Tesla: The Short Thesis Is Dying

|
About: Tesla, Inc. (TSLA), Includes: F, GM, GOOG, GOOGL
by: MangoTree Analysis
Summary

Tesla has drastically outperformed the market in the last few months, with the Q3 profitability report. Over the next few quarters, this outperformance will be amplified by a short squeeze.

The Tesla short community is made up of extremely smart money managers including Street legends like David Einhorn and Jim Chanos. Simply put, I now believe they are mostly wrong.

Tesla short sellers make up ~25% of the float. As fundamentals continue to progress, the bear thesis will continue to crumble, forcing short sellers out of the stock.

Introduction

I have been covering Tesla (TSLA) privately for the last year and a half to two years, watching as the stock was able to somehow soar despite worsening financial erosion. Profitability was rare, and a one-off event. For the most part, I loved the product but never touched the stock on the long side or the short side.

On the other hand, there have been bolder and extremely intelligent investors like Jim Chanos and David Einhorn who have placed short bets against Tesla. Both managers have bet against massive failures, with Jim Chanos betting against Enron, and David Einhorn betting against Lehman Brothers. To put it simply, I believe these two managers and the majority of the short selling community on Tesla is smart. I just think that they are wrong.

This article is an attempt on my part to see the legitimacy of certain aspects of the Tesla short thesis while scrutinizing other aspects of the Tesla short thesis to bring a more balanced risk assessment to Tesla. In no way, shape, or form is this article intended to be hostile towards individual short sellers named within its contents.

Bear Case #1: Executive Departures

There is a saying I like to employ with the executive departures that go as follows:

Once is happenstance,

Twice is coincidence,

Three times is a trend.

As of September, 41 executives had departed Tesla year-to-date. Since then, many more executives have left. Most recently, Tesla's head of global security left the firm. While having so many executives flea the company initially seems like a negative, we need to gain more perspective. There are three reasons that these departures aren't as important as they may seem:

  • A lot of these departures are moving from one role at Tesla to another, higher, role at another company. Basically, some executives are leaving Tesla for other company's because their rank in the company would be promoted elsewhere.
  • Secondly, Elon Musk is a difficult demanding boss. In Q3, Tesla was just "single-digit weeks away" from failure. To see a company on the brink of failure as many bears theorized is a scary sight for any executive.
  • Third, CEO Elon Musk, CTO JB Straubel, and CFO Deepak Ahuja have been working at Tesla through thick-and-thin. When Mr. Ahuja was asked about laying off 9% of Tesla's workforce, he basically said things have been more stressful before. Simply put, Tesla's key managers have plowed through challenge after challenge. Until one of these three executives leave, my confidence that the executive team at Tesla is devoted, remains steadfast.

If the rate of change in Tesla's executive departures remains flat or increases, then I am open to changing my stance on this prong of the bear thesis. That being said, 41 executive departures year-to-date is a scary number.

Bear Case #2: Behind In Autonomous Driving

Bears have said that Tesla is lagging the competition in the autonomous driving arena, with competitors like Waymo and GM in Stage 4 of autonomous driving, nearing regulated deployment, while Tesla is in Stage 2-3. I agree with many in the automotive industry that autonomous driving will play an essential role in the future of mobility. The market leaders in this space are the ones set to thrive in this next tectonic shift in the auto market. The question is, who are the leaders?

If you listened to the bears and skeptics, you would say that Tesla is not a market leader in autonomous driving. Skeptics have cited crashes where the automobile is on Autopilot mode, raising safety concerns. While these concerns are valid, if we look back at the history of automobiles, we see that when first created, cars were much more risky and prone to defects than the previous transportation standard of the time, namely horses. As a technology progresses, it improves. With a machine learning program like Autopilot, with more experience, the algorithm gets smarter.

Tesla's competition is not absent from these accidents, with Alphabet's (GOOG) (NASDAQ:GOOGL) Waymo and Uber both witnessing crashes. And while the frequency of accidents with the Autopilot is larger, there is an elevated number of total Teslas on the road activating Autopilot than there are Waymo enabled autonomous driving cars. The fact that Teslas are "out in the wild" is what progresses accidents, which are speed bumps (no pun intended), but not roadblocks for future technological development.

Then there is the total number of miles accrued. For the sake of simplicity, Waymo is in the millions of miles whereas Tesla is in the billions.

(Source: MIT)

(Source: Forbes)

In the autonomous driving market, similar to the advertising market, data is what will propel certain platforms to market leadership roles. With automobiles, data is collected mostly via miles driven to boost machine learning performance.

Another interesting thing to note is that if a Tesla Network (something that Elon Musk has hinted at) is developed, Tesla has delivered 362,133 vehicles as of Q3, with the Model 3 production ramp only now beginning to take effect. 49,366 of these Teslas have been sold without autopilot hardware. As of now, Tesla has 312,767 vehicles with Autopilot hardware installed. This number will only continue to grow as Tesla ramps Model 3 production and focuses on other models. Once Tesla works out autonomous driving software, they already have a fleet with installed hardware to update with new autonomous driving software capabilities. No other automaker on the market has that.

Finally, Tesla is continuing to update this already phenomenal hardware. The next time Tesla revamps its processor technology, they will begin designing in-house processors that, according to Tesla, have 10x the performance of their previous Nvidia (NVDA) counterpart while costing the same amount to produce. While Hardware 3 as it is called is yet to hit the road, once this autonomous hardware does hit the road, offerings from Nvidia and Intel's (INTC) Mobileye will be much less efficient and powerful that Hardware 3.

Bear Case #3: Competition

One of the greatest pillars of the Tesla short thesis is the competitive threat posed by other automakers. Bears always cite the plethora of electric vehicle competition coming onto the markets in the next several years as a key concern with Tesla's ability to perform well financially. I wrote a whole article about why I believe the competition argument on Tesla is invalid. I believed, and still do, that the competition is far behind Tesla in almost every single way.

There are a few key points behind my belief that the competition is invalid.

Firstly, back when Tesla's Model S and Model X hit the market, the bear thesis was not that the competition from other EVs would eat into Tesla's overall sales, but that Tesla was the laughing stock of the auto world and would not prove any threat to the sales of other ICE based cars. Since Tesla has gained prominence, its stock price and unit sales have soared, while simultaneously scaring legacy automakers into investing the EV wave. Tesla has single-handedly shifted the mindset of the auto industry, with legacy auto now recognizing how big a threat Tesla is to their business.

In my opinion, Tesla has many competitive advantages over legacy autos EVs. The first of which is Tesla's Supercharger technology.

If you didn't know, the Tesla Supercharger network is a network of charging stations that allows Tesla owners to recharge their vehicles on the go. Tesla's Supercharger network can be thought of as a network of "gas stations".

When Tesla first brought their Tesla Roadster to the market, there was no way for owners to go on road trips because of the lack of charging availability. As such, Tesla has brought these charging stations to the market. Tesla has spent hundreds of millions on this infrastructure. Tesla now has a vast amount of charging stations.

(Source: Tesla)

This allows Tesla owners to have the optionality of road trips and not be constrained by charging or lack thereof. Tesla continues to push for increased availability of these chargers, continuing further expansion in North America, and moving into markets like Asia, Europe, and the Middle East. And while there is competition to Tesla in charging technology coming from established automakers, developing a massive charging network will not happen overnight. Even then, Tesla has openly offered electric vehicles from other automakers the rights to charge on Tesla's infrastructure, a proposal that automakers have not taken Tesla up on. The bulk of this electric charging competition is coming from Europe, with legacy auto rushing to develop a lead against Tesla's massive European charging operation. This competition is virtually an exact replication of Tesla's technology while being six years behind Tesla in overall development of this network. While eventually, the competition may catch up with Tesla in the charging field, the Supercharger Network will remain a moat for a while.

Secondly, Tesla has developed a moat in its Tesla stores. These stores are strategically placed much like an Apple (AAPL) store, in high-end locations emphasizing Tesla as a quality brand.

(Source: CleanTechnica)

Tesla's stores offer a clean, nice, and simple look into the luxurious products that Tesla offers, with people being drawn in to look at the cars. Think about it. Would you rather go into an auto dealership or a Tesla store? On top of that, the current dealership model used by legacy auto is deeply flawed, with the dealerships relying on high maintenance fees they would normally collect with an internal combustion engine (I.C.E) vehicle. Electric vehicles have less parts and are damaged less often, leaving traditional dealerships less incentive to sell EVs in general. Tesla, distributing their products in a vertically integrated manner, allows Tesla to control the sales process of the car, something that the competition is yet to do. Currently, Tesla has 116 showrooms in the US, with some, but far less overseas.

Thirdly, Tesla's products are just better. While the competition seems legitimate at a glance, we have to understand that Tesla is not just sitting still. The competition has much to prove. Obstacles like over-the-air updates, production challenges, charging networks, autonomous driving capability, and import tariffs for foreign competition act as obstacles for the competition's relevancy in the EV market. Jaguar, the current threat to the Model X has already faced production delays on its i-Pace SUV, is yet to prove an ability to update hardware OTA and could be subject to import tariffs. Additionally, the product has only begun meaningful production in Europe, with sales in North America being negligible. While heavy economic investment is extremely important in scaling production, experience is even more so. And while Tesla has proven demand for its vehicles, the backlog for competitive cars is nowhere near Tesla's scale.

A key problem with the competition belief on Tesla is that it assumes that the current technology Tesla has implemented will not improve over time. Because of Tesla's ability to implement over-the-air updates to its hardware, as Tesla finds efficiencies in its technology, they can use software to upgrade the car overall. So, as time goes on, the car's efficiency increases. So while a car launched in 2020 may be able to compete with Tesla's 2018 range, in 2020, when this competition comes, the technical upgrades implemented will bolster Tesla above the competition. Basically, the competition thesis relies on the belief that Tesla's technology will not improve over time. This assumption is most likely false.

Bear Case #4: Valuation

Tesla bears and short sellers have called Tesla shares a bubble. Legendary hedge fund manager David Einhorn has but Tesla alongside other high growth names into what he calls his "bubble basket". Short-sellers will often make this point about Tesla's valuation:

Competing automakers are trading in the mid-to-high single digit P/E multiples while Tesla trades far higher. This is true. Tesla is trading at a much higher valuation than competitors like Ford (F) and GM (GM).

Chart TSLA PS Ratio (Forward) data by YCharts

But to value Tesla's stock against legacy auto firms is an irrational move, as Tesla is very different from its legacy competition. It really comes down to growth.

Name 2019 Price/Sales Gross Margin (%) 2019 Y/Y Revenue Growth Rate (%) Altman Z-Score
Tesla 2.882X 22.39% 38.10% 1.69
GM 0.374X 11.72% 0.10% 1.06
Ford 0.261X 9.78% -1.20% 0.99

While Tesla does trade at a much higher P/S ratio then Ford and GM, Tesla is growing revenues at 38% in 2019, while GM is flat and Ford is slightly negative. In addition, Tesla operates at ~22% gross margins, GM operates at ~12%, and Ford operates at ~10%. And in terms of solvency, Tesla outperforms the two competitors. And while all three companies have an increased chance of insolvency in the next two years, Ford and GM vastly underperform Tesla. Not to mention, Tesla's solvency is improving with every quarter that goes by as long as the company delivers profits and cash flows. To value Tesla, a growth stock betting on arguably the future of the auto industry against teetering titans like Ford and GM is an irrational move. Simply put, Tesla is a growth company while GM and Ford are in decline. In addition, Tesla is ahead in terms of deployment of electric vehicles versus GM and Ford. In addition, the ICE market is cyclical while EVs continue to take market share, accelerating the deterioration of Ford and GM's business.

The bottom line is, if you want to value Tesla's stock, you should value Tesla against growth companies, not legacy automotive peers.

Could Improving Fundamentals Drive A Short Squeeze?

In my opinion, Tesla's fundamental story is improving by the quarter, with the company ramping deliveries and will continue to generate profitability and cash. The question is, do the short sellers care? Despite Tesla's profitable Q3, short interest is yet to meaningfully decrease, still making up ~25% of the total float. Since October 31st, Tesla's short interest is down only 3.8%. There have been many articles on Seeking Alpha skeptical of Tesla's business, with the short selling community remaining vocal. The core belief is that Tesla will not be sustainably profitable beyond Q3's $2.90/share and $881 million in free cash flow. I believe Tesla will continue to report profitability over the next several quarters and will be cash flow positive excluding quarters in which Tesla pays off its creditors. Such a quarter may hit in Q1 of 2019 when Tesla will owe bondholders $920 million if the stock is not at ~$360. If Tesla can turn profits and generate cash in the next couple of quarters, Tesla could face a credit upgrade. And while I am not an expert on the inner workings of credit ratings, I would assume that improving working capital and profitability would help Tesla's credit rating. In Q3, Tesla's working capital improved from -$2.44 billion in Q2 to -$1.86 billion this quarter. If Tesla's credit is upgraded, many concerns of the massive short selling body could be alleviated, leading a substantial amount of the short selling community to cover their short positions.

When interviewed by CNBC, a host asked Jim Chanos when he would consider closing his short position. Basically, Chanos said that he would cover his short position once Tesla delivered sustainable profitability. If Tesla racks up quarter after quarter of profitability, the short selling community that views Tesla as a zero may cover out of their short positions. I have seen plenty of commenters on Seeking Alpha calling Tesla's Q3 profits artificial, with the company changing working capital and using tax credits to boost profitability. In reality <10% of total free cash flow came from adjustments in working capital, and only a small sliver of Tesla's overall operating income came from the sale of ZEV and GHG tax credits.

Conclusion

All in all, as the fundamental story at Tesla progresses, the short argument will substantially deteriorate. Because the short selling community is so large within Tesla, as the fundamental story plays out, many of the current ~25% of the float will be squeezed out, acting as a catalyst for shares. The bottom line is, the fundamental story is intact (in my opinion). As the short selling community recognizes this, they will cover acting as a price catalyst for the stock.

Disclosure: I am/we are long TSLA, GOOG, AAPL.

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 am not a financial adviser. This is not financial advice. Everything said here is my personal opinion. Please do your own due diligence with regards to investments in these securities.