Tesla Bears Are Irrational – Tesla Motors (NASDAQ:TSLA)

Thesis

It is silly to short Tesla (TSLA) until Tesla’s biggest story – gross margin of 25% at 5,000 Model 3s per week – falls apart. I believe that this story will fall apart in 3Q18. At that point, Tesla will have likely produced 5,000 Model 3s a week for a full quarter and will not have a 25% gross margin to show for it. Without any other story to feed the blue pill swallowers, the dream of market domination and cash generation will succumb to reality.

Introduction

For the record, I love Tesla cars and I admire the company’s vision. As an investment, however, I have always found it to be lacking. While I always found it lacking as an investment, I found it downright insane to short the company. Why would you short the company knowing full well that it is not being judged on its current fundamentals? And if you didn’t know that was the case then you have little business shorting at all.

Characterizing an investment in Tesla shares as lacking is in stark contrast to the meteoric rise of the company’s stock price. One look at the chart and it is obvious that an investment in Tesla would have paid off extremely well. Why would an investor believe that Tesla is a poor investment if said investor is up 76% in the last twelve months?

Bears are irrational

The bear case is very easy to lay out. The company continues to miss guidance and relevant targets and is bleeding more than a billion dollars in cash every quarter.
So, how is it that the share price could ascend so far while the fundamentals were so lacking?

Corporate finance teaches us that the best way to value a company is by the value of its future cash flows. If one believes the Tesla story, a discounted cash flow analysis may very well conclude that the company is worth $400 per share, perhaps even more. Add to that a charismatic entrepreneur combined with visions of extraordinary returns and there aren’t enough blue pills to go around.

With every failure, bulls could reply “it’s all about the Model 3 so your point is irrelevant.” And, quite frankly, that’s true. Who cares whether or not the Model X experiences a production hiccup or lackluster sales growth when the Model 3 is the money maker. Why care about Elon Musk’s less than faithful relationship with reality? As long as the Model 3 delivers, none of that matters.

Cracks surfacing

Tesla has promised a mass market EV car and that is what ultimately will decide whether the sword of Damascus severs the company’s head or that of the shorts. Elon is as famous for his liberty with the truth as he is for his daring vision. Already, we are seeing signs of production targets not being met. Tesla was supposed to produce 1,500 Model 3s and while no one actually expected that, the expectation was for a lot more than the 260 produced cars.

I fully expect the company to not hit its production target of 5,000 Model 3s per week until the start of 2Q18. This is going to be a very interesting quarter as investors will get a glimpse of the gross margin and average selling price of the Model 3. Musk already has tamed expectations by stating that the 25% gross margin will be seen three to four months after producing 5,000 Model 3s per week:

“but I feel like the point which we are at steady-state 5,000 units a week for Model 3 is about when we reach the 25% gross margin level. So it wouldn’t be right when we get to 5,000, because initially when you get to 5,000 a week there’s still a lot of overtime. We’re still expediting parts from all around the world. So you’ve got a lot of expedited fees, you’ve got a lot of overtime, and so it takes probably from the point at which you get to the 5,000 a week, it’s probably another three or four months before you hit the 25% gross margin. Would you agree Deepak?”

Deepak answers that he agrees, but that he “was just going to be more cautious.”

So if you believe that the first week of 5,000 Model 3s will start in 2Q18, you’ll have to wait to 3Q18 to see a “clean” quarter to assess the gross margins. I do not believe for a second that the Model 3 will show a gross profit of 25%. Many have laid this thesis out. For a very good assessment on the matter, I’ll refer to EnerTuition’s article on the matter. He is even skeptical of positive gross margins. While I wouldn’t go that far, I believe that a 25% gross margin is vastly unrealistic and that perhaps 10%-15% is achievable. The difference between our thoughts on gross margin is based on our thoughts of the Gigafactory. EnerTuiton doesn’t believe it will result in a meaningful competitive advantage, while I believe it will result in at least a small competitive advantage.

So when to short?

In any case, I believe it will become very apparent in 3Q18 that this mass market EV domination will not generate any cash which will make it impossible to actually dominate the EV market. Absent any other great cash source, the blue pill takers will be force fed a red pill. Secondary offerings, a primary source of funding, will be perceived negatively as they will no longer be executed in order to achieve growth but rather to fund losses.

At that point, there can be no doubt that the company’s first mission – profitably producing mass market affordable EV’s – has failed.

In the meantime, I will watch for cracks in investor sentiment. Currently, the shares seem to have cooled off. The momentum seems to have faded with the shares topping out twice at around $390 per share and currently trading around $355. I believe that Tesla producing 5,000 Model 3s per week in 2Q18 will initially result in some momentum. At that time, I will look to short the shares. Until then, doing so is as irrational as the bears perceive the bulls to be.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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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