June 12, 2013
A few weeks ago the son of a client wrote to ask our opinion of Tesla Motors Inc. (NYSE: TSLA) as an investment candidate. Tesla is the innovative electric car manufacturer headed by Elon Musk, the young and charismatic billionaire who co-founded PayPal. I recommended against buying it at the time, and since then the stock has surged a further 50%. The stock is up over 200% year-to-date and 100% last month.
So what do I think now? Tesla still isn’t a promising investment, and the run up in stock price doesn’t change my assessment. In brief, the company is long on narrative and short on fundamentals. It is unprofitable, has a debt-to-equity ratio of 237%, and has a history of missing earnings expectations. The narrative that excites so many of Tesla’s supporters, however, is that electric cars are the wave of the future, reducing pollution and energy costs. Just as Steve Jobs led Apple to take on the PC juggernauts of Microsoft and HP, so Elon Musk will lead Tesla to take on Detroit’s Big Three. The narrative is inspiring, but the fundamentals are not. In the one quarter of its existence when Tesla has achieved profitability (the most recent one), it did this not so much by selling cars, but by selling carbon credits to conventional automakers who were forced by the law to buy them. It was the announcement of these first quarter profits that sent the company’s stock surging last month (see the green arrow on the chart above).
The State of California requires automakers to sell a certain number of zero-emission vehicles, or to purchase credits from other automakers that exceed the required number. Because Tesla only produces electric cars, the law effectively requires conventional automakers to subsidize Tesla’s operations. Tesla can receive about $35,000-$45,000 extra on each sale of its Model S sedan thanks to the California law, from which the company is expected to take in as much as $250 million this year. California’s credits are not the only subsidy benefitting Tesla. Private purchasers of a Tesla car can also receive a federal tax credit of $7,500—in spite of the fact that Tesla cars are luxury models, with the stripped-down version of its Model S sedan starting at $70,000. Other states and municipalities offer further subsidies for buying electric cars, such as Colorado’s $6,000 alternative fuel income tax credit.
As a result of its stock run-up, Tesla is now valued at dizzying heights: its $10.9 billion market capitalization trumps the combined market capitalizations for Italy-based Fiat ($7.5 billion), which is the majority owner of Chrysler, and Paris-based Peugeot Citroen ($2.8 billion). But while Tesla sold a mere 4,900 cars in the quarter of 2013 and generated $561.8 million in revenue, Fiat and Chrysler sold 1.02 million cars and trucks during that period and took in revenue of 19.8 billion euros ($26.1 billion). Furthermore, 12% of Tesla’s first quarter revenue, or $68 million, was from carbon credits. Thus the revenue from carbon credits dwarfed the $11.2 million in reported net income for the quarter by a factor of six.
Before Tesla reported its first positive income last quarter, it was not only losing money, but typically missing earnings estimates.
This erratic history means that there is little evidence for taking the previous quarter as establishing a positive trend. The company stated that it expects annual global demand for its vehicles to exceed 30,000 cars a year, and that it will be able to increase production to meet demand. But if Tesla hasn’t been able to meet estimates before, why should its present rosy predictions be taken for granted?
Perhaps the biggest reason why Tesla’s stock has surged this year is, paradoxically, because so many investors bet against the Tesla narrative. As Steven Sears notes in Barron’s, nearly 45% of Tesla’s outstanding shares were sold short. That is, investors bet that the stock price would sink and they borrowed shares to sell, with the requirement to buy them back later at the expected lower price. But after Tesla’s nominally profitable quarter and an enthusiastic review from Consumer Reports, the stock rose, which forced the huge portion of short sellers to buy back their shares at higher prices, driving the stock rally further.
Although the beauty and technological sophistication of Tesla’s cars justly invite comparisons to the iPhone, the company’s financials are unfortunately more like Fannie Mae and Freddie Mac. Like the government-secured mortgage giants, Tesla is fueled by the dubious mix of public risk and private profit. At the height of the financial crisis, the U.S. Department of Energy prevented Tesla’s bankruptcy by lending it $465 million at exceptionally low interest rates. As Scott Wooley has recently argued in Slate,
despite all the public celebration [about Tesla’s success], both Solyndra and Tesla stand as warnings of the dangers in deputizing bureaucrats to play bankers and venture capitalists. In both loans, the government walked away laughably undercompensated for the risk it accepted in the startup companies. In fact, the Tesla deal was arguably far more costly for America than the Solyndra fiasco.
This is because in the Energy Department’s loan the government made a venture capital-style investment in a risky company “without demanding venture capital-style compensation in return…,” as Wooley puts it. Energy-efficient and low-emission transportation is an admirable public good. Tesla is ostentatiously devoted to this admirable public good, which allows it to take liberties that aren’t permitted to companies in less glamorous industries. Before the financial crisis Fannie Mae and Freddie Mac were devoted to the admirable public good of home ownership for poor people, and they leveraged this noble purpose into big profits for their shareholders—for a while, at least. When the inflated value of their assets was honestly assessed, then the house came crashing down and the shareholders lost everything. What Uncle Sam giveth, Uncle Sam taketh away.
It’s revealing that when CEO Elon Musk himself made a personal loan to Tesla in 2008, he demanded a 10% interest rate, which dwarfed the at-inflation rate given to American taxpayers, in addition to demanding stock options on the loan. When Tesla recently repaid its Energy Department loan early (which it did by selling more stock and diluting the value of existing shareholders’ position), the company thereby preempted the terms of the loan that would have allowed the government to exercise options for an equity stake, just as Musk himself did. Although the repayment returned to the taxpayers their principal, it ensured that they wouldn’t receive any further compensation for the exceptionally high risks they were exposed to. Whereas Musk has made an enormous windfall profit on being able to convert his loan to equity, over and above the interest he already received, the U.S. taxpayer got nothing.
It’s perfectly possible for an unprofitable, debt-laden, government-subsidized company like Tesla eventually to succeed as a real business venture. It’s just unlikely. Maybe Tesla will become genuinely profitable, or maybe it will be bought out at a premium by one of the conventional automakers who tires of subsidizing a competitor. As Barron’s argues, this prospect of a buyout puts a floor on the stock price: a $30 per share price if you think that Tesla should trade at a Harley-Davidson-like cash flow multiple of 10, or $10 per share for a BMW-like multiple of three. Or maybe as high as $50 per share on the strength of the Tesla narrative and Musk’s leadership. The stock surpassed this trading range in April, however, and in any case a bet on Tesla is just that: a bet. If the price crashes back down to earth, and you have cash to spare, then you might justify a bet on Tesla. Meanwhile, there’s no reason to believe the hype.
Matthew B. O’Brien, Ph.D., Securities Analyst
Disclaimer: Securities should be evaluated in light of each investor’s profile in consultation with an investment professional. This article is intended for the use of O’Brien Greene & Co. clients; the author does not own any of the securities discussed in this article.