Jim Chanos Talks Tesla and Kidney Dialysis

I’m a great admirer of Chanos and I always try to learn something when I hear him speak. Here, an inter interview produced by Bloomberg. Two of the topics discussed, among others, were Tesla and the kidney dialysis industry.

To watch the interview, click here.

Below, two parts of the interview, the first one with a few words from Jim Chanos on the kidney dialysis industry (emphasis added).

*THE KIDNEY DIALYSIS INDUSTRY*

[12:45] Joe Weisenthal: Alright, to move it back from politics and theory for a second, I noticed you said there in your answer that you’re focused on some companies that may be in trouble with the potential rollback of the essential health care benefits. So, can you give us some insight into some specifics? Who’s vulnerable to a theoretical rollback there?

Jim Chanos: One area we would really focus in on, there’s only a handful public place, is the kidney dialysis business. I think that business is really heading for difficulties.

JW: Oh, we have a chart here of some different public companies…

JC: Oh, what a coincident.

JW: …in kidney dialysis. Amazing how that happened.

JC: There’s three of them, and I should say here that any companies that you either see a chart of or I mention, either intentionally or inadvertedly, you should assume that we are short that stock. Disclosure now done. And so, the kidney dialysis business is interesting because we have Obama care exchange insurance officials on record saying that kidney dialysis is almost single-handedly breaking the exchanges. Blue Cross of California has said that for every single kidney dialysis patient they have, they need 3,800 healthy lives to cover it. It is amazingly expensive, but not in the way you would think. In the way these companies have prospered, in a weird way, is they’re actually trying to push Medicare and Medicaid patients – where the reimbursement is much lower – into Obama care, and where they get two to three times the reimbursement rate, and under the essential health benefits factor, they gotta provide it. And so, taking an elderly person who’s on Medicare, why would they go into Obama care, right? It would costs them, an elderly person, a fair amount of money. Well, they get third parties to pay a big chunk of the premium, the former charities. And guess who donates to some of those charities? And so this is one of these sort of rent-seeking behaviours that I think is gonna go by the wayside. And I think these excess returns… one of those companies that you had up there actually has a slide in their investor dec that said 90% of their business is Medicare/Medicaid and that loses money. Ten percent of their business is commercial and that makes a 110% of their operating profit.

JW. So everybody can go search for that…

JC: Yeah, they can go search for one of those three companies. I think they quite figure it out.

Scarlet Fu: So has that gained momentum? Do you hear other people pressing the company on that? How that doesn’t seem to make sense?

JC: Well, there was a wonderful… I can’t mention networks, I know it’s no good on Bloomberg. But there was a wonderful Sunday night weekly news show on a cable network, chaired by a British guy, that actually did a 15 minutes segment about one of these companies about a month ago, and we were stunned when we saw it. We had no idea that anybody else cared. But they did a pretty good job at walking you through exactly what an issue this is.

So for all investors out there interested in the kidney dialysis industry, and for example DaVita Healthcare Partners (Ticker: DVA), a Berkshire stock investment, this might be something to dig deeper into to see whether Jim Chanos and his Kynikos is on to something here or not.

Following the chat about the kidney dialysis business is a discussion about Tesla, a company Jim Chanos has been talking about publicly before.

*THE TESLA AUTOMOBILE*

[15:49] SF: Let’s move on to another company that you have spoken publicly about which is Tesla. And as I imagined…

JC: Who?

SF: Tesla. T-S-L-A.

JC: Okay.

SF: The company is holding its annual shareholders meeting right now, so they’re probably applauding themselves for their five-year return. If you look at a chart…

JC: They’re probably launching themselves to March right now…

SF: Perhaps, perhaps. The stock has somewhat launched itself. It’s gone from less than $30 five years ago to more than $350. That’s a return of more than 1,000 percent despite the absence of consistent profits and incredible cash burn. So, Joe and I were talking about this, we know you’ve been public on Tesla for some while. What would it take for you to throw in the towel? What would have to happen for you to throw in the towel and say “I give up on this short, this is not gonna work”?

JC: I think that have to see the company actually begin to make money selling products. And I should point out that we were also short Solar City that he bought in. That one worked out a little better than Tesla. So, the fact of the matter is, that this is a company that, as you pointed out, burns a lot of cash and we think they’re gonna be burning close to 750 million to a billion a quarter for the next handful of quarters. It has not finished its Gigafactory, the batteries are made by Panasonic. But most importantly it has its big test ahead of it; the Model 3. It has been loosing money selling $120,000 cars, but it hopes to make money selling a $35,000 car, which we think it will be a lot more than that. You have an executive departure list, the only one I’ve seen longer in the last two years is Valeant’s. There just people are leaving left, right and center.

SF: It’s a freight train…

JC: Well something… I mean, I don’t know. They’re certainly… they’re not waiting around for the company of the future, the stock price notwithstanding. And so we’ll see. I mean the car is supposed to go into production in July. They’ll be competing with real companies in 2018. I noted with some interest as I got here the opening remarks by Mr. Musk were talking about transforming to an energy company, an energy solution company or something like that. So he’s trying to reposition the company as something other than an automobile company. But it is an automobile company with a money-loosing solar roof company subsidiary. In addition he’s got to raise a lot of money. Rule of thumb is it takes about 50 cents in capital for every dollar of automobile revenues. So if he’s gonna be doing a 500,000 Model 3’s and 100,000 of the Model S’s and Model X’s, he’s gonna need something on the order – that’ll be thirty some billion in revenues – he’s gonna need about another ten billion in capital to do that, and he’s gonna need it soon. So the Teslarian should just embrace themselves cause they’re gonna get the chance to buy a lot more stock or convert here I suspect in the coming months.

JW: What’s the most likely way, in your view, in which the Tesla story ends? Is it something that in the Model 3 doesn’t live up to the high…

JC: He actually starts making money. That’ll be what ends it.

JW: No, but I mean like in terms your thesis becoming validated. Would it be more of a sort of an investor strike, as in conditions changed, there’s a market downturn, people aren’t able to fund the…

JC: If the Model 3 isn’t gonna be popular, that’s gonna hurt, right. That’s the one everybody’s waiting for, the one that the average person who can’t afford an S or X and wants to be part of the Tesla revolution and if the car is a lemon I think that will be a problem. […] But at the end of the day he’s gotta make a car for the masses that is successful, so that’s what we’re gonna watch.

Some takeaways from the above talk that you may want to consider putting into your investor’s toolbox are:

  1. Are all customers contributing proportionally to the company’s profits?
  2. What’s the downside to the business from any current or future regulatory changes?
  3. How much capital is needed to support future growth (capital to revenues ratio)?
    • Who will provide the capital – debt or equity holder (any dilutive effects on current shareholders)?
    • Will the company be able to raise the capital needed?
    • How long is the business able to keep on going without further capital contributions?
  4. Does the industry in which the business operates make it possible for companies to gain and sustain any sustainable competitive advantages?

Disclosure: I have no position in any stock mentioned.

Jim Chanos on Idea Generation Through Pattern Recognition

“…we’ve tended down through the years to see that a lot of our ideas fit certain broad themes.” —Jim Chanos

Podcast: Jim Chanos on the Art of Short-Selling

A few days ago I was lucky to find another great interview with Mr. Chanos, this time from FT Alphachatterbox released on April 25, 2016. In this interview Jim Chanos is asked a question about idea generation and pattern recognition:

Getting back into the general sense of where ideas come from, are there kinds of patterns that you look for? What are the sorts of things, whether it’s capital structure of a company or management that sets off alarm bells?

Answering this question Jim Chanos provided a list of six broad schemes that he admits a lot of Kynikos Associates’ investment ideas fit into. The six schemes are:

  1. BOOMS THAT GO BUST. “…we’ve tended down through the years to see that a lot of our ideas fit certain broad themes. One I mentioned is the booms that go bust, where you just get these credit-driven asset manias and the asset can’t service the debt. Usually that ends in tears.”
  2. TECHNOLOGICAL OBSOLESCENCE. “The internet’s been a great wealth creator, but it has destroyed lots of business plans and lots of moats, and we keep our eye out. And that’s, for us, an ongoing source of ideas. It’s amazing how the analog-to-digital revolution just continues to find new businesses to decimate. And we’re mindful of that. It’s the Schumpeterian view of capitalism.”
  3. CONSUMER FADS. “…you see Wall Street over and over and over again just extrapolating out single product companies with hockey stick growth, whether it’s George Foreman Grills or Nordic Tracks or Cabbage Patch Dolls or FitBits or whatever it might be. ‘This time it’s different. Everybody’s going to have five.’ And it rarely is.”
  4. GROWTH BY ACQUISITION. “Another area would be growth by acquisition. We’re just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they’re actually growth companies by buying the growth. Typically this leads to the temptation of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between the announcement of the deal and the closing of the deal so they look better once you fold them in. And so we love those kinds of stories, the rollups, or as they’ve been deemed, the ‘platform companies’.”
  5. ACCOUNTING GAMES. “Then there are just pure outright accounting stories, where we just find a company that’s just completely playing legal or illegal accounting games to obscure the reality of what’s going on.”
  6. SILLY TRADES. “…then finally, any time we can sell $1 for $2 because the market gives us some silly trade, we’ll do that till the cows come home.”
Links

Jim Chanos on Shorting Herbalife and Valeant

“A stock can be a better short even though it’s gone down, it can be a better long even though it’s gone up if you’ve got new information.” —Jim Chanos

Podcast: Jim Chanos on the Art of Short-Selling

Whenever Jim Chanos speaks I’d like to listen. I have come to appreciate the way he explains things and how he attempts to take on and analyze different kinds of businesses from a fundamental investor’s view. It’s always interesting to hear what he has to say on businesses, industries, and countries etc.

A few days ago I was lucky to find another great interview with Mr. Chanos, this time from FT Alphachatterbox released on April 25, 2016.

The excerpt below contains a discussion about Herbalife where Mr. Chanos shares his and Kynikos reasoning and decision-making that came out of their analysis of the risks and rewards at the time (emphasis added).

MATT KLEIN: So I want to take a moment to actually look at a specific example I think might be relevant to this question, which is Herbalife. It’s a company that certainly got a lot of attention. It’s dropped out of the news recently, but some people, like Bill Ackman, were saying it was a complete scam, other people were saying it was good and were buying it. You were shorting it at one point and then I saw you said you’d exited the short after Ackman gave his presentation. You said the price was no longer compelling in terms of what the upside return would be for you. Can you walk through a little bit how you did that calculation and came to that decision?

JIM CHANOS: Well, so we were short Herbalife, and when Bill put his first report out the stock was down almost 50% in a matter of days. And at that point we just determined the risk reward had changed dramatically. That unless we felt the FTC or someone else was going to immediately move to crimp their business, that two other multi-level marketing ideas that we were also short – which didn’t move as much, they were only down a little bit – actually were much better uses of our capital at that point.

Further on into the interview Mr. Chanos talks about Kynikos short-position in Valeant in connection to a question about how Chanos and Kynikos works to generate new investment ideas.

MATT KLEIN: One of the things you mentioned earlier is the importance of your colleagues or partners and your staff for generating ideas and doing research and managing risk. Can you give some more sense of what is it everyone does and how you pick them, what the value is to the organisation as a whole?

JIM CHANOS: Our model’s a little bit different than a lot of investment management firms I believe, in that one of the things I find interesting about our business is that one of the most essential parts of the process, idea generation, most investment firms hand that responsibility to the youngest, least experienced people on the staff. The portfolio manager will put pressure on the junior analyst to come up with ideas for him or her to evaluate. And I think that’s really, really asking a lot. Particularly on the short side, where you have some of these other barriers like the borrowability and so on and so forth. The rebate structure. And in our view we would rather have the partners head up research and the portfolio managers spend some time on the ideas. And we have analysts who will say: “I think we ought to be looking at something”, but before they do a deep dive, we take a shallow dive and just make sure that this looks interesting from someone who’s got a number of years of experience in doing this and can immediately see something doesn’t look right. Valeant is a good example. That’s a name we’ve been short now for a couple of years, and the first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said: “This looks like Tyco.” In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell-bent on buying companies and making them fit no matter what.

And again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sorts of things before. And having a person running a company to please Wall Street can really be problematic, and even on the first pass through you would see that with a company like Valeant, and that’s why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to… For a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great rollups of the late 90s and early 2000s. So I think that was helpful for us.

MATT KLEIN: Speaking of Valeant, there’s a couple of interesting things there. It’s a pretty strange company. The traditional model of pharmaceuticals is you spend a lot on research and you fund yourself with equity and you have cash because your earnings are going to be lumpy. You have hits and then they die out. And Valeant is the opposite. They have a ton of debt, they spend nothing on research. Their model is essentially they buy a drug someone else has already invented and they try to raise the price. How they get people to overpay is an interesting question they’re now getting in trouble with.

There’s a thing there that’s interesting in terms of the personality of the executive there and at another company that you had a lot of interesting experience with, Enron. I’m not going to say that McKinsey is the cause of either one, but it’s interesting that these are both veteran McKinsey consultants who were beloved by the industries and respected who then came in to run these companies. Initially were very successful, at least on the surface, became very rich doing it. Is this something that people should – is this an automatic signal for you, when a consultant goes into the chief executive role?

JIM CHANOS: Well I’m always wary of accountants who become CEOs too. That’s always a bad sign for me. I don’t know about that, but I do know when I see a mindset, and when you see the mindset, the company is a black box and Valeant has had some of that… Valeant also, one of my partners pointed out that Valeant, in terms of a narrative or a parallel, also resembled Worldcom. Because you had this iconoclastic guy, Bernie Ebbers, and he was apart from his other executives, and again it was this rapid, rapid deal making with questionable numbers and then open feuding with his own executives toward the end of the Worldcom story. So there’s a couple of parallels in there. And then I saw Tyco. So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and Worldcom. You’re probably on the right track if you’re a short seller if it reminds you of not only one of those, but three of those.

And it’s interesting because what made the stock attractive to the bulls was its new way of doing business. R&D’s terrible. It doesn’t yield anything. That was the new mantra. So why do it? Why don’t you selectively buy drugs that seem to be overlooked and then run them through this sausage grinder of your reimbursement model and derive all this value that others are just leaving on the table? And that was my first problem. Because it was just this easy to raise prices 800% and get reimbursed, why wouldn’t everybody do that? Why wouldn’t the guys who owned the drugs not do that? That’s the first thing that I couldn’t get an answer on. And we now know why. In Pearson’s own words from his January 2013 conference call: “Well, there are ways even if a payer refuses to pay for a script [prescription], there are ways to get paid.” I’m paraphrasing, but that was a real warning sign for us that these guys were going to play somewhat fast and loose. Then he came up with the idea, well I’m going to buy drugs, so that’s my R&D in effect. So every other drug company that’s spending 16% of sales on R&D or 15% of sales on R&D, Valeant’s spending 2% or 3%. And the difference is meaningful, number one. Number two, of course Pearson would have you add back any purchased R&D amortisation that was running through the income statement, because of course drugs don’t last forever. They do have lives. And he was buying things sometimes with relatively short lives. And in any case no drug has more than a 20 year patent.

So if you were rational about this, if he bought $40 billion worth of companies, you might want to set aside $2 billion a year – at least – to replenish that portfolio over time. And that would be the equivalent of your R&D expense. Well, no, he wanted you to add back any amortisation and he called that his proforma cash earnings per share. And Wall Street dutifully pointed out: “Oh, that’s great, because it’s noncash.” And we pointed out: “Well, yeah, but take a look at Hewlett-Packard and some of these other companies that have had to buy companies to keep their revenue growth just constant. That’s the same as maintenance capex. In the drug business, that’s the same as maintenance R&D.” So he got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5.

MATT KLEIN: The Valeant trade, I’m curious more on the specific timing. Now the share price has gone down tremendously from its peak, but there was a period when it was going up by…

JIM CHANOS: It went up 100% on us.

MATT KLEIN: Right. How is that…?

JIM CHANOS: We started in the low 100s and our first blended set of average prices was somewhere around 130. So, yes, it got our attention. It doubled first.

MATT KLEIN: You mentioned the way that Valeant was creating an alternative pro forma accounting metric that was popular with Wall Street. One of the things that I’ve been reading a lot recently is this growing gap between the official…

JIM CHANOS: GAAP [generally accepted accounting principles] and “GAAP”, yes.

MATT KLEIN: Right, the “GAAP gap”. And it seems like it’s mostly coming down to treatments of things like one-offs and stock based compensation, which sounds familiar from 15 years ago. Is this something that we should be aware of in general? Are there legitimate reasons why this could be happening?

JIM CHANOS: Well, there are always legitimate reasons why you can break out something on a line out. Doesn’t always mean it’s legitimate to give the management the benefit of the doubt if common sense belies what they’re telling you. So it’s a problem. I teach a course on the history of financial market fraud, and usually trying to ferret out when companies are playing games with their numbers, as many do, takes some digging and some figuring out. What’s so amazing about the past five or six years is they lay it all out for you. And then they just tell you: Disregard it. So whether it’s stock based compensation, which of course is compensation…my favourite is the annual restructuring charge. There are companies now that have been charging off charges every single year for nine, ten, 11, 12 years. And sometimes every quarter. And Wall Street dutifully takes that out, to which I keep pointing out: “It’s happening five years in a row. Seems like it’s recurring to me.” But Wall Street gives them the benefit of the doubt for the fact that they break it out on a line item. And this has been going on for a while now, and the problem with it, Matt, is that now the disparity between the so-called operating EPS [earnings per share] and the GAAP number, I think it’s getting close to $30 a share for the S&P [index of large American companies]. I think the trailing 12 months’ now are somewhere in the high 80s and I think the operating number is somewhere in the 115, 116. And people say: The market’s not so expensive. I’m always raising my hand and will say: Depending on what? On the $88 it certainly is expensive. But we’re going to disregard that bad stuff. And then of course I love the people that say: “Well, but of course that’s energy. Energy’s down, you’ve got to take that out.” And I say: “Well, what about when energy goes back up? Are we going to take it out then?”

But again Wall Street is always a glass half full kind of place. But in this case it’s been interesting to us just how obvious some of these things are that they want you to disregard. Valeant was a master at that. This pro forma cash EPS, which by the way was just multiples of its real cash flow, was just one for the ages.

Links

 

 

Jim Chanos: “Nothing Beats Starting With Source Documents”

GD2Yesterday, I came across an interview with Jim Chanos from the spring 2012 edition of Graham & Doddsville – An investment newsletter from the students of Columbia Business School, see pages 16-30. This interview is a good one, and one part of the discussion is about where to start ones investment survey.

Jim Chanos’ teaches his students and analysts “…nothing beats starting with source documents”, and that they conduct their investigation of different businesses in the following order:

  1. SEC filings
  2. Press releases
  3. Earnings calls
  4. Other research

GD3Below are some excerpts from the interview mentioned and quoted above (boldings added by me).

See here for full PDF.

GD4“G&D [Graham & Doddsville]: What are some of the skills that are essential to  succeeding in this field?

JC [Jim Chanos]: I teach a class at Yale’s Business School on the history of financial fraud. One of the things I teach my students, which I also teach my analysts here, is that nothing beats starting with source documents. You have to build a case for an idea, and you can’t do that without doing the reading and the work. We’ve had a little game where we’ve been watching a company that just put out its 10K. When it came out, prominent in the disclosure was that the company had just changed its domicile to Switzerland for a variety of important reasons. I told the analyst, let’s play a game: call the sell side analysts and try to ask them some questions to see if they know that the company, under the advice of their legal counsel, changed their domicile. She said that of the eight analysts that followed the company, it was the seventh analyst who had a clue of what she was talking about. None of the others had any idea, which meant they hadn’t read the document, and that 10K had been out for 10 days. This happens more than you think. It happens because Wall Street research departments are marketing departments. The people with the most experience in these departments spend much of their time marketing. The junior people are back at the shop doing models and such, but there isn’t much thought going into this. So I teach my students and analysts: start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in. They’ll hear a story, then they’ll read some research reports, then they’ll listen to some conference calls, and by that point may have already put the stock in their portfolio. It’s amazing what companies will tell you in their documents. Enron is a great example – most of the stuff was hiding in plain sight. There was one crucial piece of missing information, which was the “make good” in the SPVs that Fastow was running. The reason people invested in those and bought crummy deals from Enron was that there was a provision that if you lost money, Enron would issue stock and make you good. So that was a key missing piece of information. But in any case, it was amazing how much information was out there. Investing is like a civil trial. You need a preponderance of evidence, not beyond a reasonable doubt.

G&D: Do you recommend investors start with reading the newer filings first?

JC: Yes, look for language changes. Read the most current ones and work your way backwards. Read the proxy statements that are often neglected and are full of great information. By doing that and by spending a night or two with those documents, you can have a remarkably comprehensive view about a company. So start there and work your way out. This way you are looking at the most unbiased sources first. People on earnings calls will try and spin things, and analyst reports will obviously have a point of view. All of that is fine, because hopefully you will have first read the unvarnished facts. Primary research is crucial and not as many people do it as you think. Because there is so much information out there, it almost behooves people to read the source documents. If you are an airline analyst, you could be reading about airplane orders, traffic trends, fuel price trends, etc. all day long, and not have a better idea of what is going on at Delta Airlines or Japan Airlines. Start by reading the documents of Delta Airlines or Japan Airlines. Overtime, understanding what to read and how much time to spend reading various things becomes an art as much as a science. You need to become a good information editor nowadays.

[…]

G&D: What are some of the avoidable mistakes that you see analysts make?

JC: One of the biggest things I see quite often is getting too close to management. We never meet with management. For all of the bad asymmetries of being on the short side, one of the good asymmetries is that we don’t rely on the company. We can get information from the company if we want to, as we can go through the sellside. Those that are long the stock and are close to the company almost never hear the negative side in any detail. The biggest mistake people make is to be co-opted by management. The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive. A second mistake some people make is not reading all of the documents. I guide people to always start with the SEC documents, and then go to other sources for information. It’s amazing how few analysts actually read SEC filings. It blows me away. We have the greatest disclosure system in the world and people by and large don’t take advantage of it. I am a big believer in looking for changes in language in a company’s filings over time. During the year we were short Enron, each successive filing had incrementally more damning disclosure about the company’s off-balance sheet entities. It was obvious that internal lawyers were pushing management to give investors more detail on these deals that were being done, as they felt uncomfortable about them. Language changes are not accidental. They are argued over internally.”

JC3Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Masters in Business Interview: Jim Chanos

JC2Barry Ritholtz Interviews Chanos: Masters in Business (Audio)

Bloomberg View columnist Barry Ritholtz interviews James Chanos,the hedge fund manager of Kynikos Associates. They discuss short selling and the excess of Wall Street. Masters In Business aired on Bloomberg Radio.

 

A few pieces to read to get to learn Jim Chanos a little better: