 A trillion dollars?
We’ve scoured the Nasdaq listing rules, reviewed the SecuritiesExchange Act of 1934, and engaged a leading numerologist. We can’t find any prohibition on trillion dollar market capitalizations.3.
 
 All empires must fall.
This concern, while not as arbitrary as the first two, reinforcesour belief that the skeptics have a fundamental misunderstanding of AAPL. Their view suggests that AAPL is a hardware company. We disagree.4.
 
Growing pains.
AAPL shares are not priced for growth. Its current valuation is justified without it.
 
The latter two concerns merit further discussion. Despite its size, AAPL remains one of themost misunderstood stocks in the market. AAPL is a software company. The value comesfrom iOS, the App store, iTunes and iCloud. A Motorola RAZR phone was a one-timewinner because when someone else made a phone that was just a
little
better, RAZR salesstopped. In contrast, a consumer with one AAPL product tends to want more AAPL products. Once the user has a second device, AAPL has captured the customer. At that point,a future competitor has to make a product that isn’t just a little better, but a
lot 
better to get people to switch. The high switching cost makes AAPL’s business much more defensiblethan that of its predecessors.Further, AAPL’s ability to consistently offer innovative features (as opposed to marginalimprovements on the current features) encourages users to upgrade every couple of years.This provides a recurring revenue stream. And because AAPL embeds its software into itshardware, it doesn’t face Microsoft’s piracy problem. If the Chinese want AAPL, they haveto buy AAPL. Rather than view AAPL as a hardware company, we see it as a softwarecompany that monetizes its value through the repeated sales of high margin hardware.
2
Goldman Sachs & Co. Hedge Fund Trend Monitor, February 21, 2012
 
Page 3
 
We continue to hold AAPL. Not only do we think the skeptics are misguided, we believe theshares remain cheap. AAPL trades at a lower multiple than the average company in the S&P500. A below-market multiple implies that this is a below-average company. We have a hardtime seeing how anyone ranks AAPL as below average.Seagate Technology (STX) was the other significant winner during the quarter. It is STX'snormal practice on earnings calls to provide financial commentary looking ahead only onequarter. However, in January, STX shared its financial outlook for all of calendar year 2012,forecasting revenues of $20 billion. The prior consensus was for less than $15 billion. Agood chunk of the increased forecast comes from higher pricing enabled by the industryshortage following the floods in Thailand last year.STX also announced that it would be using some of its excess cash to ramp up its stock repurchase program, with a target of decreasing outstanding shares by 25%. When businessconditions eventually normalize, the lower share count will enable STX to generate higher earnings per share.Though the shares advanced from $16.40 to $26.96 during the quarter, the share price remainsat a very low multiple of both near-term and longer term earnings. Based on our somewhatmore conservative revenue outlook in 2012, we expect earnings to reach $10-$15 per sharethis calendar year, before settling at an average of about $5 per share in future years when theindustry shortage will have ended.We did not have any significant losers during the quarter (the closest was our Moody’s short,which traded in line with the financial sector).The debate around currencies, cash, and cash equivalents continues. Over the last few years,we have come to doubt whether cash will serve as a good store of value. If you wrapped upall the $100 bills in circulation, it would form a cube about 74 feet per side. If you stackedthe money seven feet high, you could store it in a warehouse roughly the size of a footballfield. The value of all that cash would be about a trillion dollars. In a hundred years, thatmoney will have produced nothing. In a thousand years, it is likely that the cash will either  be worthless or worth very little. It will not pay you interest or dividends and it won’t growearnings, though you could burn it for heat. You’d have to pay someone to guard it. Youcould
 fondle
the money. Alternatively, you could take every U.S. note in circulation, laythem end to end, and cover the entire 116 square miles of Omaha, Nebraska. Of course, if you managed to assemble all that money into your own private stash, the Federal Reservecould simply order more to be printed for the rest of us.There were a few notable developments elsewhere in the portfolio. First, an update on thesituation in Japan:The Japanese Yen finally showed some weakness, falling more than 7% during the quarter to¥82.79 per dollar. Several times during the past couple of years, we’ve thought the Yen wason the verge of weakening, only to be proven wrong. While the long-term fundamentals of Japan’s economy have not improved, the Yen has nonetheless continued to strengthen, to the

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