I'm no fan of the valuation of Tesla (TSLA), and I believe it's over-extended, but when I read this bearish article entitled Tesla Motors: Dilution Is Inevitable, I felt that I had to respond. The article was very well written and made a lot of good points, however, there are certain aspects of it that I respectfully disagree with. While I won't say there isn't a possibility of dilution occurrence perhaps for other reasons not mentioned, I believe it's important for investors to consider the other side of the trade.
First of all, Tesla should not be compared to Ford (F) or General Motors (GM) in terms of capital required to support growth. Ford and General Motors are low-margin manufacturers that require intensive up-front capital into each car in order to squeeze out 10% gross profits on a good day. Meanwhile, Tesla has been continually growing its gross profit margins well above and beyond what Ford and General Motors are capable of, with a forecast of 25% for Q4. The average analyst estimate for Q4 is $519 million so 25% of that would be $137 million. Since last reported quarter sales were $405 million with $100.5 million in gross profit, the $36.5 million increase in gross profit on $114 million in sales suggests an incremental gross profit margin of 32% or over triple that which Ford and General Motors typically see.
Second, even if Tesla has the poor margins of the others, the sales to asset ratio of Ford tends to be more healthy than necessary and shouldn't be used as a minimum benchmark. The proof of that is that Ford pays a 2.3% dividend yield, doubling its dividend per share quarterly payout this year over last year.
Third, it seems many of the "dilution is coming" bear crowd missed this discreetly line from Tesla's latest earnings release, halfway through the quarter:
Going forward, we expect to be non-GAAP profitable and generate positive cash flow from operations every quarter this year excluding any benefit from ZEV credits.
It was further clarified in its conference call:
As we said in the shareholder letter that we clearly intend to cash flow from operations. And you are right in pointing out that some of that will be offset by our capital expenditures and we want to be very careful about burning cash. We want to be sure we are close as possible to a free cash flow position, but that's something that we don't want to necessarily guide to how we are going to manage it, but we are going to be still judicious and spend the CapEx where we need to in order to make sure that we are growing at the right pace.
That doesn't sound like a company destined for dilution any time soon. At least not to me.
Last but not least, the financials themselves don't show dilution as a sure thing. As of last quarter's end, Tesla carried around $727 million in property, plant, and equipment and $368 million in accounts receivable and inventory. As mentioned, Tesla expects to be cash flow positive starting in Q3 with over $518 million in sales or a $2.072 billion annual rate. Using the author's target of $10.6 billion, that's roughly a four-fold increase. If Tesla were to duplicate its current operations, without accounting for any economies of scale not even in R&D or advertising, then it would require the $727 million X 4 and $368 million X 4 for a total of $4.368 billion of capital.
So how could Tesla come up with $4.368 billion without additional dilution?
1. It has $747 million in cash.
2. As of December 31, 2012 there were 25,007,776 options available with an average strike price of $21.20 each. This means the proceeds of all of the options (which has probably increased since the 10K) is around $530 million.
3. Again from the 10K: "a warrant to purchase up to 3,085,011 shares of our common stock at an exercise price of $7.54 per share and a warrant to purchase up to 5,100 shares of our common stock at an exercise price of $8.94 per share." This is another $23 million in future proceeds.
$4.368 billion in capital needed by 2020 - $747 million cash - $530 million from options - $23 million from warrants = $3.091 billion needed by 2020.
4. The author assumes a 10% net margin in 2 years. Using the 2014 analyst estimated sales rate of $2.86 billion for 2015 (to be extra conservative), that's $286 million in cash flow for the first year (2015). To hit $10.6 billion for 2020, Tesla needs to grow by over $1.5 billion on average per year. This means cash flow year 2 (2016) would be $286 million + $150 million, year 3 (2017) $286 million + $150 million + $150 million, etc. etc. Add it all up together and get $3.87 billion in cash flow, well above what is required.
I'm not saying that dilution isn't possible, but it is clearly far from inevitable. I think most Tesla investors actually welcome some relatively minor dilution as the extra cash in the bank would help lower risk.
I admit I'm nervous about going long Tesla at these inflated levels, but I would be even more nervous if I were short the stock. The highest analyst estimate next year puts the stock at a 50 PE ratio with obscene growth. Given that Tesla annihilated estimates the last two quarters, I wouldn't put it past it to do so for 2014 either. I could think of better places to short where I could sleep better at night. I wouldn't worry about dilution if I was long Tesla, but I would worry about much higher stock prices if I were short.