Note: This post first appeared on Patreon on 12 Jun 2018
A week ago, I was talking about shares in companies like Tesla going to zero. Regarding Tesla specifically, I was comparing it to Amazon circa February 2001, when Lehman Brothers’ Ravi Suria was writing about Amazon’s facing a “creditor squeeze”. And right on cue, Tesla has now announced a massive round of layoffs. Here’s how I see it.
The make or break moment for Amazon
Before I get into Tesla’s announcement, let’s go back to 2001. Here’s how I described it five months ago. Focus on the parts I have highlighted in bold.
The denouement came in February 2001 with a negative research note from Lehman Brothers’ Ravi Suria. The Lehman convertible bond analyst covered Amazon because the Internet company had issued convertible debt at the top of the market, since the debentures offered bond investors an attractive upside due to a likely conversion into equity as stock prices rose. That held down the funding costs for Amazon. The company issued 10-year paper at 4.75% in January 1999 and then still more debt in February 2000 at 6.75%. Both issues were junk-rated.
But when the Internet Bubble popped and share prices began to plummet, Amazon’s negative cash flow became a problem. Instead of focusing on the possibility that the convertible bonds could be profitably converted into common stock if the shares rose 36% above the February 2000 share price, analysts were focused on the cash burn rate at Amazon. In the summer of 2000, Ravi Suria’s analyst report detailing an allegedly worsening credit position at Amazon caused a one-day loss of 20% for shares.
By February 2001, Suria was writing about Amazon’s facing a “creditor squeeze” in the second half of the year. And he told investors to “avoid” Amazon’s convertible bonds because the company’s liquidity was “tenuous.” Of course, Suria was right from an investing standpoint. As TheStreet.com wrote around that time, “No Wall Street analyst saved professional investors more money in 2000 than Ravi Suria”. Amazon shares lost 90% of their value between when Suria first raised his concerns in the summer of 2000 and the summer of 2001. Moreover, Suria was correctly making the same calls about a bunch of debt-laden telecom issuers who were also cash-flow negative.
So, Amazon, a market darling then and a market darling now, lost 90% of its market value. Tesla shareholders face this kind of risk as well.
Tesla must demonstrate it can be profitable
Let’s use Amazon as the standard here. Going back to my January post again, here’s how I described what Amazon did next.
What happens when the music stops? In Amazon’s case, the company was forced to temporarily downshift its growth model and reduce investment in order to demonstrate it could turn off the spigots at the drop of a hat. By January of 2002, Amazon was posting a net profit of $5 million for the quarter — and using standard GAAP accounting. That compared to a net loss of $545 million in the same period a year earlier. Revenue was still up 15% too. By the summer of 2003, Warren Buffett’s Berkshire Hathaway had bought $98.3 million of Amazon’s junk bonds, as the insurance giant increased its portfolio of junk bonds sixfold in 2002.
That’s the gold standard. And that’s what Tesla wants to do. Here’s Tesla CEO Elon Musk:
As described previously, we are conducting a comprehensive organizational restructuring across our whole company. Tesla has grown and evolved rapidly over the past several years, which has resulted in some duplication of roles and some job functions that, while they made sense in the past, are difficult to justify today.
As part of this effort, and the need to reduce costs and become profitable, we have made the difficult decision to let go of approximately 9% of our colleagues across the company. These cuts were almost entirely made from our salaried population and no production associates were included, so this will not affect our ability to reach Model 3 production targets in the coming months.
Given that Tesla has never made an annual profit in the almost 15 years since we have existed, profit is obviously not what motivates us. What drives us is our mission to accelerate the world’s transition to sustainable, clean energy, but we will never achieve that mission unless we eventually demonstrate that we can be sustainably profitable. That is a valid and fair criticism of Tesla’s history to date.
That’s an exact copy of Amazon. Give Musk credit for gettig out ahead of this. He knows the day of reckoning is coming. And so he wants to simultaneously maintain his access to capital and reduce his need for additional capital.
Tesla shares popped on the news
Tesla shares were up 6% on the news. Analysts are positive about its ability to meet Model 3 production targets for the year. And in that context, the move to show profitability is viewed as a positive. The stock is now up 40% from this year’s lows and it is within 10% of its all-time highs.
Let’s not forget what happened to Amazon though. The company demonstrated it could turn off the investment spigot on a dime and its stock still tanked 90% along with the rest of the Internet. So despite the short term gains in Tesla, the risks are still there.
There’s no denying we’re in the midst of another technology bubble. Tesla has benefitted greatly because of it too. Eventually this bubble will pop. In a best case scenario, Tesla goes down with the rest of the technology sector but rises from the ashes due to its operational execution — just like Amazon did. In a worst case scenario, Tesla fails to execute and the Audis and BMWs of the world catch up before Tesla is cash flow positive. That’s a case in which Tesla shares go to zero as Tesla defaults on its bonds. Liquidation is the worst case for Tesla in that scenario. Either scenario is plausible at this point. tesla shares are essentially a lottery ticket. Caveat Emptor.