Opposing Funds Duel on Tesla Valuation

The following interview was also published in part on Business Insider

Tesla Motors (NASDAQ: TSLA) is one of the most controversial and heavily-covered names in the market in recent memory. To help investors understand the name at a more advanced level, SumZero has asked two fund professionals that cover the company closely, one long and one short, to opine on some of the biggest questions surrounding on America’s largest all-electric automaker.

SumZero sat down with John Pangere of Chicago’s Windy City Advisors (short TSLA) and Michael Frazis of London’s Torchlight GP (long TSLA) to debate the current value and future of Tesla from the perspective of fundamental investors.

John Pangere founded Windy City Capital in 2015. Prior to that, he worked in investment banking with a focus on technology, consumer goods/products and real estate/construction. Additionally John is currently a partner and managing director of Venture Connects, a venture capital and entrepreneurship company he co-founded in 2012.

Michael Frazis is launching a global multistrategy hedge fund in early 2016. He has spent the last three years at Torchlight GP, a private equity firm with a focus on media, shipping, and real estate while managing a small pension fund focussing on equity and volatility trading. Prior to that he worked for Goldman Sachs in the Asian Special Situations group.

---

SumZero: What about TSLA grabs your attention as a value investor? What is the market missing?

John Pangere, Windy City Advisors: In Tesla, I believe there to be a case of deception in the way the company frames its results to investors on a quarterly basis. To be clear, I love the product the company puts out, but from a pure investment and business perspective, Tesla has some major shortcomings that I feel the market has continued to ignore. When you factor in the fact that the company has yet to turn a profit on each car rolling off the line and the coming cash costs in order to hit its numbers in the next 5 years, I don’t see how an actual cash profit will be achieved in that time frame. For my money, Tesla is not worth more than Hyundai or Fiat.

Michael Frazis, Torchlight GP: Several things attract me to Tesla. Company comparisons are tedious and overdone, but the parallels with Apple several years ago are uncanny. The company is selling every car it can make, pricing its vehicles extraordinarily high, and making extreme capital investments in core technology, both in research and development and the factories themselves.

I’ve distilled the challenge into one sentence: Will Tesla achieve Musk’s five hundred thousand car sales per year target, and does it have the funding to do so? If so, I’d expect the stock to appreciate three to four times from where it is now in the mid term. If not, then the growth component of the equity value will vanish.

As Tesla reaches milestones on its way to maturity the stock will appreciate even if the market has priced all the risks correctly. There are real assets, brand quality, and value in this company so even in a low growth scenario the risk of total capital loss is small.

SumZero: Will TSLA’s cash burn require a future capital raise, and if so, when?

John Pangere, Windy City Advisors: This has actually already happened. Tesla’s first Gigafactory will cost approximately $5 billion to build. In order to continue growing at the rate at which management has stated, Tesla will need several of these factories to reach those goals. As a company that has yet to produce a real cash profit, the only way to finance this expansion is through a combination of the debt and equity markets. For instance, back in February of 2014, Tesla issued $2 billion in convertible notes to help finance the first of these factories. This note is potentially dilutive to existing shareholders by 5% (6 million shares). In addition, back in August the company issued another 2.7 million shares of common stock for “the growth of its business in the United States and internationally, including the growth of its stores, service centers, Supercharger network and the Tesla Energy business, and for the development and production of Model 3, the development of the Tesla Gigafactory, and other general corporate expenses.” That’s quite a list for the use of proceeds.

The fact is, Tesla may be setting sales records, but the company is also setting records of a dubious nature as well. When taking a deeper look at the numbers, the company lost an astonishing $19,810 per car sold last quarter, up from a loss of $15,975 in the previous quarter and a loss of $9,956 per car sold in Q3 of 2014. Tesla may in fact reach its production goals, but it will be at great expense to shareholders.

Michael Frazis, Torchlight GP: Tesla has unmet demand for a differentiated product that it builds out of steel and sells at a premium, so it makes sense to raise capital and build as many cars as possible. We’d prefer to have more capital doing this rather than less. Whether this is good or bad will depend on the path capital markets take. If there is a misstep and the debt and equity markets close at a time when Tesla needs cash, then any raise will be highly dilutive.

Cash is currently sitting at $1.4 billion after Tesla issued equity to raise $739 million net of fees in 2Q2015. The market response to this was positive and I’d expect Tesla to consider topping up their cash balances on an annual basis. I’m very supportive of one to three percent dilutions that take the company closer to reaching its goals.

SumZero: How big an impact will the Resale Value Guarantee (RVG) Program have on future profitability?

John Pangere, Windy City Advisors: When you look into the program from the outside, it’s a great deal for consumers; Tesla buyers “purchase” a brand new car with a guarantee that the company will “buy” that car back in 36 months at what amounts to roughly 50% of the MSRP of that car. Sounds more like a lease to me.

This program has been such a hit with consumers that taking a look at Tesla’s balance sheet shows just how much of an issue this program will have on the company’s cash flow in the future. Currently, the long-term balance of the RVG program has ballooned to approximately $953 million, up from $488 million in December 2014. The buyback window has just started to open up as an $85.5 million current liability is shown for vehicles that are currently exercisable in the next 12-months under the program. Remember, these will be real cash costs to the company.

From my perspective, this program does three things: 1) inflates sales by offering buyers with an offer that’s hard to refuse, 2) puts an artificial floor on the value of a used Model S and 3) sacrifices potential profits/cash flow in the future for the immediate gratification of reporting higher sales in the present. What will happen when Tesla has to make repairs to these cars and then sell them in the used car market? More cash out and potential losses from the sales of those used cars.

Michael Frazis, Torchlight GP: The Resale Value Guarantee is concerning, mostly for what it says about Tesla. Musk is willing to promise spending in the future to assist sales today. This is fine, but it’s a bad habit and has led to scandals in the past. The temptation to drive sales today by adding costs in the future should only be pushed so far.

Fortunately the resale market for Tesla vehicles has been very strong so we see this as a minor part of the story, and another indication of the value of these vehicles. It seems to have had a net positive benefit on sales, both directly and indirectly, perhaps by signalling that Tesla will stand by the quality of its cars. It is likely this has added more to Tesla’s brand value than it has cost. However, I do wonder if Musk would approach any future weakness in sales by making further promises and guarantees. This would not be good.

SumZero: Can TSLA expect continued income from sales of Zero Emission Vehicle Credits?

John Pangere, Windy City Advisors: In short, I don’t believe so as these programs eventually phase out. Regardless of one’s political beliefs, these credits are taxpayer funded and have been a source of pure profit for Tesla. The question is: How long will taxpayers allow their taxes to fund a private luxury auto maker? My opinion: not very.

In addition, Tesla accounts for the sale of these credits as part of automotive sales, a policy I believe to be misleading for investors as it skews the gross margin upwards because it doesn’t actually cost Tesla anything to “manufacture” these credits. (Under GAAP [Generally Accepted Accounting Principles] rules, the accounting for the sale of these credits should be itemized in Other – Income; Tesla has apparently convinced its auditors otherwise.) At the very least, Tesla won’t be able to mask profit margins in the future as these vehicle credits phase out, allowing investors to see a truer picture of profitability, or lack thereof.

Michael Frazis, Torchlight GP: A long investment case has to be independent of vehicle credits. I don’t pretend to be an expert on US policy in these areas. Globally, the attitude towards emission reduction is very positive, and we expect this to continue. As Tesla matures this will be less important.

SumZero: What about Tesla Energy, the in-home battery arm of Tesla? How has that part of the business been doing and what do the margins look like?

John Pangere, Windy City Advisors: The question here shouldn’t be how Tesla Energy is doing but why does Tesla Energy even exist under the Tesla name when Tesla is supposed to be a carmaker? Seems to me to be a classic case of “moving the goalposts” because it’s clear the car business isn’t making money yet – and won’t make any money for years to come – so why not enter a brand new business line in order to try and boost sales figures. It’s as if Tesla is trying to redefine itself as a technology company, not as a carmaker, in order to justify a higher valuation.

It’s clear to me that the energy business was set up with the intent that SolarCity would be the largest customer of Tesla Energy. So I ask: why didn’t SolarCity bring the energy production in house? It makes much more sense that a solar panel manufacturer build, market, and sell a battery backup system that compliments its solar systems than have an auto manufacturer do so. But SolarCity has its own major problems (a company I’ve been looking to short as well at the right price) and would best be left for a different discussion.

Michael Frazis, Torchlight GP: There is still something of a mystery about this side of the business. Undoubtedly Tesla has market-leading expertise, but we won’t know the truth until the products are being delivered. What we do know is that the market response has been overwhelmingly positive, with $1 billion of indicative demand almost instantly.

If sales in Tesla Energy drive economies of scale for the core car business then that alone will be enough to drive margins for the firm as a whole. The true impact of Tesla Energy may well be to increase margins in the core business and/or allow Musk to offer his vehicles at a lower cost. Tesla Energy is also the perfect bridge for any excess factory capacity.

---

---

SumZero: What competitive threats do you see on the horizon for Tesla from BMW, Google, Toyota et al., and how far ahead of the competition is Tesla?

John Pangere, Windy City Advisors: The market for all-electric vehicles is in part driven by fuel prices. We can see this in overall electric vehicle sales as reported by evobsession.com. Year to date, overall electric vehicle sales are down 4% through October as compared to the same period last year. Granted, electric only car sales are up 12.8% over the same period, but the growth in that sub-sector has been driven by BMW, Mercedes and VW, whose sales of electric vehicles have skyrocketed in the past year. Overall, electric vehicle sales have cooled by quite a bit from the explosive growth we saw in the early part of the decade.

While Tesla is ahead of the competition at this point, it’s clear by viewing the data just how quickly competitors such as BMW have been able to enter the electric vehicle market. While I currently don’t see much competition for electric cars in the same price point as the Model S (the BMW i8 is the most comparable so far), it’s starting to get awfully crowded in the lower end of the EV market, one in which Tesla is intent on entering with its Model 3.

Michael Frazis, Torchlight GP: Tesla’s focus on a small number of models has major competitive advantages. Tricks like automatic updates to core systems are far more difficult for traditional auto companies with a myriad of models and systems. This also gives something of a cost advantage to Tesla over future competitors, most of which see electric cars as a side business and something of a hedge. Every component of a Tesla has been designed with an electric car in mind. Competitors have to deal with pressures from other parts of the business to include components and styling. Competition analysis comes back to brand and pricing: right now the pricing power of Tesla is unique. They have managed to build a luxury brand and demonstrated that they can convert that into pricing power.

Musk is right when he talks about new competitors actually benefitting Tesla. Electric cars account for such a tiny portion of sales that there is plenty of room for all to grow. Tesla will be the main beneficiary of the growing acceptance of electric vehicles and the build-out of their infrastructure. Even at five hundred thousand cars Tesla will be 2-3% of the US auto market, and we expect much of these sales to come from foreign markets. Finally there’s a good chance competitors come to depend on Tesla for their market leading battery technology and their $5 billion investment in the Gigafactory.

Looking forward, it’s possible to picture a mature industry with Tesla as the premium brand and a range of competitors below it, unable to charge quite as much due to their lower brand value. Much like in smartphones right now, the leader who can charge the highest prices will capture the vast majority of industry prices, irrespective of the intensity of competition at lower price points.

SumZero: Any thoughts on the Model X crossover SUV? The initial model is even more expensive than the Model S sports car; will they be releasing a cheaper Model X, and if so, when?

John Pangere, Windy City Advisors: Personally, the Model X is not an appealing car to me; it looks more like a basic Kia to me than an $80,000+ SUV. I think the issue with the Model X is that the price point is much higher than originally thought and this may wreak havoc on projected sales. The company has stated it is expecting total production to range from 1,600-1,800 units per week by Q1 2016, but at the Model X’s current price point and a decline in customer deposits, I have my doubts as to whether sales for both the Model X and Model S will match that level of production.

Michael Frazis, Torchlight GP: Personally I wouldn’t use it as an SUV as there are no racks for surfboards, but this is designed more for families than surf bums and apparently the sales response has been excellent, especially given its outstanding safety characteristics. I can see the hospital grade air filtration resonating in the major cities of China. High pricing is here to stay until sales volumes increase substantially – certainly not before the Gigafactory is operational. I’d expect delays on the Model 3 as well.

SumZero: What about super-CEO Elon Musk dividing his time between TSLA, SolarCity, and SpaceX?

John Pangere, Windy City Advisors: To be certain, Elon Musk is a polarizing figure for Tesla much in the same way that Steve Jobs was for Apple. However, the biggest difference between the two is that Apple created – and continues to create – large amounts of free cash flow, where Tesla and SolarCity have yet to do so. Additionally, as an investor, I would be very worried about a CEO splitting time among several endeavors rather than focusing his effort on building the company I’m invested in.

Regardless, I think there’s a difference between acting in the best interest of shareholders and the behavior that Elon Musk has put forth in some of his actions. Again, a point I touched on in my original thesis is the self-dealing that has occurred among the companies he is involved in, from SpaceX “investing” in SolarCity bonds to the “demand” of the Tesla Energy Powerwall I expect to be driven by SolarCity. Under normal circumstances, these actions would cause investors to panic, but Musk has created such a powerful media presence – through avenues such as Twitter or TV appearances – that he’s able to get away with this kind of behavior without consequences. Tesla is intent on creating the appearance of success rather than being transparent and honest with investors. Eventually, as losses continue to accrue, this will catch up with the company and Elon Musk. This type of behavior just can’t last.

Michael Frazis, Torchlight GP: Musk is a business and tech celebrity. His value is in building hype for the products and being the final arbiter of quality and workmanship. As long as he can maintain his eye for detail, quality, and intelligent staff, all of his companies could perform well, as they have been for many years now.

I find Musk’s almost weekly prognostications somewhat tedious, but Tesla is a beneficiary of this kind of self-publicity, so I’m all for it. If Tesla hit major financial issues at the same time as one of his other companies then his unfocused attention would become an issue. Given the success of Tesla so far, I’m willing to bet there are plenty of capable people in leadership positions who could take up the slack. I’m more concerned about scenarios where Elon is not CEO!

SumZero: From a valuation standpoint, what's a fair EV / Sales multiple to give to a company like TSLA?

John Pangere, Windy City Advisors: To be honest, EV/Sales is not the correct ratio to view a company’s valuation in my opinion. I generally like to view the free cash flow of the business and other metrics such as EV/EBITDA, book value, etc. In short, I don’t believe there’s an easy way to assign much of a value to a business that, as it scales, is losing greater amounts of capital. If viewed from the perspective of comparative valuations of its competitors, Tesla should be selling at closer to an EV/Sales multiple of 1.5-2x, which would provide for an EV of the company at closer to $5.7-$7.6 billion [TSLA Enterprise Value was $31.89 billion as of 12/4/15]. Again, since the company continues to bleed cash and will do so for the foreseeable future, it becomes increasingly difficult to provide for a true value.

Michael Frazis, Torchlight GP: I think most would agree that Tesla is some mix of luxury and auto company. Car valuations are low as it’s an extraordinarily competitive industry. Tesla is carving out its own segment and deserves a much higher valuation. This isn’t just speculation on my part – its EBITDA margins are substantially higher and it charges a small fortune for every car.

It’s hard to remember now, but there were years where it was apparent that Apple was selling every iPhone it could make but had not quite taken the brand global. At the time Apple’s valuation was sky-high, but the share price was lower. Now the valuation is low but the share price has appreciated many multiples. This kind of situation needs careful common-sense thought. The correct play was to look through Apple’s high valuation, see where it was going to be in the future, and estimate the enormous appreciation in equity value that would result in the global roll-out of its products – which were high priced and sold as fast as they could be made.

While on the topic of valuation there’s clearly a “short US tech” story playing out - not necessarily due to fundamental issues (I expect tech sector revenues to keep increasing) but because valuations have reached absurd levels. This has already started with revaluations of some of the better ‘unicorns’. In this scenario Tesla stock will be shaky, but there is real widget-making value here to provide a floor. There’s a lot of fun to be had on the short side right now but you can do better than Tesla.

My guess is as good as any but I’d expect a mature version of Tesla to end up at an EV / Sales of ~2x, which on a 20% EBITDA margin would imply an EV / EBITDA of 10. If revenues hit $50 billion this would be equivalent to their 500,000 cars at $100,000 average price. A price of $200-250 per share will probably look like a steal in 2020. This is very back of envelope, but given we’re talking years ahead precision will not be rewarded and will only obfuscate. In reality you would estimate a lower purchase price and add in the revenue from Tesla Energy.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

John Pangere, Windy City Advisors: Investors should keep an eye on the cash flow statement and balance sheet. I believe the company will have growth in debt and/or issuances of equity, continued increases in capital expenditures as it tries to build out its manufacturing capabilities and real cash losses as the Resale Value Guarantee program matures. Some other clues to key in on are the customer deposits line item on the balance sheet – which has actually declined in Q3 from Q2 and may indicate a future slowdown in sales – and the production/delivery figures compared with company guidance. But the bottom line: it all boils down to the company’s actual cash burn. At its current rate, it is unsustainable and I believe it is only going to accelerate from here.

Michael Frazis, Torchlight GP: I’m not really worrying about production delays, but I do worry about sales and pricing, and also whether Tesla miscalculated future expenses caused by promises made to sell cars now and in the past. If the market for expensive electric cars turns out to be fundamentally limited then the upside vanishes. As an Australian I have to trust the US legal system and statements made by Tesla in their shareholder letters as to the strength of the demand for their cars. Anecdotally there’s no reason to doubt the attractiveness of the firm’s products.

If overseas sales start to pick up substantially in places like Asia you can be assured that Musk is on track. He proved ruthless in changing course in China when his initial approach failed and I’d expect him to get this right eventually. These vehicles are just perfect for the smoggy cities of Asia.

I’ll start worrying if I can order a Tesla and pick it up the next day and I’m offered a discount.

---

SumZero is an online community of professional investors. For those who do not work on the buyside, you can get limited access to SumZero investment ideas, interviews, and more, when you join SumZero Basic here.

Investment professionals working at funds can use their credentials to become full Buyside members. Join SumZero Buyside, a research platform containing thousands of research pieces from other professional investors around the world, via the link below.