America was built on the entrepreneurial backs of dreamers like Elon Musk. There is so much to be said for men and women who eschew conventional dogmas and take chances on creating something that moves civilization forward, confronting complicated and expensive problems such as the emission of greenhouse gases into the atmosphere. When Tesla (NASDAQ:TSLA) was virtually left for dead during the financial crisis, Musk invested a significant portion of his net worth to save the company, and his confidence and fortitude have made him a billionaire. The thing about the stock market, however, is that great stories are perpetuated and sold to the public without regard to the crucial question ... what is the value of the business that I'm receiving fractional ownership in vs. the price that I'm paying? It is in this regard that Tesla's stock seems exceptionally risky and scary on the long side, while potentially offering a huge payoff to shorts.
There is no doubt whatsoever that Tesla has created beautiful automobiles, and bolstered by the company's proprietary powertrain technologies, the cars drive exceptionally well, particularly for a zero-emission automobile. The brand is already sexy and could even gain more acceptance as the company is able to ramp up production, particularly in other regions such as Europe and Asia. Battery technologies will continue to improve, and over time it is very realistic that there will be charging stations that service most of the key transportation routes in North America, increasing the practicality of owning the cars. As a consumer, I love the technology, the brand and the future of the company. As an investor, I hate the stock, because it reeks of speculation. Every bubble is created based on a good story, so all of these positives don't outweigh the fact that market participants speculating at these levels are likely to face a bad landing.
Solar power generation has been a wonderful story over the last decade and was economically viable in some areas, thanks to aggressive subsidization programs in various countries. When these subsidies were pulled back, so did demand for solar panels because it just didn't make financial sense. The United States is facing a tremendous amount of debt and leverage, contrasted with very slow growth prospects. The zero emission credits that Tesla has benefited from make a lot of sense to me as the technology is certainly a huge positive for the environment, but this is a big risk that should require a larger margin of safety before establishing a position in a stock like Tesla.
Automotive manufacturing is not exactly one of the more attractive industries to participate in despite what Tesla's valuation implies. This is an industry in which there are massive capital expenditures and upfront costs. It is a very difficult industry for new entrants even in gasoline powered automobiles because return on invested capital is rarely higher than the cost of capital. Tesla not only has to deal with these issues but it also has to be the leader in building out its charging stations, which it intends to offer free access to. I'm not saying that this company can't succeed in becoming a huge player in the industry, but there are serious risks that aren't being factored into the current valuation.
The automotive industry is filled with deep pocketed and massive international corporations. Some companies benefit from government assistance, and it seems very unlikely to me that these companies can't reduce the technological edge that Tesla possesses on electric vehicles by a material margin. General Motors (NYSE:GM) and other industry heavyweights are already ramping up investment and brainpower in this area. Tesla certainly has a solid first-mover advantage but unless its technological edge can become some type of industry standard that is distributed to other manufacturers or licensed to them, I don't believe that the technological edge amounts to any durable competitive advantage. Size is also something working both for and against Tesla. The company is able to move much more rapidly than its competition, and Tesla isn't burdened with many of the legacy costs that still impact other companies in the industry. Tesla's size hurts in terms of purchasing raw materials and in areas such as distribution and manufacturing. For Tesla to attain critical mass, I believe the company will have to rely heavily on the capital markets via equity issuances. This requires investor optimism and relatively robust equity markets, which have not been in short supply of late, but this is something that shareholders should be keenly aware of.
On August 7th, Tesla reported 2nd quarter financial results that exceeded expectations. Net income (non-GAAP) increased 70% sequentially to $26MM, or $0.20 per share. These results excluded one-time and non-cash items, as well as the impact of lease accounting. In the beginning of the 2nd quarter, the company introduced the resale value guarantee for customers who finance their Model S through the company's banking partners, and even though the company receives full payment upfront, GAAP requires the company to account for these sales as leases and spread the recognition of revenue and cost over the term covered by the resale guarantee. Q2 revenues were $551MM on a non-GAAP basis and $405MM on a GAAP basis. The company sold a record 5,150 Model S vehicles in North America while posting a non-GAAP gross margin of 22%, despite a significant reduction in zero emission vehicle (ZEV) credits. The company believes that it is on pace for Q2 gross margins of 25%, excluding ZEV credits.
The company has over 13,000 Model S customer vehicles on North American roads and the company is now beginning to deliver Model S vehicles to customers in Europe. The first cars will be arriving in Norway, Switzerland and the Netherlands. TSLA believes that in Norway alone, the company can deliver almost 800 vehicles this year based on current vehicles. The company also stated that if demonstrated demand in North America is matched by similar demand in Asia, annualized sales for Model S could exceed 40,000 units per year by late 2014. During the 2nd quarter, the company improved its production rate by 25% from 400 to almost 500 vehicles per week. Tesla also opened seven new retail locations in the quarter for a total of 41 locations worldwide, including 30 in North America, 8 in Europe and 3 in Asia. The company intends on opening several more stores this year, including the first store in China.
Management is putting more emphasis on increasing the coverage of its service centers, which should ultimately drive substantial Model S sales in regions that have a critical mass of Model S customers. In the 2nd quarter, Tesla opened 6 service centers for a total of 47 globally, but will be accelerating this dramatically in coming quarters. The company is rolling out 120 kW Superchargers, which are 33% faster than Tesla's current version and can replenish half a charge in just 20 minutes, for free. The company is rapidly expanding the supercharging footprint in key geographies. In addition, the company recently announced an automated battery pack swapping capability, which will allow a customer to swap in a fully charged battery pack in as little as 90 seconds, in about half the time it takes to refill a traditional car with gasoline.
During the 2nd quarter, Tesla raised a little over $1 billion by issuing 4.5MM shares of common stock and $660MM of convertible debt. The company used about $450MM of the proceeds to pay off the DoE loan in an effort to remove any stigma of government assistance, beyond the benefits the company is already receiving from the ZEV credits.
The company plans deliver slightly over 5,000 Model S vehicles in Q3 and remains on track to deliver 21,000 vehicles worldwide in 2013. Q3 non-GAAP gross margins are expected to remain in the low 20% range, with improvements in Model S vehicle margins being offset by significantly lower ZEV credit revenue. The company plans on ramping up R&D expenses even further as it looks to accelerate product development efforts on the Model X as well as many other initiatives. Of course SG&A expenses will be rising as well, driven by the expansion of retail locations, service centers and Supercharger facilities. Moving forward, the company believes that it will be non-GAAP profitable and generate positive cash flow from operations every quarter this year, excluding any benefit from ZEV credits. Tesla expects to spend about $150MM in the 2nd half of this year on CAPEX, including the recent purchase of 31 acres of land adjacent to its factory, which will enable the company to expand its operations.
Based on 118,193,608 shares outstanding and a recent price of $170, Tesla has a market capitalization of roughly $20.1 billion. The company has a net cash position of about $167MM, so we can assume an enterprise value around $20 billion. Book value is approximately $629.426MM even after the $1 billion dollar capital raise in the 2nd quarter. Clearly, book value understates the incredible proprietary technology that Tesla has created but it is difficult to know by how much. The company is not profitable on a GAAP basis and while I understand the nuances of lease accounting, there is risk on the resale value guarantee program. Over the last twelve months Tesla has generated about $1.323 billion of revenue, $212MM of gross margin, and net losses of $220MM. Companies like Toyota Motor (NYSE:TM) and Daimler (OTCPK:DDAIF) are fortunate when they can crank out profit margins in excess of 5% and return on assets close to 3.5%.
Let's assume that over time Tesla's growth story continues at the same rapid rate and that the company is generating 10 times the trailing twelve months revenue. At a 5% profit margin on $13.230 billion of revenue, the company would be looking at $661.5MM of net income. Even this optimistic scenario would only offer a 3.3% earnings yield based on the current valuation. At the end of the 2nd quarter, Tesla had $1.888 billion of total assets. If the company were to earn a robust 5% return on assets, the earnings would be about $94MM. Because the company isn't likely to generate substantial profits in the short-term, assets can only be increased through equity issuances or increasing the debt load. Both of these options require super-attractive access to the capital markets. Any material disruption to the brand, to the tax credit situation or to the infrastructure build-out could have very dire consequences for the company's ability to access capital markets on such favorable terms
I don't believe that I have the knowledge of the electric automobile industry or Tesla's technology to accurately value the company. There are so many unknowns that I don't believe there are too many people that can. I do believe that the intrinsic value is far below current prices, and I believe the best way for the company to increase the intrinsic value is by issuing as much equity as it can, and I think Elon Musk is smart enough to do that. All of the aspirational goals are wonderful and I hope that electric cars become the norm, but I very much doubt that over the next decade Tesla will be reaping robust profits well in excess of its cost of capital because I believe its competition will encroach on Tesla's turf with very viable alternatives. The competition can offer both cheaper and more expensive versions because they have the financial capacity to outspend Tesla. They could have electric cars be loss-leaders in growing their brand while still registering reasonable profits from the gasoline-powered vehicles, which Tesla has no presence in.
I believe there is at the very minimum 50% downside to Tesla's stock. Many market participants and analysts will be coaxed by human beings' nature of short-term memory bias into thinking that the stock will just continue performing so exceptionally into the future despite a lack of profits. I have no doubt that many will believe that they will see the end before it comes around, just missing the collapse of what is quite obviously a bubble of sorts. There is tremendous risk in being short the stock with short-term or borrowed money to the heavy short-interest, but over the long-term I believe a carefully constructed short position could be extremely lucrative. One cowardly way to play it is selling the January 2015 $355 calls for $11.50 per contract. Tesla would have to have a market capitalization in excess of $40 billion to breach your calls, and if implied volatility or the stock goes down, your calls will decrease in value, which means profits for you as the seller of options. I'd obviously be more than willing to go short at those levels. Of course, you can be more aggressive than that but I don't want readers of this article to short the stock if they don't have the psychological or financial fortitude to be able to have the patience that could be required. Either way, it will be exciting to watch this story unfold.
Additional disclosure: I am short Tesla (TSLA)