Feb 4 2020 - 5 Reasons Tesla Shorts Should Double Up, Not Give Up

Summary

Tesla shares have nearly quadrupled from their May 2019 lows below 200, despite unimpressive YoY numbers.

Increased competition from other EV makers, especially in China, are already showing in Tesla's slower sales growth and declining margins.

Tesla is still far from regularly making more cash selling cars to customers than stocks and bonds to investors and insiders, and even the insiders aren't buying.

Convertible bond maturities and executive incentives over the next six months are also important factors to watch as drivers of future share supply and valuation.

Much of the recent buying of TSLA seems to have come from passive index funds and short covering, rather than any actual improvement in fundamentals.

Shares of Tesla Inc. (TSLA) rose another 11.5% after hours to 8/share, after reporting a quarterly GAAP profit of .58/share for 2019Q4. This is lower than the .81/share reported for 2018Q4, so seems to indicate that share price euphoria is again getting ahead of actual earnings.

In this article, I show 5 simple reasons, with charts, as a reality check on Tesla's valuation and forces that are likely to help bring its share price back to earth over the next 12-36 months.

#1: Tesla Still Has Yet To Be Profitable Over 4 Straight Quarters

The big rise in Tesla's shares over the past three months came largely on the surprise positive EPS number in 2019Q3, followed by this week's second, though smaller, quarterly profit. So far, the losing quarters have remained many times bigger than the profitable ones, and Tesla has yet to prove these profits will be anything more than periodic blips.

ChartData by YCharts

#2: Tesla Still Far From Returning Cash to Shareholders

We can debate the importance of looking at GAAP vs. non-GAAP earnings short term, but over the long term, what matters to TSLA shareholders is whether TSLA returns back more cash than they put in. Until very recently, Tesla was still raising more cash from selling its own shares and bonds to investors than from selling cars to customers, and the recent chart shows they are not far from going back to that pattern. One would also expect the capital expenditures (most of the red line below) to be steadily growing or levelling off at Tesla's stage of development, not declining by over half as seen in recent years.

ChartData by YCharts

#3: Tesla's Revenues Are Already Leveling Off, With Declining Margins

TSLA's lofty (though far from the record) valuation of over 4x revenues implies the market expects very strong future sales growth, likely accompanied by healthy margins. As with its quarterly earnings though, YoY revenue growth has so far come mostly in a few spikes, and the past two quarters show signs that revenue growth may already be flattening out. On top of that, TSLA's gross margins are declining as they have been moving downmarket to pick up more volume with their model 3, where they face far more competition from Chinese EV makers. Back in 2017, I listed "China" as the most significant of the "7 C's" I thought would eventually make TSLA shares crash.

ChartData by YCharts

Especially for those who believe the world has reached "peak auto" (the maximum annual number of cars that will ever be sold), one would have to expect much of TSLA's future revenue growth to come from taking market share from major competing automakers. Among these are Japan's Toyota Motor Corp (TM), Germany's Volkswagen AG (OTCPK:VLKAF), and the US's General Motors Co. (GM) and Ford Motor Co. (F). Combined, these four companies have regularly reporting annual revenues over US0 billion per year versus a 2020 revenue estimate of around billion for TSLA.

ChartData by YCharts

#4: Who's Buying TSLA? Not Insiders, It Seems

One imperfect indicator I use as a check against financial indicators is a look at who is buying or selling shares of a company. Over the past 3 months, insiders sold over 100,000 shares of TSLA and bought none, and over the previous 12 months, sold almost 4x as many as they bought, according to Nasdaq.com.

Insider sales and purchases can be due to any number of reasons unrelated to the future prospects of a company, but one would expect to see more insider conviction and open market purchases if TSLA's future is really as bright as its valuation indicates. Even the recent "insider buy" transactions all seem to have been option exercises rather than open market purchases.

There is plenty of incentive for Elon Musk to have put any and all efforts into pumping Tesla's market cap over 0 billion, and then to try and keep it there for the next 6 months. This is a contract condition to net him a huge payday in the form of more options. If anything, it seems these options are likely to result in an additional supply of shares, which Mr. Musk may find better sold than held.

Slightly longer term, TSLA also has convertible notes due in 20212022, and 2024 for which management would want to keep the share price above the conversion price so that these can be paid by issuing more shares rather than with cash.

So, who has been buying TSLA shares? As a mega-cap momentum stock, many of the large passive index funds in our 401(k) plans become automatic buyers of more TSLA shares. Among the largest increases in institutional holdings of TSLA, shares have come from the likes of Vanguard, Blackrock, State Street, Invesco, and FMR LLC (Fidelity), all large sponsors of ETFs and funds in 401(k) plans.

#5: TSLA Short Interest Back Near Multi-Year Lows

The final chart of this article shows that the recent tripling of TSLA's share price has coincided with its largest short covering so far. TSLA's short interest has fallen by about half in recent months to around 25 million shares, or less than 19% of float, right around the lowest levels in the past 5 years. Some shorts may have had to close out because of margin calls, while others may have quit fearing future profits, while others may find now to be the best TSLA short opportunities so far.

ChartData by YCharts

Implementation and Risks

The risks of shorting TSLA have already proven to be very significant, and there are different ways to implement a short position depending on how likely you expect the "tail risks" to be. Here, I will outline just three ways of implementing the shorts with their advantages and risks.

The most straightforward way is to simply short TSLA shares outright. Depending on your broker, this may be the most cost effective of the three ways to carry the short position indefinitely but is also the only one of the three ways with unlimited risk of loss (more than your capital). One of the boldest calls is by ARK Innovation ETF (ARKK) manager Cathy Wood, who recently raised her "base case" price target to ,000/share by 2024. That would imply TSLA's market cap breaks trillion within the next four years, and that's assuming shares outstanding remain constant (for which there is no indication they will). Of the four US companies that have hit a market cap of trillion so far, three have TTM net incomes significantly higher than TSLA's total revenues and are in businesses with far better moats, margins, and scalability than making cars and batteries.

ChartData by YCharts

So, while there is a chance Cathy Wood may be right, and those of us with outright shorts here risk losing several times our current 0/share short position, someone would outright believe another crash is far more likely. To put it in rough numbers, ignoring time value, 0 can be thought of as:

  • An 89% chance of getting zero vs. an 11% chance of getting ,000
  • A 2/3 chance of getting 0 vs. a 1/3 chance of getting ,560

Depending on the range of outcomes you want to model, being short outright means you believe the probability of decline is higher than that on the left side of those two bullet points.

The second and third ways we look at shorting involves buying put options. The two biggest advantages of using put options over outright shorting are:

  • Losses are limited to 100% of net premium paid up-front
  • Longer term put options purchased and held longer than one year may qualify for long-term capital gains treatment or be tax loss harvested before one year, for US taxable accounts

Method #2 is to short TSLA with in-the-money put spreads. As one example, the 900/500 put spread (centered around yesterday's close of 780) expiring on March 19, 2021, closed at a net cost around 0/share for a max payout of 0/share if TSLA closes below 0/share at expiration. The put spread benefits from having a lower "time decay" than the next method but caps the profits if TSLA were to fall much below 500 and does not have as significant a carry benefits as put spreads on many other names. This is because the March 2021 "volatility smile" of TSLA is high, but relatively flat, with an implied volatility of 50% and 55% for the 900 and 500 strikes respectively.

Method #3 is to buy outright out-of-the-money put options. Two examples here would be to buy and hold the March 2021 500 strike put for around /share, or to buy and roll nearer term, closer to the money puts, for example, the May 2020 600 put for /share. Both offer full exposure below the strike price for maximum returns if TSLA shares were to decline well below those strikes but also the highest chance of losing 100% of premium, albeit a limited amount. To put some numbers on it, if TSLA were to go back to 300 by March 2021, the longer-dated options would have returned +300%, but would still lose 100% if TSLA shares fall and settle just above 500.

Conclusion

This was meant to be a simple "step back" look at some of the "big picture" numbers as a sanity check on TSLA's recent share price rise. While deeper analysis of TSLA's fundamentals or its global market outlook might adjust our forecasts, TSLA's valuation still seems based more on hot air than hard numbers. While priced for a vision to become next Apple or Netflix of automotive transport, investors should not ignore that TSLA faces much higher capital costs and far closer competition from rivals with more revenues. One should also consider the high likelihood of a greater number of shares coming up for sale from many sources: insiders, short sellers and then the index funds following them down. The likely disappointing future profit numbers, split among an increasingly large number of shares, is why we run the probabilities in the risk section, we see more gains from shorting or buying puts on TSLA than in buying TSLA shares. Within limits, we believe this presents a good opportunity for short sellers not to abandon the short thesis, but rather to double up at current valuations.

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.

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