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November 7, 2011 Dear Partner: Greenlight Capital, L.P., Greenlight Capital Qualified, L.P. and Greenlight Capital Offshore (collectively, the “Partnerships”) returned (1.2)%, (0.6)% and (0.8)%1 net of fees and expenses, respectively, in the third quarter of 2011, bringing the respective year to date net returns to (6.2)%, (5.6)% and (6.1)%.1 The quarterly letter is a little bit later than usual as we spent the window in which we usually write the letter (the couple of weeks between the end of the quarter and the beginning of earnings season) preparing a presentation for the Value Investing Congress. This year, David presented the thesis behind our Green Mountain Coffee Roasters (GMCR) short position. After our presentation, one of the largest GMCR shareholders sent us a Keurig coffee brewer and ten K-cup boxes of coffee straight from the warehouse. Not only did we appreciate the gesture, it was nice of them to assist in our field research, as the majority of the K-cups were too close to expiration to be sold through normal retail channels. The PowerPoint slide-show that supported David’s speech has been widely disseminated, and we believe that it is contributing to the conversation about GMCR. The reaction from the press has been better than our previous experiences, as the attention has focused on the merits of the argument (without the personal attacks that often follow these sorts of presentations). We can’t say the same for the sell-side analysts. KeyBanc Capital Markets’ analyst offered a more nuanced response than the title of their report would suggest (“A New Credible Source, but the Same Old Short Thesis”), but Mitchell Pinheiro of Janney Capital Markets wrote, “There is not a single argument that Einhorn presented today that couldn’t have been made or wasn’t made a year ago when the stock was at $30 per share.” We disagree. Much of our analysis is dedicated to things that have happened in the last year. For example, we haven’t seen others question whether GMCR has inflated its March 2011 quarterly results by burying operating expenses from the Van Houtte acquisition into goodwill. Though aspects of the recent Starbucks deal with GMCR have been questioned previously, we have not seen anyone dissect the economics of the deal. And while consumers across the web have repeatedly pointed out the high cost of K-cups compared to traditional alternatives, analysts seem to have ignored this. But we think two of the bigger 1 Source: Greenlight. Please refer to information contained in the disclosures at the end of the letter. 2 Gr and Cen tr a l Tower 140 East 45 t h S tr e e t, 2 4 t h F lo o r N ew York , NY 10017 Phon e: 212-973-1900 Fax 212-973-9219 www.gr een ligh tcap ital. com Page 2 issues we raised are the accounting issues stemming from GMCR’s capital spending and the relationship with the company’s key fulfillment partner, M. Block & Sons. GMCR spent $350 million to expand its operations in 2011 and plans to spend twice that in 2012. It costs about $20 million to create enough manufacturing capacity to roast and package 1 billion K-cups a year. GMCR needs to expand capacity by a few billion K-cups a year, which may explain perhaps $100 million of annual spending. So where did GMCR spend the balance of the $350 million in 2011 and where does it plan to spend the balance of $700 million in 2012? If it can’t be explained, it raises the question: where is the money going? The part of the presentation that has garnered substantial attention is the field research section. Here, we reported on the results of recent interviews we conducted with former workers of GMCR and M. Block & Sons, who offered consistent reports of recent apparent misconduct. While most of the sell-side has largely ignored this topic, SunTrust Robinson Humphrey (whose banking arm, along with Janney Capital Markets, has received significant fees from underwriting GMCR offerings) came out with the following: “This is not new ‘field research.’ Instead, it was lifted from a deposition in a year old shareholder lawsuit.” The analyst, Bill Chappell told Forbes, “If you look, there’s no quote, there’s no M. Block employee talking about 2010 or 2011. It all has to do with 2009, of which they’ve since restated their numbers and scrubbed their numbers… It’s not new field research. It’s all taken from a class action lawsuit that has publicly been out there for six months. You’d have to ask him why he didn’t find anything new this year.” Mr. Chappell didn’t ask us himself and apparently he didn’t look very hard because the presentation is replete with quotes about 2011 and explains that our field research only began with what we learned in the class action lawsuit. It is perhaps GMCR’s non-response that has been most surprising. It has remained silent since our presentation, citing a self-imposed, artificial ‘quiet period’ before it announces earnings, which are scheduled to be released shortly. It will be interesting to see whether and how management plans to address the serious questions we have raised. It has been an eventful third quarter. While the market had a broad decline with a lot of volatility, our conservatively positioned portfolio essentially went sideways with much lower volatility. Generally, our longs fell a bit more than the market, but our shorts fell even more and our macro investments helped mitigate the loss from being net long in a declining market. The biggest winner was the energy-technology short that spiked in the first quarter, gave back the gain in the second quarter and fell precipitously in the third quarter. Our gold investment was the second largest winner as the price advanced from $1,499 to $1,624 an ounce. During the quarter we exchanged a portion of our gold position for additional investment in the Market Vectors Gold Miners ETF (GDX). While the price of gold has advanced significantly, the shares of gold miners have not. It has reached the point where gold mining stocks should do well even in a stable gold market; we expect the price of Page 3 gold to appreciate further, so gold miners should do even better. Even with the reduction, physical gold continues to be our largest portfolio holding. The biggest loser in the quarter was Arkema (France: AKE), whose shares fell from €70.99 to €44.00, as the market discounted the earnings of cyclical companies. Generally, we had minimal long cyclical exposure heading into the quarter, as we had sold Vicat, Lanxess and nearly half of our AKE stake. Nonetheless, we kept some AKE as the valuation appeared reasonable even at the top. We believe that the recent decline is more than overdone and have repurchased a portion of the shares we had sold. Sprint (S) shares fell from $5.39 to $3.04 in the quarter. First the company announced a disappointing quarterly result, driven by increased phone subsidies in an effort to achieve its targeted level of customers. From there, management went into an investor relations meltdown, hosting an investor day where S presented a capex-driven funding requirement over the next two years that was greater than it had previously communicated, and at the same time failed to explain how S would fund the additional investment. The company even managed to bungle the October announcement that it would finally offer the iPhone. Management is on the verge of losing the confidence of the financial markets. We believe the business opportunity and asset values remain sufficient to justify holding the shares, and we wouldn’t be surprised if shareholders begin to agitate for significant strategic change. Given the heavy need to invest, the S opportunity may be better pursued by a new owner with a lower cost of capital. Delta Lloyd (Netherlands: DL) was the other significant loser during the quarter. The shares fell from €16.39 to €11.95 as the market sold all European financials, regardless of the actual exposure to the sovereign debt and banking crisis, to which DL does not have very much. We believe the business performed very well and that management is alert to the crisis and has planned well for it. During the quarter, we established positions in CBS Corporation (CBS), General Motors Company (GM) and Marvell Technology Group Ltd. (MRVL). CBS is a diversified multimedia company with businesses that include a top-rated TV network, digital content production, publishing and outdoor advertising. CBS stands to benefit from growing retransmission fees (payments) by cable operators for the right to carry CBS stations. We believe this income stream could amount to several hundred million dollars of new earnings to CBS annually. The company has also been early and aggressive in pursuing high margin incremental deals with online video streaming services like Netflix to monetize its content library. CBS will also benefit from a broader recovery in advertising markets and what looks to be a big upcoming political cycle. CBS is repurchasing stock and has reduced debt. We established a position in CBS at an average price of $20.79 per share, less than 10x our estimate of 2012 earnings. The shares ended the quarter at $20.38 each. GM is the largest auto manufacturer in the United States. After the business failed under its legacy high-cost structure during the recession, the U.S. government bailed out the Page 4 company and took over most of the ownership. Last November, GM completed an IPO of about 30% of its stock at $33 per share. The government continues to own about one-third of the company. After the IPO, the shares initially advanced to almost $40 before retreating. When the shares broke the IPO price, we determined that the shares were attractive, but only purchased a small position, believing that there might be a better opportunity later when the government exited the rest of its stock. Instead, during a weak third quarter where the market punished all cyclical stocks, the shares fell well below the price where we planned to add to our position. We decided that the shares were cheap enough that we were more than fully compensated for the possible overhang of the government’s stake, and we established a position at an average price of $25.78 per share. GM is being priced by the market as a cyclical company trading at less than 6x this year’s earnings. While some may see it as normal to value cyclicals at low multiples of peak earnings, we believe that 2011 is not a peak and, in fact, is below mid-cycle. Prior to the crisis, U.S. auto sales ran between 15 and 19 million units for many years. While sales have bounced from the recession low to about 13 million units, GM is poised to grow earnings from both a return to mid-cycle volumes, which we estimate to be 15 million units, and from a coming major refresh of its North American product portfolio. The market appears focused on GM’s “legacy liabilities.” However, the new GM does not have pension and healthcare liabilities that are likely to over-run the company. Instead, GM sits with $33 billion of gross cash which represents nearly its entire current market capitalization. We see potential for GM to begin to return capital to shareholders over the next year. While we are cognizant of the various investment risks that include near-term global economic weakness and the government ownership overhang, we think these concerns are more than priced in at current levels and see significant upside even if the U.S. experiences a very slow "new normal" type of economic recovery. The shares ended the quarter at $20.18 each. MRVL designs semiconductors that serve as the brains of cell phones and hard disk drives. The Street is bearish because hard disk drives may eventually be replaced by flash memory (SSD, or “solid state drive”), and because MRVL’s largest cell phone customer has been Research In Motion (RIMM), a structural loser. In our view, hard disk drives show no sign of disappearing any time soon, and MRVL’s position in the SSD storage market is at least as strong as its position in the hard disk drive market. In cell phones, RIMM has already declined sharply as a proportion of MRVL's sales, and MRVL has offset it with growth from new customers. Meanwhile, the shares are cheap at 6x our 2012 earnings estimate net of almost $4 per share in cash. We established our position in MRVL at an average price of $13.35 per share. We expect MRVL to buy back 12% of its stock this year, and still have about 30% of its market cap in cash. In short, this is a well-run company in structurally-defensible markets that is being valued as if it is neither. The shares ended the quarter at $14.53 each. We exited several significant positions worth noting during the quarter. We exited Pfizer because much of our thesis played out and we became increasingly concerned about future reimbursement cuts for branded pharmaceuticals and the recent Page 5 disclosure of additional government investigations into its marketing practices. Over our two and a half year holding period, the investment generated a double-digit annualized return that modestly outperformed the market. We sold BP at a roughly break-even result in fear of falling energy prices and to make room for new opportunities, including those described above. We exited our profitable multi-year short in Amedisys. Reimbursement reductions, aggressive accounting and questionable business practices finally caught up with the company. Gaurav Sharma joined us at the end of August as an analyst. Prior to Greenlight, Gaurav worked at Highbridge Capital Management in London. Of Indian descent, born and raised in Australia, formerly living in the U.K. and now residing in New York, Gaurav notes that he has no exposure to the sovereign debt of any of those nations. Welcome Gaurav! In addition, Dennis Loffredo, an Operations Analyst, left to pursue other endeavors. We thank him for his contributions and wish him well. Also, during the quarter we added Credit Suisse to our roster of prime brokers. The Greenlight children continued to outpace the Greenlight staff with three new additions. Madelyn Offner was born in August, giving Mike another reason to stay up late at night in addition to researching value long-short hedge funds. Hey Mike, are Maddy’s initials a sign of the Red Sox envy of Mariano (“Mo”) Rivera? In October, Luke Christopher Lepone was born. Luke is already quite the talker and enjoys napping after power lunches. Sound like anyone that you know? Evelyn Mary Charecky came into the world in early November, arriving on her exact due date just like her brother Alex. Her punctual papa John is proud. Please mark your calendar for our Sixteenth Annual Partners’ Dinner, scheduled for Tuesday, January 17, 2012. The meeting will be held at the American Museum of Natural History. We will be sending out formal invitations shortly. At quarter end, the largest disclosed long positions in the Partnerships were Apple, gold, Market Vectors Gold Miners, Microsoft and Vodafone Group. The Partnerships had an average exposure of 94% long and 55% short. “There’s no such thing as an easy two.” -- Bernard King (NY Knicks legend) Best Regards, Greenlight Capital, Inc. Page 6 The information contained herein reflects the opinions 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 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. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. All trade names, trademarks, and service marks herein are the property of their respective owners who retain all proprietary rights over their use. This communication is confidential and may not be reproduced without prior written permission from Greenlight. Each Partnership’s performance returns reflect the total returns, net of fees and expenses, for an IPO eligible partner. The returns for Greenlight Capital, L.P. and Greenlight Capital Qualified, L.P are net of the modified high-water mark incentive allocation of 10% and reflect the returns for partners who were invested on or prior to January 1, 2008. The returns for Greenlight Capital Offshore reflect our standard 20% incentive allocation. Performance returns for 2011 are estimated pending the year-end audit. Past performance is not indicative of future results. A partner’s actual returns may differ from the returns presented. All exposure information excludes credit default swaps, gold, currency positions/ hedges and other macro positions. Positions reflected in this letter do not represent all the positions held, purchased, or sold by the Partnerships, and in the aggregate, the information may represent a small percentage of activity in the Partnerships. The information presented is intended to provide insight into the noteworthy events, in the sole opinion of Greenlight, affecting the Partnerships. THIS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY INTERESTS IN GREENLIGHT CAPITAL OR ANY OF ITS AFFILIATES. SUCH AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY INTERESTS MAY ONLY BE MADE PURSUANT TO DEFINITIVE SUBSCRIPTION DOCUMENTS BETWEEN A FUND AND AN INVESTOR.
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