Tesla Inc. TSLA is undoubtedly one of the most (if not the most) polarizing stocks in today’s market. As with most stocks, the battle between bulls and bears can be seen playing out in the conventional venues of financial press and investment banking analyst letters. However, the Tesla battlefield is far larger than this. Boosters and critics are locked in seemingly perpetual combat on social media, especially Twitter. A cottage industry of clean tech and auto blogs has popped up to provide air cover for the company and Elon Musk, its mercurial CEO.
A new front has recently opened up in this long-running feud: academia. On March 19, Tom Bachrach presented a striking lecture to students at the University of Pennsylvania’s Wharton School of Business. In it, Bachrach highlighted a number of serious issues with Tesla’s behavior and corporate governance. Specifically, he identified four “contextual risk factors” that make Tesla worthy of deep scrutiny:
- High growth dependent on outside capital.
- Complex corporate structure and opaque reporting.
- High level of management turnover.
- CEO and corporate governance issues.
Before we dig into each of these risk factors, it is important to note that Bachrach’s investment fund, PFH Capital, is short Tesla. Bachrach does not make any effort to conceal this fact, disclosing his fund’s position early in his presentation:
“Disclosure: My fund is ‘short’ Tesla via long put options and bear put spreads. It is reasonable to consider me biased against Tesla (though I do my best to manage this bias).”
While Tesla bulls might not be quick to trust this particular messenger, given his short interest, the clear evidence and analysis Bachrach presents are quite cogent. Bulls and bears alike should pay close attention to this analysis. It bodes ill for the upstart electric car company. Investors should be prepared for what may soon hit.
High growth dependent on outside capital
The first red flag Bachrach discussed concerns Tesla’s growth narrative, including the necessity for massive amounts of capital expenditure to achieve growth expectations set by management:
“Rapidly growing, capex intensive businesses require capital to scale, in particular when they are suffering substantial and growing losses. Their ability to favorably issue equity hinges on the ‘growth story’ ... and if that story busts, look out below.”
“With survival often dependent on short-term, quarter-to-quarter results, these high growth companies will have greater incentive to manipulate results (all else equal).”
Even the most cursory examination of Tesla reveals that it is a company and stock built on a narrative of rapid growth. The stock continues to trade around 50 times the analyst consensus earnings estimate for 2019, even after the recent significant downward revisions to estimates by numerous analysts. Despite being portrayed as a growth company, Tesla has actually been slashing capex to the bone, casting doubt on its ability to build production capacity and pursue promised products.
Last year, Tesla pulled out all the accounting stops to engineer a blowout third-quarter profit, a feat we have explained in detail previously. In essence, the company pulled a number of one-off stunts to orchestrate the result that cannot be repeated. Mounting signs of falling demand and collapsing margins in the first quarter of 2019 (visualized very elegantly by anonymous analyst Tesla Charts) lend further credence to the argument that Tesla’s late-2018 efforts were wholly unsustainable.
Complex corporate structure and opaque reporting
Bachrach’s second red flag involves Tesla’s unusual corporate structure. The company has a myriad of subsidiaries and opaque business units. As Bachrach explains, this convoluted and byzantine structure can make tracking all the moving parts exceptionally difficult:
“Tesla has an enormously complex structure of subsidiaries, VIE’s and financing arrangements (leasing, resale value guarantees, etc). Financial reporting can feel purposely opaque, providing neither enough detail to confirm nor disconfirm our suspicions.”
Obviously, there is nothing illegal about an overly complex and opaque corporate structure in and of itself. However, when that structure appears to be designed to obfuscate the underlying situation at the company, then problems start to emerge. Such a situation appears to be playing out at Tesla currently:
“While PwC audits Tesla’s consolidated financials, subsidiaries may use local auditors, e.g. Tesla’s Singapore entity it moved $610 million through on 11-Feb-2019 (likely in relation to the Gigafactory 3 construction in Shanghai).”
When a company is deliberately obfuscating aspects of its business, whether it does so for malign purposes or not, investors should worry. Investors in public companies rely on a steady stream of disclosures in order to make their investment decisions. Tesla makes that effort distressingly difficult.
High level of management turnover
A company experiencing high levels of growth and looking forward to an exciting future tends to attract talented individuals who want to share both in its mission and in its financial rewards. Managers want to stick around when things are good. Conversely, when things start to look bad, managers tend to jump ship, as Bachrach explained:
“When that ‘growth story’ begins to bust, management may begin to leave for multiple 'non-nefarious' reasons, including concern for future job security and/or option heavy pay packages that are less likely to finish ‘in-the-money’.”
Elon Musk, Tesla’s CEO, has spent many months talking up Tesla’s future, declaring that the company has turned the corner and is well on the way to sustainable profitability. Such a situation ought to be a time of jubilation in the company’s executive offices. Instead, there has been an astonishing exodus of talent over the past year. Indeed, more than 100 senior staff headed for the exit in 2018, as carefully tracked by analyst Paul Huettner, CFA. many leaving substantial options-based compensation on the table when they did so.
The concern over management departures goes beyond sheer quantity, however. More worrying is the fact that many of those departing are long-time Tesla veterans, or individuals holding critically important roles within the company. Tesla lost two chief accounting officers in the space of the year, the second of which lasted less than a month. More recently, Tesla’s long-time CFO Deepak Ahuja announced his retirement. The exit was disclosed in the final moments of the fourth-quarter earnings call on Jan. 30. Taking Ahuja’s place is Zach Kirkhorn, a 34-year-old relative novice. That is hardly a welcome development for a company already notoriously deficient when it comes to financial and operational disclosures.
Tesla has lost numerous other important executives in recent months from across the organization, including key engineering leaders. Taken together, these departures do not paint a picture of a company in good health, let alone on the verge of a fresh growth spurt.
CEO and corporate governance issues
The final issue Bachrach addresses concerns the dearth of corporate governance at Tesla. According to Bachrach, the issue starts at the top with Musk:
“Elon Musk has displayed a willingness to openly lie, especially when his business is under threat (a necessity he alluded to years ago). His most brazen 18-Q3 lie: a fake go-private announcement he had run by no board members or potential funders.”
“Tesla slowly walked this back over the following weeks and Musk was forced to settle with the SEC in late September, subsequently taunting them and refusing to follow the settlement terms (hence the SEC asking he be held in contempt in March 2019).”
We have discussed Musk’s poor judgment concerning the SEC and spoofed go-private effort in a previous research note, but the story has only continued to evolve. Having recently offered suspect production guidance, Musk is once more in the SEC’s crosshairs. Musk’s fate as CEO now rests in the hands of a federal judge, Alison Nathan. Judge Nathan has access to a number of potential remedies, and could even go as far as to declare a D&O ban, which would bar Musk from serving as a director or officer of a public company. While a number of high-profile analysts, including Jim Cramer, have suggested a D&O ban may very well be in the cards, it seems more likely that Musk will face another, heftier fine and a final warning.
Verdict
Ultimately, Bachrach identifies a whole lot of smoke emanating from Tesla today, but whether there is a fire remains to be seen:
“Tesla’s 2018 Q3 results present multiple red flags, but they do not provide enough information (intentionally or unintentionally) to draw strong conclusions...Tesla reported a slightly reduced profit in 2018 Q4 (essentially breakeven), but worked through their remaining Model 3 backlog and are showing a massive sales decrease in 2019 Q1 so far. If games were played in Q3/Q4, that should become apparent soon.”
First-quarter earnings will not likely be announced until May, but a few events in the meantime should provide significant insight into what lies ahead. Most importantly is the report of delivery numbers for the quarter, which Tesla is expected to announce next week. With all signs pointing to a nasty demand cliff, investors should pay extremely close attention to the delivery report.
The outlook continues to darken for Tesla, yet its share price remains inflated to mega-growth stock levels. With reality set to bite in the next several weeks, the stock looks poised for a sharp tumble.
Disclosure: Short Tesla via long dated put options.
