One of my favorite tools is what I call the Berkowitz kill list. It's a simple check list that holds a huge amount of power for investors looking to keep risk to a minimum. And right now Tesla (NASDAQ:TSLA) is falling well short of passing this simple test.
Killing the company
Famed investor Bruce Berkowitz has a penchant for trying to kill his own investment ideas. The logic is simple; we all get caught up in stories and numbers. So, Berkowitz looks at the other side, trying to see what could go wrong instead of focusing only on what could (or has to) go right. From some of his notable quotes, I've created a short list of items that Berkowitz suggests frequently leads to corporate distress. Although this isn't his whole process, it's a great way for small investors to do a quick screen that double checks the assumptions and biases we all have.
Here's my abridged version of things that can kill a company that I created from a collection of comments by Berkowtiz and others:
- It doesn't generate cash (doesn't make enough)
- It burns cash (spends too much)
- It's over leveraged (too much debt)
- It plays Russian roulette (taking large win big/lose big risks)
- It has idiots for management
- It has a bad board
- It "de-worsifies" (expands into bad/inappropriate businesses)
- It buys back stock at too high a price
- It plays games with GAAP accounting
With the news of Tesla looking to buy sister company SolarCity (SCTY), I thought it would interesting to take a step back and try to kill the electric car maker.
It doesn't generate cash
From a top-line perspective, Tesla's revenues have been expanding quickly since it came public. But so, too, have its costs. And it hasn't turned a profit in any full-calendar year since it IPOed. Earnings, however, aren't cash, which is found on the cash flow statement. The news isn't any better there... Tesla's net cash provided by operations has been negative in all but one year (2012). Tesla fails this one.
It burns cash
Tesla has been spending an increasingly heavy amount to build its auto business and a massive battery factory. To put some numbers on this, it spent around $260 million on capital investments in 2013 and $1.6 billion last year. Since it's still working on that big factory and a new version of its electric vehicle, the costs aren't likely to end soon. Free cash flow has been negative in each year of its short life. You can argue that all this spending will eventually lead to profits and positive cash flow, but I'd say it fails bullet point two, as well.
Looking at Tesla's first-quarter balance sheet, from a big-picture perspective, debt and long-term leases make up about 70% of the company's capital structure, totaling a cool $2.5 billion. The bulk of the debt showed up in 2014 with the sale of 2019 and 2021 convertible bonds worth a combined $2.3 billion or so. It's reasonable to argue that a lot of the company's debt could be turned into shares of stock and the rates are very low, so maybe this isn't as onerous a load as it seems. But based on the first two kill list items, I'm inclined to err on the side of caution and say this is a fail, too.
It plays Russian roulette
Tesla is basically taking on every major automaker as it tries to create a new model for the auto industry. I'd say that counts as a high risk bet that's either going to work out really well or fail spectacularly. Building a massive battery factory looks like another boom or bust idea. And now Tesla is seeking to buy sister company SolarCity, which has been struggling and has a heavy debt load of its own. If SolarCity continues to struggle, it will just be a distraction and weight on a much larger Tesla - this looks like another sizable bet that could end pretty badly to me. So that's the fourth checklist item down and more than enough reason to stop moving on to item number five... but let's go on anyway.
It has idiots for management
The most important person at Tesla is Elon Musk. It's hard to call Musk an idiot. In fact, it's probably more appropriate to use a word like visionary. That doesn't mean his vision is reachable or even if it is that it can be reached in a way that will be profitable for investors. Lots of people love Musk, and perhaps for good reason, but I think the jury is still out on this one. Is Musk a brilliant man? Yes. Is Tesla benefiting from his aura and bravado? I think so. Will investors? Not sure how that will fall out just yet.
It has a bad board
There's no one on the board that really stands out as horrible, I guess. Though Elon Musk's brother and Brad Buss, the CFO of SolarCity, do stand out a little. And some prominent investors are saying very negative things about the proposed acquisition from a corporate governance standpoint. But I'll give this one a pass for now, too, saying more time is needed for a definitive answer. That's an easier punt since I think Tesla falls short on the first four items and, thus, already fails the Berkowitz test in my eyes.
Diversification can be a great thing, but if a company extends itself into areas that don't make sense, it can be a disaster. Tesla started with making all-electric cars. Then it moved into making batteries and power storage, tangential but still related. And now it wants to buy a solar panel company. The logic is that it integrates the entire process of electricity from making it to using it, but that's a stretch in my book. This looks like a step too far, particularly since the battery effort has hardly been a proven success just yet.
It buys back stock at too high a price
No notable buybacks here, so Tesla gets a pass. Though you could potentially argue that it is paying too much for SolarCity, which is being offered a premium of as much as 30% to the stock price before the announcement. And since Musk owns around 20% of SolarCity, I think there's still a question mark worth keeping in the back of your mind. So I wouldn't say it fails this test, but I wouldn't say it passes it either.
It plays games with GAAP accounting
I can't say I recall seeing anything on this front about Tesla. That said, SolarCity does use a fairly interesting financing model, involving selling so-called solar bonds. And Musk himself has been aggressive with his own investments in both Tesla and SolarCity, using margin loans to buy stock that, if there were a margin call, could result in a large number of shares hitting the market at, perhaps, the worst possible time. Again I wouldn't call this a fail for Tesla, but I still see enough question marks that I'm not going to give it a pass, either.
No company is perfect
This Berkowtiz kill list is meant to raise questions where I might not have thought to because I've been seduced by a story. That happens more often than I'd care to admit, by the way. And the story with Tesla is very exciting, with a dashing leading man, a fight against industry incumbents, and seeming success if you look at the sexy cars it makes. However, I think there are too many points where Tesla falls short for conservative investors to step aboard.
While no company is perfect, Tesla doesn't cleanly pass any of the nine items above. The shortfall is material on some of the points. And the proposed SolarCity acquisition won't help at all, only making matters worse in many cases. In my opinion, Berkowitz's kill list was a gauntlet Tesla couldn't live up to. Only aggressive investors should be in this stock.
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.