This article is the final piece of a 3-part series. (Click here for Part 1 and here for Part 2).
Some very public short-selling made David Einhorn a familiar name starting in the early 2000s. But Greenlight Capital’s shorting acumen was evident from the late 1990s. Einhorn's successful shorts from that time frame included:
Boston Chicken
Greenlight’s research recognized that by financing (up-front fees and loans) franchise operations that were not making money, Boston Chicken was heading for PE contraction and would stop growing. The call was spot-on; Boston Chicken went bankrupt as franchisees defaulted on their loans.
Samsonite
Samsonite was shorted at $28, and Einhorn stayed put as the stock soared to $45. Greenlight’s investigation identified Samsonite had simultaneously raised prices and broadened the distribution network by opening more of its own stores. Those stores, upon competing with other retail stores, resulted in an excess inventory problem, and the shares collapsed to $6.
The perils of shorting are best exemplified by Greenlight’s experience with Computer Learning Centers (CLCX). CLCX is a precursor to fraudulent CEOs attacking the shorts. The Department of Education (DoE) launched a program review to examine compliance and a civil fraud complaint was filed against CLCX. Two months later, the attorney general of Illinois settled with a puny $500,000 fine, and the stock doubled. Einhorn covered, losing 2.5% of capital. Two years later, CLCX went bankrupt as the government identified the fraud and demanded the return of all student loans it had ever advanced. Long story short, although Einhorn’s research was right on the money, he lost significantly on that call.
Short positions that paid off for Greenlight from the early 2000s include:
Seitel
Seitel's business plan involved building a library of seismic data used to find hydrocarbons. The data is arrived at by shaking the ground and measuring the reaction, a costly investment. Energy companies partner with Seitel and obtain a license to exclusively use the data for a limited period, after which Seitel can choose to re-license the data. Einhorn astutely realized that the bulk of the licensing revenue came from licensing rather than re-licensing, and that the data did not have an indefinite shelf life -- if the data on a particular location is good, the energy company will drill; otherwise, why bother?
Furthermore, Seitel assumed a dollar invested in obtaining the data would generate $2.50 in revenue, assuring a 60% margin. This assumption inflated earnings as the initial licenses only covered a fraction of the cost involved in getting the data – the company was reporting earnings while burning at both ends! The short provided excellent returns in 1999 as the shares fell sharply at the end of an energy cycle. Einhorn waited another three years for the accounting problem to play out. In the spring of 2002, the company went bankrupt, and the CEO was sentenced to five years in prison.
Conseco
Einhorn shorted Conseco in 2001 after he perceived the bonds were trading at 65c on the dollar while the company was valued at $10 billion. The company had lost its A-rating thereby affecting profitability. Einhorn purchased the bonds and sold short the common stock. A new, high-profile CEO was brought in, which pumped up the stock initially, but eventually the shares imploded and the CEO resigned.
Orthodontic Centers of America
Greenlight’s analysis on this rollup of orthodontist practices yielded that the business was front-loading revenues and back-loading expenses – orthodontists’ compensation was expensed on a “cash” basis (rather than accrual basis) and almost all of the profits from patients in a multiyear treatment cycle were recognized in the initial months. Einhorn protested to the SEC, which took the company to task and demanded they change revenue recognition to a straight-line basis. The stock initially recovered most of the losses, but went bankrupt anyway the following year.
Elan Corporation (ELN)
Einhorn’s investigation exposed the revenue gaps in reporting and licensing deals that were shams – Elan would invest in a small biotech, license their drug delivery technology for the same amount, and recognize it as revenue at 100% margin. In reality, the company was selling off its drug portfolio and booking the sales as product revenue. Following an SEC review, the company restated its earnings and adjusted earnings by a penny. The stock peaked at $65 at the completion of review in June 2001, and then went into a downward spiral, reaching $1 by 2002 October.
The timing risk with shorting stocks has hurt Einhorn badly on a couple of positions during the period:
Chemdex
The rationale for shorting Chemdex, an internet B2B (business-to-business) start-up, was that Chemdex was booking the entire value of the goods exchanged on their network as revenue. The actual revenue is only the small commission incurred on each transaction via their network. The stock was shorted at $26, but there was no holding it back – Einhorn covered at $164, making that the biggest short loser of all time – 4% of capital. Later that year, the stock touched $2 on its downward march after peaking at $243.
1-800 contacts
This was shorted on the conviction they sold lenses without properly verifying the prescriptions. FDA investigated but did not initiate action. Einhorn covered the short at a large loss, but later that year the stock dropped precipitously when JNJ discontinued its lens supplies, fearing litigation.
Executives attacking short-sellers and the headline-grabbing battle between company executives and short-sellers are best represented by Einhorn’s shorting of Allied Capital starting in 2002. Warren Buffett indicated in 2003 that it was an uphill task for short-sellers to win, even if their arguments were right:
Basically, for a hedge fund, the stock concerned is just one position, but for the company and the management, it is the whole ballgame. So, they will say and do things hedge funds wouldn’t consider doing in order to win.
Einhorn fought Allied Capital and its corrupt executives for six long years, and achieved what he termed a “Pyrrhic victory.” His book Fooling Some of the People All of the Time describes the story of a corrupt company with political connections playing a dirty game and almost winning. Einhorn’s initial theory involved recognizing Allied was slow in marking down troubled loans, not using “fair-value” accounting in situations where there was a liquid market, and fraudulently claiming a loss rate of just 1% of principal per year for their mezzanine loans. On digging deeper, he found fraud being committed through the SBA and USDA government lending programs, and other shams by the management, such as a scheme for insiders to cash out. The following quote from Einhorn’s book is representative of the kind of activity that went on during those years:
Six years ago, I told the SEC about Allied’s aggressive, inappropriate, and illegal accounting. Five years ago, I told multiple government agencies about the fraud at BLX. Four years ago, I told the FBI that other Allied critics and I had our phone records stolen. Three years ago, I notified Allied’s Board in detail about its management’s misconduct and made a detailed presentation to the U.S. attorney in Washington outlining a variety of illegal activities. Two years ago, the USDA was notified about BLX’s pervasive fraud at that agency. One year ago, Allied admitted it had Greenlight’s and my phone records. Neither Allied nor any regulator has commented on the matter since. It is hard to imagine that an investigation should take so long, if Allied is, in fact, co-operating.
The list below is a look at Einhorn’s recent shorts that paid off handsomely:
Garmin Limited (GRMN)
The stock was shorted at $98.33 and covered in the 1st quarter of 2008 at $64.27 for a return of 84% IRR. Recognizing that the 2007 holiday sales as the company’s peak and that growth prospects going forward for this one-product (GPS) company was limited were key to arriving at this decision. Other small-caps Einhorn successfully shorted in this period include Jackson Hewitt Tax Service and Heidrick & Struggles International.
DryShips Inc (DRYS)
The stock was shorted at $83.69 and covered at $63.94 in the 3rd quarter of 2008 on the grounds that the very high operating and financial leverage would cause problems when the cycle turned. The thesis played out, with the company trading in the vicinity of $2 recently.
McGraw Hill Companies (MHP)
The stock was shorted at $54.65 and covered at $24.88 in the 4th quarter of 2008 for a gain of 50% IRR. Einhorn is a non-believer in rating agencies, and McGraw-Hill has a rating agency wing in Standard & Poor’s. Currently Einhorn has also shorted Moody’s, and that investment shows a large loss at this point.
\Southwest Airlines (LUV)
The stock was shorted at $13.49 and covered at $6.94 in the first quarter of 2009 for a gain of 75% IRR. The short idea involved recognizing Southwest’s energy hedges made it an energy speculator instead of a pure airline. When oil prices collapsed, its fortunes reversed.
Alcoa Inc (AA)
The stock was shorted at $8.63 and covered at $6.96 in the 3rd quarter of 2009 for a gain of 38% IRR. The investment decision was buoyed by recognizing that the company was levered and had a poor relative cost position and weak balance sheet.
Palm Inc.
The stock was shorted at $11.16 and covered at $5.72 for a large gain of 92% IRR in the 2nd quarter of 2010. The takeover speculation that had propped up the stock price fueled the short decision. The takeover did happen, but at a very low price.
Corinthian Colleges (COCO)
The stock was shorted at $16.94 and covered at $11.61 for a large gain of 91% IRR in the 3rd quarter of 2010. Recognizing the exposure to new government regulations was the guiding light to this shorting. Einhorn also successfully shorted a few other players in the same area.
The following is a list of Einhorn’s recent shorts that were exited with losses:
Federated Investors (FII)
A case of timing risk hurting Einhorn – the stock was shorted at $39.56 and covered at $41.71 in the 1st quarter of 2008 for a loss of -37% IRR. The short thesis played out after Einhorn exited the position.
Williams-Sonoma (WSM)
This is another stock which Einhorn failed to time right. He recognized correctly that Williams Sonoma, a mature retailer with limited growth prospects, was trading at a high multiple. The stock price saw a short-term increase following some aggressive cost-cutting measures. The stock was shorted at $22.21 and covered at $28.93 for a large loss of -111% IRR.
UST Inc
The stock was shorted at $55.10 based on valuation, but Einhorn covered at $66.20 resulting in a loss of -76% IRR. The company was acquired by Philip Morris (PM) at a premium as a way to enter the smokeless tobacco market.
AutoZone (AZO)
The stock was shorted at $141.21 and covered at $158.49 in the 2nd quarter of 2009 for a large loss of -85% IRR. The investment theory underestimated the strength of the business in the face of a weakened consumer base.
Federal Realty Investment Trust (FRT)
The stock was shorted at $47.22 and covered at $71.17 for a large loss of -65% IRR in the 1st quarter of 2010. Recognizing the deteriorating fundamentals led to this short, but it did not play out as expected. Einhorn had several other unsuccessful shorts in the REIT area in that timeframe.
Royal Caribbean Cruises (RCL)
The stock was shorted at $15.15 and covered at $29.25 in the 3rd quarter of 2010 for a huge loss of -123% IRR. The argument was that the combination of high leverage and exposure to a weakened customer base would drive the company to bankruptcy. But consumer spending stabilized unexpectedly, negating that logic.
