Stanphyl Capital’s letter to investors for the month ended August 31, 2019.
Friends and Fellow Investors:
For August 2019 the fund was up approximately 6.8% net of all fees and expenses. By way of comparison, the S&P 500 was down approximately 1.6% while the Russell 2000 was down approximately 4.9%. Year-to-date 2019 the fund is up approximately 19.4% while the S&P 500 is up approximately 18.3% and the Russell 2000 is up approximately 11.8%. Since inception on June 1, 2011 the fund is up approximately 96.4% net while the S&P 500 is up approximately 158.7% and the Russell 2000 is up approximately 97.6%. Since inception the fund has compounded at approximately 8.5% net annually vs 12.2% for the S&P 500 and 8.6% for the Russell 2000. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two and please note that individual partners’ returns will vary in accordance with their high-water marks.
The fund remains very net short, as I continue to believe we’re entering a bear market for U.S. stocks as the U.S. economic slowdown worsens. Here are some charts explaining why:
…while global negative yielding debt (a sign of a massive looming economic slowdown) has broached the insane level of nearly $17 trillion:
In fact, pretty much the only good economic news out this month were a slightly rebounding Chicago PMI (to 50.4 within an overall trend that’s clearly ugly)…
…and a July retail sales figure which doesn’t look much different to me from what we saw in 2007, just before “economic Armageddon”:
And keep in mind that much of the U.S. bull market’s rise came from corporate buybacks and those tend to slow drastically when the economy does. As the looming recession unfolds and those buyers disappear, look out below.
On the other hand the short-lived era of net “quantitative tightening” among the big three central banks (the Fed, ECB and BOJ) is over. The Fed’s balance sheet contraction stopped in August and it’s rumored that in October the ECB will resume printing money to buy still more bonds while, the BOJ continues doing so. I’m very aware of the effect these moves may have on already grossly inflated asset prices, and thus I’m a bit more cautious in my short bias than I had been before the new European QE was telegraphed at July’s ECB meeting. On the other hand, this ECB stupidity may blow up its banks and perhaps even the euro, resulting in all kinds of stock market carnage. After all, if printing money is the solution to economic stagnation, why bother collecting taxes and having government budgets? (There’s no need to answer that—it’s a rhetorical question!) So we’re very short, but prepared to cover quickly if necessary!
Also, stocks are not at all pricing in the increasing possibility of a Democratic presidency. Trump’s corporate tax cuts juiced earnings by an instant 10% or so and his easier regulatory environment may have helped earnings by another couple of percent. This would be almost instantly reversed (and then some!) by any Democratic candidate, all of whom have also endorsed strict limits on the corporate stock buy-backs that have been another huge force behind this bull market.
Although stocks have often done well during Democratic administrations, we’re now in a unique situation due to the three factors (tax rates, buybacks and regulation) I mentioned above, as well as the fact that Trump is running budget deficits that would make any Democrat “proud,” thus leaving minimal room for a new administration to increase them.
Thus, seeking the most overvalued of all stock indices (and the one least likely to be bought by overseas investors with their newly printed yen and euros), we remain short the Russell 2000 (IWM), which has a trailing twelve-month GAAP PE ratio of 43 on what I believe are peak earnings, while 35% of its constituents lose money. We’ve also been short the S&P 500 (SPY) since Trump said it’s likely China won’t make a trade deal until after the 2020 Presidential election, as rumors of such a deal have been a huge positive driver of stocks and international trade is much more important for the constituents of the S&P 500 than it is for those in the Russell 2000.
Elsewhere in the fund’s short positions…
We remain short stock and call options in Tesla Inc (NASDAQ:TSLA), which I consider to be the biggest single stock bubble in this whole bubble market. The core points of our Tesla short thesis are:
- Tesla has no “moat” of any kind; i.e., nothing meaningfully proprietary in terms of electric car design or technology, while existing automakers—unlike Tesla—have a decades-long “experience moat” of knowing how to mass-produce, distribute and service high-quality cars consistently and profitably.
- Tesla is losing a ton of money and has a terrible balance sheet.
- Tesla is now a “busted growth story”; demand for its existing models is only being maintained via continual price reductions, and it will have to raise billions of dollars to produce new models in a market soon to be saturated with enormous competition.
- Elon Musk is extremely untrustworthy.
Tesla’s stock got a bit of a pop today on news that China would exempt its cars—as it’s doing for all EVs—from a 10% sales tax (an exemption scheduled to end in December 2020). Offsetting this for Tesla is a 2%+ price increase announced today to offset some of the yuan’s depreciation against the dollar (with Tesla’s margins eating the rest of the depreciation), so this is essentially just an 8% price cut until (absent a trade deal) tariffs increase from 15% to 40% on December 1st and prices thus become massively higher. Now, let’s put this in perspective…
Tesla currently sells around 24,000 cars a year in China including all its models. The rule of thumb for the elasticity of auto pricing is that every 1% price cut results in a sales increase of 1% to 2.4%. If we (generously) use 24,000 as a baseline number just for current Model 3 sales and (again, generously) a 2.4x “elasticity multiplier,” domestically produced Model 3s that are 25% cheaper (due to the 10% sales tax savings plus the 15% tariff savings) would result in annual sales of 38,400 Model 3s (additional sales of 25% x 2.4 = 60% more), meaning Tesla’s new Chinese factory would be a massive money-loser as it
would be running at only 26% of its initial 150,000-unit annual capacity. And here’s a great overview (from today’s Wall Street Journal) of what a dogfight the Chinese EV market has become.
In July Tesla released a disastrous Q2 financial report, with a GAAP loss of $408 million despite higher-than-expected deliveries of a bit over 95,000 cars. In fact, due to massive price cuts to maintain demand, Tesla actually booked significantly less revenue than it did in Q4 2018 when it sold nearly 5000 fewer cars, and despite multiple price cuts since January 1, Tesla's estimated U.S. deliveries dropped by 43 percent in the first half of this year vs. the second half of 2018, and overall deliveries were down by 9% despite this year’s introduction of Model 3 sales to Europe & Asia where it was unavailable in 2018. And to kick off Q3 (the quarter we’re in now), Tesla cut prices yet again!
Keep in mind too that Tesla’s Q2 loss would likely have been $100 million greater if it were providing adequate customer service. The internet is filled with complaints from aggrieved owners who can’t reach anyone to fix their myriad problems within a reasonable timeframe, thereby resulting in real-time brand destruction. Yet due to the high cost of batteries, Teslas are inherently unprofitable, and thus improving the ownership experience would only increase the company’s losses. In other words, Tesla is truly a non-viable business.
In Q3 & Q4 2019 the “growth company” known as Tesla will show significant revenue declines vs. Q3 & Q4 2018 (so much for those “year-over-year comps”!), and its 2019 full-year GAAP loss will be roughly $2 billion.
The party’s over, folks. With no profitable growth, massive ongoing losses and tens of billions of dollars in debt and purchase obligations, the equity in Tesla will eventually prove worthless. Yet as the stock miraculously closed today at $225.61/share, I shall continue…
For those of you looking for a resumption of growth from Tesla’s (supposedly) upcoming Model Y, by the time it’s available in late 2020 (if Tesla is still in business), it will both massively cannibalize sales of the Model 3 sedan and face superior competition from the much nicer electric Audi Q4 e-tron, BMW iX3, Mercedes EQB, Volvo XC40 and Volkswagen ID Crozz, while less expensive and available now are the excellent new all-electric Hyundai Kona and Kia Niro, extremely well reviewed small crossovers with an EPA range of 258 miles for the Hyundai and 238 miles for the Kia, at prices of under $30,000 inclusive of the $7500 U.S. tax credit. Meanwhile, the Model 3 sedan will have terrific direct “sedan competition” in 2020 from Volvo’s beautiful new Polestar 2, the BMW i4 and the premium version of Volkswagen’s ID.3.
Meanwhile, sales of Tesla’s highest-margin cars (the Models S&X) are down by nearly 40% worldwide this year, thanks partially to cannibalization from the Model 3 but primarily due to the recently introduced Audi e-tron and Jaguar I-Pace, and this sales drop is before this fall’s arrival of the Mercedes EQC and Porsche Taycan, with multiple additional electric Audis, Mercedes and Porsches to follow, many at starting prices considerably below those of the high-end Teslas. (See the links below for more details.) In fact, the fantastic Porsche Taycan alone may drive Model S sales down to approximately “zero”.
And if you think China will be the saving grace for Tesla, I have bad news for you: first, the competition there for EV market share is becoming a vicious dogfight (see the links further down in this letter). Second, Tesla currently sells fewer than 25,000 Model 3s a year in China; how much would that increase with a domestically produced car and a 20% price cut (the tariff & labor savings)? Even more than doubling sales to, say, 50,000 a year would leave its new Chinese factory hugely unprofitable, and would be a drop-in-the-bucket vs. the “China expectations” built into the stock price. And meanwhile Beijing is switching its subsidies to hydrogen fueled cars, which it perceives as better than EVs.
Meanwhile, Tesla has the most executive departures I’ve ever seen from any company; here’s the astounding full list of escapees. These people aren’t leaving because things are going great (or even passably) at Tesla; rather, they’re likely leaving because Musk is either an outright crook or the world’s biggest jerk to work for (or both). Could the business (if not the stock price) be saved in its present form if he left? Nope, it’s too late. Even if Musk steps down in favor of someone who knows what he’s doing, emerging competitive factors (outlined in great detail below) and Tesla’s balance sheet and massive additional liabilities make the company too late to “fix” without major financial and operational restructuring.
In May Consumer Reports completely eviscerated the safety of Tesla’s so-called “Autopilot” system; in fact, Teslas have far more pro rata (i.e., relative to the number sold) deadly incidents than other comparable new luxury cars; here’s a link to those that have been made public. Meanwhile Consumer Report’s annual auto reliability survey ranks Tesla 27th out of 28 brands and the number of lawsuits of all types against the company continues to escalate-- there are now over 700 including a real beauty in August from Wal-Mart which was a victim of a secret Tesla cover-up of solar roof fires, and the whistleblowers keep on coming!
So here is Tesla’s competition in cars (note: these links are regularly updated)…
AUDI E-TRON GT FIRST DRIVE: LOOK OUT, TESLA (available 2020)
Mercedes to launch more than 10 all-electric models by 2022
And in China…
Here’s Tesla’s competition in autonomous driving…
Here’s Tesla’s competition in car batteries…
Here’s Tesla’s competition in charging networks…
And here’s Tesla’s competition in storage batteries…
Yet despite all that deep-pocketed competition, perhaps you want to buy shares of Tesla because you believe in its management team. Really???
So in summary, Tesla is losing a massive amount of money even before it faces a huge onslaught of competition (and things will only get worse once it does), while its market cap is larger than Ford’s and roughly 75% of GM’s despite selling only around 350,000 cars a year while Ford and GM make billions of dollars selling 6 million and 8.4 million vehicles respectively. Thus this cash-burning Musk vanity project is worth vastly less than its over $50 billion enterprise value and—thanks to roughly $34 billion in debt, purchase and lease obligations—may eventually be worth “zero.”
Elsewhere among our short positions…
We continue (since late 2012) to hold a short position in the Japanese yen via the Proshares UltraShort Yen ETF (ticker: YCS) as Japan (despite having substantially tapered its QE) continues to print nearly 4% of its monetary base per year after quadrupling that base since early 2013. In 2018 the BOJ bought approximately 67% of JGB issuance and in 2019 it anticipates buying 70%! In fact, the BOJ’s balance sheet is now larger than the entire Japanese economy:
…and it owns nearly 78% (!) of the country’s ETFs by market value.
Just the interest on Japan’s debt consumes 8.9% of its 2019 budget despite the fact that it pays a blended rate of less than 1%. What happens when Japan gets the 2% inflation it’s looking for and those rates average, say, 3%? Interest on the debt alone would consume nearly 27% of the budget and Japan would have to default! But on the way to that 3% rate the BOJ will try to cap those rates by printing increasingly larger amounts of money to buy more of that debt, thereby sending the yen into its death spiral.
When we first entered this position USD/JPY was around 79; it’s currently in the 106s and long-term I think it’s headed a lot higher—ultimately back to the 250s of the 1980s or perhaps even the 300s of the ‘70s before a default and reset occur.
We continue to hold a short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.36% at an average effective maturity of 9.8 years, and with Eurozone inflation now printing 1.1% annually I believe this ETF is a great way to short what may be the biggest asset bubble in history. Currently the net borrow cost for BNDX provides us with a positive rebate of 1.4% a year (more than covering the yield we pay out) and as I see around 5% potential downside to this position (vs. our basis, plus the cost of carry) vs. at least 20% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement of this insanity.
We also have relatively small short positions in Netflix (NFLX) due to its egregious valuation within the context of increasing cash burn and competition (particularly from Disney), Square (SQ) due to its egregious valuation and a stock-dumping CEO who so effusively praises (and enables) Elon Musk that I suspect he’s equally untrustworthy (and indeed in June the company fired its auditor), Carvana (CVNA) due to a laughable business model with escalating losses, a founder with a sketchy past and insiders who dump stock steadily, and Wayfair (W), an egregiously bad on-line furniture business with yet another team of insider stock-dumpers.
And now for the fund’s long positions…
We continue to own Communications Systems, Inc. (ticker: JCS), an IOT (“Internet of Things”) and internet connectivity & services company. The company’s multiple divisions are best explained by the slide presentation from its annual meeting and this terrific recent contract, and its recently improved performance is highlighted in its Q2 earnings report; what attracted me to JCS is its great balance sheet and how cheap it is on an EV-to-revenue basis. At our average cost of $3.04/share and assuming $62 million in annual revenue, $17.8 million of net cash and 9.32 million shares outstanding, we paid just a bit over 0.17x revenue for this roughly break-even company with a gross margin of 37% and climbing.
We continue to own Aviat Networks, Inc. (ticker: AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in August reported a solid FY 2019 Q4, with revenue up slightly year-over-year accompanied by a significant improvement in operating income. More importantly, the company guided to a very strong first half of FY 2020 (which began July 1, 2019), with income and cash flow up substantially year-over-year. Additionally, Aviat has $408 million of U.S. NOLs, $8 million of U.S. tax credit carryforwards, $212 million of foreign NOLs and $2 million of foreign tax credit carryforwards; thus its income will be tax-free for many years so GAAP EBITDA less capex essentially equals “earnings.” Valuation-wise, if we assume $14 million in FY 2020 adjusted EBITDA (first-half guidance is $7.5 million) and remove $1.7 million in stock comp and $5.3 million in capex we get $7 million in earnings multiplied by, say, 14 = approximately $98 million; if we then add in approximately $37 million of expected year-end net cash we get $135 million, and if we divide that by 5.4 million shares we get an earning-based valuation of around $25/share. Alternatively, if we look at Aviat as a buyout candidate its closest pure-play competitor, Ceragon (CRNT) sells at an EV of approximately 0.5x revenue, which for AVNW (assuming $240 million in 2020 revenue) would be 0.5 x $240 million =$120 million + $37 million expected year-end net cash = $157 million. If we value Aviat’s massive NOLs at a modest $10 million (due to change-in-control diminution in their value), the company would be worth $167 million divided by 5.4 million shares = just under $31/share.
We continue to own Westell Technologies Inc. (WSTL), which in August replaced its CEO for the umpteenth time (and its CFO left for a larger company) after reporting an awful FY 2020 Q1, with revenue down 31% year-over-year and a drop in gross margin from 45.5% to 36.1% and negative free cash flow of around $1.2 million; about the only good news here is that the company ended the quarter with $24 million in cash and no debt. That said, we continue to own Westell because it now sells at an enterprise value of approximately negative $2 million, so on that metric it’s dirt cheap (although clearly the business needs to stabilize and grow). Westell also suffers from a dual share class with voting control held by descendants of the founder, yet the company is so cheap on an EV-to-revenue basis that if management can’t start generating meaningful profits it seems primed for a strategic buyer to acquire it. Assuming 15.6 million shares, an acquisition price of just 0.6x run-rate annual revenue of $36 million would (on an EV basis) would be nearly $3/share.
We continue to own a small position in the PowerShares DB Agriculture ETF (ticker: DBA), as agricultural products remain the most beaten-down sector I can find that isn’t a “buggy whip” (something on the way to obsolescence) or cyclical from a demand standpoint; however, I reduced this position size considerably in July when near-term hopes for a trade deal with China fell apart and terrible weather in the farm belt was unable to move prices meaningfully higher.
Thanks and regards,