The Double Trap Ahead For Tesla Investors


The iPhone was an enormous gamble, as its pushed the limits of then-available technology – the microprocessor, screen, battery, and wireless capability were beyond what seemed possible in 2007. Undoubtably, if Apple hadn’t created the iPhone, someone else would have created a similar device later. But when? There is no way to know, but the iPhone definitely accelerated the arrival of the future. Its success gave birth to a brand new half-a-trillion-dollar smart phone industry, and hundreds of billions of dollars were to poured into R&D, accelerating development of technologies and applications that were unimaginable just a decade ago.

The iPhone was the most important product invented in the first decade of the new century. It is impossible to look at almost any part of our lives and not see them touched by the iPhone or another smart phone inspired by the iPhone.

This brings us to Tesla, the most important company born in the US since Apple. Before Tesla, we equated electric cars to golf carts. Tesla has shattered that image, showing that the electric car can be an equal and in many ways superior product (with its high performance, lower energy consumption, and quiet ride) to the ubiquitous internal combustion engine (ICE) car. Unlike the iPhone, though, the Model S could have been born a decade or three earlier, as its core technologies – the battery and the electric motor – have not seen major improvements in decades.
Tesla’s Model S is the accelerator that will cause the auto industry to transform dramatically. Consumers and car companies alike are starting to look at ICE cars as relics, despite the fact that 95% of cars sold globally are still ICE cars. It is clear to any thinking person that electric (and maybe fuel-cell) cars are the future. This future is only a few years away, but it would be much further off without Tesla’s Model S, which was a paradigm changer in an industry that had not seen revolutionary changes since Ford’s Model T.

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Unlike Apple, though, Tesla may or may not be around in five years Mass producing a car is an incredibly difficult, capital-intensive undertaking. Tesla has showed that it can make a phenomenal, expensive ($100,000), luxury electric car, which addresses a limited market. But on its own the Model S cannot justify Tesla’s current valuation. For that, Tesla needs to profitably mass produce hundreds of thousands of cheaper Model 3’s, a $35-40,000 electric car.

The iPhone did not have real competition on the day it was introduced. It was competing with $150 dumb Nokia phones and $350, only slightly smarter Blackberries. Apple was able to charge $700 for the iPhone because the cost was subsidized by wireless carriers and because the product was exponentially better than the lower-IQ competition. And even without the subsidies, a few hundred extra dollars did not make the product unaffordable for most consumers.

It is much harder for Tesla to do the same. Tesla’s cars are competing with their ICE brethren, as well as with electric cars introduced by established auto makers. Tesla’s car may be superior to ICE and other electric vehicles currently on the market, but the main function of a car is to get you safely and in relative comfort from point A to point B. Thus the economics of Tesla’s Model 3 are grounded by current ICE cars, and Tesla cannot charge a significant premium above the competition’s products.

At today’s valuation of about $50 billion, Tesla’s shareholders are definitely paying for future earnings, not the $650 million in losses Tesla had in 2016. In ten to fifteen years, Tesla needs to make at least about $4-5 billion in profits to justify today’s price.

When interest rate are at zero (or less) the future is cheap, and thus Tesla is trading on very rosy expectations.

When you look at the success of companies like Apple and Amazon and their charismatic founders, it is easy to juxtapose this excitement onto Tesla. At first look this juxtaposition is well-founded – what Elon Musk has achieved so far with PayPal, SpaceX, and even Tesla is astonishing. But Warren Buffett has a saying: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

The auto business is incredibly difficult. Even when they’re not producing a single car, factories are losing a lot money – this is what is called fixed cost. The path to profitability lies through producing a high number of units, each contributing a little to cover that loss. If you produce enough units, fixed costs will be covered and you’ll earn a profit.

Tesla has been losing hundreds of millions of dollars a year forever, but its free cash flows have recently exploded to the negative side, hitting almost $1.5 billion on a trailing basis. Part of this loss was driven by Solar City, which Tesla acquired in 2016 after it lost $700 million in 2015, and in part the loss is due to the fact that mass producing cars is very difficult and expensive.
Tesla’s success will depend on its ability to achieve scale to produce hundreds of thousands of cars a year. But to get to that number it will need financing. Bond investors, even in this environment, will look at Tesla’s losses and either refuse to lend to Tesla or demand an interest rate that will make Tesla look like a junk bond borrower (which, looking at its profitability profile today, it is). The only other way to finance losses is by issuing stock. The more expensive the stock, the cheaper the financing. This is where we come to the paradox of Tesla stock: Tesla’s success as a business and its value is completely dependent on the price of Tesla’s stock. If the stock price stays high, then the company will be able to issue stock to finance its growth and cover its losses until its get to scale.

If the stock price fails to cooperate and declines (a reminder to my readers: stock price do decline at times), let’s say to $100, Tesla’s market capitalization will be around $15 billion. Then, to raise $1.5 billion Tesla’s shareholders will be diluted by about 10% (at today’s price this dilution is only 3%). This is why Elon Musk comes out with goals Tesla never reaches, and every few weeks announces new products that are always pushed further into the future – he needs to keep the dream (and the company) alive. This is another way in which Tesla is different from Apple: Tesla makes a lots of promises it never fulfills on time, while Apple goes out of its way to keep its future products a secret.

As an investor in Tesla stock you have to be both good at predicting Tesla’s success as a business (its ability to produce good, profitable cars) and at predicting Tesla’s stock price level before it turns profitable. Even if you get the first one right, if the stock price declines before Tesla gets to profitability, your interest in the stock may be severely diluted.

Even if Tesla fails as a business it has succeeded in creating an incredible public good: It has changed the auto industry forever and global geopolitics too. Just think about one side effect: oil. The geopolitical policy of this planet in the latter half of the twentieth century was completely dictated by oil, and wars were fought over it. Electric cars need electricity, but they don’t demand oil. Electricity can be made out of anything – wind, solar, hydro – the “clean sources” that are less toxic to the planet; and yes, it can be made with nuclear power, coal, and natural gas, which are less clean but less scarce and thus less geopolitically important than oil. One company has helped to change the balance in that complex energy equation. Thank you, Tesla and Elon Musk.

Abbreviated version of this article was published in Financial Times.

Article by Vitaliy N. Katsenelson – Contrarian Edge

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).

His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”. To receive Vitaliy’s future articles by email or read his articles click here.

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I was born and raised in Murmansk, Russia (the home for Russia’s northern navy fleet, think Tom Clancy’s Red October). I immigrated to the US from Russia in 1991 with all my family – my three brothers, my father, and my stepmother. (Here is a link to a more detailed story of how my family emigrated from Russia.) My professional career is easily described in one sentence: I invest, I educate, I write, and I could not dream of doing anything else. Here is a slightly more detailed curriculum vitae: I am Chief Investment Officer at Investment Management Associates, Inc (IMA), a value investment firm based in Denver, Colorado. After I received my graduate and undergraduate degrees in finance (cum laude, but who cares) from the University of Colorado at Denver, and finished my CFA designation (three years of my life that are a vague recollection at this point), I wanted to keep learning. I figured the best way to learn is to teach. At first I taught an undergraduate class at the University of Colorado at Denver and later a graduate investment class at the same university that I designed based on my day job. Currently I am on sabbatical from teaching for a while. I found that the university classroom was not big enough for me, so I started writing and, let’s be honest, I needed to let my genetically embedded Russian sarcasm out. I’ve written articles for the Financial Times, Barron’s, BusinessWeek, Christian Science Monitor, New York Post, Institutional Investor … and the list goes on. I was profiled in Barron’s, and have been interviewed by Value Investor Insight, [email protected], BusinessWeek, BNN, CNBC, and countless radio shows. Finally, my biggest achievement – well actually second biggest; I count quitting smoking in 1992 as the biggest – I’ve authored the Little Book of Sideways Markets (Wiley, 2010) and Active Value Investing (Wiley, 2007).