Tesla: Management Is Paid To Burn Cash
Prior to Tesla (TSLA), I attempted only one short position, and it wasn’t based on any fundamentals. Rather, it was based on a personal dispute with a corporation (seems as though I forgot the Buffett adage that a stock’s feelings aren’t hurt when I short it). Needless to say, I lost money on the bet, albeit less than $ 100 in an options trade. A year has passed, and I’ve taken on my second and more informed short position, via buying put options against Tesla.
There are three primary reasons I entered into a short position with Tesla, which I’ve outlined below:
- David Einhorn copycat position – Often times I rely on smart value leaning hedge funds for position ideas. Einhorn – founder of Greenlight Capital – wrote one of my favorite investing books on his short position battle with Allied Capital called Fooling Some of the People All of the Time, a Long Short Story. The book details his research style as well as methods of identifying potential short candidates. In “short” (pun intended), Einhorn clearly does his research, and he does it thoroughly. So I feel pretty good riding the coattails of his research and following him into the position. However, the book reminds me that short positions can take years to pay out, as was the case with Allied Capital’s ponzi scheme.
- The second reason is that the market is generally overvalued right now, according to the Buffett market value indication of Wilshire 5000 total market index to GDP. In this market, I have found it difficult to find conservative value stocks, so I am exploring the short side. In the event of a market downturn, this gives me some exposure to profiting from the correction.
- The last reason is based on my own research of Tesla – I’ve highlighted a few points below:
- Tesla has managed to pay stock-based compensation to management of $ 872 million while managing to have negative $ 10.8 billion in free cash flow since inception (2010), having never once yielded a profit on an annual net income basis (see 10-year financial results).
- Questionable accounting techniques – like capitalizing IPR&D costs and not listing any allowance for doubtful accounts in 2016 10-K (see page 68 and page 67).
- Management incentives – the majority of this article will compare the management incentive plans for Tesla and General Motors (GM). As you will see, Tesla management has no direct incentive to earn profits or cash flow, unlike GM.
As of the winter of 2017, David Einhorn has two high-profile auto manufacturer positions: General Motors and Tesla. I will spend some time comparing management base salaries and milestones that trigger bonus incentives from the two companies.
Below is a copy of Tesla’s management and CEO stock option plan in the 2016 10K (page 92 of the PDF):
CEO Stock Option plan 2012:
In August 2012, our Board of Directors granted 5,274,901 stock options to our CEO (the “2012 CEO Grant”)…
Each of the ten vesting tranches requires a combination of one of the ten pre-determined performance milestones and an incremental increase in our market capitalization of $ 4.0 billion, as compared to the initial market capitalization of $ 3.2 billion measured at the time of the 2012 CEO Grant.
As of December 31, 2016, the market conditions for seven vesting tranches and the following five performance milestones were achieved and approved by our Board of Directors:
Successful completion of the Model X Alpha Prototype;
Successful completion of the Model X Beta Prototype;
Completion of the first Model X Production Vehicle;
Aggregate vehicle production of 100,000 vehicles; and
Successful completion of the Model 3 Alpha Prototype.
December 31, 2016, the following performance milestones were considered probable of achievement:
Successful completion of the Model 3 Beta Prototype;
Completion of the first Model 3 Production Vehicle;
Aggregate vehicle production of 200,000 vehicles; and
Aggregate vehicle production of 300,000 vehicles.
A close reading of the incentives for CEO Elon Musk shows that none of his 5.2 million of stock option grants are based on actual earnings or cash flow generation for the business. Rather, the CEO incentives are based on prototype and production goals, all of which – as Tesla shareholders and analysts have seen – drain cash at an alarming rate. With these types of CEO incentives, it is no wonder that Tesla has raised $ 4 billion in cash from equity raises and $ 8.4 billion in cash from debt offerings since 2007. In light of the fact that the company has yet to turn any sort of profit in any fiscal year of existence, I find it shocking that shareholders are not up in arms regarding these management incentives. It seems like Tesla shareholders are swooned by Musk’s refusal to accept his CEO’s salary compensation of $ 45,760 cash, due to the California law that requires employees be paid minimum wage. I look at this gesture – like Musk’s high-profile vehicle prototype reveals – as a red herring, obscuring the fact that Musk continues to lead an operation that runs on cash from financing activities and not from cash from operations. Indeed, Musk pays himself – via stock options – with equity and debt financing from investors solely from achieving milestones that are financed through shareholder dilution and debt leveraging.
To make matters worse, the 2016 Proxy statement states that Elon Musk’s interests “align” with shareholders because he owns 22% of shares outstanding. That seems to explain why the CEO’s compensation package is indirectly related to shareholder profits since his vote represents nearly a quarter of voting power. For critics of this view, I should point out that Musk is not on the compensation committee of Tesla’s board. Nevertheless, I find it hard to believe that he doesn’t have any weight with the milestones created by the compensation committee when he holds 22% of the stock.
In theory, stock options are generally shareholder-friendly ways for compensation committees to align shareholder and management interests. In Tesla’s case, however, the theory does not align with the practice because Tesla’s achievement milestones that trigger stock options are not profit or cash flow milestones. In truth, Tesla’s compensation milestones are highly capital intensive. The milestones incentivize management to burn cash, which is exactly what management is doing.
By contrast, I compared Tesla’s compensation package to that of General Motors, David Einhorn’s long automotive investment. Below I copied a screen shot from GM’s 2016 proxy statement that outlines the STIP (short-term Incentive plan) for GM’s executive team. Admittedly, none of the GM executive management team is so austere as to accept a minimum wage base salary of $ 45K, like Elon Musk. Nonetheless, I believe the overall GM STIP is far more aligned with shareholder interests than Tesla’s.
The first STIP measure is EBIT – earnings before interest and taxes. This is a levered measure of profitability. The second GM STIP measure is adjusted FCF (free cash flow). As many readers know, free cash flow measures cash flow from operations minus capital expenditures, an important denomination for capital intensive industries like automotive. Many investors consider free cash flow the gold standard of profitability because it is a shareholder consideration of the cash left over in a business after reinvesting in capital projects. The last two measures of the GM executive incentive plan are around global market share and global quality, again both of which align to shareholder interests, albeit not necessarily directly profit related.
There have been many great critical pieces written about Tesla, especially from the Wall Street Journal. Elon Musk publicly attacked journalists and editors that wrote the negative pieces about Tesla in the Q3 earnings call, ultimately attacking their journalistic and personal integrity, calling “shame” upon them. Frankly, I found Elon’s Q3 opening response quite odd, not to mention hypocritical in light of his aforementioned compensation package. Indeed, Elon’s behavior in the Q3 earnings call reminded me of Allied Capital’s management to short sellers in Einhorn’s book Fooling Some People All of the Time.
Looking at the cost benefit of a straight short sale vs. buying put options, I found that the options strategy was more attractive for me. For one, a small and or individual investor is usually not intending to impact the stock price by selling short. Moreover, I agree with the general proposition from Mohnish Pabrai: “Why take a bet where the best return is 100% and the downside is unlimited?” With buying long-term put options, you can capture downward movement of the stock without knowing exactly when (or if) the stock will move. Furthermore, you are risking less capital through options leverage to potentially make more than 100% of the invested capital. Below is a basic analysis I put together comparing an outright short sale of Tesla versus buying long-term put options (the January 2019 contract):
I purchased the 280 strike price because 280 is around a recent support line for the stock, using technical indicators. I made the purchase in October 2017, when Tesla was trading around $ 340. As the table above demonstrates, a price of about 240 yields an even return percentage from an outright short sale compared to buying the 280 put options. Thereafter, the put options leverage starts to kick in, and the yield of the options are far more attractive. Additionally, the capital risks with a put option limit the amount of capital you can lose.
In terms of selecting which option contract to buy, I used basic technical analysis. Looking at the chart below, if Tesla falls through the 280 support price, then it has a long way to go down to the next support price (see chart below):
In the spirit of a Pabrai/Buffett style value investor, don’t sell short. However, if you’re going to be a value investor and take short positions, consider buying put options on stocks with the following characteristics: a company with no profits, a leveraged balance sheet, lots of cash burn in a highly capital intensive business, double-digit negative ROIC, and a management with incentives to spend cash (as opposed to making profits). For what it’s worth, that’s how I found myself short Tesla.
Risks of Tesla Short Position
Headline for an article from Electrek: “Elon Musk teases Tesla shorts who lost an estimated $ 5 billion since the beginning of the year.” – Fred Lambert – June 8, 2017
There are inherent risks being short Tesla. While buying long-term put option contracts limits capital lost to the cost of the premium on the option, there is still a chance it never materializes. As the Fred Lambert headline suggests, many have been short Tesla and lost plenty of money on the trade. As of November 26, 2017, Tesla short percentage of float is 26%, and it has been in that percentage range all year.
In anticipation of the Model 3 ramp, the stock has managed to run up 61% in a year when TTM net income is negative $ 1.4 billion and TTM FCF is negative $ 4.8 billion. You just don’t know when bubbles are going to pop, and the past year’s Tesla stock price is evidence to that point. Of course, I could be wrong about Tesla, and it might not be a bubble. The Model 3 ramp could be perfectly successful, and the company could turn a profit whereby the current $ 315 price is supported by a realistic valuation metric like P/E, EV/EBITDA, DCF, etc. A simple look at Tesla’s financials since IPO show no evidence that this will happen, but it is a possibility.
Generally, I believe that people are motivated by their incentives. While it certainly is possible that Tesla could switch from a cash burning corporation to one with positive cash flow streams, I would point out what I’ve been saying in this article: Tesla management incentives are not designed for profitability. I would argue that management incentives are designed for high profile showmanship – the like of Steve Jobs would be proud of – for expensive and fancy cars that burn shareholders’ cash.
In closing, I would like to point out that eight years after the Apple (NASDAQ:AAPL) IPO, the company made $ 400 million of net income in 1988 with $ 545 million in cash and $ 1 billion of total liabilities on the balance sheet. With all the comparisons between Elon Musk and Steve Jobs, those financials suggest that Steve Jobs ran his company more like GM (post 2009 government bailout) than Tesla.
Disclosure: I am/we are short TSLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.