Monday, July 23, 2018

Characteristics of Questionable Businesses, Tesla and Valuation

Tesla is a fascinating company for many reasons, but, to me, by far the most interesting aspect of the company is the extreme range of outcomes that are possible in a relatively short time frame. What I mean is that based on all the information available as of now, it seems like Tesla could be anything from a world changing technological achievement driven by a once in a generation entrepreneur, to a total fraud that will end with executives being hauled away in handcuffs.

At a given point in time a handful of these type of companies / stocks are out there. Great debates rage on websites like valueinvestorsclub.com, seekingalpha.com, etc... about whether or not these companies are undervalued gems with near term catalysts, or frauds that will go to 0. Having tracked many of these over the last decade I've noticed a few things:
  1. These companies almost always have promotional management teams that seem overly interested in the share price (probably because they want to cash in on stock options) and they utilize overly ambitious performance guidance for the company along with what I would call promotional news stories to try and juice the stock price
  2. These promotional management teams often have executives with a history of exercising questionable ethics
  3. Lack of board oversight
  4. There are usually questions as to whether or not the products these companies sell are actually effective / disruptive / a value-add in the marketplace
  5. Often there are regulatory issues--the company is / was..."aggressive"...in how it approached regulatory issues and may lose a significant portion of its business once regulators adjust
  6. The companies burn a lot of cash and rely on capital markets to pay the bills
  7. Financial statements rely heavily on non GAAP metrics

These type of companies with these issues typically have this kind of valuation profile:
  1. Due to all the business risk / headline risk / potential of the equity being worthless, etc...these stocks often seem cheap based on a few metrics which in turn attracts the value investors
  2. Pricing that reflects significant upside (2-3x upside potential) if all the issues clear up (regulatory risk goes away, cash burn turns positive, etc...)
  3. In general, pricing that reflects a low probability of massive upside and high probability of a massive downside in equity value

Let's take a look at Tesla with this framework:
  1. I would describe Elon Musk as very promotional (think Thai cave rescue headline grabbing on Twitter), overly concerned about stock price ("short burn of the century coming!!!!!" type tweets) and has a very poor history of providing accurate, realistic guidance. The only caveat to this point is that I think with tech / Silicon Valley companies, founders have to be promotional and "sell a dream," so to speak, to create access to capital. Maybe with that perspective it's somewhat justified.
  2. On one hand, Elon Musk has a great track record of success. SpaceX seems to be a huge success, based on info we have at this point, and he was an early investor in PayPal, a highly innovative company. On the other hand, Tesla's recent acquisition of SolarCity  must be considered an incredibly unethical act. SolarCity was about to go bankrupt and Tesla comes in and OVERPAYS for the company when there is no cover bid whatsoever. In its simplest form, Tesla took money from its shareholders and used it to enrich SolarCity shareholders, many of whom are related to Elon or Elon himself. Let's not sugar coat it, this was stealing. A massive red flag to me.
  3. Go take a look at Tesla's board. Hmmmm, a few family members, VCs with money invested in Tesla...and that's it. Where are the independent overseers? Where are the automotive experts who can lend manufacturing expertise? And to make it all worse, Elon himself has a stranglehold on the board. Weak boards are non uncommon, but keep in mind Tesla is a $70 billion enterprise value company. $70 BILLION AND IT HAS NO BOARD OVERSIGHT!!!! Guys, this is crazy.
  4. Here Tesla seems to score well based on consumer and expert reviews. The Model S seems to be a massive, market changing success. The Model X, maybe not so much. The Model 3 is still a question. It could be argued that Tesla got lucky with the Model S and may be reverting to their true competency level with the Model X and 3. The other potential red flags are some of the safety concerns with the battery packs, safety concerns with the autopilot and apparent lack of quality control with the Model 3 production, but these don't seem to be glaring issues as of now.
  5. Regulatory issues are always tough to gauge. A company doesn't seem to have issues until it does. Just based on headlines, it would appear that Tesla has an aggressive stance towards regulation and tends to push things forward without asking for permission. Safety concerns regarding the battery packs and autopilot could lead to regulatory issues as well. Overall, I think Tesla probably scores pretty well here.
  6. Tesla obviously has a massive issue with cash burn. Some analysts seem to think they could be burning as much as $12 million per day. Tesla has been relying heavily on capital markets to fund its operations and growth. The company has taken on $20 billion in debt and has issued equity at these recent elevated prices. In fact, it is painfully obvious that point #1 is directly related to this issue. Elon knows he has to keep Tesla in the headlines and the stock goosed to be able to raise more equity in the future (company appears to have fully tapped-out the debt markets). Massive issue and red flag, in my opinion.
  7. Tesla's financial statements rely very heavily on non GAAP metrics. In fact, Elon has stated that Tesla's goal is NOT profitability. Pretty big red flag, in my opinion.

The valuation portion of the Tesla discussion is where it gets especially ridiculous. Given the risks outlined above, it would seem reasonable that Tesla should trade at a valuation similar to what I described above: Relatively cheap if it gets through its various risks (2-3x upside) but with a high probability of the equity being worth 0 priced-in. Does Tesla trade at that type of valuation? Of course not. In fact, it is priced as if it has already achieved all of its future growth (produces and sells as many cars as GM and has better margins...)!

Should be interesting to see how this plays out...

No comments:

Post a Comment