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I believe Tesla Motors is a compelling and timely short.  Over the past several years, we have seen investors repeatedly get burned by stocks that are based on high hopes for clean energy technologies such as car battery companies like Ener1, A123 Systems and Valence Technology (all three of are now in bankruptcy), solar companies such as First Solar, Sun Power, Suntech Power, etc. and natural gas transportation companies such as Westport Innovations (which I wrote up as a short idea here on VIC), Clean Energy and Fuel Systems.  I believe Tesla is imminently headed down a similar path to financial ruin, yet, the company is now trading at an enterprise value of over $4 billion (basically at or near its all-time highs).

In 2008, Tesla gained widespread recognition with the introduction of the first all-electric sports car in the U.S. called the Roadster.  The car cost a bit over $100,000 and less than 2,500 vehicles were sold until manufacturing was discontinued earlier this year when British car company Lotus ended an agreement to complete the initial assembly.  Tesla and its investors are now banking on the successful launch of its all-electric luxury sedan called the Model S which retails for a rough average of $80,000.  Tesla claims it will produce 20,000 cars annually at a 25% gross margin.  This would translate into a gross profit of $400 million.  Unfortunately, the company’s operating expenses should amount to approximately $450 million annually, so even hitting these objectives would leave Tesla in a tough spot.  In reality, Tesla has little chance of selling 20,000 cars annually as gross orders are running at a rate of barely 10,000 (and that is not adjusting for likely cancellations).   In fact, the company has been taking orders for several years and the backlog has only amounted to a total of 13,000 units.  Furthermore, I don’t believe the company’s 25% gross margin is particularly realistic, especially for a company whose only manufacturing plant is located in the high-cost state of California – frankly, even a 15% margin would be the envy of many of its lower cost peers.  At a more realistic 10,000 vehicles annually and a generous 15% gross margin, Tesla would only produce $120 million of gross profit, leaving it with over $300 million in annual losses.

But even more concerning is the fact that Tesla is in the midst of finding out that making a car is a rather complicated task, particularly when it is your first time doing it (recall the Roadster was assembled by Lotus) and more than half your employees were hired in just the past eighteen months.  Production has recently fallen well behind schedule with 2012 deliveries now expected to be under 3,000 vehicles versus a projection given just a few months ago of 5,000 vehicles.  Additionally, the company’s gross margins were negative in the third quarter of this year (not a good start).  Several customers have seemingly grown frustrated with the delays leading to over 1,000 customer cancellations in the last few months alone.  Things have become so challenging that the company has been forced to restructure a Department of Energy (“DOE”) loan for $465 million to avoid being in default (this is from the same program that funded the failed solar company Solyndra).  The DOE has demanded pre-funding conditions for this loan, and Tesla recently had to raise roughly $250 million from a stock sale just to fund its ongoing losses. 

It is remarkable that investors in Tesla are so complacent with a company that by any measure is in severe financial distress (its market capitalization remains close to its all-time high).  I wouldn’t underestimate the odds of further production issues or potential product recalls given the enormously complicated task of building a new car using a new technology with new employees (competitor Fisker suffered through a product recall as has General Motors with the Chevy Volt).  Such an outcome would likely be catastrophic for Tesla. 

Perhaps investors are comforted by CEO Elon Musk who in September predicted the company will be “cash flow positive by next month” (an outcome that seems utterly impossible).  His prior predictions haven’t built much credibility in my eyes – not only has the company fallen way behind his production forecasts but Musk repeatedly assured investors after the IPO that “Tesla does not need to ever raise another funding round.”  In fact, the company has raised over $400 million to cover losses and I suspect even that will not be enough. 

1)  Tesla has negative book value of $28 million.  This is for a notoriously highly capital intensive business.  In the context of a $4 billion market capitalization, this makes no sense.

2)  Tesla needs to produce well over 20,000 cars annually to be profitable.  Not only is this two times current demand, but it is out of context of other cars in its class.  The well established Mercedes S has YTD U.S. sales of 9,310, the Audi A8 has YTD U.S. sales of 4,561 and Porsche Panamera has YTD U.S. sales of 6,451.  I personally would be surprised if once the hype dies down if Tesla is even able to sustain annual demand above 5,000. 

3)  For Tesla’s enterprise value to make sense it would likely need to generate $500 million of operating profits at some point in the near future (auto companies, after all never trade anywhere close to 8x EBIT or higher).  For that to happen, Tesla would need to generate around $1 billion of gross profit or $4 billion of sales at their very aggressive gross margin target of 25%.  At $80,000 per vehicle, this is 50,000 vehicles per year or 5x current demand (and this assumes the company would not have to materially increase capex to satisfy that demand) and multiples of other luxury cars.

4)  Auto companies typically trade at P/E multiples net of cash of 6x-8x.  At 8x, Tesla would have to generate $500 million of net income.  This would likely require annual production of nearly 70,000 vehicles.

5)   Reservation payments (basically deferred revenue) are $138 million.   If orders slow, this will create negative cash flow and put further pressure on Tesla’s finances.

6)   After production ramps, selling new Tesla S models will only get harder.  The company will need to compete with used market sales of perhaps a couple of thousand per year.

7)  Consider BMW (posted by Flubber on VIC two weeks ago).  Total common + pref market capitalization is 44 billion euros.  The company has 13 billion euros of cash and 7 billion euros of book value in its finance business.  So, the Auto enterprise value is around 24 billion on 70 billion of sales or 0.34x sales (under 4x EBIT).  If Tesla sustainably produces 20,000 vehicles at $80,000 and trades at 0.34x sales, the enterprise value is around $500 million, leaving virtually no equity value.

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