Long TSLA Update: Smartest Guys in the Room

"You could then go twice long the market, be short my portfolio, and have 2X the market plus a few percent, minus your cost of the additional carry. And that's the proposition, and that's why short selling alpha is so prized in the marketplace when you can find it, because it enables you to be more long. As I keep saying to people: I'm in the insurance business" Jim Chanos

Smartest Guys in the Room

Believe it or not, I think the money managers who act as insurance providers - Chanos and Spitznagel specifically - are among the most brilliant people in the industry, much brighter than the big name L/S guys (no offense to Einhorn, Ackman, etc.)

In fact, Chanos has already beaten Elon Musk (and me!) once, on SolarCity.

Chanos correctly demolished the pro SolarCity surface argument - Growing like gangbusters! Rapidly advancing technology! Superstar CEO! - by examining the interplay of numbers at a deeper level: even if SolarCity eliminated all SG&A expenses, the return on capital was only 5%, while the company’s bonds yielded more than 7%.

Furthermore the rapid advance in technology was actually terrible for SolarCity customers: the 20 year lease obligated them to 20 years of rising prices, effectively turning an asset into an liability.

Paint by Numbers

- Handsome Fella, Chanos in ‘82

“At the end of the day, the language of business is numbers… There’s nothing better than analyzing the company’s numbers themselves to find the anomalies because modern GAAP is as much an art as a science, as any good accountant will tell you.” - Jim Chanos

Chanos solves complex financial puzzles, it's what he does best, and he's been doing it for over 30 years.

Beginning in 1982, Chanos bucked the trend (at 24 years old!) and wrote a sell recommendation for Baldwin-United, a one time piano manufacturer turned financier.

Baldwin had started selling SPDA’s - Single Premium Deferred Annuities - through brokers who took a (hefty) 5% commission. To make this business profitable, Baldwin passed the sale revenue from its life insurance subsidiary to the pension subsidiary - reducing the effective tax rate from corporate (46%) to life (23%) - and booked an “internal profit” of 12%.

Sound fishy? Chanos thought so too. To make matters worse, Baldwin accountants had used questionable practices and booked profits from SPDA sales immediately, rather than the standard 5-6 years after sale.

There’s more to the story and if you’re an accounting/finance geek you can read it in detail here , but basically Chanos’ report was the beginning of the end and Baldwin soon restated earnings and filed for bankruptcy.

A Star is Born

Stud.

Baldwin made Chanos and cemented his future as a short seller. For good measure, let’s look at one more well known Chanos short, Enron.

Chanos’ interest in Enron was piqued when he was forwarded a WSJ article that explained how energy trading firms had begun using “gain-on-sale” accounting, a tactic that allowed management to (inaccurately) estimate future profitability and create earnings out of thin air.

Digging further, Chanos examined Enron’s 1999 10k and discovered the company generated a 7 percent return on the capital it deployed, 200 basis points below its cost.

Worse still, Chanos’ investigation found MASSIVE insider selling at the very highest level of Enron - founder Ken Lay sold $101.7 million worth of stock - trading daily - in the two and a half years leading up to the bankruptcy, and Jeff Skilling began liquidating at a rate of 10,000 shares per week beginning in late 2000.

Enron fell straight to bankruptcy hell and took Arthur Andersen - one of the former Big 5 and a case study in conflict of interest law - down with it, SOX was introduced, and the rest is history.

Play by the Rules

“One of the models we look at is a wonderful checklist by Marianne Jennings. I will tell you at both Valeant and Enron, the CEO’s and the situation fit about 6 or 7 of them… And again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sorts of things before." Jim Chanos

Valeant, Tyco, Commodore International, Coleco, Integrated Resources, Boston Chicken, Sunbeam, Conseco… the list goes on. Chanos has been extremely successful in ferreting out scoundrels and making them pay, literally.

I found the list Chanos referenced above, and the seven signs are:

1. Pressure to maintain numbers.
2. Fear and silence.
3. Young ‘uns, and a bigger-than-life CEO.
4. A weak board.
5. Conflicts (of interest).
6. Innovation like no other.
7. Goodness in some areas atoning for evil in others

If you add accounting shenanigans, insider selling, and executive departures, you’ve got yourself a pretty awesome little playbook for identifying short sale opportunities...

So how does Tesla stack up as a short against Chanos’ criteria?

• Pressure to maintain numbers? Check.
• Young ‘uns and a bigger than life CEO? Check.
• A weak board? Check.
• Conflicts of interest? Check.
• Innovation like no other? Check.
• Executive departures? Check

Even the recent earnings call where Musk cut off the RBC and Baird guys is comically similar to Skilling:

Analyst: You're the only financial institution that cannot produce a balance sheet or cash flow statement with their earnings.
Skilling: Thank you very much, we appreciate that.
Analyst: We appreciate that.
Skilling: A%%-hole.

If I was a short seller using this list as a guide, Tesla would be love at first sight.

Interlude - Typecast

Once again, Chanos is a brilliant analyst, arguably the best when it comes to complicated accounting schemes…

However the man is not infallible.

Chanos gets into trouble when he a) fails to account for external trends, and b) focuses his analysis on more qualitative measures.

For example, Chanos lost money when Greenspan lowered interest rates in the 90’s to bail out Citicorp. He lost even more cash during the internet boom with a bad bet on AOL. Franklin Resources and Charles Schwab cost him dearly when he thought he could time the end of the market mania.

Probably his biggest loss was on Federal Express - he claimed that FedEx was overvalued, and that new competitors would eat at margins. The company tried to assure Chanos that these problems were solvable, however he held fast and the stock jumped 40% that quarter.

Beauty is Skin Deep

"Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, “Hey! Look at all that value creation!” and the game goes on." - Warren Buffett

Unfortunately for Mr. Chanos, lust is often mistaken for love, a deadly sin.

I can understand → 100% ← the argument that going Long TSLA is bad news. Chanos and the short side make a compelling argument for why Tesla is not worth the current share price, mainly:

• Tesla can’t deliver products on time
• Musk has a liberal definition of the truth
• Fierce competition is coming shortly
• The stock price is insane

What I → 100% ← cannot understand is the argument that shorting TSLA is a good idea.

• Bankers working for a CEO with a proven track record can continue raising money indefinitely
• Fanatical investors will continue to invest without looking at the numbers
• 5 years ago Tesla was in a very similar situation, and the stock price promptly tripled with an earnings beat
• Musk has forecasted profitability for Q3 this year.

During the dot-com bubble, companies with no sales traded on multiples of hope, and Musk managed to create real value even then:

(Side note: super cool video filmed right in the middle of the Dotcom Bubble)

I made my own 7 point list, I call it “My Main Squeeze” (see what I did there?):

1. Pressure to maintain numbers
2. Fear and clamor
3. Young ‘uns, and a bigger-than-life CEO
4. A weak board
5. (un)Vested Interests
6. Innovation like no other
7. Goodness in some areas atoning for evil in others

It’s very similar to the list Chanos uses, but contains some small (but important) differences. This is what my list would look like for Tesla, if I used Chanos' approach of examining the interplay of deeper details:

• Goodness in areas like autopilot and 0-60 times help atone for evil in area like delays and initial build quality. Musk, a bigger than life CEO with (un)vested interests is all-in.
• Without a weak board to stop him, Musk has the power to do the long term right thing.
• A team full of Young ‘uns under pressure to maintain numbers, fearful of failure and egged on by clamor, can produce innovation like no other.

It's the little things that can mean the difference between falling in love, and getting fucked.

Too Smart by Half

“They think that intelligence is about noticing things are relevant (detecting patterns); in a complex world, intelligence consists in ignoring things that are irrelevant (avoiding false patterns)” - Nassim Taleb

When you spend all of your time obsessively looking for something, eventually you’re going to find it, whether it exists or not, and unfortunately for Chanos he spent his time looking for a reason to short Tesla.

Remember, Chanos’ specialty is complex financial puzzles, and when he starts to look at qualitative factors he gets into trouble. What are his longstanding concerns with Tesla? (more info in my last post )

• Executive departures
• Missing delivery dates
• The competition is coming
• Behind in technology
• Cult like leader

Over time, this list has shrunk, and in my opinion Chanos appears to be less confident with each each new TV appearance.

For example, while I wouldn’t call Chanos eloquent, his speech is utilitarian and clear, kind of like clean accounting. Here is an excerpt from his most recent Tesla talk on CNBC:

“Lots of futuristic, um, shall we say hype, but um, but, somehow the company and its leader could not see the immediate future, and uh, and see the layoffs they were about to announce a few days later…. So again its its its often this matter of, eh, its about, its about the future, its about keeping investors, uh, focused on some point out in the future…” Jim Chanos (full video below, it's less than 2 minutes long)

https://www.cnbc.com/video/2018/06/13/chanos-musk…

Even CHANOS concedes that Tesla is likely to be profitable Q3 of this year.

Wings of Icarus or Dreams of Avarice?

“Hubris is manifest in the use of rigid formulas. The rigid formula problem arises when shorts start acting like wall street analysts and apply the same formula to a group of stocks without thinking. If they have seen six S&L’s go under with the same profile, it is easy to short the seventh without worry. And that is the one that will bite.”

The common threads that run through all of Chanos' successful trades are accounting that enables fraud and insider sleaze. Tesla accounts a little differently than "peers," but it's certainly not enabling fraud. Furthermore, The only insider trades as of late are by Musk himself, and he is buying large amounts of stock, not selling it...

I'm honestly starting to wonder if there is some conspiracy to steal the money I paid for my options, because the trade seems SO obvious that I can't believe it's even available, let alone selling for rock bottom prices.

Good hunting.

Best,

CC

Edit: 2 sentences, some spelling and grammar mistakes.