Elon Musk and Nikola Tesla may have more in common than they realize. Both created disruptive technologies, both have a tendency to embrace more radical theories that sometimes border on science-fiction, and like Nikola, Musk may eventually end up penniless from investing so much of his own money into his endeavors. Hopefully, this does not come to pass, for the future of electric vehicles hangs in the balance.
Ever since I started learning about investing, the company Tesla (NASDAQ:TSLA) has always been a fascination of mine. I've struggled to understand how a company so unprofitable, that requires so much externally-generated capital, and whose management consistently misleads its own shareholders could still receive so much praise and adulation from Wall Street.
I could compile a list pages-long of reasons not to invest in Tesla, and in fact, I have. Here are just some of the reasons why investors should balk at the thought of buying more Tesla shares, disregarding even the more recent scandals, such as with Mobileye (NYSE:MBLY) or "Autopilot" fatalities:
- Growing debt overhang.
- Model 3 or EV market interest could fade.
- Government incentives could decline.
- Possible execution risks/delays (Gigafactory).
- Management consistently misleads investors on future profitability and capex decisions.
- Consistently misses sales targets (e.g. deliveries report for Q2 2016 - only 14,370 vehicles, consisting of 9,745 Model S and 4,625 Model X, putting the 1H2016 total at 29,180 vehicles delivered; 5,150 customer-ordered vehicles still in transit - below guidance of 50,000 deliveries target).
- Consistently misses production targets (e.g. Tesla will still be nowhere near achieving the "half a million units manufactured by 2018" goal introduced to us in May even if production ramps up to 5,000 units a week, more than double where it is now).
- Risky and potentially negative-value projects, including but not limited to (1) expanding the electric vehicle product line to include all major segments, including the "Tesla Semi," (2) creating a "ride-sharing" fleet of self-driving Teslas, including a software system that would allow owners to "... significantly offset and at times potentially exceed the monthly loan or lease cost... to the point where almost anyone could own a Tesla"
The strange thing is, even with all of these issues and risks, even though at times, certain high-profile investors, such as Cramer or more recently Chanos, have spoken out against the company, funds still continue to flow into Tesla's pocketbooks as it seems Wall Street is more than happy to pay the bill.
And then, thanks to SA Editor Marc Pentacoff's most recent piece on the history of EBITDA, I began to put the pieces together. This same story has played out countless times before - sometimes, to resounding success, as with John Malone's Liberty Global (LBTYA, LBTYB, LBTYK) which took over the European telecoms industry through rapid capital-intensive expansion, but at other times, to catastrophic failure, as with Worldcom, now part of Verizon (NYSE:VZ).
This story is the capital structure irrelevance theory, or "value without profits" story - the Modigliani-Miller theorem that value generation has no relation to profitability or capital structure.
This idea, first postulated formally by Franco Modigliani and Merton Miller in 1958, attempts to describe how, in an essentially perfect vacuum market, the matter of corporate financing (e.g. debt or equity) is irrelevant; that is, capital structure has no bearing on value generation or rates of return, excluding financial risk, tax incentives, systematic risk, etc.
The theory became particularly popular in the late 80s/90s as the Internet/telecoms age grew to prominence, EBITDA became an accepted measure of financial analysis, and borrowing costs continued to decline. Investors, management, and the media began looking for some way to describe the unusually high valuations and capital-intensive growth markets that arose around these tech companies, and so, value generation was used as the rationalization for investing in these markets.
As we all know, most of the companies that embraced this "survival of the fattest" strategy would eventually collapse or fall prey to consolidation in the dot-com crash, with few exceptions...
How does this relate to the valuation of Tesla?
Tesla follows this same path of aggressive and risky expansion to a T. Like the ubiquitous tech companies of the 90's, Tesla consistently advertises non-GAAP measures, takes on highly risky and potentially negative-value projects (e.g. Gigafactory), and ultimately, has to resort to desperate measures such as raising equity (or having Musk buy SolarCity (NASDAQ:SCTY) bonds for example) as a last resort to maintain the expansionary scheme.
This is not necessarily a bad strategy; like I stated before, there have been many success stories resulting from this aggressive strategy, mostly in the utilities and energy sectors. However, there is always a turning point - an internal scandal, systematic decline, or other external influence that threatens to tear the whole risky endeavor apart.
With investors doubting the success of the Tesla-SolarCity merger, scandals emerging from Tesla's rather swift adoption of semi-autonomous driving software, and of course, the ever-present cash flow concerns, Tesla is at such an inflection point right now.
Tesla can emerge triumphant from this crisis; I do not doubt that. But, I believe three certain events must occur.
1. Tesla-SolarCity merger must succeed.
Much has been said already about Tesla's questionable proposed merger with SolarCity; I have no interest in reiterating the concerns relating to possible nepotism or lack of actual synergy. What I am concerned with is the market's perception of the merger and the consequences of the possible failure of the merger.
As detailed by Liam Denning of Bloomberg, the Tesla-SolarCity implied merger arbitrage spread is about 25%, which implies a 150% annualized return for arbitrageurs. Investors have no faith in the deal passing through and really do not like the idea of adding SolarCity's cash burn on top of Tesla's already record-breaking cash burn.
But, this is precisely why the deal must succeed. Without the success of this merger, Musk (and by proxy, all of his endeavors, including SpaceX (Private:SPACE)) will begin to lose even more credibility and faith in the eyes of the market.
2. Tesla must adopt more stringent accounting and communication standards.
This is an incredibly simple task for Tesla to follow through on, yet it would add so much more value in the eyes of investors. Tesla must restore fiduciary trust and investor confidence by prioritizing classical accounting standards, i.e. GAAP measures, communicating clear capital structure measures, and ensuring future official statements refrain from exaggeration.
For example, perhaps a more fruitful measure would be for Tesla to intentionally understate its production or sales potentials as to not mislead the public. Additionally, that means no more ambiguous tweets or ramblings, at least in an official context. I think we all know what I mean by this...
3. Tesla must reignite Model 3 (and EV as a whole) demand on a massive marketing scale and meet its production targets.
This is the most tricky and risky task that Tesla faces. Despite Tesla's record-breaking pre-orders (which are refundable and non-binding) for the Model 3, social interest (as measured by search interest for example) in the Model 3 and electric vehicles as a whole has waned since its debut. Tesla is essentially already overvalued enough (if the equity issuance wasn't enough of an implication for you).
If Model 3 and EV interest fades and sales can't meet up with Tesla's massive production ramp-up, then it will all be for naught. I am not an expert in marketing, so I do not know what Tesla needs to do in this regard, but I do know something needs to occur to reignite the public's interest in electric vehicles, such as by illustrating the cost-benefits of switching to Tesla's vehicles or showcasing Tesla's declining battery costs.
Rather than risk your capital in Tesla's shares which don't have much upside momentum or in attempting some form of Tesla-SolarCity arbitrage, probably the safest bet right now is Tesla's senior convertible notes. The high risk of Tesla's potentially negative NPV projects means that gains will continue to accrue for debt holders as opposed to shareholders.
Additionally, the possibility of yet more equity issuance means that dilution is an ever-present threat for shareholders. Financial market risk will also make it more difficult for shareholders to eke out gains, while debt holders and underwriters can continue to profit. Regardless of what happens with the merger, convertible note holders can always adjust and hedge out risk by mixing equity and debt investments.
Perhaps it has not always been clear, but more than anything, I want Tesla to succeed in its endeavor to deliver to the world an easier and more efficient mode of transportation. But without these measures, Tesla may not succeed especially at this critical inflection point in which so much is bearing down on Tesla's management.
I sincerely hope Tesla the company does not end up like Tesla the person - penniless and fruitless in some of his most promising ideas - because this goes beyond crackpot theories or fantastic inventions... the future of electric vehicles hangs in the balance.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.