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.

Comments (20)

Most Helpful
Jun 18, 2018

I tried responding earlier but WSO deleted my comment (@AndyLouis can you look into this? maybe an issue with work comp, maybe WSO, who knows).

I stopped reading before the 1999 silicon valley video. as I've said before, I hope your long position goes well. it's clear to me you have dedicated a lot of time and effort to your thesis so to say you're stupid is untrue. while we disagree with the implications of the info we have about TSLA, you definitely have thought this through.

instead of sharing why I disagree with you on TSLA, I figured I'd offer some advice that may not help you today, but it will make you a better investor long term.

hubris is the worst thing to happen to an investor. while your ideas are thought out, you are clearly gloating (and you admit as much). have some humility. having a stock that can't seem to do anything but go up will lead you to fall in love with it if you're not careful. rather than seeking to prove others wrong, you should ask yourself "am I wrong? if so, where? how could I be wrong in the future?" this is not to say that every investment thesis will be perfect, just that if you don't ask yourself those questions, you will eventually be blindsided.

also, to point out the fallibility of someone with a 35+ year investment career without acknowledging you can be wrong on TSLA is just sad. you, like Chanos, are human. you may very well be right on TSLA and for the sake of your net worth, I hope you are, but what if you're wrong? maybe not today, maybe not in 6 months, maybe not until 2020, but what do you do then? do you chalk it up to a bad market? do you chalk it up to the capital markets not understanding Elon's vision so he's unable to get funding?

finally, you're starting to remind me of a buddy whose hubris got the better of him and some of his positions started going south while he watched with a near religious faith that everything was fine. his problems were compounded by the fact that all of his analysis went into the 5-8 names in his portfolio, so he got fucked twice for being cocky and being underdiversified. if you're unemotional, diversified, and challenge your own ideas, you'll be a great investor.

essentially what I'm saying is lose the 'tude, dude. be unemotional. buy tesla on its merits and then shut the fuck up. if you want to start a debate, ask a question, but if you keep slow stroking your TSLA options trade and tagging me, your credibility will go down faster than Chanos's short on TSLA if you're right.

TLDR - good on ya for making money, be more humble, don't marry a stock, keep your mouth shut about a good trade

    • 8
    • 3
Jun 18, 2018

Hey thanks for sharing, this is a great post.

My post is 2000 words long and roughly 400x the characters in the average tweet. Combine those numbers with the fact that this forum is naturally combative, and it behooves me to dial up the aggression on the rhetoric.

I'm not sure if you saw, but I acknowledged I was dead wrong on SolarCity and that Chanos was the person who stuck it in and broke it off... that was an expensive lesson, but worth the price IMHO.

There is plenty I don't agree with in your post but I'll leave it at that - you're right, I could use some more humility.

As for calling me Not Stupid.... Thanks?

Jun 18, 2018

Haha I shorted Tesla today. But not very big.

Car companies aren't worth Tesla's valuation and they are a long way to being something else. With a ton of debt coming due.

But I mostly just shorted it on being up a lot in a short period of time.

I don't see anything close to a profitable busI was model at Tesla. Innovative yes, but he's not in any businesses that turn into cash cows.

Array
    • 1
    • 1
Jun 18, 2018

Tesla is up 3.5% so far today. Keep shorting. Maybe you'll eventually be right before you're bankrupt.

Jun 18, 2018

Thanks?

Jun 18, 2018
CuriousCharacter:

Thanks?

Just speaking generically to all the short-sellers.

Jun 18, 2018

Great post - looking forward to following.

Jun 18, 2018

Going to zero hero

Jun 18, 2018

Totally possible.

Jun 19, 2018

Nice write up

Jun 20, 2018

Do a buffet bet for charity, would love to see wso ppl compete for a cause.

If the glove don't fit, you must acquit!

Jun 21, 2018

Profit beats are meaningless, free cash flow is everything.

The short thesis comes down to two things:

  1. If Tesla is profitable in Q3, the stock may temporarily go nuts, but the real problem with Tesla is its investment in working capital and CapEx. Per their F18 Q1 10-Q, EBITDA is more or less breakeven, but investment in NWC was $326MM, and CapEx was $729MM bringing free cash flow to -$1.04B for the period. So even if Tesla is profitable in Q3, unless they're able to reach that point while DRASTICALLY reducing investment in NWC (which is almost guaranteed with revenue growth) and CapEx, it'll be a phyrric victory. I am also ignoring $150MM in quarterly interest that is going to start chewing up more funds going forward as well.
  2. Tying into point 1, with negative free cash flow of $1B a quarter, and $2.7B of cash on hand, that burn rate can only last so long before Tesla is forced to raise additional capital to achieve its vision. If they raise equity, it'll be dilutive to existing shareholders which will be negative for the stock. If its debt, it'll be under punitive terms given the cash flow situation.

So really, as a short seller, you win under two scenarios: 1) Elon Musk is too stubborn to raise outside capital so the firm files for Chapter 11, or 2) reality bites and Tesla raises additional capital.

Beyond the short selling thesis, the thing that strikes me the most about the firm is that the stock price provides no protection for risk. Any negative outcome has a significant impact on the price (another positive for shorts). But the real reality is that buying into Tesla is essentially a wager that everything will go exactly as planned, something that is a tough pill to swallow for any rational individual.

    • 6
Jun 18, 2018

If he shows a profit he will be able to issue equity at a 300 stock price minimum. But having to dilute every year has a good chance of keeping the stock from ever rallying. But he will be able to finance those things.

Array
Jun 21, 2018
Jul 1, 2018

Everyone has been focused non-stop on Model 3 production rates, but how much of that is going to fix the real structural problem of free cash flow? I don't see them going without a capital raise if this continues, which I don't see not continuing any time soon.

How I passed all the CFA Program exams: https://www.youtube.com/watch?v=2DUdnYkojtk&t=37s

Jun 18, 2018

step 1: meet model 3 production targets
step 2: ???
step 3: FCF baller time

    • 1
Jun 18, 2018

Looks like you guys might have the last laugh

https://www.nytimes.com/2018/08/16/business/elon-m...

Aug 21, 2018

I am shorting Tesla and expect it to go to $0. I don't expect the company to ever generate a profit and to file bankruptcy.

The writing is on the wall on this one and in my opinion investors deserve to lose their money.

Some of the problems with the company:

*Autopilot crashing cars into barricades at high speeds, often resulting in a fiery death

*Active SEC investigation for market manipulation, CEO lied about a deal secured

*Whistle blower claiming production numbers are fraudulent

*Whistle blower claiming defective cars with punctured battery packs are being shipped, potential fire hazard

*Whistle blower claiming that braking safety checks are being skipped to rush cars out the door

*Cars hammered together and rusting in a uncontrolled environment tent

*Company paid for a ton of automation but then ripped it out to build by hand (they have no clue what they are doing)

*Promising a $35k car but bait and switching a 55k car

*Never making a profit over 10 years. Company still acts like it is a startup

*CEO acts crazy on conference call and won't answer "boring boneheaded" financial questions

*Numerous production targets missed

*Bond prices have collapsed, indicating a high default risk

*Many executives leaving because they aren't yes men for Musk

*Bailout for Solarcity which was basically bankrupt. All sales stopped after buyout

*Competition will eat their lunch. Toyota can make these cars at a scale that is much more efficient and higher quality

*Federal Government subsides will be ended for Tesla soon

*I personally toured their HQ. The place was completely disorganized, the employees were completely arrogant

*CEO is a lousy manager unwilling to delegate or give control to others

*Company focuses on hype and circus acts rather than business fundamentals. They want everyone to focus on future possibilities. You are suppose to ignore the present, disregard their finances, profitability, lack of meeting goals, etc. Only then can you see the "value" of Tesla.

*Cars seem to have quality issues. Lots of complaints.

*Company is not paying suppliers, extending payment terms, and asking them to give money back to delay bankruptcy

*Stock price makes zero sense. They sell at 10 times the value of other car companies. Example: Ford sells 6 million vehicles a year, Tesla sells 250,000 yet Tesla is worth 30% more than Ford. Auto manufacturing is a highly competitive, low margin business yet Tesla trades like it is a high growth dot com technology company.

    • 2
Sep 5, 2018
Comment

WSO's COO (Chief Operating Orangutan) | My Linkedin

    • 1