- Tesla's SolarCity deal has definitely added risk to the equation due to debt that has been added to the balance sheet.
- Musk's claims about low Model 3 prices, addressing the expanding debt and the new cheaper solar roof are over-hyped.
- Don't expect the $7,500 grant currently available in the US to continue.
I wrote an article recently about Tesla (NSDQ:TSLA) in which I discussed my bullish thesis but also outlined the underlying risks that are definitely present in this company. The automaker may have increased its upside potential significantly with the latest $2 billion SolarCity (NSDQ:SCTY) deal, but a sizable risk has also been added to the table. The cash flow burn in both the companies is huge and the debt levels are worrying, especially now as we are entering a period of rising interest rates. Bloomberg recently called Tesla a "story stock" and I have to agree. Elon Musk owns 21% of Tesla and 22% of SolarCity and has championed the acquisition for quite some time now. The CEO announced earlier this month on his twitter account that if things got ugly in the short term, he would absorb SolarCity's debt of around $3.4 billion. Again the maverick comes to the rescue and the worrying thing is that many take him on his word.
Still Too Much Hype Surrounding Musk's Claims
This is why Musk's actions or non-actions bring the "key man risk" to this company. Everything he does must be viewed as being positive by the investing public. Can he alone bring the share price to the promised land? I'm not so sure. Investors should seriously look at his track record in order to ascertain whether we can believe in what he is promising. Firstly he is saying that the Model 3 will be priced initially at around the $35k level with higher specked cars selling for up to $7k more.
These numbers look very low for a car that is projected to be substantially superior to its predecessor and I personally am not buying this story especially because the volume levels are still very low. Again if we look at Musk's track record here, we can see that he initially stated that the Model S would sell for under $50k but in reality, the car started selling at just over $67k. Furthermore, he is saying now that the new Tesla/SolarCity solar roof will cost less than a normal roof. Again, I believe management is way off and investors should not read too much into these boastful comments considering the track record of his claims. However, the recent hype over SolarCity and Tesla's rare profit in its Q3 FY16 will keep shareholders interested - at least for a while.
Q3 Was Encouraging But Future Margins May Get Compressed
We saw in the third quarter that a spike in the volume lead to the GAAP revenue more than doubling to $2.3 billion. Furthermore, Musk has stated that the next quarter could also be a profitable quarter (diluted EPS of $0.14 reported in Q3). Gross margins almost reached 28% last quarter as commitments from the Model X have started to wind down but investors shouldn't think that margins increases will become a sustained trend for this company going forward.
Why? Because gross margins are closely linked to volume numbers and fixed costs. Tesla has been saying for quite some time now that it was finding it difficult to extract cost savings from the Model X. Why then should investors be so confident that it will be able to aggressively realize cost savings for the Model 3 rollout ? Remember this vehicle will have to be priced much more competitively and will be up against a stronger competition (especially from German manufacturers) which will make costs savings all the more difficult. (Also Read: Can GM And Toyota Hurt Tesla Motors?)
Trump Could Make Things Difficult For Clean Energy Companies
The incoming president Donald Trump has also been vocal about his climate change theory which he reputably denies. In fact, he wants to crater the "Paris Agreement" (which 200 countries have already signed up for). These regulations have been good for clean energy companies like Tesla as they have put attention on the harmful gasses that supposedly make the earth hotter. Taxes on automobiles have risen substantially over the past few years based on the levels of CO2 they emit. If Trump manages to deregulate everything here in the US, it will undoubtedly make Tesla's case more difficult which investors should be aware of.
However, the biggest risk to Tesla in the near term is from rising interest rates. Mortgage rates have spiked to almost 4% over the past few weeks (up from 3.2%) and if this trend continues, it is going to put the brakes on disposable income in the US rather quickly. Here is where Trump is going to come up against major difficulty with regards to his spending plans. Spending $1 trillion on infrastructure whilst at the same time reducing taxes meaningfully for businesses simply cannot happen if the US enters another recession with rising interest rates. In fact, Tesla will continue to remain an automaker for the upper middle class and rich if interest rates continue to rise meaningfully.
Growth Will Be Hard To Come By In A Rising Interest Rate Environment
This is the big hole in Trump's grand plan. The US would not be able to afford it as his manifesto means less funds coming in but far more going out. This is also Tesla's biggest risk at present. Demand. Its a growth company and needs strong demand (at least in the countries where it is strong). If interest rates rise, it will put the shackles on its volume growth which would be detrimental to its margins and balance sheet. As I have mentioned at the outset, the reward potential may have gone up a notch with the SolarCity acquisition but the downside risk has gone up two notches. Caution is warranted at present here. (Also Read: Why The Tesla Motors Inc Hack Is Great News For BlackBerry)
Tesla stock just doesn't have enough competitive advantages to justify the downside risk at this stage. Investors have to ignore the hype and look at the numbers. The success of the Model 3 now is crucial. Time will tell whether it can deliver but I remain doubtful, to say the least.
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