America Online traded at a high multiple of what many short-sellers believed to be low-quality earnings. America Online spent heavily on marketing or “customer acquisition costs” to generate monthly fee-paying subscribers. Short-sellers believed America Online inflated its income statement by capitalizing these costs and writing them off over the expected life of the subscriber relationship. America Online’s accounting did not comply with GAAP, which required the costs to be expensed as incurred.
I evaluated shorting America Online and determined that even if the accounting were wrong, it was a lousy short because the true economics of the business were incredibly compelling. The stock was inexpensive considering the company’s economic profits. I calculated the net present value of a subscriber by comparing the up-front cash customer acquisition costs to the subscription payments over the expected life of the customer relationship. America Online was adding so many new customers that it would not take long to justify its seemingly lofty stock price. Add in the possibility of new revenue streams, including advertising, and I saw it was a really bad short idea. Perhaps this is what “value investor” Bill Miller saw that convinced him to step out of the box and take a large long position. I did not have the guts to buy America Online, but contented myself by not shorting it and arguing with those who did.
When America Online bit the bullet and took a huge write-off of its capitalized customer acquisition costs and agreed to expense them as incurred in the future, the short-sellers had nothing left to criticize. Though America Online had lower earnings under the more conservative accounting, the market understood the high return America Online generated on its investment in customer acquisition costs and looked through the lower reported earnings. As the market appreciated America Online’s powerful model, after a small initial decline, the stock soared. America Online traded at a higher multiple than Coca-Cola and was still a buy! Coke lost its market leadership. Now, no multiple was too high to pay for a leading “new economy” stock. Many misunderstood the real chain of events and interpreted America Online’s soaring stock as proof of the dubious theory that traditional valuation measures no longer applied.
By early 1999 the market saw that the best and the brightest of the short-sellers had been proved wrong on America Online. If they were wrong about America Online, they could be wrong about every other Internet stock. Never mind that only a handful had viable, let alone robust, business models. Bearish arguments were no longer considered. I believe the hubris from the victory over the America Online shorts was a primary cause of the Internet bubble.
For the most part, we avoided the damage in the short portfolio by refusing to sell short anything just because its valuation appeared silly. We reasoned that twice a silly valuation is not twice as silly. It is still just silly. Kind of like twice infinity is still infinity. Instead, we concentrated on selling short companies with high valuations combined with misunderstood fundamentals and deteriorating prospects. As always, frauds were preferred.
We found several good frauds in 1999. One of them, Seitel, had a multi-client library of seismic data used to find hydrocarbons. Energy companies partnered with Seitel to “shoot” (shaking the ground and measuring the reaction) data—a costly investment. The energy partner received an exclusive period to use the data. After that, Seitel could re-license it to other energy companies. Seitel capitalized the investment in shooting the data and expensed it in proportion to the expected licensing and re-licensing revenue. Seitel assumed that a dollar invested in data would generate $2.50 in revenue. As a result, under Seitel’s accounting it was guaranteed a 60 percent margin on any license or re-license revenue.
However, Seitel did not generate anything close to $2.50 of revenue per dollar of investment. Seismic data do not have an indefinite life. If the data shows a high probability of hydrocarbons, somebody drills to find out. After that, who needs the data? Most of the license revenue came from licensing, rather than re-licensing. As a result, the 60 percent margin assumption inflated Seitel’s earnings.
Worse, the initial licenses covered only a small fraction of the cost of shooting the data. Under Seitel’s accounting, shooting data and the related initial licensing fee generated earnings but burned cash. Re-licensing generated cash, but re-licensing sales were harder to make. In an effort to maintain accounting profits, Seitel increased uneconomic, cash-burning investments in new data shoots.
Based on this analysis, we sold Seitel short during a strong period for energy service stocks. When that cycle ended, Seitel’s shares fell sharply and the short contributed to our 1999 return. However, we did not cover because the accounting story had not played out. Seitel was heavily leveraged and we thought it would go bankrupt. Seitel shares made a strong recovery in 2000, and we stuck with it for a three-year fight until it did finally go bankrupt in the next downturn in the spring of 2002. The CEO was eventually sentenced to five years in prison.
We also found a good long idea that year. Reckson Associates, a large real estate owner, spun off a nondescript entity called Reckson Services. In early 1999, I met the CEO Scott Rechler, who was young, aggressive, and smart. I left our two-hour meeting with only a vague sense of the strategy, but a strong sense that Rechler was going to do exciting things. Reckson Services was an assortment of opportunities, including speculative real estate ventures in student housing and gaming; a shared-office space business; a concierge services provider; and OnSite, which was a money-losing start-up that wired office buildings for Internet access. I calculated there was enough intrinsic value in the traditional businesses to justify the current share price of about $5 without giving any value to OnSite. I wanted the free option on OnSite and felt that Rechler would do something great, so Greenlight invested 3 percent of
