Tesla Motors: Dilution Is Inevitable

| About: Tesla Motors (TSLA)

There is a heated debate going on between bulls and bears about Tesla Motors (NASDAQ:TSLA). Arguments are flying back and forth, from the intricacies of battery technology to the business wisdom of Superchargers. To me, these are details that do not really matter. I am a little surprised that most discussion around Tesla overlook probably the most important issue: car manufacturing is a very capital intensive business, and Tesla does not have enough capital to support its growth.

Years ago I used to run two companies in the automotive components sector with about 8,000 employees between them. Based on my experience and data from the other car manufacturers, I estimate that Tesla's assets will have to grow by at least 0.8 percent for each 1 percent of increase in sales. This is a very optimistic (if you are a TSLA shareholder) assumption. More realistically assets will have to grow in line with revenues, considering that Tesla plans to sell cheaper models. For example, in 2012 Ford (NYSE:F) had revenues of $134 billion, and to support this level of sales Ford had $190 billion in assets on its balance sheet (1.4 times its revenues), including $125 billion in current assets. Right now Tesla has $1.8 billion in total assets with $1.3 billion in trailing 12 months revenues (the same 1.4 ratio).

I anticipate that at this point some Tesla fans will point out that Tesla is not a "regular" car company. For some reason, they often compare Tesla to Apple (NASDAQ:AAPL).

I admit that TSLA is a great company and it does many things differently: building its own network of charging stations, bypassing dealers, and guaranteeing a buy-back price. These initiatives, however, require more capital compared to more traditional car manufacturers, not less. Also, TSLA is not APPL, because cars require more capital to develop and manufacture, 40 percent margins on mass-produced cars are impossible, people do not change cars every year or two, and for many other reasons. To me, TSLA is a car company as long as most of its revenues come from selling cars.

Analysts expect Tesla to grow very fast. The key question, in my view, is how the company is going to fund this growth.

Let's start with very generous assumptions:

1. Investors buying Tesla stocks today expect a very modest 10 percent annual return going forward (price at the time of writing was $183.39).

2. Tesla will reach 10 percent net margin within 2 years and will maintain it uninterrupted going forward.

3. Tesla stocks will trade at P/E multiple of 40 in 2020, well above any other car maker.

4. Tesla will not pay any dividends, and it will not issue any stock or stock options.

5. Finally, as mentioned earlier, every 1 percent increase in production capacity/sales will require only 0.8 percent increase in assets.

Using these assumptions we can calculate that:

1. Tesla stock price needs to reach $350 by 2020. This share price translates into a $42.5 billion market cap.

2. Tesla will have to make $1.06 billion in net profits on $10.6 billion in revenues to have a P/E multiple of 40.

3. This means 8 times increase in sales, requiring a 6.4 times increase in assets - from the most recent $1.88 billion to app. $12 billion.

4. During these years Tesla will generate $3.6 billion internally. Still, it will have to raise $6.5 billion through new debt and/or equity.

If Tesla borrows a substantial share of its capital requirements, we will have to adjust our model for interest paid on this debt (therefore reducing the retained earnings), which will require even more capital. For example, if Tesla gradually borrows $3 billion over the next 7 years at an average interest of 7%, it will have to raise an additional $4.9 billion in equity (the remaining $3.5 billion from our original calculations plus $1.4 billion to cover interest payments during these period).

To me, the conclusion is obvious: even under these extremely favorable assumptions Tesla will have to raise a lot of new capital, most of it by issuing new equity.

Here is the best part: our assumptions included "no new stocks issued". If we account for the new equity, the company will have to grow even faster to maintain that very modest 10 percent annual appreciation in its stock price. Faster growth requires even more assets, forcing the company to issue even more new equity, which demands even faster growth, and so on - this equation has no solution.

In other words, Tesla's stock price reached the point where it is MATHEMATICALLY IMPOSSIBLE to achieve a meaningful appreciation going forward, assuming that at some point the P/E ratio comes down to a more realistic, sustainable level.

You can try to prove me wrong and use your own assumptions, but you will keep running into two fundamental limitations. On the one hand, faster growth requires even more new capital. On the other hand, the company can only grow at 12-16 percent p.a. without issuing more stocks, which makes it very hard to justify a P/E multiple of 40.

I do not rule out a possibility of a short-term spike driven by momentum traders, but sooner or later momentum wanes and the fundamentals kick in. When it happens, TSLA stock has to go down 2-3 times to make the numbers work.

Tesla is run by very smart people. I suspect they are busy now preparing a massive new equity offering to take advantage of the current share price. This new offering may trigger a major re-adjustment of a stock price to a lower point.

I am short TSLA because my analysis suggests that the stock price will have to come down from the current levels even if the company meets all the rosy revenue projections. We can only speculate how low the stock will drop if something goes wrong.

Disclosure: I am short TSLA. 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.

Additional disclosure: 15 years ago I was a majority owner, chairman and president of two companies in the automotive components sector. Currently, I have no direct involvement in the industry.

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