Tesla Stock To Split - The Hard Way!

| About: Tesla Motors (TSLA)

Summary

Sales are falling sequentially and competition is taking market share.

There are headwinds in China that will lead to lowered expectations.

Aggressive accounting practices will begin to haunt Tesla in 2016 when it buys back leased vehicle above market value.

The truth about Tesla's gross profit margins on auto sales is an accounting gimmick; legal, but misleading.

The Dream

Design and build an all-electric drive luxury sports car that looks cool, has more power and better handling that most traditional sports cars with combustion engines and get everyone's attention. Check!

Get lots of federal subsidies. Check!

Design and build an all-electric drive luxury sedan with elegant lines, extraordinary comfort, a longer driving range that other all-electric sedans and create the dream of saving the world from polluting fossil fuels. Check!

Make company founders extremely wealthy. Check!

Design an affordable sedan for the masses with extended range capabilities and gain enough market share to establish a sustainable business model that could actually really save the world from polluting fossil fuels. Work in process.

Build a gigantic battery factory to engineer and manufacture the millions upon millions of batteries to meet the burgeoning demand for electric cars from all around the globe. Work in process.

Report consistently rising profits quarter after quarter. I am not holding my breath. This one could take a few years.

The Reality

Everything was going fine. Tesla (NASDAQ:TSLA) started out hitting four out of four. Then reality set in taking the form of gasoline prices falling from nearly $4.00 per gallon to less than $2.00 per gallon. When gas cot $4.00 per gallon more people thought that an electric car made sense. Now, with gas costing less than half that amount…not so much.

Sales in the third quarter of 2015 were lower than in the three previous quarters. The total market capitalization of Tesla equals almost seven times the trailing twelve months sales. That sort of multiple is usually reserved for companies that are profitable and growth sales, profits and margins consistently at a very high rate. The gross profit margin has widened to the second highest quarter over the last year. At the same time selling and general administration [SG&A] expenses have risen 20 percent. The net loss from operations has more than doubled. Inventory has grown by more than 35 percent while sales are down. Total debt has only risen by 8.4 percent because the company borrowed nearly $2.3 billion in the prior year. The company also raised $454 million from the sale of stock in 2014 and another $844 million in the first three quarters of 2015. In the third quarter of 2015 TSLA recorded a net loss of $229.9 million on sales of $936.8 million. Believers want to believe it is just growing pains. I believe it is something far more insidious than that.

BMW is mounting competition for Tesla's upscale market. Competition for the mass market sedan is vicious both in the U.S. and in China. Tesla had been counting on significant sales coming from the Chinese market. So far, it looks like the Chinese are buying electric cars build in and by China. The major problem that Tesla faces in China, in my estimation, is the potential of Chinese companies cloning its cars and selling for less. It is a real threat to growth for Tesla in China and that market is considered a key to the success of the company. But it remains tough sledding for Tesla in China for a number of reasons according to this article from another Seeking Alpha contributor.

If problems in China are not enough, the price of oil is not likely to inspire sales of electric cars. I expect the price of oil to remain low for years as I outline in my recent article, "How Low Can Oil Go." But that is not the only headwind that I believe Tesla will be facing in 2016.

Starting in 2016, Tesla will need to resell vehicles that were originally sold on synthetic leases. The company promised to buy the cars back from the original owners at one half of the original sales price. Will used Tesla electric vehicles retain value much better than competitors' vehicles? Maybe. But resale of used electric vehicles are facing some headwinds as potential buyers are weary of the battery life; for good reason. This is uncharted waters and those batteries will cost thousands of dollars to repair or replace. Other three-year-old electric vehicles are being sold for 25 to 33 percent of the original cost. Part of the reason may be that there are no federal or state tax credits for used electric cars. This is a big question hanging over the financial results for 2016. My belief is that this issue has not been included in analysts' assessment thus far. I will get into the accounting issue on this in the next section. It is not pretty. It is a reality that Tesla has not yet had to deal with but will for the first time in 2016.

Another problem in Tesla's future is its over-reliance on government subsidies. Tesla has generated hundreds of millions of dollars from regulatory credits and still loses hundreds of millions of dollars a year. What will fill that gap when the subsidies dry up? Government leaders will eventually tire of subsidizing this industry and force it to stand on its own. When will this reality seep into the minds of analysts?

But even more concerning is the fact that demand for electric cars is leveling off. To be successful Tesla needs demand to keep rising by large percentages every year. If demand picks up then the company will need to fend off competition.

In 2014 total U.S. sales of electric vehicles hit 123, 049. In 2015 total sales actually fell to 116,597. Tesla U.S. sales rose from 17,300 to 25,700, an increase of over 48 percent, while total U.S. sales fell by 5.2 percent. Still, Tesla has competition for its market share in a contracting market! Over the same period, BMW increased its sales of electric cars from 6,092 in 2014 to 11,024 in 2015, an increase of 80 percent. Of course, BMW did not sell an electric vehicle until May of 2014, so it is not such an established player in this space. But it does appear to be acquiring market share that may have otherwise gone to rival Tesla. My point here is that while still the king of a very small hill, the Tesla brand is not insurmountable by competitors like BMW. Going forward, if there is a profit to be made in the EV market the competition will heat up and come from established brands that are more respected than GM or Ford. This is another reality that will set in sometime in 2016.

Worldwide sales tell a better story with total sales growing from 2014 to 2015 from 320,713 to 447,617. However, with the price of oil falling I expect that the rate of growth will slow considerably in 2017. Also, the most important market for EV growth remains China and I sincerely believe that competition will begin the stunt Tesla sales in that market.

Demand for electric cars has peaked for this cycle, in my opinion, and is not likely to continue its climb again until the price of gasoline rises back to near $3.00 per gallon. I really do not see that happening for several years without a major war in the Middle East. This reality should become obvious by mid-year.

The Accounting

Now for the main reasons I expect shares of Tesla to fall back down to earth. The company uses some of the most aggressive accounting I have come across. I am a retired CPA and CFA. I have gone through a lot of annual reports and financial statement in my lifetime. I will admit that the accounting policies of Tesla are completely legal and have cropped up previously in other companies. But there are techniques used by Tesla that I had not found together in one company.

The synthetic lease that Tesla offers is accounted for as a sale and the full price of the vehicle is recorded as revenue. Tesla is contractually obligated to purchase those vehicle back from the original buyer after the 36 or 39 month term of the lease. The company has not accrued for any losses that may occur when it tries to sell these vehicles as used to the public. It seems to me that it is highly unlikely that Tesla will be able to sell these vehicles for half of the original price on a wholesale basis. That means that the company will, at the very least, end up with additional selling expenses related to each vehicle. If Tesla cannot sell the vehicles for more than it has agreed to repurchased them for it will need to take a write down on not only each sale as it occurs, but on all past sales by lease with similar commitments. When analysts realize that the expected future sales and especially earnings projections will be cut drastically. The reality will play havoc with the share price by the second half of 2016.

Next up is how Tesla accounts for the regulatory credits it received from government when it sells an electric car. The company accounts for all regulatory credits as automotive sales revenue on its income statement. Those credits are not automotive sales. This accounting policy is designed to inflate its auto sales and profit margins attributable to those sales. It gives the appearance that margins on sales of its autos are much higher than reality. This will not require an adjustment. It is legal. It is just very aggressive in my book. In other words, the business of selling luxury electric autos is not nearly as profitable as it appears. If there is even a hint of the government beginning to reduce the subsidies it now provides analysts will dig into this issue and adjust the numbers accordingly. This may not happen in 2016, but it may come up when the other aggressive account practice comes to light leading to additional downward adjustments to future profitability and growth. Government will end the gravy train at some point. It is only a matter of when. That reality has not set in yet either.

Conclusion

I do not hate Tesla. I actually like what the company is trying to achieve. I just do not believe that the time has come for a radical expansion of market share by electric vehicles, including Tesla. Demand will rise eventually, but with the cost of a gallon of gas now under $1.60 where I live I cannot justify paying more for a car that I will not use on long trips. Remember, the baby boomers are retiring and have the money. We no longer commute. And there are not enough young drivers willing and able to pay more for a luxury vehicle with limited range.

Tesla is a great idea that is ahead of it time. It is a company designed to change the future but the future is not here yet. I am sorry, Mr. Musk, but the world is just not ready. In 2016 the reality will hit the fan and the price of Tesla share will be cut in half, not by a stock split, but the hard way to less than $100 per share. Within three years I expect Tesla shares to halve again and trade under $50 per share. The shares may even be worth that much someday.

Why is my price target $100? It is complicated but let me try to explain. Tesla is not profitable and revenue growth has diminished so it makes valuing the company difficult. So, we need to consider what got the price to these insane levels in the first place. So, I want to consider who owns the stock and why those investors bought it. First there is a cult following that would buy whatever Elon Musk is willing to sell them. Second, there are the founders. Did they buy all that stock? No. The largest category of shareholders is the institutional investor. Each institutional investor has its own reason for buying and owning a stock. I cannot help but suspect that a large contingent of Tesla owners are momentum investors. If the stock begins to crumble many from that group will bail and protect gains or limit losses very quickly. But as long as the stock remains in an overall uptrend most will hang onto shares. They will until they see something they do not like. As I explained above there are several things to not like that will become more obvious as we move through 2016.

When I consider those groups of owners the one characteristic that runs through all types is that perception, rather than fundamental analysis, drives their investing decisions. That is a form of market psychology in my book. So, I decided that my target price needed to be a psychological support level of significance. As I look at the five-year chart for TSLA I see strong technical support at $185 and some weak support at around $125. I do not believe that the $185 level will hold this year when the company faces write downs on previous years sales if it cannot sell the returned leased vehicles at break-even. The $125 level is weak support so I decided to opt for the huge psychological barrier of $100. I expect the true believers to defend that level vehemently. Otherwise, I would select an even lower target.

TSLA Chart

TSLA data by YCharts

Action I intend to take

I do not intend to make a short sale because I do not like to hold positions with unlimited upside risk. Even if I invest with conviction I do not take undue risk. Thus, I never sell stock short. I prefer to define my risk up front by buying a put option contract. I know exactly how much I could lose and I can also reap the rewards of the leverage involved. My preferred contract is the TSLA January put option with a strike price of $170. If the stock price hits my target my potential gain is equal to at least $4,315 per contract which represents the intrinsic value minus the original premium paid of $2,685 (plus commissions).

But there are two forms of value that make up the price/premium of an options contract: intrinsic and extrinsic. The intrinsic value is simply the difference between the underlying stock price and the strike price of the contract. With the stock price at $199.97 (as of the market close on Thursday, January 21, 2016) and a strike price of $170, the intrinsic value is zero (it does not go negative). The entire $26.85 premium is made up of the extrinsic value at this point.

The extrinsic value of an options contract has two elements: time value and volatility. At the moment the volatility element has pushed most option prices higher but I am not too concerned since I believe that this stock will become even more volatile over the course of the coming year. The time value will decay over the life of the contract until expiration on January 20, 2017, at which time it will be zero.

The earlier in the year that investors wake up and rush to the doors the better for me as I may be able to salvage much of the extrinsic value of the option contract. The current bid premium on the aforementioned contract was $24.15 and the ask premium was $26.85. If the stock price of TSLA is flat on Friday I would expect to be able to buy one contract at the midpoint of $25.50 or less. The expect gain if I get this price would be $4,450 (minus commissions), or 175 percent, on an initial investment of $2,550 (each contract is based upon 100 shares). The maximum amount I could lose is the original cost of the option ($2,550) plus the commission. If the stock hits my target of $100 before the contract expires in January 2017 I will walk away with at least $7,000 (including my initial investment). I like the risk/reward profile!

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

For those interested in learning more about my investment philosophy you can find more detail in a series of articles titled, "How I created my own portfolio over a lifetime." For those who prefer to listen rather than read I was interviewed by Brian Bain, of Investor in the Family, about my investment philosophy and you can listen to the podcast here.