Stanphyl Capital’s letter to investors for the month of January, 2020 regarding Tesla Inc. (NASDAQ:TSLA).
Friends and Fellow Investors:
For December 2019 the fund was down 11.4% net of all fees and expenses. By way of comparison, the S&P 500 was up 3.0% while the Russell 2000 was up 2.9%. For all of 2019 the fund was down 6.5% while the S&P 500 was up 31.5% and the Russell 2000 was up 25.5%. Since inception on June 1, 2011 the fund is up 53.7% net while the S&P 500 is up 187.5% and the Russell 2000 is up 121.8%. Since inception the fund has compounded at 5.1% net annually vs. 13.1% for the S&P 500 and 9.7% for the Russell 2000. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends. The fund’s performance results are approximate; investors will receive exact figures from the outside administrator within a week or two. Please note that individual partners’ returns will vary in accordance with their high-water marks.)
As those of you in the fund know via previous correspondence, faced with yet another down year (our unacceptable third in a row!), in late December I decided to take the fund back to its successful roots and focus primarily on finding deep-value microcap/nanocap long positions and (as I won’t alter our definition of “value” to suit a worldwide asset bubble) holding more cash if necessary. (I say “successful roots” because our cumulative performance from inception at mid-2011 through the end of 2016 was +128%, an annual net compounding rate of 15.9% vs 11.9% for the S&P 500.) So here’s what I’ve specifically done with the fund:
1) Eliminated all "macro" positions except our short position in BNDX, which is non-volatile, extremely one-sided valuation-wise (i.e., ex-U.S. long-term sovereign debt yielding near zero is the biggest bubble I've ever seen) and positive-carry. As for our other macro ..
Regarding our long-term yen short, as the U.S. is now printing money faster than Japan I'm increasingly less comfortable being long the dollar against anything (even the yen), so I took it off. It's a position we'd had on since late 2012 (!) and was mildly profitable, although the IRR was modest considering the length of time involved.
As for our 30-year U.S. treasury short, my thought is that as I’ve killed most of our equity shorts (see #3 below), if the currently euphoric stock market does tank (even temporarily), the initial reaction may be into Treasuries (even if they're doomed eventually), and thus without those equity shorts I don't want to be short Treasuries right now, so I took that off at a small profit.
As for our long position in agricultural products (DBA), it had a nice little pop this month on news of the "Phase One trade deal" but we then learned that China's purchase commitment is both vague and exaggerated so I sold it. (It's a position on which we made a little this month and lost a moderate amount since inception.)
That covers "the macro." As for the rest of the portfolio...
2) I cut the Tesla equity short position down to approximately 10% of the fund (it had most recently been 20% and was often higher in the past) and—barring unexpected positive developments for the company— will maintain it at around 10% going forward. Unlike our other equity shorts which were "just bubbles," there's major league fraud involved here and all the Fed printing in the world won't ameliorate that; I thus want to have some meaningful equity participation in addition to our short call position, which we’re also maintaining.
3) I've eliminated our other equity shorts for as long as the Fed is printing money. When the money- printing stops we'll start shorting again, but until then it's like playing poker against a guy with a chip- making machine on his lap—he can call every bet a short-seller makes and I'm tired of "playing against the house." I’ve actually done this with some regret, as collectively our recent non-TSLA shorts were profitable, as NFLX, SQ, W, NVTA and ROKU were all down since we shorted them; only CVNA wasn’t, so I suppose if anyone wants to hire me to run a short portfolio excluding auto-related businesses connected with securities fraudsters, I’m your man!
The above actions will combine to free up time (and, as importantly, "mental focus") to seek out more of the deep-value long positions which have worked so well for us in the past. Meanwhile, if you have any doubt whatsoever that this stock market is being driven entirely by renewed Fed money-printing, here are a couple of charts (courtesy of @ZeroHedge) that lay it out perfectly:
…as the Fed’s balance sheet rapidly adds back everything removed during its short-lived “quantitative tightening”:
And if you have any doubt that the Fed has blown yet another stock bubble (its third in 20 years), Shiller’s CAPE ratio has risen above 30 only three times in history, and (courtesy of multpl.com) this is one of them:
…while the S&P 500’s price-to-sales and EV-to-EBITDA ratios match or exceed record highs:
Meanwhile, the real-world physical economy remains weak. Have a look at the latest Cass Freight Index…
…and 2019 rail traffic was just as bad, down 4.9% overall vs. 2018, with intermodal down 5.1%.
Now for the fund’s positions…
We continue to own Aviat Networks, Inc. (ticker: AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies (here’s a great Seeking Alpha article describing the company), which in November reported a solid FY 2020 Q1. Although revenue was down slightly year-over-year there were significant improvements in both operating income and gross margin and the company’s guidance promised similar improvements for the full year. Additionally, Aviat has over $400 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 $6.1 million in capex we get $6.2 million in earnings multiplied by, say, 14 = approximately $87 million; if we then add in approximately $32 million of expected year-end net cash we get $119 million, and if we divide that by 5.4 million shares we get an earnings-based valuation of around $22/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 + $32 million expected year-end net cash = $152 million. If we value Aviat’s $400+ million in NOLs at a modest $10 million (due to change-in-control diminution in their value), the company would be worth $162 million divided by 5.4 million shares = $30/share.
We continue to own Communications Systems, Inc. (ticker: JCS), which we accumulated over the summer at an average price of $3.05/share. (We sold a chunk of shares at around $8 to control the position size, then in December bought back some of them in the $6s during a correction.) JCS is an IOT (“Internet of Things”) and internet connectivity & services company (the company’s multiple divisions are best explained by its investor presentation) which in October reported fantastic Q3 earnings of .19/share with a 42% gross margin and $2.20/share in net cash. JCS is now making an annualized .68/share (based on the first nine months of the year, so as not to overemphasize one great quarter), however we should tax- adjust that to .48 as it’s been minimizing taxes by utilizing its NOL carryforwards. A 14x multiple on that plus the cash plus a $4.5 million valuation on $15 million of NOLs would value the stock at around $9.40/share. Additionally, the company is in contract to sell its headquarters building for $10 million; if that closes it generates $1/share in additional cash, making the stock worth $10.40. (The company then plans to rent a smaller facility and save approximately $200,000/year vs. the P&L impact of its current facility.)
We continue to own Westell Technologies Inc. (WSTL), which in November reported a horror-show of a quarter, with a 25% year-over-year revenue decline and a large GAAP loss driven only in part by a one- time inventory write-down. About the only good news from Westell was that it ended the quarter with $21.7 million in cash and no debt, and as burn going forward should be “only” around $1.2 million/quarter, the company still has at least 18 quarters of cash runway to return to break-even (it’s projecting to do so in five), and obviously many more than that if it can cut the burn along the way. Following the report the CEO and several board members stepped up and bought stock in the open market (at least they’re putting their money where their mouths are) and the company simultaneously posted a new investor presentation. We continue to own Westell because it’s a $30 million/year, 38% gross margin business with over $1.25/share in cash that currently sells for a significantly negative enterprise value. Assuming 15.8 million shares, an acquisition price (by a cost-eliminating strategic buyer) of just 5x revenue would (on an EV basis) be around $2.20/share. Preventing such an acquisition is that Westell suffers from a dual share class, with voting control held by moronic descendants of the founder who refuse to sell company despite the stock’s horrible performance. However, I’m hopeful that someone will knock enough sense into their small brains to inspire them to salvage what’s left here, and thus walk away with at least something from what they’ve squandered. If they do the stock should be at least a double from here, and possibly more. In other words, it’s too cheap for me to sell but the board is too incompetent for me to buy more.
Finally for the longs, we recently accumulated a moderately sized position in a small software company that roughly breaks even on a 65% gross margin and sells for less than 0.5x revenue. I’m not revealing the name yet as it’s fairly illiquid and I’m evaluating whether to buy more.
On the short side we remain short stock and call options in Tesla Inc. (TSLA), which I still 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; e., nothing meaningfully proprietary in terms of electric car 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, as well as the ability to subsidize losses on electric cars with profits from their conventional cars.
- By mid-to-late 2020 Tesla and its awful balance sheet will return to losing
- Tesla is now a “busted growth story”; revenue was roughly flat sequentially and declined year- over-year while unit demand for its cars is only being maintained via continual price reductions and expiring tax
- Elon Musk is a securities fraud-committing pathological
When Tesla reported Q3 earnings in October, revenue for this alleged “growth company” was hundreds of millions of dollars lower than the year-ago quarter, and due to much lower ASPs Q4 2019 revenue vs. Q4 2018 will be roughly flat despite higher unit sales, while—thanks to the January reduction of subsidies in the U.S. and Netherlands—Q1 2020 revenue will be down sequentially. In other words, the Tesla “hypergrowth” story is over.
Tesla did unexpectedly print a tiny $153 million profit in Q3 (vs. our expectation of a $300 million loss), but in October’s letter I laid out multiple reasons why Q3 would, in fact, have shown a multi-hundred- million-dollar loss without various unsustainable expense cuts and accounting games (one of which was warranty fraud—here’s a great new article about that) and in November fund manager Jim Chanos laid out a concise case on Twitter why even if one accepts Tesla’s numbers its equity is worth “zero.”
We may also see a similar low level of temporary Tesla profitability in Q4 (the one we’re in now) or Q1 of 2020, when in one or (divided between) both of those quarters Tesla recognizes approximately $500 million of non-cash (it’s already on the balance sheet) deferred revenue from its fraudulently named “Full Self-Driving” (the capabilities of which offer nothing of the kind). By rolling out various useless and dangerous features of this homicidal software suite, Tesla may claim that prior buyers of this nonsense received what they paid for, and thus may run those non-cash profits through its financial statement, thereby again perhaps providing this money-losing company with a fleeting moment of minor profitability. As with Q3, these will be non-repeatable one-time gains (or, if you prefer, “games”), and later in 2020 the losses will resume.
For those of you looking for a resumption of growth from Tesla’s upcoming Model Y, when it’s available in Q2 2020 it will both massively cannibalize sales of the Model 3 sedan and (by late 2020) 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 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.
And if you think China is the secret to the resumption of Tesla’s growth, let’s put that market in perspective: prior to a recent 10% VAT exemption Tesla was selling around 30,000 Model 3s a year there and “the story” is that avoiding the 15% tariff and 10% VAT, plus a $3600 EV incentive that expires at the end of 2020 will allow it to sell a lot more. However, the rule of thumb for the elasticity of auto pricing is that every 1% price cut results in a sales increase of up to 2.4%. If we assume a 2.4x “elasticity multiplier,” domestically produced Model 3s that are 33% cheaper would result in annual sales of just 54,000 (33% x 2.4 = 79% more than the previous 30,000), meaning Tesla’s new Chinese factory would be a massive money-loser by running at just slightly over 1/3 of its initial 150,000-unit annual capacity and 1/10th of the capacity it will have in 18 months. This guarantees hugely missed growth targets and it’s “growth” (or more accurately, the fantasy of growth) that drives Tesla’s stock price. Also, here’s a great overview of what a dogfight the Chinese EV market has become.
Meanwhile, sales of Tesla’s highest-margin cars (the Models S&X) are down by over 30% worldwide this year thanks to cannibalization from the Model 3 and the recently introduced Audi e-tron and Jaguar I- Pace, and this sales drop is before January 2020’s European arrival of the Mercedes EQC (it comes to the U.S. in 2021) and the Porsche Taycan (available on both continents next month), 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.)
Meanwhile, Tesla has the most executive departures I’ve ever seen from any company (including in December its head of manufacturing and third Chief Corporate Counsel this year!); 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 23rd out of 30 brands (and that’s with many stockholder/owners undoubtedly underreporting their problems—the real number is almost certainly much worse), and the number of lawsuits of all types against the company continues to escalate-- there are now over 800 including one proving blatant fraud by Musk in the SolarCity buyout (if you want to be really entertained, read his deposition!), an allegation that unsafe door handles caused a Tesla driver to burn to death in his car, and evidence that the company secretly rolled back battery performance without compensating owners. And watch out for a major problem with sudden acceleration.
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 EQC Electric SUV Available Late 2019
Mercedes to launch more than 10 all-electric models by 2022
Kia Soul (available mid-2019) EV’s Range Jumps to 243 Miles
And in China…
Here’s Tesla’s competition in autonomous driving…
Cadillac Super Cruise™ Sets the Standard for Hands-Free Highway Driving
Magna joins the BMW Group, Intel and Mobileye platform as an Integrator for AVs
BMW and Tencent to develop self-driving car technology together
Groupe PSA’s safe and intuitive autonomous car tested by the general public
Fujitsu and HERE to partner on advanced mobility services and autonomous driving
Here’s where Tesla’s competition will get its battery cells…
Panasonic (making deals with multiple automakers)
Northvolt (backed by VW & BMW)
Most car makers will use those battery cells to manufacture their own packs. Here are some examples:
Here’s Tesla’s competition in charging networks…
Petro-Canada Introduces Coast-to-Coast Canadian Charging Network
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 about to face a huge onslaught of competition with an enterprise value (excluding financial services debt) that’s larger than Ford’s and GM’s combined despite selling fewer than 400,000 cars a year while Ford and GM make billions of dollars selling 6 million and over 8 million vehicles respectively. Thus, this cash-burning Musk vanity project is worth vastly less than its approximately $85 billion enterprise value and - thanks to over $30 billion in debt, purchase and lease obligations - may eventually be worth “zero.”
Finally, 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 0.57% at an average effective maturity of 9.9 years. With Euro area core inflation at 1.3% and—due to the ECB’s money-printing ultimately headed much higher—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 approximately 0.4% a year and I think it’s a terrific place to sit and wait for the inevitable denouement of this insanity.
Thanks and regards,