BHFAO - Greenlight Capital Q1 2023 Letter
2023-05-02 02:44:00 ET
Summary
- Green Light Capital is a privately owned hedge fund sponsor. The firm invests in the public equity and fixed income markets of the United States. It primarily invests in value.
- The Greenlight Capital funds returned (1.3%) in the first quarter of 2023, net of fees and expenses, compared to a 7.5% return for the S&P 500 index.
- During the quarter, our longs gained 9.9%, while our shorts lost 10.8% and macro lost 0.4%, net of fees and expenses.
- We added three new small long positions and one medium-sized one.
Dear Partner:
The Greenlight Capital funds (the “Partnerships”) returned (1.3%) 1 in the first quarter of 2023, net of fees and expenses, compared to a 7.5% return for the S&P 500 index.
Many have commented that in the beginning of 2023, whatever worked in 2022 didn’t work and vice versa. That seems about right to us. During the quarter, our longs gained 9.9%, while our shorts lost 10.8% and macro lost 0.4%, net of fees and expenses.
Starting with the good, Green Brick Partners ( GRBK ), which was our largest loser in 2022, was, conversely, our largest winner in the first quarter. The shares advanced from $24.23 to $35.06. Analysts have raised 2023 EPS estimates from $3.16 to $3.34. While that might not seem significant, it reflects a reversal of the downtrend in those estimates. With the market gaining confidence that the earnings expectations had fallen too far, the shares have rerated to just over 10x estimated 2023 earnings (but still less than 6x trailing earnings). GRBK has the highest gross margins, and nearly the highest ROE, in the industry. It also has an enviable land position in some of the most desirable markets. The $3.34/share earnings estimate for 2023 would be about a 15% ROE. If that is what a down year looks like, it’s hard to understand why a single digit P/E would be warranted.
Our second biggest winner was Kyndryl Holdings ( KD ). KD is an IT services provider that was spun off from IBM in late 2021. Though we began acquiring our stake around that time, we haven’t previously discussed this investment as we were patiently building the position. This proved to be a prudent approach, as the stock fell from $18.10 to $11.12 per share in 2022. So far in 2023, the shares have rebounded to $14.76. Over our 12-month buying period, the Partnerships acquired their shares at an average price of $11.37.
KD is a “bad business” spin-off. Prior to the spin, IBM often positioned its services unit as a loss leader in order to sell more hardware. These service contracts last for several years and, in aggregate, KD has no pre-tax income. Yet the turnaround strategy is straightforward. By no longer being part of IBM, KD can now offer solutions from multiple vendors and, as contracts expire, it is better positioned to raise both pricing and margins. About 60% of KD’s contracts earn greater than a 20% gross margin, while the other 40% are about breakeven. We believe that many of the no margin customers will accept higher prices. Our field work has made us believers in KD’s excellent reputation, while concluding that there aren’t any competitors willing to work for free. That said, it will take several years to work through the pre-spin backlog of no margin contracts, and it is inevitable that there will be some customer churn, which will make KD an unexciting story from a revenue growth perspective in the near term.
With an enterprise value of $4.5 billion and $17 billion of revenues, KD trades for less than 0.3x sales. Meanwhile, all of its peers trade for at least twice that multiple. We expect the shares to rerate over time as KD closes the margin gap with its peers.
Macro was a small detractor for the quarter, with positive contribution from our gold and inflation positions, which were slightly more than offset by negative-performing interest rate and credit default swaps positions. Gold advanced 8% in the quarter and was our third largest winner. The gain occurred after the Silicon Valley Bank ( SIVBQ ) failure, as the market expectations for further rate hikes reversed into expectations of rate cuts, starting as soon as this summer. One concern is that the problems with the banks may force the Federal Reserve to prioritize preserving financial stability over defeating inflation, causing the next leg up for inflation. The higher gold price appears to be taking some of that risk into account.
In response to the SIVB problem, we decided that the likely change in Federal Reserve policy might be incrementally bullish for both inflation and stocks. While we think the market is wrong about rate cuts this year, we doubt that there will be many further hikes from here. As a result, we shifted our equity positioning from bearish to neutral, by covering our index shorts, the remainder of our 2021 and 2022 bubble baskets and several other shorts. We also covered our housing hedge basket, added to several existing longs and bought a few new things detailed below.
The economic outlook is unusually difficult to project. On the one hand, employment, wages and household balance sheets look quite strong. We also believe that both monetary and fiscal policies remain stimulative. On the other hand, there is a genuine concern that tightening lending standards will constrain the economy and create a substantial slowdown. Our net long exposure is now back in line with its long-term average. We are equally open minded to becoming even more net long, or pivoting back to bearish, as economic events unfold.
It is our view that rate cuts are not going to happen this year, while the market is expecting them in the back half of the year. As such, we added to our interest rate positions via Fed Funds futures. Expressing this thesis directly means that we are only subject to the central bank’s decisions for the balance of the year, rather than being subject to the market’s expectations.
As mentioned above, the short portfolio had a difficult quarter. While we will continue our policy of not discussing individual open short positions, we can make a couple of observations. First, covering the bubble basket shorts prevented them from being material losers during the quarter.
Second, we will discuss Oak Street Health ( OSH ), which we closed out after costing us 0.8% (net) during the quarter. CVS Health Corporation ( CVS ) is buying OSH for $39 per share, or about $10 billion. When shorting, there is always the risk that someone with deep pockets will buy out the company at a silly price, or maybe even at twice a silly price. CVS is worth $115 billion (or it was the day they announced the deal; subsequently, CVS’s shares have fallen and it’s now worth $93 billion), so it can afford to piss away $10 billion.
OSH is in value-based care, which has become a trendy segment of the market. Most of the “value” comes from doing a more thorough and aggressive job of documenting how sick a patient is, so as to maximize Medicare payments. OSH operates 169 clinics (costing between $1.5-$2 million to build) in mostly lower income neighborhoods and employs 600 doctors. CVS projects that in 2026 the pro forma entity will have 300 clinics and “embedded EBITDA” of $2 billion, plus over $500 million of synergies.
In 2022, OSH generated less than $1 million of adjusted revenue per doctor [2] and lost $500 million (almost $3 million per clinic). Even if it triples the number of doctors by 2026, it will need over $1 million of “embedded EBITDA” per doctor, implying margins shifting from a loss to nearly 100%. Obviously, this can’t happen, as the doctors need to be paid and there are other substantial costs. The amazing thing is that when rumors of this deal circulated, we reached out to CVS management and had a call where we walked them through the math… and they went ahead with the deal anyway. When the proxy came out, it revealed that OSH conducted an auction and, like a late-night eBay shopper who had one too many glasses of wine, CVS raised its uncontested bid several times... Rant over.
Brighthouse Financial ( BHF ) was the other material loser during the quarter, with shares declining by 14%. In response to the bank failures, partially caused by a few banks buying long duration bonds that fell in value when interest rates rose, the market sold other industries that own long duration bonds as well. Life insurers went to the top of the pile and, well, BHF is a life insurer and owns a lot of bonds. Though BHF is a beneficiary of higher rates by virtue of having very long duration liabilities, which are quite different from short-term deposits that can leave abruptly, the market decided to simply ignore this difference and focus on its exposure to bonds. We don’t believe any of the concern is BHF specific, as other life insurers suffered similar stock performance.
We added three new small long positions and one medium-sized one. We will defer on disclosing the medium-sized long as David intends to discuss it at the Sohn Investment Conference on May 9.
The new small long positions are Black Knight ( BKI ), New York Community Bancorp ( NYCB ), and First Citizens BancShares ( FCNCA ).
BKI is a software provider to the mortgage servicing and origination industries. Shareholders agreed to sell the company to Intercontinental Exchange ( ICE ) for a package of cash and shares worth just about $75 per BKI share. In order to cure the only meaningful overlap between the two businesses, ICE has also offered to divest BKI’s mortgage origination unit. Despite the pending sale of this business to Constellation Software, the FTC sued to block the deal. It is now up to a federal judge to determine the merits of the case. We estimate a conservative value for BKI in a deal break scenario to be $51 per share. We acquired our stake for an average price of $60.59 per share. BKI shares ended the quarter at $57.56, implying just greater than a 25% chance of the deal succeeding. We handicap the odds at closer to 75%.
NYCB and FCNCA are similar investments, as they were the FDIC auction buyers of Signature Bank and Silicon Valley Bank, respectively. Both acquisitions occurred at deep discounts and should lead to impressive improvements in earnings. Though we invested after the purchases, both stocks had been depressed by the banking crisis. We see them emerging as stronger than they were entering the crisis, and believe both merit higher values going forward. We take further confidence by virtue of the FDIC deeming them capable of these acquisitions.
In addition to closing out the bubble basket shorts with large gains, and OSH with a moderate loss, we also exited Victoria’s Secret ( VSCO ) with a small loss over an 18-month holding period.
Gav Balasingam joined us as an investment analyst after 11 years in a similar role focused on both long and short investments at Southpoint Capital. Prior to that, Gav spent 6 years at Davidson Kempner in the Distressed Group, where he was primarily focused on financials and structured products. He began his career in 2004 in investment banking in the Financial Institutions Group at Goldman Sachs, after graduating from the University of Pennsylvania. Welcome, Gav!
Amelia Wierzbicki has been our receptionist since 2010 and she has become both a face and a voice known to most of our investors. She will be transitioning to become our Partner Relations Coordinator to help Jason with all of our Partner Relations efforts. We are on the hunt for her replacement at the front desk… and don’t be fooled by her petite feet, these are quite big shoes to fill.
At quarter-end, the largest disclosed long positions in the Partnerships were Brighthouse Financial, CONSOL Energy (CEIX), Green Brick Partners, Kyndryl Holdings and Teck Resources. The Partnerships had an average exposure of 106% long and 50% short.
Best Regards,
Greenlight Capital, Inc.
| Foot Notes 1 Source: Greenlight Capital. Please refer to information contained in the disclosures at the end of the letter. 2 We think the economically relevant revenue is net of flow through claims expenses that OSH pays out to third party providers, like hospitals and specialists. Unadjusted for this, total revenue reported by OSH in 2022 was $3.9 million per doctor. ______________________________________________________________________ The information contained herein reflects the opinions, estimates and projections of Greenlight Capital, Inc. and its affiliates (collectively “Greenlight”) as of the date of publication, which are subject to change without notice at any time subsequent to the date of issue. Greenlight does not represent that any opinion, estimate or projection will be realized. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. Greenlight has an economic interest in the price movement of the securities discussed in this letter, but Greenlight’s economic interest is subject to change without notice. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. GREENLIGHT® and GREENLIGHT CAPITAL, INC. with the star logo are registered trademarks of Greenlight Capital, Inc. or affiliated companies in the United States, European Union and other countries worldwide. All other trade names, trademarks and service marks herein are the property of their respective owners who retain all proprietary rights over their use. These materials are (a) confidential and may not be disclosed, distributed or reproduced without the prior written permission from of Greenlight, and (b) intended solely for the use of the person to whom the materials have been delivered by Greenlight. Unless otherwise noted, performance returns reflect the weighted average total returns, net of fees and expenses, for “New Issue Eligible” investors invested since inception in Greenlight Capital, L.P., Greenlight Capital Offshore Qualified, Ltd., and the dollar interests of Greenlight Capital Investors, LP and Greenlight Capital Offshore Investors, Ltd. (collectively, the “Partnerships”). Performance returns exclude the gold interests of Greenlight Capital Investors, LP and Greenlight Capital Offshore Investors, Ltd. The performance of the dollar interests and the gold interests have been different. Upon request, Greenlight will provide the specific performance of each type of interest to help investors understand these divergences over time. Combined performance of components of the Partnerships is model performance presented for illustrative purposes only and does not reflect the performance or risk profile of any individual fund. Model performance should not be considered an indicator of the future performance or risk of any investment. Actual performance of the funds, which is available upon request, may differ substantially from the model performance presented. Each Partnership’s returns are net of the modified high water mark incentive allocation of 10%. This is the allocation experienced by an investor whose capital account is below its modified high water mark. Investors whose capital accounts are not below their modified high water marks would experience different performance. An investor's actual returns may differ from the returns presented due to several factors, including the timing of each investor's capital activity and the applicable incentive allocation rate, which may be 10% or 20% depending on whether such investor is below such investor's modified high water mark. All figures are unaudited. Greenlight does not undertake to update any information contained herein as a result of audit adjustments or other corrections. Past performance is not indicative of future results. Each investor will receive individual statements from the funds’ administrator showing actual returns. Reference to an index does not imply that the Partnerships will achieve returns, volatility or other results similar to the index. The total returns for the index do not reflect the deduction of any fees or expenses which would reduce returns. All exposure information is calculated on a delta-adjusted basis and excludes “macro” positions, which may include, but are not limited to, government debt, currencies, commodities, credit default swaps, interest rate swaps, volatility indexes, credit indexes and derivatives on any of these instruments. However, equity indexes and derivatives on such instruments are included in long/short exposure. The largest disclosed long positions represent individual issuers to which the Partnerships have the highest exposure. Greenlight, in its discretion and in the interest of investor protection, may exclude from this list any position that has not been disclosed but would otherwise be included, and instead include the Partnerships’ next largest position. All weighting, exposure, attribution and performance contribution information is inclusive of positions held both directly and indirectly through the master funds, reflects the weighted average of such figures for investments by Greenlight Capital, L.P., Greenlight Capital Offshore Qualified, Ltd., Greenlight Capital Investors, LP, and Greenlight Capital Offshore Investors, Ltd. (excluding gold interests), and is the result of classifications and assumptions made in the sole judgment of Greenlight. All exposure calculations include the impact of month-end redemptions and subscriptions as of the first day of the following month. Net performance contributions by attribution category apply an allocation of operating expenses, management fee and incentive allocation to the applicable gross contribution. These pro forma net contributions are shown for illustrative purposes only to meet regulatory requirements. Different assumptions than those made by Greenlight can result in different net performance contributions at the category level. A description of the calculation methodology is available upon request. The fund terms, performance returns, and portfolio characteristics reflected in this document are not indicative of future returns or portfolio characteristics and do not modify the terms of the funds as detailed in each fund’s confidential offering memorandum. The specific investments identified and described are not representative of all the positions held, purchased or sold, and in the aggregate, the information may represent a small percentage of activity. It should not be assumed that any position identified has or will be profitable. There can be no guarantee that similar investment opportunities will be available in the future or that Greenlight will be able to exploit similar investment opportunities should they arise. The information presented is intended to provide insight into the noteworthy events, in the sole opinion of Greenlight, affecting the Partnerships. The opinions expressed represent the current, good faith views of Greenlight at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. THESE MATERIALS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THESOLICITATION OF AN OFFER TO BUY ANY INTERESTS IN ANY FUND MANAGED BYGREENLIGHT OR ANY OF ITS AFFILIATES. SUCH AN OFFER TO SELL ORSOLICITATION OF AN OFFER TO BUY INTERESTS MAY ONLY BE MADE PURSUANTTO DEFINITIVE SUBSCRIPTION DOCUMENTS BETWEEN A FUND AND AN INVESTOR. |
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Greenlight Capital Q1 2023 Letter