An Artist's Depiction Of Tesla In Its Prime
In this article, I am going to expose yet another Tesla (NASDAQ:TSLA) risk. A risk that nearly every Tesla investor seems to ignore wholesale. I'll expose it in a rather novel fashion, so bear with me.
We know now that in the early years of the twentieth-first century the car world was being watched closely by intelligences greater than man's and yet as mortal as his own. We know now that as car makers busied themselves about their various concerns they were scrutinized and studied, perhaps almost as narrowly as a man with a microscope might scrutinize the transient creatures that swarm and multiply in a drop of water.
With infinite complacence car makers went to and fro over the earth about their little affairs, serene in the assurance of their dominion over the large auto markets. Yet across an immense ethereal gulf, a vast intellect, cool and unsympathetic, regarded this market with envious eyes and slowly and surely drew his plans against the car makers. In the twelfth year of the twentieth-first century came the great disillusionment.
It was near the end of December. Business was better. The deflation scare was over. More men were back at work. Sales were picking up. On this particular evening, December 31, Internet World Stats estimated that nearly 2.5 billion people were browsing the web in various ways, from their desktops to, increasingly, their mobile phones.
At twenty minutes before eight, central time, Professor Farrell of the Mount Jennings Observatory, Chicago, Illinois, reported observing several explosions of incandescent gas, occurring at regular intervals on the planet Mars. The spectroscope indicated the gas to be hydrogen and moving towards the earth with enormous velocity. Professor Pierson of the Observatory at Princeton confirmed Farrell's observation, and described the phenomenon as "like a jet of blue flame shot from a gun."
We now know those first observations precluded the arrival of the machines. First slowly, and filled with defects, but then by the thousands per quarter. The early models were sleek, fast, and unlike anything else on the market. Moreover, soon enough they seemed to drive themselves, requiring no operator. Their prowess at this was limited, and they invariably crashed, but not before wreaking havoc with other car makers' sales in the same segment, as well as with shorts betting against the Martians.
Indeed, both car makers and short sellers seemed powerless. The strength of the Martians, which excelled not just with these machines but also in building the rockets to deliver them (reusable ones at that), lay waste to all those that stood before them. The first model machines were then supplemented with another fiery machine, whose doors spread like wings. And the Martians even promised that they'd deliver more machines still, more numerous and smaller, at lower costs to boot.
The Martians were believed, and soon created a congregation on Earth, which paid tribute to them. Even though the machines were expensive and failure-prone, the faithful complied. On Earth, the car makers seemed slow to respond, set in their old ways of long and painfully testing their products.
The Martians were ambitious, though. They wanted to conquer and rule as fast as possible. Though their performance was impressive, they promised way beyond their ability to deliver. And with those promises came great leverage. And with great leverage came great risk, not just for others, but for also for themselves.
Still, even as shorts warned about the risks, their weapons were ineffective. Competition is coming! Valuation! Leverage! Quality! Reliability! No profits! No Free Cash Flow! Nothing, literally nothing, stopped the machines or the share price.
Suddenly, something happened. The Martians and their machines, once all-powerful, started falling to the ground. Vultures, previously circling above, descended upon them to pick on their carcasses.
The Martians, apparently, had succumbed against something which was always there: The oldest of auto threats, for which the Martians' leveraged systems were unprepared. Slain, after all of car makers' and shorts' defenses had failed, by the humblest thing that God in His wisdom put upon this market. The auto cycle.
The Auto Cycle
Things get a bit more serious here. Why this story? This story is because we've focused on a lot of different risks to Tesla, but one has been left behind. The auto cycle. The past killer of giants, including General Motors (NYSE:GM). The event that, when it makes its appearance, makes all automakers shudder.
Mostly, the auto cycle is so destructive because the auto business has very high fixed costs. This, when capacity is underutilized, quickly leads to massive losses. On top of this, the car business is extremely capital intensive. Thus, it isn't difficult for an automaker to end up being levered, which multiplies the risk. Nowadays, most automakers run on net cash (in the auto business, though the financing arm usually clouds things). Tesla, however, doesn't.
In the best of days, Tesla has been running at a free cash flow deficit. This has required, and will continue to require, that Tesla get more and more money from the markets. Now, let's imagine an auto cycle hits Tesla in such a way that it loses 20% of its volume/revenues*. I'll do this on a ceteris paribus (all else being equal) fashion. In fact, things would be worse than I am going to estimate, because I am not taking into account fixed cost deleveraging within gross margins.
So what would happen with a 20% volume drop? Straight away, it would reduce automotive revenue by 20%, and thus (even ignoring fixed cost deleveraging) gross margin would also decrease by 20%. SG&A and research would likely stay flat at best, since many of the costs are either recurring (research) or tied to the fleet size (service, superchargers). Remember, the fleet size increases even if annual sales decrease.
All of this taken together means that the 20% drop in gross margins would flow all the way down to net profit. So 20% of gross margins being gone would increase the loss by roughly $320 million or ~$1.93 per share. This would increase Tesla's losses by nearly 50%.
But that wouldn't be the worst. The worst is that during such sector implosions, shareholders lose their will to buy equity on the imploding businesses. As such, Tesla's ongoing need for more equity would likely not be met with interest. The result would thus be a dying Tesla, lying on the field, surrounded by vultures, which might want to prey on the brand.
So How Is The Auto Cycle Doing?
This is the dangerous part. It might be that at least in the US, the auto cycle is peaking. This is a function of three factors:
- The current cycle leaned heavily on debt and leasing, with the record high for auto originations being hit on Q4 2016. This cycle included reliance on subprime financing at levels similar to those hit at the top of the 2008 debt bubble.
- Recently, default rates on this debt have started rising.
- Finally, due to large use of leasing, used car prices have also started declining significantly in recent months.
Source: Ally Financial Presentation; NADA; Manheim
These factors can make for a vicious cycle:
- Increased defaults mean credit must be tightened (make it harder for consumers to qualify, so that qualifying customers are of higher credit quality and default less) or pricing must be increased (to compensate for defaults). Both lead to fewer cars being sold, either because the consumer doesn't qualify or because the lease/loan becomes more expensive. This also leads to a move downmarket (unfavorable for more expensive cars, such as Teslas).
- Reduced used-car pricing means residuals on leases need to be reduced as well. This means the same car becomes more expensive to rent (higher lease payments), which also reduces demand for cars. This also leads to a move downmarket (unfavorable for more expensive cars, such as Teslas).
Both taken together create a headwind for new car sales. They start the ball rolling towards a negative auto cycle. Now, since car factories have high fixed costs, their owners are leery of slowing down production. So they must move production, so they increase incentives and/or reduce prices. This affects revenues and profits for all players.
By the way, you already see this in Tesla, which is showing increased new car inventory quarter after quarter as to avoid slowing down production, which would imply less fixed cost leverage. Tesla then discounts those cars to move them, as would any other automaker. Ultimately, Tesla also has used factory stoppages, such as those during the last two quarters (always justified by "something else," of course).
Also noteworthy, the segments Tesla acts in are among those being hit the hardest by declining used-car prices, as can be seen above.
Again, this dynamic (cycle) might already be in motion in the North American market. This is a powerful reason why both car makers and parts makers trade at very low valuations - except for Tesla, that is. But Tesla is not immune, and indeed, due to its leverage and need for constant equity infusions, it's even more exposed to the auto cycle than traditional car makers. Hence, "The War Of The Worlds," where the Martians were ultimately defeated by something, which was always there - the auto cycle - instead of all the other threats put forward.
Tesla is unprepared for a negative auto cycle, which might actually be starting right now in its main market. This is yet another risk that the stock doesn't price in the least.
* A 20% revenue drop for a specialized producer like Tesla isn't much. Even wildly diversified Ford (NYSE:F) lost 15% of its revenues from 2007 to 2008 and a further 23% from 2008 to 2009, making for a 34% revenue drop from 2007 to 2009. That's the reason Ford was rapidly at bankruptcy's door and GM actually went under.
Disclosure: I am/we are 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.