Tesla: A Case Study

Apr 2, 2018 | Case Studies

Tesla’s financial position is weak due to ongoing and cumulative losses from operations. Because Tesla continues to lose money, it is reliant upon new capital to support its continued operations. The weakened financial position and growing capital needs put the company in a precarious position, with the very survival of the company left to the whims of the capital markets (the providers of capital).

With its lack of earnings and large cash burn, Tesla has relied on raising new capital at regular intervals to continue with ramping production. To date, the capital markets have obliged with fresh capital. In our assessment, capital markets have done so with very cheap credit, especially considering the company’s up-until-now single-B credit rating (this is very weak). With such a high equity market capitalization and no earnings, the company cannot consider (though we think it should) raising equity without driving share prices off a cliff. Successive investors would demand a more favorable entry price, and existing investors would seek to avoid dilution so that the stock price would respond adversely.

 

Without reasonable access to equity capital, Tesla is left to just borrow more. Except, creditors seem to have finally awoken from their slumber. Negative cash flow, limited value assets (again, negative cash flow), senior management departures (we counted three in March alone), quality control issues, ongoing failure to meet production targets, et cetera are causing creditors to rethink Tesla’s risk premium. Helping wake creditors, Moody’s downgraded Tesla’s senior unsecured credit rating deeper into junk territory from single-B to triple-CCC (B3 to Caa1), citing production shortfalls of the Model 3 and pending maturities of convertible bonds. We don’t think Moody’s is wrong in doing so because Tesla is precariously close to bankruptcy. The bond price collapsed, and yields spiked higher as a result.

Recent market activity – namely, bonds repricing for much greater risk – seems to have shuttered another door for much needed capital. As its cash burn continues, Tesla has a tall order ahead for replenishing liquidity. While we suspect Tesla has another trick or two up its sleeve to raise capital, each successive round will require ever more pounds of flesh, which comes at the expense of existing capital providers – both equity and creditor. Creditors assuredly woke up, and now, equity investors may be waking up too…

In the latest SEC 10-K filing (annual report covering the year ended 12/31/17), Tesla reported a net loss of -$1.96 billion attributable to common stockholders (its biggest ever loss) and cash flow from operations of -$60 million. The latter number seems almost refreshing when framed against the $4.97 billion accumulated deficit reported in the shareholders’ equity section of the balance sheet. This is because it implies Tesla is $60 small-million away from breakeven operations – from a cash flow standpoint anyways. But this figure comes before considering cash needed for investing activities. Even mature companies spend large sums refurbishing fixed assets just to maintain operations. During 2017, Tesla spent $3.41 billion on capital expenditures (how else would Tesla manufacture cars, if not with equipment?) and $660 million on other equipment purchases related to long-term sales financing of solar panels. (We won’t delve into solar financing, which is under the Solar City brand, here because the explanation is too wordy for purpose of this writing.) The combined automobile manufacturing and solar equipment expenditures totaled more than $4 billion. Because cash flow from operations has been negative in each year (with exception of 2013) going back to 2009, Tesla has relied on new capital to finance capital expenditures. Economic law dictates that (in the long-run) cash flow from operations must exceed capital expenditures if capital providers are ever to get their hard-earned money back. With ever increasing losses and continued cash burn, investors must make value judgments of when, if ever, and by how much cash flow from operations will exceed capital expenditures. Without such rational assessment, an investor is speculating – and likely to face – permanent loss on their investment.

 

Tesla’s current equity market capitalization is $42.5 billion, but it reached a high of $60 billion in January and February this year. As noted above, Tesla lacks earnings and positive cash flow, does not pay a dividend, and carries a credit rating of triple-C. For context, here are profiles of Tesla’s American competitors:

 

  • General Motors (GM): net income of $10.6 billion, cash flow from operations of $17.3 billion, which exceeds $8.4 billion of capital expenditures for $8.8bn free cash flow. General Motors pays a dividend, currently yielding 4.25% at $35.70 share price. The credit ratings are triple-B (investment-grade). Market capitalization is approximately $49 billion.
  • Ford Motors (F): net income of $6.4 billion, cash flow from operations of $18.0 billion, which exceeds $7.0 billion of capital expenditures for $11.0 billion free cash flow. Ford pays a dividend, currently yielding 5.55% at $10.80 share price. The credit ratings are triple-B (investment-grade). Market capitalization is approximately $43 billion.

 

We ask rhetorically, why should investors be willing to pay more for Tesla than General Motors and Ford?

 

In the old days, growth capital came from equity financing. Once an asset was proven to generate reliable cash flow, credit could be applied to the asset to create leverage and increase returns to equity. Nowadays, in the era of central bank monetary easing, credit has flowed easily and depressed risk premiums in both credit (low interest rates) and equity (high multiples) markets. Investors seemingly couldn’t find business ideas they didn’t like. In the case of Tesla, credit was applied to assets not yet producing reliable cash flows – more than $5.4 billion has been borrowed in the name of Tesla. Without cash flow, the creditors cannot be paid unless more capital is raised. In the old days, without payment to creditors, companies would go bankrupt, and assets transferred from common stock owners to creditor owners.

 

With Tesla’s current operating profile and capital needs combined with the company’s market price, we think of the situation as akin to running with a noose around your neck. Maybe you won’t trip and fall, but running is quite careless. In Tesla’s case, a stock priced for perfect operational execution (as we think recent price indicates) seems careless. Any operational tumble could result in that noose tightening and an air pocket like drop in stock (and bond price). We wonder if recent drops in price of Tesla’s stocks and bonds may be foretelling.

Producing the Model 3 (Tesla’s mass-market car) profitably and on (the new revised) schedule is, more than ever, critical to Tesla’s ability to raise more capital and continue as a going concern. Even if Tesla can deliver on said requirements, we are not convinced the equity is priced right for the ongoing risks of an immature company competing with established and mature titans – who have decades of manufacturing experience and greater financial fire-power.

 

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Netflix: A Case Study

Nov 6, 2017 | Case Studies, Market Commentary

We pick on Netflix (ticker NFLX) here for no special reason. The company issued debt during October, and that caught our attention. NFLX seemed like a good example to highlight our thinking about companies specifically, as well as to peek into the kind of thinking you get from Ballast. We hold no position in Netflix, and we do not expect to any time soon.

Netflix has an equity market capitalization of approximately $86 billion. The company added to its debt outstanding, successfully issuing $1.6 billion of 10-year notes during October. Netflix debt outstanding is now $4.9 billion, and the company credit ratings are B+/B1, which is a weak rating but certainly not an outlier. The new notes pay 4.875% coupon, consistent with the market for the rating. Use of note proceeds will go towards acquiring original video content.

 

From 2014 to 2016, Netflix spent a total of $18.2 billion to acquire new digital content, increasing spending from $3.7 billion in 2014 to $8.6 billion in 2016. Over the same period, cash flow from operations – cash generated and available to capital providers in the case of positive OR requiring additional capital funding in the case of negative – totaled negative -$2.2 billion, shifting from cash flow positive $16 Million (that’s an ‘M’) to negative -$1.4 Billion (that’s a ‘B’). Moreover, reported net income over the same period totaled positive $576 million, but it decreased from $266 million during 2014 to $186 million in 2016.

 

Year-to-date results during 2017 were not much different. Netflix spent $7.3 billion to acquire content which caused -$1.3 billion in negative cash flow from operations, but net income did rise to $373 million.

 

Cumulative digital content acquisition from 2014 through 2017 YTD has been $25.5 billion. With recent 12-month reported income of $440 million, we wonder how long it will take NFLX to earn it back, especially since acquisition must continue to grow.

 

Netflix stock is valued at approximately 160x expected earnings (Price-to-Earnings ratio). By inverting this figure, one arrives at the earnings yield. In the case of Netflix, the earnings yield translates to 0.625%. By owning the stock, buyers are willing to receive – in return for their capital – projected earnings of 0.625% for each dollar of capital invested. [Remember: Netflix does not pay dividends, so the only thing stockholders expect in return for the risk taken is for the future value to be even higher.] Typically, the trade-off would be justified by earnings. We ask – would you want to own a bond that pays you 0.625% for 10 to 30 years? Remember that with equity, there is no contractual obligation to return principal back to the investor at some stated future date so the value could be higher or lower – that’s called equity risk. Equity, because it is perpetual, is considered a very long-term asset, arguably longer than a 30-year bond, which does carry a contractual obligation to return principal to the investor. In the case of NFLX, the longest notes outstanding are the 10-year discussed at the start of this piece. We think a prospective buyer of equity, taking greater risk than the lenders, should want more return on their capital. While this is highly simplistic, and one could expect earnings to grow, it does cause you to frame company valuation in a constructive way.

 

Our opinion is that NFLX’s valuation is high – relative to recent cash flow and earnings. Cash flow has been increasingly negative, and it is requiring more capital to finance operations – increased debt. Overall, earnings and cash flow have moved in opposite directions.

 

Netflix is a disruptor – it disrupted the likes of Blockbuster, a video rental store. Now Netflix is disrupting conventional cable and satellite providers, as well as traditional content providers. We have no doubt that the threat is real. Where we struggle following along with the Netflix’s investment narrative is in how much the company must spend to acquire new content and therefore, what the ultimate gravity of earnings to cash flow is if subscriber base does not keep pace. New content is required to draw new subscriber interest and to keep existing subscribers. However, new and existing subscribers are only monthly subscribers, and they pay nominal fees as compared to cable and satellite subscriptions. Not to mention, NFLX does not have the benefit of advertising revenues.

 

While this embodies the disruptive force of Netflix and similar companies, the challenge is that the subscriber base is largely comprised of “binge watchers” and seasonal consumers. Once consumers have consumed the content, NFLX needs to replenish the content or subscribers move on. This creates, in our judgement, a vicious cycle whereby Netflix must expand content ever more quickly and ever costlier – relative to economic gain – until it has both matured its subscriber base (a large base with low or stable turnover) and it has reached critical mass of content (sufficient content to appease subscriber base perpetually), as is the case with incumbents like NBC, CBS, etc. The latter examples have massive libraries of content and a mature base of viewers that provide staying power. Of course, the incumbents must not rest on their laurels, but it does give them defend-able moats. It’s also important to point out that NFLX is competing with incumbents (NBC, CBS, etc mentioned previously) and similar platforms run by titans like Amazon, Google/YouTube, and Hulu, which have the backing of Disney, Fox, Time Warner, etc. The challenge is staggering – and so is the valuation.

 

Netflix is in the S&P 500, so many investors have exposure to the company, if not directly by owning NFLX stock. We dare not count how many more like it are in the S&P 500 or some other common index. Examining Netflix highlights that we are discerning investors and, as such, we evaluate each investment we invest client money in. Knowing that it is in many large indexes also underscores our philosophy on the limitations of using funds as a primary investment vehicle, a method of investing that has become mainstream. NFLX’s (and others like it) presence in many indexes represents a major drawback to owning a passive index – selection is not made by a discerning investor, but by a committee in academic exercise. Such process and use of precious invested savings may well be destructive diversification. A discerning investor is able to ignore a lot of the investments contained within an index after doing the analysis and constructing appropriate portfolios.

 

Regarding use of funds in portfolios and considering passive versus active investing, it may come to pass that making a little return by paying higher fees to active managers may be better than paying lower fees to a passive fund and losing some money. We concede that it will always depend on the individual investor – on both their perceived edge and their time horizon – but we think the near-term reality is stacking up in favor of one over the other. We are bound to find out.

Moreover, the cold reality of it and the current market is that if price continues upward, nothing else matters. The right will look wrong longer and the wrong will look right longer with time the final arbiter. Even the smartest of us investors will get sucked in to making a bad decision. This has happened since the beginning of investing history and there is no reason to think it has stopped now. It’s simply a bubble.

Investing with Ballast, we emphasize investing in individual securities over funds and select investments on their own merits. We discern so that you don’t have to.

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