Is Tesla’s Bubble About to Burst?
Since its public listing in 2010, Tesla has been feted by the media—and Elon Musk is never one to shy away from the limelight. With fanboys galore and being labelled as the ‘real-life iron man,’ Musk has always played to his strengths, capitalising on the attention at every turn of his career. However, not many are aware that he isn’t the original founder of Tesla, Inc. In fact, Martin Eberhard and Marc Tarpenning founded Tesla Motors in 2003 (which was later renamed Tesla, Inc. in 2017), where Musk was only an investor in the company. After a falling-out between Musk and the founders involving legal proceedings and a settlement, Musk was granted the permission to call himself a “co-founder” of Tesla.
Not long after, Tesla began marketing Model S and X, touting it as the mass-market electric vehicles of the future. Musk was certain, too, that Tesla-made cars would never depreciate. Of course, this was buffoonery and Musk had to eat his words. In January 2020, Tesla exceeded Ford’s peak market capitalisation of US$80.8 billion with as little as US$24.5 billion in revenues and a loss of US$862 million. Ford Motors, on the other hand, reached that value with US$160 billion in revenues and a net income of US$7.2 billion in FY1999.
By 2018, Tesla had grown its revenue by a factor of 210 times since 2010, but suffered 13 years of consecutive losses. Coming close to bankruptcy on several occasions, the company had its fair share of critics but scathing public feuds involving Musk took centre stage. With an ultra-low interest rate environment, Musk always found ways to save his company; sometimes by the skin of his teeth. Since 2013, the company had issued convertible notes with interest rates as low as 1.25 per cent. These convertible notes could be exchanged for shares if certain conditions were met, allowing Musk to borrow cheaply from willing investors who bought into Tesla’s story. Equity markets loved Musk and believed in the growth story. But debt capital markets didn’t. If Musk had raised money from debt securities in the debt capital markets, Tesla would have likely gotten junk bond ratings as it did not earn enough to foot interest payments.
When Tesla reported positive Q2 2020 results—a net income of US$104 million and an increase in revenues to US$6.04 billion from US$5.37 billion, suspicion took over. Astute market observers will be quick to point out that the automotive sector is suffering from a bout of coronavirus-induced losses, with many automotive manufacturers reporting a fall in revenue by 30 to 50 per cent during the first half of the year. Additionally, the three largest car manufacturers in the US (General Motors, Fiat Chrysler and Ford Motors) have racked up combined losses of approximately US$2.9 billion for the second quarter—which is why Tesla’s results deserve scrutiny for being an outlier.
For one, the cars that Tesla sells are exorbitant—Model X alone is priced at US$120,000, almost five times as much as the average cost of a 2020 Ford Fusion. In such dire times, do big-ticket items still sell?
Tesla also faced a slew of operational issues caused by a government-enforced shutdown of its factories in New York, California, Nevada and China, during the first half of the year. With declining deliveries and production in Q1 and Q2 2020, how was it possible that Tesla actually generated a profit during Q2 2020, just as the coronavirus surged?
There is no doubt that Musk is a talented entrepreneur but the growth story is beginning to get ridiculously expensive. And investors need to sit up and take notice. With such a phenomenal quarter, while other automotive companies agonise over payroll and other issues, something does not quite add up.
In 2015, SolarCity, a solar energy company started by Musk’s cousins, Lyndon and Peter Rive began showing signs of distress. The teething issue was US$500 million in revolving facilities and term loans due in 2016. By that time, SolarCity’s business model of leasing solar panels was in question: it had racked up a cumulative loss of almost US$270 million over four consecutive years, putting the company on the edge of bankruptcy. SolarCity’s operations were also financed by SpaceX which owned 77 per cent of SolarCity bonds. Through a trust vehicle, Musk was the indirect beneficial owner of SolarCity and if the untoward should happen to SolarCity, Musk would go down with it.
In April 2016, Musk received a desperate call from the Rive brothers, to find solutions to the debt that was maturing in a matter of months. With an enterprise value of around US$6 billion, the company needed an injection of equity or a refinancing package that would pay off its obligations. The impending failure of SolarCity would result in spillover effects, which would affect not only SpaceX and cash-strapped Tesla but also the value of his wealth.
Musk had to act quickly and bulldozed his way through the acquisition of SolarCity in a deal worth US$2.6 billion, getting approval from a very pliant Tesla board. The deal was completely absurd according to market observers, who felt that there were no operational synergies between both companies.
Valuation and Other Matters of Concern
At a US$280 billion valuation, Tesla’s market capitalisation exceeds the total market capitalisation of the top three automotive manufacturers in the world—namely Volkswagen Ag, Toyota Motor Corp and Fiat Chrysler Automobiles. Yet, it produces less than four per cent of the combined revenues of these companies. What else is worth US$280 billion? A tax-free perpetuity (rate of return of 8 per cent) generating an annual income stream of US$22.4 billion.
Tesla also reported free cash flow of US$968 million for FY 2019. Even if that is compounded at 30 per cent per annum over the next decade before levelling off to a period of zero growth, annually, that will not even come close to exceeding US$20 billion. Would Tesla’s sales eventually reach a level equal to the combined sales of Volkswagen, Toyota and Fiat Chrysler? Highly unlikely, because for that to happen, it would need more than 20 times the capital it currently employs (worth approximately US$202 billion) and a slew of ‘foolish’ investors. Moreover, Tesla is not the sole manufacturer of electric vehicles. While the company can be credited with making the ownership of electric vehicles sexy, other players like Audi, BMW, and Volkswagen have jumped on the bandwagon. Tesla’s geographical footprint, which includes mostly the US and China, also puts it at a disadvantage when other car companies have more established supply chains to serve the global market.
After CFO Deepak Ahuja left the company in March 2019, Tesla reported a fall in selling, general and administrative expenses from the prior year—a first in the company’s history of rising costs. In that same year, free cash flow also became positive for the first time. Was this all a mere coincidence or did Tesla suddenly figure out how to be profitable through aggressive accounting?
Along with the departure of Deepak Ahuja, there were 201 senior or directorial-level executive departures, from 2016 to 2019, which was not a healthy sign. Although Musk is famously known to have an erratic temperament, why would they give up their generous incentives such as vesting stock options and leave for greener pastures?
These events heighten the likelihood that Tesla is not all it has been made out to be. While some have called out Tesla for accounting fraud, there isn’t conclusive evidence that the company is indeed one. But the fact that the company had a profitable Q2 even as the main factory in California shut down for an entire month of April, does raise some interesting questions. Is Elon just a supremely talented businessman or are the numbers overhyped? As Jeffrey Archer said, “If you make a deal with a fool, don’t be surprised when they act foolishly.”