Streetwise for Sunday, April 22, 2018
While investment opportunities are always plentiful, you need to have a willingness to belly up to the bar and take decisive action with an overwhelming sense of self-assurance.
Can you stay the course despite the consternation of others? To paraphrase a line from a Rudyard Kipling poem, you need to keep your head when all around you are losing theirs.
There is no better example of the essence of self-confidence than Elon Musk, the CEO of Tesla (TSLA). Although Musk may have as many detractors as fans, I would bet that from Musk’s perspective, he would view his detractors as, “when all around you are losing theirs.”
What is attractive about a company with no earnings, high capital needs, and an inherent degree of potential failure? To put it simply, Musk is a technological evangelist with the ability to make things happen that others just talk about.
At the same time, Tesla finds itself among the top 10 most popular shorts. Note that short selling is the sale of a security that is not owned by the seller. Essentially the seller has borrowed the stock. Short selling is motivated by the belief that a security’s price will decline, enabling the shares to be profitably repurchased at a lower price.
Although the huge short positions of Tesla’s shares are conviction bets, short sellers are nonetheless playing a dangerous game. Tesla is about a month away from first-quarter earnings and Musk has already stated that he will not need to raise additional capital any time soon. Moreover, Musk continues to offer up guidance directed at achieving profitability and positive cash flows in the second half of 2018.
In other words, Tesla’s short-sellers could find themselves caught in a serious short-squeeze. A short-squeeze occurs when shares that were sold short (they are usually “borrowed” from a brokerage house) need to be repurchased and subsequently returned to the lender.
The squeeze comes in when the shares rise in price and a buy-back becomes increasingly expensive. The good news is that when short sellers repurchase stock they add to the stock’s upward price momentum.
Academic research, such as the paper, “Short Interest and Stock Returns,” by Paul Asquith, Parag Pathak and Jay Ritter, NBER Working Paper #10434, has shown that consensus shorts are profitable. However, there is a size factor. For example, in this paper much of that underperformance comes from the short selling of small-cap stocks, not $50 billion large-cap stocks like Tesla.
Nonetheless, Tesla has been a popular short since shares first hit the public markets. With a lofty valuation and momentous challenges in getting its first real production car, the Model S, on the road, short sellers flocked to bet on a drop in Tesla’s share.
Tesla’s year-over-year revenue grew by 68 percent, while the percentage of revenue allocated for warranty claims declined from 2.5 percent in 2015 to 2.2 percent in 2016 and to 2.1 percent in 2017, illustrating Tesla’s continuous improvement.
The most recent quarter saw a favorable 2.0 percent, which confirms Tesla’s statement that it is focused on “quality and efficiency rather than simply pushing for the highest possible volume in the shortest period” with its Model 3 production ramp.
However, the actual warranty cost the company incurred in 2017 was $123 million, representing a 55 percent increase from previous year’s $79 million. This figure represents the actual warranty expense incurred, not a management estimate and one that encourages short-sellers.
Some believe that a ramp up to 5,000 Model 3s per week is not realistic, while others are agnostic on that point. The contention is that the Model 3 cannot be sold profitably at its advertised price points. It will not be until the fourth quarter we finally see representative data that will assert or disprove the claim that the Model 3’s unprofitability.
While Tesla’s the red ink may not disappear this fiscal year, it is likely to be reduced substantially, or it could even turn positive. Meanwhile, my projected 12-month share price is $315.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddInternational.com.