Mon May 05 2014
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Tech Stocks with David Einhorn’s New Short Criterion of 90% Downside

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!


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