A friend just sent me a troublesome report from a private investor newsletter called the Stansberry Digest. Apologies for its length. Because it so inflammatory and contains material omissions (several of which I will post next), I was wondering if Tesla or any of you may have a well-reasoned response to this piece. By the way, I am a proud owner of a fully-loaded 2014 P85D, after trading in my early 2013 P85, and I just signed up for the Powerwall. I post the article here:
The Best Short Opportunity
The best short opportunity, of course, is a fraud. But they are rare and difficult to uncover.
But with luxury electric-car maker Tesla Motors (Nasdaq: TSLA), we have the trifecta: deadbeat, obsolete, and fraudulent.
Billionaire wunderkind Elon Musk and a small group of investors founded Tesla in Silicon Valley in 2003. The goal was simple – to popularize and mass produce an all-electric car that could replace the traditional combustion engine that has ruled the road since Henry Ford's Model T back in 1908.
Coincidentally, in 2008, almost exactly 100 years later, Tesla Motors introduced its first all-electric car, the Tesla Roadster. The Roadster became the first "highway-ready," mass-produced electric car... but it came with a big price tag. For the right to drive this car, you had to fork over more than $100,000. Despite its excessive cost, Tesla managed to sell more than 2,300 of these first-generation cars.
In 2012, it began selling a newer, more advanced luxury car – the Model S (in a nod to Ford's Model T). To date, Tesla has sold more than 70,000 of its Model S cars. Both the Roadster and the Model S are powered by expensive 1,000-pound lithium-ion batteries. The Model S base cost is around $70,000, but it can easily cost more than $100,000 with a longer-range battery and other add-on options. While exact figures aren't known, the costs of the batteries range from 25% to 50% of the cost of the cars. Keep this figure in mind...
Tesla's cars were obsolete before the first one ever rolled out of the factory. The cars will have minimal resale value, because after five years their batteries will be dead... completely dead and not usable.
Normally, a battery works by exchanging electrons from an anode to a cathode. But time, hard temperatures, and repeated recharging cause a battery's electrical and chemical potential to break down. A lithium-ion battery will have more and more of its lithium ions permanently stuck to the anode through its lifetime, gradually decreasing its capacity and limits an electric car's range. As the technology is relatively new, there is not yet consensus regarding the sustainability of lithium-ion batteries. Various studies – and the accounts of the early-adopter owners – provide widely varying results.
Generally, most commentators assume that after three years, a battery pack might be at 80%-90% its original charge, or less in extreme climates. So a 200-mile range might become a 170-mile range. Over the next couple of years, the rate of deterioration will accelerate. So these battery packs will need to be replaced after several years of use. And it won't be cheap for the owners.
Another factor making Tesla's cars obsolete is that they're impossible to use in the way that most people would use a large, fast road car. You can't easily drive the thing from New York to Florida because you have relatively few places to recharge the battery. You would have to plan out a special route. Plus it takes time to recharge them.
It takes a long time to recharge these cars. So I don't know how it could ever become something that you could do on the road or on the fly. It just doesn't make any sense. The way the company is presenting information to investors is highly misleading. We classify this as fraud.
As you recall, when we talk about shorting "frauds," we don't necessarily mean fraudulent in the legal sense. We mean that a company is being willfully misleading... often using complex accounting to obscure what is going on with its finances. In Tesla's case, we believe the numbers published and discussed with analysts – and widely reported by media outlets – are extremely misleading.
For instance, Tesla's CEO Elon Musk, who is a celebrity-playboy type, once said on his conference call with Wall Street analysts that Tesla had no plans to raise any additional debt or equity. And he said that Tesla will be profitable on its operating basis going forward.
Two weeks later, the company announced a huge debt-in-equity issuance. Again, I'm not accusing Musk of doing anything illegal. But if that's not talking out of both sides of his mouth... I don't know what is.
Generally Accepted Accounting Principles ("GAAP") form the legal road map for what publicly owned companies must report. Often though, companies will also report non-GAAP numbers to highlight certain attributes of their businesses.
Non-GAAP numbers are not necessarily a horrible thing. Warren Buffett – the paragon of investor transparency – provides non-GAAP numbers in his shareholder letter, for example. Specifically, Buffett breaks out certain noncash amortization expenses from the income statement. As he explains: "We present the data in this manner because (we) believe the adjusted numbers more accurately reflect the true economic expenses and profits of the businesses."
But what should you do when a company is providing non-GAAP numbers that are... well... extremely creative? We'd advise extreme caution. We have seen, time and time again, management teams that set out to fool shareholders with creative accounting. They inevitably end up fooling themselves and driving a business into the ground.
We believe Elon Musk and Tesla Motors are falling into this trap. Let's look at what they're doing to fudge their numbers and why. This is an example of a practice we consider misleading enough to be considered fraud...
The RVG Lease Program
Tesla offers a "Resale Value Guarantee" ("RVG") that allows buyers of the Model S to sell their cars back to Tesla after 36-39 months, regardless of the buyers' loan term. That buyback price is 50% of the original base purchase price of the 60-kilowatt Model S plus 43% of the original purchase price for all of the add-on options, including an upgrade to the 85-kilowatt battery pack.
The new buyback option removes the risk of obsolescence for a buyer of a new Model S and shifts the obsolescence risk squarely on Tesla. This is a great selling point for its customers since they think they don't have to worry about the battery or if the cars will hold their value. Tesla is guaranteeing it.
Many lauded this program as a groundbreaking way to sell cars. We think it's a great marketing idea and a really smart way for Tesla to motivate otherwise wary buyers to take the plunge. But is it really groundbreaking?
Accountants have a way of getting to the substance of a transaction. And in this case, they realized that – despite the fancy name – the RVG program is really nothing more than a lease. So for GAAP purposes, Tesla must account for these RVG deals as leases.
So assume a customer buys a car for $100,000 under the RVG program, and Tesla agrees to buy it back for about $48,000 three years later. In this scenario, on a GAAP basis, Tesla would recognize the net revenue of $52,000 ($100,000 received minus the $48,000 returned) over a three-year period. That's the period during which the gross profit was earned. And that's all that Tesla can hope to make from the deal.
But that's not how Tesla prefers to calculate it. In its non-GAAP reporting, Tesla treats the RVG transactions as sales, not as leases. In other words, it's taking credit for all of the revenue and profit upfront rather than over time. This treatment is only appropriate if all of the RVG customers decide to keep their cars at the end of the three-year term– which is an absurd assumption.
By making these adjustments, Tesla acts as if it has no further obligations to its customers. But remember, if its customers elect to sell their cars back to Tesla – and we believe almost all will – then Tesla will have to return a significant portion of this "non-GAAP revenue."
This bogus non-GAAP adjustment artificially inflates Tesla's revenue and earnings. In 2015, this adjustment added $1.2 billion (a 31% increase) to revenue and $310 million to net income. Without this adjustment, Tesla would have reported a 2015 non-GAAP net loss of $604 million. But with its accounting magic, it reported a net loss of $295 million.
A couple of things to keep in mind as you watch this RVG program ramp up and the cars start coming back.
First of all, Tesla could eventually have to spend hundreds of millions in cash buying back these used cars. Secondly, once it buys back these cars, it will have to sell them in the used-car market. If Tesla can't sell these used cars for what it paid to buy them back, then it will have to eat those losses.
We doubt Tesla will be able to fetch upwards of 50 grand for a three-year-old car with a depleted battery... especially with competitors like BMW entering the electric-car market with new cars that cost around the same amount as Tesla's used cars.
And then there's this interesting fact: Tesla itself expects to have its own brand-new$35,000 electric car on the market at some point in 2017. Why would anyone pay $50,000 for a used Tesla when the new model is $35,000? Sure, the $35,000 model will probably not be as fancy as the used Model S... but it will reportedly have a new battery that's going to be far better.
Clearly nobody – not us, and not Tesla – fully understands the dynamics of the 2017 Tesla used-car market. That's what makes its non-GAAP reporting so ludicrous and, in our minds, fraudulent. Tesla has no basis whatsoever to estimate the value of these used cars and plenty of reasons to believe it will end up being significantly discounted.
We could detail other "imaginative" things Tesla is doing to mislead shareholders, like using stock options and not accounting for it as an expense. But we think we've made our point on the company and its management's creative activities relating to finances. So, in our view it's fair to say these activities are highly misleading.
We've shown you that Tesla's management can't be trusted. We've shown you its business model is extremely challenged. Yet management continues to pursue growth that can't be financed from its operations, at the expense of its shareholders.
We've seen this act before during the last big tech-stock bubble. Remember the frauds at AOL and MCI WorldCom?
Both companies' management teams, armed with bogus accounting numbers and noncash earnings, convinced investors they were earning huge amounts of profits. In reality, they were spending a fortune on capital investments and losing billions every year. When the music stopped, the damage to shareholders was horrific – losses in the tens of billions of dollars for both companies.
What current investors in Tesla are forgetting is that, eventually, a business has to make money. Real money, not manipulated, non-GAAP earnings. Real earnings allow companies to expand without diluting existing shareholders. But Tesla is expanding by continuing to issue more debt and equity that dilutes its shareholders.
And Tesla's debt load is a whole other issue that we won't get into here. To sum it up, Tesla has plenty of debt no matter how you measure it... It's hard to say what an insurmountable debt load is for a company that doesn't have any real profits. It issued an equity offering to pay off the $400 million it owes the government, which is a sign that it's not really able to afford its debts.
In our view, Tesla (and many of today's high-flying tech stocks) have simply gotten capitalism backwards. Rather than using their businesses to reward their owners (the shareholders), the management teams at these companies use their shareholders to reward their customers and themselves. It's almost a new kind of socialism... shareholders volunteer for it (we believe) because they don't really understand who is holding the bag in the deal.
We recommended selling TSLA shares short in April, 2015 when they were trading for around $190. Unfortunately the share price continued to rise over the next few weeks and triggered our stop. We closed the position for a 21% loss in our model portfolio. But our thesis remained unchanged. And the market eventually agreed. Shares went on to slide soon after our stop loss was triggered. And shares now exchange hands for $166 – approximately 12% lower than our original entry price.