5 Principal Reasons Why I'm Still Short Tesla

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About: Tesla, Inc. (TSLA)
by: Amit Ghate
Summary

I review my long-standing TSLA short position.

Despite a large run-up in price, I find the reasons to be short the stock more compelling than ever.

In particular, corporate governance, emerging competition, bloated valuations and a slow change in sentiment toward the company may help reverse the stock run-up.

I typically write on small cap and other stocks which are much less followed than Tesla (TSLA) because doing so helps fill an obvious coverage void. TSLA, on the other hand, is extremely well-covered, and so there’s less of an opportunity to make new points and/or present a fresh angle. Indeed, I regularly read all of the short-side experts (Montana Skeptic, EnerTuition, Anton Wahlman, etc.) as well as many of the best longs to get a better understanding of the opposite side of my trade (Trent Eady, ValueAnalyst, Randy Carlson, etc.) Yet while the coverage from both sides is extensive and extremely thought provoking, the sheer volume and pursuit of minor details can often obscure the essential investment (short) case. For example, while it’s very interesting to ferret out the costs of each supercharger location, in the end, the results won’t materially affect the probabilities of TSLA’s ultimate success or failure.

In order to stay focused on the bigger picture, I like to review my longer term positions every six months or so, with the goal of distilling my investment case, including identifying any potential developments which might cause me to change my mind. In this article, I present the results of my review in the form of a top 5 list of reasons (in order of importance) for why I have a long-term TSLA short position, in the hopes that it might also be helpful to other readers who may have become overwhelmed with the volume of TSLA coverage.

1. Corporate Governance / Executive Turnover

In my view, the single biggest negative with TSLA is its corporate governance. I know that claiming that the company disregards shareholder interests will be reflexively met by the cry “look at the stock price,” but please hear me out anyway. The most egregious example of disregarding TSLA shareholder interests was the bailout of SolarCity. Let’s give TSLA the benefit of the doubt and assume that the strategy of going vertical makes economic sense (I personally don’t think it does, but leave that aside for now) wouldn’t an objective approach require valuing all of the solar companies in the field, and then explaining to shareholders why the particular buyout candidate was the best value and best fit? Moreover if one is trying to buy from a clearly distressed company, wouldn’t one consider buying some of the assets and IP, without necessarily assuming all of the debt and liabilities? Yet there is no sign that any of this was done in the case of the SolarCity buyout/bailout.

Instead, TSLA failed to survey the field to find the best valued candidate, it didn’t pursue tough negotiating practices to wring out as much possible value from the clearly distressed SCTY, nor did it consider only buying parts of SCTY. In and of itself this is extremely shareholder unfriendly, but it becomes scandalous when one considers that SCTY was largely owned by Elon Musk and his cousins, and that Musk’s private company SpaceX also benefited from this exorbitant bailout (see link above for details). In the long run, TSLA’s choices to favor its founder’s interests over those of other shareholders are the biggest single reason to be short the stock.

But problems in management don’t end with the obviously conflicted corporate governance - they extend to an inability to integrate and retain top management talent. Most recently TSLA’s director of battery technology resigned, but that is just one in a long string of executive defections. Orange Peel Investments has covered this aspect of the story for a few years now. Reading between the lines, it would appear that Musk’s management style isn’t conducive to building an empowered and committed executive team. Instead, Musk’s flights of fancy (e.g. the Model X must have “sexy” falcon wing doors regardless of any objections) would seem to override any reasoned input from his underlings. Capable and thoughtful executives won’t abide such direction/management over the longer term.

Not only is constant executive turnover costly and disruptive, it also plays into my fifth point (below) regarding TSLA’s lack of manufacturing scale and experience.

What would make me change my mind? For this first point, I think the SCTY debacle is hard to overcome, but perhaps if the executive turnover ended and the new board members clearly asserted themselves in favor of minority shareholders, I would begin to reconsider.

2. Emerging Competition

TSLA deserves enormous credit for carving out a new product category and taking the early lead in producing BEVs. But it will soon become a victim of its own success as numerous well-heeled and experienced automotive companies begin producing mass-market BEV’s. Indeed Volvo has announced that from 2019 forward all of its new models will either be electrics or hybrids. Anton Wahlman estimates that by 2022 there will be 143 pure BEV’s on the worldwide market. Notably, GM’s (NYSE:GM) Chevy Bolt was the first sub $40K 200-plus mile range BEV to be sold commercially, and while its sales are somewhat disappointing given initial predictions, the sales numbers have been steadily increasing:

(image source)

GM will have almost a year lead over TSLA’s Model 3 in terms of volume production, not including the fact that GM tests its cars and production methods before entering commercial sales, while TSLA adopts the beta-tester approach using its customers as final testers.

Next up is the refreshed Nissan (OTCPK:NSANY) Leaf which will be revealed in September and which is expected to also have a 200-plus mile range. Let it not be forgotten that the Leaf is the worldwide EV “sales king” with 277,000 vehicles sold to date.

Then comes Jaguar’s 220 mile, 0-60 mph in about 4 seconds I-PACE, which will be priced to compete with the Model X and which Car and Driver deemed “worth waiting for.” It will begin deliveries in Europe as early as end of this year (though many estimates have it launching early 2018 in Europe), and will be available on these shores in second half 2018.

By 2019 there will be a plethora of BEV’s to choose from.

Perhaps more important than just the sheer number of emerging competitors, is the reality check that TSLA’s Model 3 reveal allowed. Up until then, people were comparing a forecasted car against actual cars, both in terms of features and pricing, and so, of course, the promised — but non-existing — car won the competition in most peoples’ minds.

That will all change now that it’s possible to compare actual cars head to head. For example, the Bolt price and features will be looked upon much more favorably when consumers stop using a $35,000 number for the Tesla Model 3 and instead substitute the actual price of the revealed Model 3 in their comparisons. As Paulo Santos points out, all of the TSLA Model 3 seen so far are in the $50,000 price range, they’re not the $35,000 model that everyone has hitherto been expecting. Indeed those cars are long ways from being produced:

It also was expected that the first cars delivered by Tesla wouldn’t be the base model. Tesla reaffirmed its intention to have a $35,000 Model 3, but said that for now only the longer range (310 miles EPA estimated) version will be available. This version will have a $44,000 base price. The $35,000 version is supposed to have a 220-mile range. The battery capacity was not disclosed but is likely to be 50-55 kWh for the smaller battery version and 70-75 kWh for the longer range version."

[…]

The $44,000 base price won’t be available initially. Instead, only a $49,000 version will be available. The difference, $5,000, is due to the inclusion of a premium interior package.

With the actual prices and features available, I expect that sales of the Model 3 competitors will increase substantially as consumers make much more realistic shopping comparisons (see also quote in point 4 below).

Finally, I’ve focused exclusively on BEV competition here, but in reality, a person buying a car chooses between all the types available. Even someone who is averse to buying an ICE car, may readily consider PHEV hybrids and even fuel cell cars, all to the detriment of TSLA.

What would make me change my mind? Using sales figures from the final quarter of 2017 as a baseline (such that some Model 3 sales will be included), if TSLA manages to increase or even maintain market share in the BEV segment, either in unit volume or in dollar value, I’d begin to reconsider the importance of competition on TSLA’s eventual (financial) success. On the other hand, if TSLA’s market share rapidly declines due to the continued emergence of competitors, then I’d weigh this particular component of the short thesis even more heavily.

3. Financials and Valuation

TSLA’s sky high valuation and its deteriorating financials have garnered so much press that it’s probably redundant to recite all of the numbers yet again. Instead, let me just summarize some of the most salient metrics in order to substantiate why this is the third most important factor in my short case.

Moreover, the trend isn’t improving, and likely won’t given the emerging competitive pressures outlined in point two above.

Chart TSLA Net Income (NYSE:TTM) data by YCharts

Indeed the company just announced the need for another $1.5B in debt financing, and Moody’s assigned a B2 Corporate Family Rating to the company (which per Wikipedia means that the issuer is “judged as being speculative and a high credit risk”), and a B3 rating to the unsecured notes.

Finally, there’s a risk that the valuations will get worse because the bailout of SCTY included the assumption of balance sheet valuations on long-term leases that are fraught with assumptions, most of which were likely on the optimistic side (as SA contributor EnerTuition covered in various articles, e.g. this one which contains the following quote, my emphasis):

What is likely is that John Hancock left SolarCity with the O&M burden as well as the cash flows corresponding to O&M (including inverter replacement).

If we make such an assumption, this would also imply that SolarCity is responsible for all the residual risk including decommissioning of the asset at the end of life or on customer non-payment.

What would make me change my mind? If TSLA starts producing cars at a substantial profit, then this concern not only goes away but becomes a positive and I would immediately cover my short position. However, in my opinion, there’s almost no chance of that happening.

4. Eventual Loss of “Most Favored” Status

This is a purely qualitative factor, but an important one. Until recently, TSLA has been the recipient of substantial subsidies, fawning praise and a “fanboy” following. In other words, it has received large financial benefits from various governments which were not available to its automotive peers. It’s been judged by a non-critical press, and any problems with product quality and/or delays in timelines have been readily accepted by its hardcore supporters. All of this has combined to build the quixotic narrative which justifies the sky-high valuations outlined above.

Yet this is now beginning to change for two reasons, both of which will eventually catalyze a revaluation of TSLA’s stock price.

First, the promises on which TSLA garnered its “most favored” status have matured to the point where reporters and others can actually test them. Montana Skeptic has done yeoman’s work in showing how the promises made to both Nevada to subsidize the “Gigafactory” and those made by SCTY to build the “Gigafactory 2” in Western NY have been obvious shams. And while politicians may not care (after all it’s not their money that’s being wasted), journalists are (slowly) beginning to notice.

Second, the demographics of TSLA consumers are gradually shifting from exclusively true believers to a more representative cross section of the entire populace. Non-fanboy buyers aren’t as willing to accept obvious quality problems (which were most notable with the Model X), nor will they buy Teslas at any price. Here’s a representative post from someone who was a Model 3 reservation holder, but cancelled (my emphasis):

I needed a car by May 20, long before I would have gotten the M3. My brilliant plan of getting my company to let me use our electric Focus in the meantime (which nobody uses and just sits in a parking lot) fell through. So rather than dealing with finding a short-term lease (a likely expensive option) I just bought a CPO 2015 Honda Accord Touring hybrid. I'll keep it for 5-8 years and then probably buy an electric car. At that time, I think there should be a lot of good options.

I'd been a little hesitant on the Tesla anyway, since I've always been leery of buying a car that is a brand new platform in its first model year. Also, if the M3 starts at $35k that means the one I'd want would probably be about $50k - too much to spend.

Let me reiterate that this point isn’t that the sky is falling, rather, TSLA’s valuation and previous status in people’s minds was so unrealistic, that any return to normalcy will likely serve to sink the stock price.

What would make me change my mind? One of two things would make me reconsider this point. First, if TSLA actually convinces the state of California to write a new subsidy tailored to benefit TSLA exclusively. Or second, if conversion rates for the Model 3 reservation holders exceeds 60% over time.

5. Lack of Manufacturing Scale and Experience

The final point in the short thesis is that TSLA is under-sized and under-experienced for the global manufacturer it pretends (and is valued) to be. The company builds all of its vehicles in a single factory in California. That means all of its subcomponents must be shipped there and then all of the finished (or mostly-finished) vehicles must be shipped to their delivery destinations. Compare this to the competitors listed above who have whole supply chains and manufacturing plants on a minimum of three continents and often on five.

Also, and I’ve highlighted this previously, TSLA doesn’t have much appreciation for the logistical difficulties inherent in building a global automobile manufacturing company. That’s the only explanation that can be given for the following quote being offered as some kind of revelation (my emphasis):

The Q1 delivery count was impacted by severe Model X supplier parts shortages in January and February that lasted much longer than initially expected. Once these issues were resolved, production and delivery rates improved dramatically. By the last full week of March, the build rate rose to 750 Model X vehicles per week, however many of these vehicles were built too late to be delivered to their owners before the end of quarter.

The root causes of the parts shortages were: Tesla's hubris in adding far too much new technology to the Model X in version 1, insufficient supplier capability validation, and Tesla not having broad enough internal capability to manufacture the parts in-house. The parts in question were only half a dozen out of more than 8,000 unique parts, nonetheless missing even one part means a car cannot be delivered.

TSLA’s lack of experience in this area, and the fact that it treats logistics problems as being beneath it, will continue to hamper the company’s production and profitability.

What would make me change my mind? I’ll be watching to see if TSLA not only makes a concerted effort to increase its worldwide presence, but more importantly if the company begins to treat logistics in a manner that gives some respect to what many automotive companies have learned and developed in this area.

Trading

After reviewing the short thesis on TSLA, I’m still confident in the short and indeed it’s one of my larger positions. However, based on the past few years of trading history, I’m now treating two-thirds of my shares as “traders” which I’ll aim to cover opportunistically and then re-short on inevitable bounces, while about a third of my shares will be held for a longer term, ultimate price target.

Post Script

When I initially presented my short thesis on TSLA (unfortunately at substantially lower prices) I also listed the top five reasons underlying the idea. Comparing that original article to today’s situation suggests that — despite real progress at the company and an incredible stock price run — the overall prognosis for the company’s stock price has gotten worse, not better. Hopefully, however, my timing will prove better with this article than the first one!

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.

Additional disclosure: I actively trade around core positions.