Perseid Capital - Tesla Short Thesis

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Tesla Short Thesis

I’ve recently become somewhat active as part of the $TSLAQ community on Twitter. It’s a group of people who are discussion the short thesis for Tesla, with many convinced that that Tesla will go bankrupt (Nasdaq adds a “Q” to the symbol of a bankrupt company).

The discussions vary in quality and tenor, but overall, I’m impressed with the degree to which it hasn’t devolved into an Internet shouting match. There are many good discussions about financials, latest news items, on the ground research, etc. However, there are a lot of voices with different perspectives, and you have to pull your own meaning out of the torrent of tweets. Here’s mine.

Macro Environment

Before we get into the more controversial stuff, I want to point out that a Tesla is facing a serious headwind from the macro environment. This headwind is strong enough to challenge any car manufacturer—but when you combine the difficult environment with Tesla’s unique weaknesses, the threat becomes existential.

1. Flat US car sales

It’s always easier to be successful growth company in a growth industry. When the industry is stagnant, growth comes at the expense of other competitors—and ensure a harder battle. Worse, 600,000 fewer cars were sold in February 2019 than in February 2017. A significant part of “flat” unit sales was due to the September ’17 storms.

Looking forward, things look worse. From The Detroit Bureau:

Industry forecasters and some auto executives predict sales this year will fall well below that figure, dropping to under 17 million vehicles for the first time since 2014.

Not good.

2. Rising US auto loan defaults

At the same time that unit sales are flat, the US consumer is showing signs of stress. Tesla has been looking to increase volumes by attacking lower price points (compared to other Tesla models), but even the $35k Model 3 isn’t exactly cheap (though subsidies help). In any case, the rising number of delinquent loans suggests that it’s going to be harder and harder to find customer who, financially, have the ability to consider a new Tesla purchase.

3. Inventory levels are rising across the industry

The Detroit Bureau reports:

AIADA noted there were 3.95 million vehicles on dealership lots at the end of January, a 4% increase from December and up nearly 3% from the prior-year January and observed that analysts are saying the rising stock levels are becoming problematic because car companies will start this year with more unsold inventory than they had three years ago when U.S. auto sales peaked at 17.55 million for the year.

So, we’re entering the year with more unsold inventory than a year that outperformed current year projections by over 3%. For an industry where both carrying costs and inventory obsolescence are major issues, this is a very concerning setup.

4. Rising EV competition reports several new electric vehicles coming out next year:

  • Audi e-tron 2019
  • Mercedes-Benz EQC 2019
  • Mini Electric 2019
  • BMW i3 2019
  • Nissan Leaf 2019 with 60 kWh battery pack
  • Porsche Taycan
  • Kia Niro EV
  • Volvo all-electric XC40

That’s quite the line up of competitors. Even just holding market share in the face of so many new competitors would be a challenge for any company.

5. Economic slowdown outside the US

January car sales in China fell 15.8% year over year. Japanese and South Korean economic numbers have significantly undershot expectations. Italy is in recession. Germany has escaped technical recession, but growth has been weak enough to drive Draghi to reverse course and restart TLTROs. Australia and Canada both face housing bubbles that look to be deflating.

Tesla may be hoping geographic expansion can help drive growth, but right now, the US economy is the by far the strongest. Expanding a premium product in troubled economies doesn’t sound like a winning strategy to me.

Overall, I’d say it’s fair to say the next year promises to be stormy for auto industry.

Unit Economics

Tesla’s unit economics took a major hit on 2/28 when Elon Musk accompanied the $35k Model 3 announcement with major price cuts on all models. John Engle make the case succinctly:

In Q3, Tesla sold 83,775 vehicles. A reduction of $9,000 in average per-vehicle revenue would result in a total revenue reduction of $754.0 million. Tesla reported a $312 million GAAP profit for the quarter. Yet, if today’s prices had prevailed at the time, all else remaining equal, Tesla would have faced a $442 million loss.

There is no evidence the price drops came with cost reductions.

The unit economics on the $35k Model 3 are especially concerning. As Martin B. Spiegel points out:

$TSLA told DB’s analyst it will make a $1500 “cash profit” on $35,000 M3s…there’s around $5000 of D&A per car, meaning…the EBIT loss will be $3500/car

Currently, the $35k Model 3 is:

  • enabling Tesla to continue to perform on volume commitments made to suppliers
  • improving Tesla’s cash position by letting them monetize WIP inventory
  • leveraging Tesla’s sunk cost investment in to the Model 3 production line

However, it is not contributing enough profit to sustain Tesla as a going concern.

Balance Sheet Concerns

By far, the #1 balance sheet concern is the amount of actual cash in Tesla’s accounts. Tesla reported $3.7B as of 12/31, but that is looking significantly window-dressed. The Financial Times’ Alphaville did an analysis of interest income that suggests that Tesla’s cash balance could have been $2B less than reported, or $1.7B

Telsa had to pay out $920M for the March 1 bond payment. In addition, in order to secure the 3.5B Yuan loan from Chinese lenders for Gigafactory 3, Tesla seems to have had to contribute $610M in cash via a holding company in Singapore. This suggests that Tesla’s cash balance could be as low as $170M, before Q1 operations and financing activities. I won’t bother to go into those here—there’s not a lot of visibility, and the story here is that a $50B company is flying this low to the ground.

In addition to the cash situation, Telsa’s reported tangible book value per share was $26.63. Book value has been a pretty outdated quantity to judge a company’s valuation—but there is one context where it really matters: restructuring. While going concerns can justify their valuations based on growth, free cash flow, various moats, etc., when a company goes in to bankruptcy, book value is pretty much all that matters.

So not only does Telsa’s reported book value represent a 90% write down to the current share price, there are reasons to think the $26 number is highly optimistic in actual restructuring. Various factors that will likely lead to a major reductions from there: legal costs, asset impairment, and settlement of pending/future litigation.

I believe that this is the primary reason that Tesla’s been so loathe to utilize the bankruptcy process to right its ship. A bankruptcy will nuke the capital structure, leading to a near total loss for all equity holders. Many of Telsa’s recent actions could be described as “bankruptcy without the filing”. I believe the low book value is a significant hurdle to Elon Musk voluntarily declaring bankruptcy.

Stock Holder Concerns

@CrowPointParnters did a detailed analysis of Tesla’s stock trading volumes and concluded that institutions are very rarely trading their shares—and when they do, they move the price substantially. In the past 6 months, institutions have been slowly exiting their positions, including T.Rowe Price and Fidelity. With 63% of the stock still owned by institutions, this represents a huge threat to the stock price.

There’s also the concern of Elon Musk facing a margin call. u/stockbroker posted on Reddit that the terms of Tesla’s policy allows Elon to use his company stock as collateral, as long as the loan amount is below 25% of the the value of the stock. Musk owns about 38.6 million shares of stock. As the reddit post points out, Musk has pledged 41% of his shares (or 15.8 million). At 2018’s low of $250, that would be about $1B in debt.

Given that Musk recently mortgaged his 5 mansions for $61M, there are legitimate concerns that he’s over levered. I’ve read Twitter rumors that Musk’s margin call price may be in the $230 - $250 / share range.

That suggests that a 12% drop in price from Friday’s close could trigger a massive forced sale of shares into a very thin market.

Red Flags

1. Haven’t raised capital

By far, the biggest red flag is that Tesla, a company that looks to be facing existential threats—and has the highest valuation in the industry—hasn’t raised money. Diluting existing investors to de-risk the company makes such obvious sense that not doing it suggests that there must be some unannounced reason it can’t be done. The top theory is that the SEC won’t approve the raise, but whatever the cause, the fact remains: Tesla seems to be cutoff from the capital markets.

2. Hasty Announcements

The $35k Model 3 was announced with Elon Musk tweeting at 2am on Tuesday that there would a big announcement on Thursday of the same week. In the 13 days since that first teaser tweet, the announcements have piled up:

  • $35k Model 3
  • 25% - 40% price reductions across the line
  • Q1 will not profitable (big change to guidance)
  • Stores closing
  • Sales staff compensation changes
  • Model Y reveal
  • Supercharger v3
  • Store closings frozen
  • Gigafactory financing closed
  • ABL financing increased

The pace of announcements is too rapid. Not only do the wins get mashed together too quickly for full effect (highly unlike Elon’s usual style of maximizing the PR impact of everything), the content of the announcements is contradictory and the employees report being blindsided. Not the signs of a well-run company that’s killing it.

3. Executive flight

Yahoo finance created a timeline of executive leaving since the start of 2018. It’s hard to wrap your head around—but 88 executives had left at the time of the article (during a span of time that included Tesla’s 2 best quarters for financial results).

Then, on March 8th (5 days after announcing the Model Y reveal), Tesla also lost its VP of Engineering (the one who designed power trains). The timing of this departure is especially suspicious, as he had been an employee for almost 3.5 years. The departure seems sudden.

4. Goosing sales by selling to employees

Business Insider reported that, in Q3 and Q4 2018, Tesla encouraged its employees to buy cars using their paid vacation days. SpaceX employees were also offered the discount. This may seem innocuous at first, but there are couple major questions:

  • How much of those 2 profitable quarters were driven by employee purchases?
  • What about employees who were laid off shortly after purchasing a car using their PTO?

Nothing conclusive here—but it’s not the kind of behavior you see from a company struggling to capitalize on “unlimited demand”.

5. Announcing store closures (and reversing course)

On Feb 28th, 2019 Tesla announced that it would be closing most of its stores and moving all sales online. This took a lot of people by surprise, including their employees. There are so many things wrong with this:

  • Why was it done so fast?
  • Why was it done without properly notifying the stores being closed?
  • Why was it done without a thought for the process/penalties involved in breaking commercial leases?
  • Why was the decision frozen one week later?

The way this decision was announced and implemented suggests the company is in disarray.

6. Reducing expenses beyond reason

On top of the hastily implemented store closures, Tesla also took a number of actions that seemed to be motivated by a desperate grab for cash:

Powder Kegs

Finally, there are also several issues that, depending on how they develop, could be disastrous for the company. I’ve attempted to provide an overview below, not an exhaustive list. Each one of these topic represents an existential threat to the company, and deep dives are out of the scope of this post. But suffice to say, there are a lot of existential threats.

At the end of the day, the sheer number of issues that Tesla is facing is a red flag in and of itself. Here’s @jakegordon1997’s attempt to capture the details. It’s a long read, but worthwhile for anyone wanting to take a deep dive.

Summary of Bear Thesis

Overall, the bear thesis is that Tesla:

  • Faces a stormy industry outlook
  • And rising competition
  • With a poor balance sheet that limits its options
  • And weak, over-leveraged stock holders
  • While showing signs of internal chaos
  • And plagued by a number of known-unknowns, any of which could be a company-killer