Having been about a year since Kinder Morgan Inc. (NYSE:KMI) imploded, I've been reflecting on the fervor leading up to its ultimate share price collapse and can't help but notice the parallels to Tesla (NASDAQ:TSLA).
When KMI lost investor confidence its share price fell precipitously from $32 per share in October 2015 to a nadir of $11 per share in January 2016 having since steadily recovered to $21 per share. Anyone that bought in the spring of 2015 would still be sitting on a 50% loss and reduced dividend. The factors that led to KMI's decline are similar to TSLA and serve as a warning to TSLA's shareholders.
At first glance there doesn't seem to be a strong parallel between a natural gas infrastructure company and a company building space-age electric vehicles. Granted, the SolarCity (NASDAQ:SCTY) acquisition will bring Tesla into the infrastructure business and Musk's long-term goal is that Tesla be an energy company, one that powers your home and your car. But pipelines in the ground and sophisticated tech on wheels are seemingly disparate businesses to compare. However, the capital structure and financing strategy are similar.
TSLA is investing heavily in capital and research to build its multitude of businesses and has accessed capital markets frequently to fund those expenditures. Separately, a common criticism among TSLA bulls is that the company accesses capital markets despite forecasts that no such access will be needed. KMI was accessing capital markets for its significant growth capex while using cash flow generated from operations to pay a large dividend and was clear to their investors that was their strategy. KMI was amalgamated with a number of related entities effective December 31, 2014. The intention was that growth capex would be funded approximately 50/50 debt and equity.
A quick look at KMI's cash flow data (below) shows how they raised $5.4 billion in new capital in 2015 to fund capex while paying out $4.2 billion in dividends. Without capital market access, KMI still had $5.3 billion of cash flow from operations that could pay a reduced dividend and reduced capex but needed capital markets to sustain its existing business model.
TSLA shows lumpier activity as a new, high-growth company:
TSLA's steady growth of capex as shown above from $250 million in 2013 to $1.7 billion in 2015 is indicative of its high-growth phase as a young company. The investments in mass-market vehicles as well as the Gigafactory for battery production are being financed on a speculative basis (as opposed to internally generated cash flow) with the expectation that they will increase the earnings potential of the company in the future.
Here's a closer look at the investment side of TSLA's results:
Research and development expense affects GAAP earnings and net cash flows from operations but may provide an enduring benefit to the company. The uncertainty requires their expense but investors can look at these amounts as potentially driving future growth to the extent that they are developing new products and sources of future cash flow. The positive side is the amount being invested in future potential of the company. The negative side is that the company has to invest heavily to reach the point that it becomes sustainably profitable and that heavy investment implies continued capital needs.
In addition to TSLA's capex and R&D needs, the SCTY acquisition recently approved by shareholders would be expected to negatively impact cash flow further based on its historical results:
SCTY has had negative operating cash flow for nearly three years while investing heavily in its business. When TSLA announced in June its intent to acquire SCTY, investors were concerned that SCTY's cash needs would be a strain on TSLA's cash flow requiring further, dilutive capital raises. Musk has since touted the synergies the companies will have while changes to the SCTY business model (less leasing, more cash sales) will improve cash flow. But how reliable are Musk's forward-looking statements?
Musk told investors in August that TSLA would likely need to raise additional capital in 2016 on the order of $1.5-$3.0 billion (mid to upper single digit percentage of market cap) but has since walked away from that statement, expecting improved cash flows from operations of both companies to mitigate the need for additional capital for the immediate future.
In August The Wall Street Journal reported a fair summary of Musk's missed forecasts, targets and goals stating that "in the past five years, Tesla failed to meet more than 20 of his projections, and missed 10 goals by nearly a year on average" despite Musk setting goals he believes are achievable. The article can be found here. Tesla missed forecast vehicle delivers for the second quarter of 2016 by 15% (14,370 vs. 17,000 forecast). Tesla's Model X sport-utility vehicle was delayed nearly two years. The Model 3 sedan was initially targeted for a 2014 rollout but is now expected in 2017. In May Musk said the Model 3 would start production July 1, 2017, but now expects it to be later. Musk predicted August 2014 that 8,000 vehicles would be made and sold monthly by the end of 2015 but it was instead about 5,800 a month. Musk's February 2015 forecast of 55,000 vehicle deliveries for 2015 fell short as well.
These misses, while reasonable given the nature of the business, undermine investors' confidence in Musk's capital promises.
Capital structure or Ponzi scheme?
I disagree with the common refrain that frequent access of capital markets to fund a cash flow negative growth business equates to a Ponzi scheme. For Kinder Morgan the critique was that new capital was raised while significant cash was distributed in a way paying out existing shareholders with new shareholders' money. The insult is thrown about loosely in TSLA article comment threads but clearly the money is being invested in something. The debate is whether that something will eventually create discounted cash flows in excess of invested capital sufficient to create a reasonable risk-adjusted return to current shareholders.
What I find appealing about the use of the primary market for capital is that it is in a way a pure form of capitalism. Shareholders are able to invest their money directly into a company that is investing that money into something real that is expected to provide an enduring benefit to society. It's a more romantic type of investing than watching some charts for a cup and handle of a hardly understood company just to execute a trading strategy. But it is risky.
Investing in the future
Natural gas has been an ascendant energy source in the US since the fracking boom began. Cheap, abundant natural gas provides low-cost feedstock to US chemical and manufacturing companies and provides a clean source of energy for electricity generation. Long-term forecasts were for sustained decades-long growth as gas-fired electricity displaced coal-powered electricity. KMI investors believed this long-term growth environment would allow for significant and sustained cash flow generation and dividend growth. That growth story is still positive but didn't prevent KMI's capital access problems.
TSLA investors also believe in a cleaner, better future with affordable solar power for everyone and their electric cars. Solar power has been getting steadily cheaper for decades. We are on the verge of a green energy renaissance. But you could have said that at any time in the last 20 years. It's a good narrative but doesn't provide any assurance that TSLA will necessarily succeed. The excitement of having a good-looking, maintenance-free, energy-producing roof of similar cost to today's roofs is exciting. I caution investors to not let that excitement cloud their judgment.
TSLA's Elon Musk is a famous billionaire, credited as a genius and visionary who built a car company from scratch - the real-life Tony Stark. Many invest in TSLA because of their faith in Musk. The same was true for KMI. Many investors trusted Rich Kinder's history of success, trusted his judgment and trusted his motives since his wealth is heavily invested in KMI. They chose to invest in him as much as in the company itself. In the end Rich and his management team felt the pain of KMI's drop along with the other shareholders but they still didn't anticipate the violent capital market upheaval, whether due to hubris or otherwise. Elon Musk's wealth is invested heavily in TSLA and SpaceX. If TSLA goes bust he has everything to lose. The lesson is that brilliant, successful leaders with skin in the game can still fail.
The single biggest difference between TSLA and KMI is cash flow. KMI has plenty of it and TSLA has none though they promise to have a lot any quarter. KMI invests heavily in growth capex for new infrastructure projects. It was funding that activity with debt, preferred shares and common equity offerings while paying out dividends in excess of GAAP earnings based on cash flow from operations. Eventually the naysayers were proven right (and I wrong) as the capital markets became too expensive for KMI to access. The solution for KMI was simple (if painful) - cut the dividend and use internally generated cash flow to fund growth capex. The result is a lower distribution and lower share price but a more sustainable company.
If TSLA loses the market's confidence and gets shut out of capital markets, it faces a more challenging problem. TSLA needs cash and would either be forced to dilute current shareholders heavily to issue equity or pay significant premiums on debt or debt-like financing. High premiums may be justifiable in the short run but they undermine the business model in the long run, particularly for the leasing of solar panel roofs.
The bulk of KMI's revenue comes from its monopolistic pipelines under long-term contracts often rate regulated to ensure it earns a fair return. This provides significant protection to its cash flow. KMI has competitors but primarily only in the bidding for projects. TSLA on the other hand faces steep competition from a large, established automotive manufacturing industry with a history of over-production. TSLA is expected to be competitive in its target markets but there is material risk that other car-makers will take sufficient market share as to limit TSLA's growth.
Fall from grace
KMI increased its ownership in Natural Gas Pipeline Company of America for $136 million cash consideration and assumed $1.5 billion in debt, announced November 30, 2015. The increase in leverage was sufficient for Moody's to downgrade KMI's debt outlook to negative from stable on December 1, 2015, and the share price collapsed, effectively shutting KMI out of equity markets. Kinder Morgan was forced to slash its distribution when it got cut off from capital markets and fund its investments internally while also scaling back its capital activity, forcing it to slow growth. The precipitating factor was a relatively modest acquisition that assumed high-leverage debt. KMI management was taken by surprise.
What would a precipitating factor be for TSLA? Musk has consistently made over-optimistic predictions and forecasts and investors shrug them off. Perhaps one day TSLA will miss goals and investors will not accept it. Perhaps it is use of an exotic financial instrument to reduce capital costs or severe dilution of existing shareholders or an unexpected Trump policy that severely limits TSLA's potential. The point is not predicting the catalyst but recognizing there are many plausible catalysts that could lead to TSLA's undoing.
KMI was able to choose to stop accessing capital markets when they became too expensive. TSLA may not have that ability considering its lack of operating cash flows. Musk has shown savvy managing his companies' capital programs so far and may be able to find creative ways to finance TSLA's capital needs in the event that regular capital markets become prohibitively expensive. However, given the large cash burn historically and the sources of those funds there is a material risk that TSLA wouldn't be able to continue as a going concern if this occurred.
Without capital, what would TSLA be worth? In short, nothing. TSLA and SCTY have a combined net equity position of about $3 billion. Assuming liquidation values of those assets were at least carrying value (unlikely in a liquidation scenario) then you'd get 10% of your investment back but more likely than not there would be nothing even if taken private.
So the question TSLA investors should ask themselves is, how likely is it that there could be a material loss of confidence in TSLA by the market? Given that, what are the chances the company could survive, let alone thrive, without access to new capital? And in that scenario the company would be worth a small fraction of its current market value or nothing at all.
Personally I'd say there's at least a 50% chance of something happening that affects TSLA's access to capital given all the risk factors. Further to that there's at least a 20% chance that Musk couldn't keep TSLA going without effectively wiping out common shareholders.
Are you willing to take a 10% risk that you will lose 90% or 100% of the value of your TSLA investment?
Many investors are implicitly comfortable with that risk, hoping the company will one day become a tech behemoth like Facebook (NASDAQ:FB) or Apple (NASDAQ:AAPL) or an industrial giant like GE (NYSE:GE) with a market capitalization worth multiples of today's value. However, my warning is for those investors who are overlooking the risks that heavy reliance on capital markets entails.
Many Kinder Morgan investors were blind-sided by the sudden dividend cut and share price collapse but those who recognized the risks of relying on capital markets regularly could see the possibility. Tesla has ardent supporters and investors who have accepted delays and missed forecasts for the potential of tomorrow but they need to be aware that there is a risk it won't go as planned and could lead to Tesla's fall from grace.
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.