Thursday, 16 August 2018

Is Elon Musk's attempted Tesla privatisation a covert bail-out?

I've been a long time follower and admirer of Elon Musk. I've listened to all his interviews, watched many of his presentations, and read the excellent biography written by Ashlee Vance. The serial entrepreneur has achieved feats of growth and innovation over the past 15 years that ex anti most (myself included) would have considered impossible.

Starting a rocket company, for instance, that has achieved more innovation in the past 10-15 years than NASA has in the past 40, with initial start up capital of less than US$200m, is a truly remarkable feat. It is also amazing how far he has taken Tesla given the limited resources it started with, and the formidable odds against success. Either accomplishment alone would be impressive, let alone running both companies at the same time! Yes, Musk frequently misses his aggressive self-imposed deadlines, but I've often joked that Musk promises to do in 2 years what would take most people 10, and then when it ends up taking 3, people claim he can't execute!

Musk's idealism and not-for-profit motives, as well as his sheer boldness, are also easy to admire. Musk is taking on difficult rather than easy problems, and is genuinely trying to make the world a better place and advance the cause of humankind. He envisages a world of clean, sustainable energy (electric cars powered by solar energy), as well as human beings as a space-faring civilization. He is pushing for new, innovative modes of transportation (the hyperloop), and cares passionately about the risks AI poses to humanity. This idealism, coupled with his unassuming presentation/conversational style - something that makes him both likable and believable - has endeared him to his fans and made him a cult figure that is easy to root for.

As anyone in the public spotlight attempting to do bold and controversial things does, he has attracted his fair share of critics and sceptics - particularly amongst the financial community. I view some of these criticisms as unreasonably harsh. Musk is trying to change the world. Portfolio managers are just trying to make a buck. What have the latter done for the world lately (or ever)? Even if you're sceptical of whether Musk will succeed, you have to applaud the guy for trying. The world needs people like Musk. As George Bernard Shaw once said, "[t]he reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man". Musk is as unreasonable as they come.

Nevertheless, high-minded goals and a tireless work ethic alone do not guarantee success, and market forces can be punishingly cruel. More often, the unreasonable man is forced to bend to the will of the world. From the very beginning, Musk has candidly admitted that the odds of both Tesla's and SpaceX's success was remote. Success being "one of the potential outcomes" was considered enough to give it a go. Tesla's mission was also never to make profits, but rather "to accelerate the adoption of electric vehicles". Musk has also stated in recent years - quite reasonably and level-headedly - that Tesla's share price "is much higher than we have any right to deserve". Curious it is, then, that he is now attempting to take it out at a material premium - by way of Twitter announcement no less (and in a manner that quite likely breached SEC regulations).

As I discuss below, I think a reasonable inference can be made from recent events, coupled with the experience of SolarCity which I discuss at length, that Tesla's troubles may run much deeper than they first appear (particularly to the bulls), and that the mooted privatisation is actually a quasi-bailout and a ploy to buy the company much more time to dig itself out of its financial mess - as well as much needed capital and privacy. Musk is an innovator and an inspiring figure, but it is important to remember that Elon Musk has never built and run a profitable enterprise. As much as I admire Musk, he does not walk on water, and is subject to the same laws of financial gravity as the rest of us.

I hope I'm wrong however, and it is also possible Musk has simply tired of being 'kept on a leash' by financial markets. In this respect, the move might be purely opportunistic. I hope so. I'm rooting for Musk to succeed. But I can't help but conclude that something might be amiss.


The Solar City precedent

The first cracks in the Musk facade began to appear for me when I looked into rooftop solar company SolarCity - another Musk-backed, change-the-world inspired company, then run by his brother Kimbal. While the company was reporting considerable losses and FCF burn, I was intrigued not only by the company's rapid growth and potentially large addressable market, but by the 'net present value of existing installations' the company reported. On this latter metric, the stock looked cheap, with the share price trading roughly in line with the discounted cash flows from existing installations (net of debt) - a metric that was growing rapidly each year with new installed volume - and offered no premium for value creation from new installations (which at face value, appeared robust). On an NPV-added accounting basis, the stock actually looked remarkably cheap. Installation prices also continued to trend down, aided by the well-publicised 'Moore's-law' like decline curve in wafer prices that was occurring.

A weekend of research, however, quickly revealed the flaw in the business model/investment case, and made me question how and why Musk - someone of considerable intellect - had not picked up on this. For the first time, I began to wonder whether Musk's judgement was being clouded by sci-fi fantasies about a future, idealistic world - in Solar City's case, a world where all of our energy is produced cleanly and sustainably from rooftop solar installations - to the point where he was overlooking obvious economic realities.

Solar City's customer value proposition was (seemingly) simple - we will pay for the installation of a rooftop solar system on your house, and we will continue to own the solar system and sell you the power generated by the system under a 20yr PPA (power purchase agreement) at a price starting at 20% below current retail electricity prices, with a contracted ~2% annual price escalator. The marketing pitch was, with no money down, we can reduce your electricity bill by 20%, while in the process you can help save the planet (and show off your environmentally-friendly credentials to your neighbours to boot). What was not to like? Not surprisingly, the company's installation volume grew rapidly. The company booked upfront losses/negative FCF, as they had to bear the cost of system installation upfront, but the annuity revenue stream they then received from customers over the following 20yrs (plus hoped-for extensions) promised solid returns on investment over time.

However, the fundamental flaw in the business model was this: the ability of the solar system to profitably generate and sell electricity to customers at a 20% discount to on-grid prices was critically dependent not just on hefty upfront government installation subsidies (which were at constant risk of removal), but also crucially, on the traditional bundled model of retail electricity pricing.

In the past, per-kWh retail power prices have been bundled into a single price that includes (1) the wholesale cost of energy purchased from electricity generators; and (2) the cost of electricity transportation provided by power transmission and distribution companies (we will ignore relatively minor administrative and customer billing functions). The wholesale price of power is typically significantly below the retail price, due to the significant costs of power transportation/distribution.

The problem with Solar City's customer value proposition was that the sub-20% cost of its electricity was a wholesale price, not a retail price. Wholesale electricity prices were 5-8c per kWh, whereas SolarCity was signing customers up to pay 13-17c for 20 years (13c in year 1, rising towards 17c by year 20). Retail prices billed by electricity companies were higher, at closer to 15-17c, but only because these prices included the cost of electricity transmission and distribution (as well as billing and customer service functions).

But isn't rooftop solar energy 'distributed' - i.e. produced and consumed at the same location - removing the need for transmission/distribution? One of solar's fundamental problems is its intermittency. The sun doesn't shine at night, and the level of insolation varies with both the seasons and the weather. Consequently, roof solar actually relies more heavily on the grid than the average customer, as it feeds electricity back onto the grid when the sun is shining, and then draws energy back off the grid at night and other times of low solar efficiency. The grid also provides essential back-up services at all times.

The promised 20% electricity cost savings therefore relied on rooftop solar customers underpaying for grid services - indeed not paying anything for the cost/upkeep of transmission and distribution lines at all, despite using that infrastructure much more actively than conventional electricity customers. This is particularly the case because the increased volatility in system demand and supply caused by solar is very costly from the perspective of maintaining grid stability.

In other words, rooftop solar customers increased the cost of administering the power distribution system, but paid very little for the privilege (only on the net power drawn in excess of total solar production). The costs didn't disappear, but instead were passed on to other (non-rooftop solar) system users, in the form of higher power transportation tariffs. This, in turn, then made rooftop solar even more cost competitive as bundled on-grid prices rose, accelerating adoption further, and so forth.

This flywheel was clearly unsustainable. Somebody had to pay for the cost of grid upkeep, and Solar City was saving its customers money merely by offloading those costs on to other network users, and essentially arbitraging outdated legacy bundled billing arrangements. It seemed to me that what ultimately had to happen was that retail electricity tariffs would need to be unbundled, with the bill separated between grid access costs and wholesale electricity prices.

Warren Buffett's Nevada NV Energy was one of the first to understand and deal with the problem, announced a change in billing practices in 2016 (as usual, Buffett was well ahead of the pack in identifying emergent problems and taking steps to address them). Solar City and other rooftop installers tried to argue that this move represented vested interests resisting disruption of their business models, but this was disingenuous - in practice Buffett was simply insisting on applying what was economically logical, rational, sustainable, and fair. Someone has to pay for the grid, and there is no sound economic rational why particularly heavy grid-users, such as roof-top solar owners - ought to be exempt from paying.

An unbundling of billing would devastate the value proposition SolarCity had promised its customers (and locked them into for 20 years). Instead of saving them money, they would end up having to pay considerably more for their electricity, and for a long period of time. They would have to pay grid access charges equivalent to an average of say 8c per kWh, and then pay 13-17c per kWh for their wholesale electricity, instead of 5-8c on-grid. Their electricity bills would probably end up rising some 50%.

Furthermore, any removal of net metering would be even more disastrous, as solar customers would have to pay 13-17c per kWh to SolarCity on solar generated by the panels, but would only receive wholesale prices of 5-8c per kWh if they did not contemporaneously use the energy and sold back onto the grid. This would multiply bills further still, and would require customers pay for a significant and costly installation of in-home batteries - an additional cost not previously budgeted for. And that cost would have to be borne merely to cap excess electricity bill costs at 50% for 20 years.

A customer revolt was quite likely, if not massive lawsuits from customers who felt they had been mislead into signing long term contracts with false and misleading advertising, with a poor understanding of the risks. To avoid this liability, and not to mention a significant PR fallout that could damage the Musk halo, huge subsidies would have to be provided by SolarCity, including renegotiating lease rates, and/or paying for the installation of battery packs. However, this burden would be far greater than SolarCity could afford, and would turn their installed base from an asset into a major liability. Bankruptcy in this scenario would seem inevitable.

Furthermore, if those problems weren't significant enough, the cost of installations had started to level off, and even tick up slightly. What had happened to the 'Moore's Law' decline curve in solar prices the solar bulls had enthusiastically preached of? The issue was 'balance of system costs'. Wafer prices have declined a lot, but the cost of glass, concrete, and installation labour, it turns out, have not, and these had become the largest costs involved in installing a system. All-in system costs looked to have bottomed out, and at levels no where near low enough for solar to be competitive with on-grid wholesale pricing. Worse, clear evidence was emerging that utility-scale solar was much cheaper and more efficient than rooftop solar, as there were much greater economies of scale with installation costs; greater locational flexibility; and the ability to install panels in a manner able to dynamically adjust their angle to the sun throughout the day, increasing insolation. All of these factors, viewed together, suggested that the rooftop solar business case was well and truly busted.

I was surprised Musk was seemingly unaware of these structural flaws in the business model, and for the first time, I began to doubt Musk's judgement. He seemed to have been so blinded by his sci-fi vision for what the world could be, that he had overlooked economic realities.

Musk does, however, appear to have finally woken up to these problems, and his solution was to have Tesla launch a takeover of SolarCity in late 2016. This coincided also - probably not coincidentally - with Trump's election - someone who had promised to withdraw the US from the Paris Accords, and hence was unlikely to perpetuate important solar subsidies and net metering policies. Musk's epiphany was never publicly acknowledged, with the motivation for the takeout instead obfuscated with talk of 'no brainer' synergies between the two companies (despite those synergies being far from self-explanatory). However, tellingly, his brother Kimbal who had been previously running Solar City for many years, and which Musk had previously lathered praise on and said "executed brilliantly", was asked to step down.

The true motivation for the takeout, I believe, is that Musk realised that Solar City was on the verge of financial catastrophe. Changing regulations (particularly given Trump's hostility to climate change policies) and unbundling billing practices was likely to mean that the company was going to need to provide massive subsidies/compensation to its customers (or let them walk away from existing contracts) to avoid both lawsuits and a a PR disaster, and this was a financial burden the company could ill-afford. Furthermore, such a public blow-up of one of Musk's companies could be highly damaging to his reputation and credibility, potentially impacting Tesla's ability to raise much-needed funding as well. It was preferable to absorb SolarCity's problems into the larger Tesla entity, where the losses/evidence and PR-fallout could be quietly buried, and public scrutiny avoided.

Was this unethical? Musk's actions are certainly entirely understandable. He had started out with the best of intentions, but had realised there were serious unanticipated problems brewing. He was already in over his head and the stakes were high, both for Musk personally, and for other stakeholders such as customers and employees. It would no doubt be a very difficult situation to find oneself in - as a shareholder, you can simply sell and move on, but it's not so simple when you are already committed and 'all in'. It is therefore entirely understandable Musk behaved the way he did. It seemed like the best solution for all (except - that is - Tesla shareholders). But understandable does not mean excusable.


Tesla

It is with this context in mind that I found Musk's recent announcement of an intention to take Tesla private intriguing. It is very possible Musk's desire to privatise Tesla stems from a similar motivation to his desire to absorb SolarCity into Telsa - namely a belated recognition that he has overlooked a structural flaw in the business model that has set the company on an inevitable collision course with reality, and a desire to retreat from the scrutiny of public markets. This is particularly the case given growing signs financial markets could be rolling over and monetary policy is starting to tighten.

Realising he is potentially in over his head, and the incredibly high stakes involved, he may be looking for solutions that minimises the risk of a serious blow up. The extent of Tesla's internal problems are still unclear, and are unlikely to be as severe as SolarCity's (although, let it be remembered, SolarCity's problems are now Tesla's problems), but it is at least possible Musk has had a similar 'a-ha' moment in respect of Tesla as he did for SolarCity.

Much has been made of the fast pace of executive departures at Tesla. I don't consider that a smoking gun (although it could prove to be). Seldom mentioned is that Amazon also suffered a stunning rate of executive departures during 2000-02 as well (albeit that was also a dicey time for Amazon). Like Bezos, Musk is no doubt an intolerably difficult person to work for - not everyone has a desire to work 120 hours weeks and strive for almost impossible-to-deliver outcomes, year after year after year. Burnout is quite likely. However, it does suggest at least the possibility of deeper problems.

One issue could be that Musk has realised that it is simply not going to be possible to produce the putatively mass-market Model 3 profitably and in volume at the promised US$35k price tag - at least not in the foreseeable future. The company overlooked its access to battery raw materials as a potential issue, and the price of key battery inputs such as cobalt has recently skyrocketed. Supply is short, and Tesla's has not locked in any long term supply contracts. Executing on the manufacturing ramp-up has also proven far more complicated than previously expected.

Perhaps even more ominously, a potentially major problem is that Musk's electric vehicle (EV) PR offensive has been arguably too successful, such that governments all around the world are now making EV sales penetration targets mandatory for automakers (notably in Europe and China). This is a potentially big problem for Tesla, because if regulatory mandates are too aggressive relative to underlying organic customer demand (at economic prices), traditional automakers - almost all of whom are investing heavily in EV roll-outs - will have to sell them at a loss to comply with regulatory mandates, and subsidise the losses with much more profitable ICE vehicles. Telsa lacks internal-combustion models, and hence will have to compete with efficient, battle-hardened global automotive companies with considerable financial resources, who are being forced into selling EVs at a loss. It would be an unenviable position to be in to say the least - particularly if the company continues to face serious internal operational issues and/or less forgiving financial markets.

Tesla has also taken on a number of financial commitments, including free recharging for life at its supercharger network, and customer buyback warranties on certain cars, and it also remains responsible for Solar City's considerable financial obligations. It is unclear how burdensome these will be for the company. And there may also be other issues that we are not yet aware of.

Some of Musk's actions this year betray increasingly frayed nerves - something that is understandable given how much is at stake for Musk. His April Fool's tweat that Tesla had declared bankruptcy was particularly bizarre. In my interpretation, Musk may well have been - consciously or unconsciously - attempting to 'reverse psychology' the market: he wanted people to conclude if Musk were really truly concerned about bankruptcy, there is no way he would joke about it like that. That was my immediate reaction - I worried that Musk might actually be harbouring deep anxieties about the deteriorating state of Tesla's financial health. His exasperated responses to analyst questions on the company's earnings conference call a few months back, which were widely condemned, were another sign of a strung-out individual under an intense amount of stress.

So what benefits would a privatised Tesla have for Musk? It would serve to buy the company more time, capital, and privacy to attempt to solve its problems, while allowing major shareholders to continue to control the valuation. As I've discussed in past blog articles, the real reason there have been so few IPOs of loss-making tech unicorns is that it democratises the price discovery process, and a lot of these private-market unicorn valuations will not withstand the scrutiny of public markets, and promoters know it. Privatising the company will allow Tesla to 'bury the losses' in much the way SolarCity's losses have been buried within Tesla, and avoid capital market and media scrutiny.

If Tesla remains listed and its financial problems deepen and investors start to lose confidence - particularly if this occurred during a major market sell-off - Tesla's share price could collapse, and if it did, the company could quickly find itself unable to raise enough capital to survive and/or meet its aspirations. Musk's credibility would also take a huge hit, which might imperil SpaceX's fundraising potential as well. That sort of blow-up scenario is less likely to happen if the company is private - existing shareholders are able to prop up the valuation and continue to fund it - provided they have the money - sustaining paper profits and the illusion that there has been no degradation in value.

It is also possible, however, that I am reading too much into this, and that the move is instead purely opportunistic. It is possible Musk has simply tired of being 'kept on a financial leash' by public markets and the constant media harassment, while at the same time, there remains a huge amount of dumb money out there at the moment intent on chasing past heady paper profits in the VC-funded tech space, that is ripe for the plucking. The Saudi's in particular, which Musk have been talking to, have repeatedly demonstrated a tremendous ineptitude when it comes to investing their royal fortunes, and have been duped time and again into buying the wrong thing at the wrong time. Musk might simply be taking advantage of this opportunity.

But the timing and manner of this mooted takeout (announcing it over Twitter) suggest to me it is also just as likely an impetuous act of growing desperation. Time will tell.


Conclusion

I really want Musk to succeed. I admire the guy and his high-minded and bold ambitions. I'm rooting for him. Someone that hard working, with an ability to inspire both customers and employees, who has such a long history of defying the odds, should never be underestimated. Tesla has had a difficult time ascending the manufacturing learning curve, but any organisation that is as innovative as Tesla will - provided it can survive long enough - probably eventually succeed (provided the business model is not structurally flawed). I will continue to root for Musk, and wish him the best of luck (which I'm sure he will need), but I most certainly will not be investing in any of his companies.


LT3000





11 comments:

  1. Lyall, congratulations-remarkable work, very balanced and truly thorough. Must read!

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  2. Another great post Mr Taylor. Elon Musk's aspirations and goals are too selfless for public markets. He is better off with private "Investors" or let's say private Philantropists.

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    1. Thanks Hector. Agreed - particularly at the company's current valuation. What is particularly silly about some US$80bn valuation at Musk's mooted take out price, is that even if Tesla ultimately succeeds at becoming a viable, profitable auto marker - something that will take a lot of time and a lot of additional capital - tens of billions of dollars to build out global production capacity for instance - the size of the ultimate prize is not that significant.

      Toyota - the world's largest auto producer at about 10m pa vehicles, only has a market cap of some US$200bn. And it also requires US$200bn in book value (invested captial) to produce all those vehicles. Tesla's book value is currently only US$4bn. In the absence of reinvested profits, it's going to have to raise a lot of money to scale up. And even with reinvestable profits, it will take decades and decades to accumulate the economic assets needed to scale.

      So even if Musk does pull it off, there is very little upside in the current price. The current valuation seems to imply that Tesla will come to dominate the global industry and/or make significantly above-average margins. Both, and particularly the latter, seem most unlikely. What the bulls have forgotten is that the 'auto' industry has long been intensely competitive. Consequently, there are many very well run and efficient companies in the industry. It's better to 'disrupt' an industry that has previously been a far monopoly. That most certainly is not the case in autos. In addition, autos is a highly competitive industry where business models are not scalable in the manner I discussed in my Spotify post. Autos is an 'old world' business.

      So I agree - investing in Tesla to make money makes no sense. Its a philanthropic endeavour at its core.

      LT

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  3. I really enjoyed this post.

    What is your perspective on investing in companies where a single person is so important? There is an additional risk of accident/decreased performance due to non-business reasons, and they cannot be replaced.

    I guess BRK was such a company before Buffett divested himself of a lot of the work.

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    1. Hi James,

      Yes that's also another excellent point - in addition to all the other risks, there is also a huge amount of 'key man' risk with Tesla. Chanos has argued - convincingly I believe - that Musk's main passion is actually SpaceX and that he wants to exit running Tesla at some point.

      All else held constant, in principle stocks with key man risk arguably deserve a discount. However, the complexity is that on the other hand, you generally want to back someone with aligned interests (major personal equity ownership) and a good track record, and in that respect, someone that is a 'key man' can add a tremendous amount of value over time. That's also the case because well run companies will often also plan succession well. Provided they don't suffer an untimely demise/incapacitation, there is usually plenty of time for them to build the company into a sustainable enterprise before they depart. Such individuals also seldom conform to conventional retirement ages of 65. They are born to work and work until they are unable to continue. So in practice, key man risk is often less significant than in first appears.

      This is also particularly the case also because often, behind the media-hogging front man, is a large team of capable people working with the individual, but out of the spotlight. That's why companies like Apple have been able to continue to grow and prosper after Jobs' unfortunate passing. That was only because Jobs visionary leadership had rebuilt Apple to a point of economic strength and product category dominance that it was strong enough to self-sustain its success from that point.

      Telsa is long way from the point where it could survive without Musk though. I suspect that as soon as the company reaches that point where it profitable/soundly financed, and is a large enough enterprise with a deep enough bench of management to carry on without Musk, Musk will exit. Right now, Musk is needed not only to run the company, but to maintain the customer, media, and investor hype around the name. This is very important both to building the brand/sales, as well as sustaining investor confidence such that the company can continue to raise capital. Without Musk, Tesla would likely collapse into a steaming heap at the moment.

      Cheers,
      Lyall

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    2. Weighing "key man risk", against key man advantage, is always interesting. The best way to avoid key man risk would be to avoid businesses headed by outstanding individuals - perhaps.

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  4. Thanks for sharing such a useful and informative post like this. Keep updating more updates like this.

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  5. Would there be anything to accuse Musk of legally speaking, if the following scenario was true: he's planning (solo!) to use SpaceX funds to buy Tesla as cheaply as possible. In his mind it'd be a juggling act of lowering Tesla stock value with crazy stunts, while carefully retaining enough authority to make the buyout happen. If he'd really be the only person aware of such a plan, can it be proved or the behaviour otherwise legally condemned?

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  6. This is a very thoughtful analysis, along with many other of your posts. I agree that Tesla and SpaceX are pseudo philanthropic missions. The profits and products support the mission, not vice versa.

    What needs to be explored is whether incumbent automakers can compete with Tesla on the performance to cost ratio. Recently introduced (and hyped) models - eTron and iPace - are far off. It's questionable whether these vehicles can be sold profitably. How much capital will shareholders allow these companies to burn through to catch up?

    The other thing to think about is organizational advantages and DNA. Is software going to be a core component of the vehicle experience and also the manufacturing process? Tesla does software better than any of the incumbents by a wide margin. Software is hard. Further, can Tesla continue to innovate faster than incumbents on drive train, battery technology, customer service, and in cabin experience? Also, how are incumbents going to compete on price when they have to concede hundreds of basis points of margin to the dealer network? Will dealers demand even more margin because there's very little value in the maintenance and service of EVs?

    Finally, how do you value Tesla's brand? Apple has somehow taken a commodity product and created an enormously profitable franchise out of it while retaining a minority share of the market. Can't Tesla carve out a place in the transport market and sustain profits over the long term (note, none of what I'm writing suggests the future prospects of the business justifies the equity valuation in the market; however, I don't believe this is a company that is going to easily disappear).

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