Note: Reflexivity is a phenomenon that occurs when the perception of a company may influence its fundamentals, and the fundamentals may influence the perception. These often take the form of self-reinforcing "boom" phases, financed by equity and debt leverage, followed by self-reinforcing bust phases. For more on this theory, I would suggest reading George Soros' Alchemy of Finance. Also, take a look at my article on 3D Systems Corporation, where I plotted out the stages of that reflexive cycle.
In this article I propose that Tesla Motors (TSLA) is in the early stages of a reflexive boom-bust cycle. I describe the various components that I believe will contribute to the boom, followed by the components that will cause the turning point and subsequent bust. I then suggest a course of action: taking a long speculation at the current time, and then reversing it to a short position at the time of a turning point.
The Four Leverage Components Fueling the Boom:
The first is a low interest rate loan from the Department of Energy. The total amount of the loan is $465 mm, which paid the majority of Tesla's costs for developing batteries and the Model S sedan. Tesla got a sweet deal on these loans, with the most recent draw-downs on this facility coming in at a miniscule cost of 1.0-1.2% interest. These low interest costs have allowed the company a competitive advantage over other competing luxury vehicles.
The total amount available under the Department of Energy's Loan Facility was reached in the third quarter of 2012. Tesla is not able to issue more debt, because the terms of the DOE loan require that Tesla maintain a certain Assets-Liabilities ratio, so now Tesla has chosen to use equity leverage to finance its operations.
This second leverage component has generated a similar amount of cash. Tesla has completed two public offerings subsequent to its IPO in July 2010. In June of 2011, Tesla generated $231.5 mm of equity from public offerings and private placements. More recently, in October of 2012, the company generated $221 mm.
However, Tesla is going to ramp up production throughout 2013 and 2014. As CEO Elon Musk said in the Q4 Conference Call, "we want to make sure that we've laid the ground work for an improvement above 20,000 units a year in 2014." A part of this ground work will likely include the financing to pay for the extra supplies and labor that it will take to get the production up to this level. I would guess that further public offerings are coming.
This makes Tesla an ideal candidate for a reflexive boom. The company can use share issues to up its production, the increased production will allow it to increase earnings, the increased earnings will increase the share price, and the increased share price will allow it to issue further shares. As long as the share price stays above the intrinsic value of the company, the company can sell shares to grow its intrinsic value. This is one case where overvaluation is an advantage, rather than a disadvantage.
Federal and State Electric Vehicle Credits
A third leverage component is the government's $7,500 credit to buyers of the first 250,000 vehicles that Tesla makes. This substantially lowers the cost of the cars. In addition, many states offer additional rebates on electric vehicle purchases. For instance, in California, purchasers of a new Tesla get a $2,500 rebate (1, 2). However, these credits contribute to my argument of an eventual turning point (more on this later).
Tesla's "Revolutionary New Finance Product"
A fourth leverage component has recently been announced. This takes the form of an aggressive financing option that makes the car available to lower income buyers with a 10% down payment and ~3% annual interest. This plan, combined with the above-mentioned credits, lowers the initial cost of purchasing a Model S to nearly $0. In addition, monthly payments are being advertised as low as $500 per month. As an added bonus, Tesla has guaranteed the repurchase of its cars after 36 months at a residual value pegged to the Mercedes S-Class, i.e., about 43% of its original sales value. This will persuade people who did not believe they were capable of affording a Tesla to make the purchase. But something sounds fishy about these zero-down, $500/month loans... (more on this later).
Less Tangible Components of the Boom:
Peer-pressure, and the Color "Green"
I believe that if Tesla can become profitable, the company's success will work through another reflexive mechanism. The profitability of the company will be touted as evidence of the long awaited electric car revolution, which will lead to a more positive prevailing bias towards the company.
The electric car revolution has a deep rooting in the American psyche, especially on the West Coast. It is part of the movement to be "environmentally-friendly." There is almost a moral imperative behind this phenomenon - people who drive environmentally-friendly cars may get self satisfaction from a sense of moral superiority. This may add to the "cool factor" of Tesla's cars (evidenced by Motor Trend's naming of the Model S as the car of the year) and the cost-savings of electric versus gas vehicles to make the cars a new "must-have" gadget, albeit an expensive one. Thus, consumers who have been late to join the electric car party will feel pressured to do so, in the same way that iPhones had a self-reinforcing success as a status symbol.
The Visionary Founder and Leader Worship
To complete the Apple analogy, Elon Musk has a certain self-fulfilling confidence about him. He is already seen as a visionary leader, with recent successes with SpaceX, and ongoing success in SolarCity contributing to his mystique. I believe that, in time, he will engender the same kind of feverish devotion that Steve Jobs once did. And this devotion, should it take hold, will only strengthen with the success of the company; that is, as the company becomes more successful, the devotion will increase, and this will add to the success of the company, by increasing desirability for Tesla's products. I believe this will lead to a Tesla fan base similar to the one that developed for Apple.
The Five Risks Leading to a Turning Point and Eventual Downfall:
The Step Down of Government credits
The $7,500 government credit will be stepped down after Tesla has sold 250,000 cars. It may take years for Tesla to reach this milestone, but I believe this step down of credits will be the way to time the turning point of the boom phase. After the credit runs out, Tesla cars will enter a higher price bracket, and I believe the extra cost will dissuade new purchasers.
Tesla the Insurance Company
The financing agreement that the company offers means that Tesla has essentially entered the insurance business. They are taking down payments and monthly payments now to finance any future repurchasing commitments that Tesla may be obligated to fulfill. However, if the flood of new sales stops, they may be left holding the bag with regard to future repurchasing commitments. Once the government credits begin to step down, I suspect that the rush of new sales will slow down, which would lower the down payment "premiums" it collects to cover its repurchase liabilities.
The Offer That's Too Good to Refuse
Now about those zero-down, $500/month loans. As Consumer Reports pointed out, the monthly payments on a new Model S are not $500. They are actually a little over $1,500. The $500 figure comes from the combination of some very real cost-savings, like gas, and some more nebulous ones, like shortening your commute time by driving the carpool lane. The Tesla website explains the fuzzy math.
My guess is that these low advertised prices will entice customers who cannot truly afford the cars to enter into contracts they cannot pay. Eventually, such customers would be forced to sell the cars, flooding the resale market and dropping resale prices. If prices drop below the residual value of a Mercedes S-Class (the repurchase price that Tesla has committed to), Tesla will have to mark down vehicles it repurchases, creating asset impairment losses that would carry over to the bottom line of the income statement.
The Equity Fountain Runs Dry
To make matters even worse, if the preceding events occurred, the stock price would fall. This would prevent Tesla from issuing further shares to finance the repurchase commitments, at exactly the same time that earnings are falling because of fewer down payments and asset impairment losses. So Tesla would be unable to save itself from a cycle of lower stock prices, vehicle mark-downs and growing repurchase liabilities.
The Hidden Risk Most Investors Ignore
If a self-reinforcing reflexive bust begins, it may become impossible to stop. Elon Musk's personal stock portfolio is highly leveraged, as indicated by the "Risks" section of the 2012 10-K statement:
"Mr. Musk borrowed funds from an affiliate of our underwriter in our public offering in 2011 and pledged shares of our common stock to secure this borrowing. The forced sale of these shares pursuant to a margin call could cause our stock price to decline and negatively impact our business."
A CEO's personal portfolio is a hidden risk that investors are often unaware of. But, as recent events in both Chesapeake Energy (CHK) and Green Mountain Coffee Roasters (GMCR) show, it is a risk that investors cannot afford to ignore. Founders Aubrey McClendon and Robert Stiller, respectively, had large insider ownership in their own companies, but with a highly leveraged personal portfolio, they left themselves and shareholders vulnerable to a large decline in share price. Once the decline began, both founders were faced with margin calls that sent shares spiraling downwards, fueling the bust. A similar course of events could follow if Tesla's share price were to suddenly drop.
So Where Are We Right Now?
The company recently underwent a test phase. Public perception of its innovations turned more negative in light of articles stating concerns about both battery life and recharging time. These are very real problems, and they could severely damage the popularity of the company's products.
However, the negative perceptions do not seem to have affected customer demand yet. As Elon Musk stated on the last conference call, "we have enough reservations right now to fill out the year, - and just on sheer momentum sell every car we make, even if we closed every store we have got."
Further, Elon Musk has announced plans for new charging stations and programs to replace old batteries as new, longer life ones become available. So it seems that the company may pass the test.
Waiting On the Report Card
Proof that the company has survived the test will come in the form of first quarter earnings. If the company shows profitability, it will be taken as a sign that the company has turned a corner, and this will propel the stock price higher. Higher stock prices will allow the company to sell stock to satisfy its supply-side issues, finance charging stations, and develop new, longer-life batteries.
George Soros advised, in the Alchemy of Finance, to become involved with speculation only after it has successfully survived a test phase. But I am tempted to enter into speculation early with Tesla. Often the maximum profit can be made just at the point that a company shifts from unprofitable to profitable. And Elon Musk has been strongly hinting at a profitable first quarter of 2013.
Take a look at this exchange from the last conference call:
Andrea James - Dougherty & Company
Hi. Thanks for taking my question. You are suggesting positive net income in Q1 and just, I guess, what still needs to happen to get there if anything -- and then would anything throw that off for the rest of the year as well?
Elon Musk - Chairman, CEO, and Product Architect
Sure. Good question. So, I mean, unless there is some force measure event like a giant earthquake or something, a big flood or typhoon, yes, we feel really confident. In fact, I mean, I would say that we will be comfortable in the absence of force measure event this quarter.
It's my aspiration and I think it is aspiration of everyone at Tesla to be profitable in subsequent quarters as well, and I'm cautiously optimistic about that. But I don't want to commit to it until I know more, whereas we are committing to Q1, and I think cautiously optimistic about Q2 is way to think about it, yes.
Andrea James - Dougherty & Company
What sort of information would sort of make you more constructive on Q2 like what do you hope to learn as Q1 goes on?
Elon Musk - Chairman, CEO, and Product Architect
Well, maybe I am hedging too much, I just don't want to - I don't want to be over confident really. I do think we will be profitable in Q2, and yes, in subsequent quarters too. But I guess rather than sort of an absolute commitment, I'd say, I'm just really highly confident of that being the case.
My Personal Take
While I always take a CEO's comments with a grain of salt, I think Musk may be right that the company will be profitable. So, I think the time is right to speculate on a long position in Tesla. I believe the recent stock moves are the beginning of a long bull run in Tesla. But I don't believe it will end in a pretty way. The speculation hinges on being able to recognize the risks as they manifest. After the turning point, investors usually get a few days before the stock really dives into a reflexive downward cycle, so there will be time to exit the position and enter into a short position.
There are four leverage components fueling the boom
1. DOE Loan
2. Sales of high priced stock
3. Government credits
4. The financing option which allows a low down payment
There are less tangible reasons behind the boom
1. Tesla cars as a symbol of status and commitment to the environment
2. The positive perception of Elon Musk as a visionary leader
There are five risks which may lead to an eventual bust
1. The phase out of the government credits
2. Consumers buying Tesla cars they cannot afford
3. Tesla taking on financial commitments to repurchase its cars at a set residual value
4. A dependence on stock sales (and thus investor perception) to finance the company's initiatives
5. Elon Musk's highly leveraged personal portfolio.
The company may be about to turn profitable. If you are more risk-averse, wait until Tesla proves that it is profitable, then enter a long position. If you are more open to risk, begin a long speculation now for maximum profits. If any of the risks manifest, shift to a short position.