Tesla Shorts Are Too Short-Sighted

Intro

Tesla (TSLA) reported earnings Wednesday, November 1st, with the entire call and much of the quarterly letter focused on the Model 3. One of the most prominent pieces of information that came out was that the vehicle faces a 3 month delay to reach a 5,000 a week run-rate. For those paying attention, this was not a complete surprise, as a supplier already announced a 3-month postponement of higher volumes for a part for Tesla, and Panasonic admitted delays in the production lines at the Gigafactory.

The stock reacted negatively the next day, dropping nearly 7% by Thursday’s close.

In this article, we will take a walk down memory lane and examine the Model S and X releases, and see if there is any clues about potential outcomes for the stock at different points in the Model 3 ramp.

Model Releases & Stock Effect

2012: Model S

A very long time ago in Tesla time, Model S was just about to be released. The supercharger network concept had just been introduced, and the only vehicle Tesla had ever sold was the Roadster, an amalgamation of IP from the company Tesla had grown from, and the Lotus Elise.

People were skeptical Tesla could produce a compelling, reliable car in any sort of volume. The automaker was aiming to produce 20,000 a year of the car. News eventually broke from Tesla they were having trouble ramping some variants of the Model S. The stock lost ~21% of it’s value from the news before bottoming out.

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TSLA data by YCharts

As Tesla proved their ability to manufacture a vehicle designed in-house from the ground up and slowly ramp production, investor confidence soared to new highs as can be seen in the chart below:

Chart
TSLA data by YCharts

The stock posted gains from July 1st, 2012 ($29.02) to July 1st, 2013 ($117.18) of over 400%. This does not include gains had from the bottoming-out of the stock near ~$20 that occurred from the temporary delays.

2015: Model X

After many delays of the final reveal and official delivery as opposed to the initial reveal in 2012 seen here), the Model X finally started rolling off the assembly line in September 2015. The stock had gotten over-hyped pending the release of the model and had gone to new-highs of $280 in July.

Since it’s initial release, the Model S had improved in reliability significantly, had undergone range and performance enhancements, and had gone on to sell 50% more than the planned ~20,000 a year from 2012 in 2014 with 31,655 deliveries.

The Model X then began rolling off the assembly in line in severely low numbers, with shorts calling the beginning of deliveries “fake” and the share price being tested. From September to February, the share price of Tesla fell from around $250 the time of the Model X delivery ceremony to $151 as the Model X failed to be produced in significant numbers.

Chart
TSLA data by YCharts

Just a couple month later, as it was proven that the Model X ramp was salvageable and the production rate (and reliability of the vehicle) was brought up to speed with Model S investor confidence once again returned, propelling the stock near new highs.

Chart
TSLA data by YCharts

This rally would continue due to many catalysts other than the Model X (like growing anticipation of Model 3, Merger with SolarCity, Gigafactory progress) until the Model 3 delivery ceremony.

All in all, the stock had dropped 47.37% from the highs reached before deliveries began, only to recover almost 70% from the bottom once the Model X situation had been remedied. Looking at the gains from the high pre-Model X deliveries to pre-Model 3 deliveries, the gains were approximately ~37% above previous highs.

Chart
TSLA data by YCharts

2017: Model 3

Tesla stock saw the return to new-highs, like leading into the Model S and X ramp, as anticipation of the Model 3 worked up to feverish levels. Shortly before the highly anticipated launch of the model, the stock reached a peak of $383 in June (and again when it achieved $385 in September).

In keeping with the past, as the hype has worn off and volumes of the vehicle have failed to materialize, the stock has slowly slid to present levels of the low $300’s, or a little more than a 20% decrease from previous highs.

Chart
TSLA data by YCharts

Now that we are brought up to speed with the past performance of the stock in relation to the ramps, and have identified the trend seems to be continuing with the Model 3, let’s look at implications for the share price going forward. Below is a table looking at the changes as different sentiments regarding the ramp have been achieved.

Gains and Losses in Relation To Ramps & SP Lows/Highs

Model SP Loss from High Due To Delays SP Gain from Previous High On Successful Ramp SP Gain Over Ramp Related Low
Model S ~21% ~225% ~432%
Model X ~47% ~37% ~70%
Model 3 ~20%* ? ?

*20% As of publishing

Thoughts On The Trend

I believe that as the ramp gets worked out, whether it be in a month or in 6, the stock will rebound quickly to the previous upwards resistance level around $385 and surpass it be a fairly large margin. As long as reliability is average or above when reviews do start coming out in earnest, (or even if they do not as Model X showed) I think investors will be very pleased whenever the Model 3 run rate of 5,000 is achieved. Obviously, the sooner the better, but I would expect investors would prefer a knock-out product later rather than one that could jeopardize the vast log of reservations sooner.

It definitely seems that each model ramp has had a significant impact on investors, with worries from delays creating tremendously attractive buying opportunities. If the share price increases over the previous high in a similar to manner to the Model X rally, the new high would be over $500.

Before we conclude with a summary of the above and our stance on the stock, I believe it is worth taking in a point about the nature of ramps at Tesla.

A Point About The Ramp

One point Musk tried to really drive home, as he has done in the past, is that the ramp is really a “stepped exponential”. What this means essentially is that it does not follow a linear path. I wish to illustrate the point further than he was able to on the call with a scenario as outlined below:

linear vs exponential graph

(Image Source)

Suppose the assembly line has 100 process steps to complete the product. 90 of the steps are capable of creating 1000 of the product a day, the companies desired run rate. 5 of the other steps are able to do 1,200, which is actually above the companies goal. The other 5, unfortunately, are only able to do 100, 200, 300, 400 and 500 a day, respectively.

The company fixes the step that is only able to do 400 a day and makes it 500, however they can still only do 200 a day, as that is the bottleneck of the entire production process. Then, they make that one able to do 1000 a day. Now, they can only do 300 a day. Even if they fix the two that can do 500 a day, they will still be limited to 300 a day.

What this lengthy hypothetical demonstration above shows is that they could be making vast improvements to various processes on the line each day, however they will not reflect in the daily, weekly, or even monthly production levels unless they were able to increase the rate of whichever process was causing the biggest slow-down. This could be equated to the buffalo herd theory.

What this means for us is that if people begin extrapolating based off how much they were able to improve the run-rate in a certain amount of time, they could be blown away by sudden improvements that occur seemingly overnight. This is also why management is not guiding for certain levels by quarters end, but in slightly broader time frames.

Additionally, it is worth noting that they have been planning for “volume deliveries in second half of 2017” since before Q3 2016. This seems to be relatively on track, although it will only be somewhere below 3,000 until March and not the full 5,000.

Other Effects of The Delay

Of course, the delay will impact Tesla in a very real way besides investment sentiment. These include possible customer dissatisfaction (or lack thereof), and increased duress on their financials.

Customer Satisfaction

If the delay is underestimated and expected delivery dates get repeatedly pushed back (something already occurring as documented here) they could see a mass influx of cancellations. While I expect demand to remain quite healthy for several years to come for the Model 3, unhappy customers can be a nightmare for companies. For more insight into how important customer satisfaction can be, consider looking at my recent article about google(GOOG) (GOOGL) and customer service here.

While there will likely be many customers to take the place of those who do cancel, it will certainly not be good for Tesla. The even bigger impact will be on lost or deferred revenue, however.

Financials

If the Model 3 is delayed beyond the initial 3 month estimate, Tesla’s financials will start to deteriorate rapidly. Investors were more than happy to expedite the production of Model 3 when the company last raised capital, but this will not hold true if they must repeatedly raise more and more money to accomplish the same task.

Any minor dilution is not a cause for concern for many bulls due to the fact that if Tesla succeeds it will generate massive returns for shareholders so dilution should negligibly effect returns. However, they may have issue being lent more capital if their share price deteriorates significantly, which may continue if the ramp struggles for much longer than currently expected.

An inability to raise capital on favorable terms (as a result of a lack of investor confidence) could compound the problems and create the perfect storm the shorts are waiting for. I would assert that this is the single biggest threat to Tesla right now (other than their execution itself).

Conclusion

Since the news broke of the delay, Tesla has retained support above the $280 level, and recovered 2.5% to $306 to close-out the week, less than $15 below where it was heading into Earnings.

The historical data shows repeated dips in the stock around model ramp delays, with investors getting spooked about Tesla’s ability to execute. Once the delays had been overcome, the stock soared to new all-time highs over 1/3 higher than previous.

Tesla is not a conventional company, and they do not do things in conventional ways. Although their ramps may differ in style and timeliness from industry norms, they are capable of doing so and will reward investors when they do ultimately deliver. Tesla has delivered 250,000 cars since it’s inception over a decade ago. Next year they plan to deliver 500,000 (and I think they will deliver at least 275,000). Regardless of where they fall in that range, they will double the number of Tesla’s on the road from today in one year.

It seems that there is not much additional downside for Tesla in the near-term with the stock already dropping 20% off the news of the delay and possible removal of the tax-credit. However, it’s worth noting support levels of around $220 is the stock does drop further. Regardless of short-term movement, a year from now after the ramp is considered a success, I believe the stock will likely be at new highs in the $400-$500 range.

Investor Take-away

With significant milestones achieved in the recent quarters, the Model 3 ramp delayed (and who can say they are honestly surprised) but on track and the Semi reveal slated for this month I only see positive catalysts in the near-term for Tesla, besides a potential capital raise and confirmation of the removal of the tax-credit.

If you are long the stock, holding is definitely the recommended position at this time going into 2018. I think the stock is bottomed out for the next several months and shorts should cash out if they are in the money.

If history is anything to go by, this may be the last opportunity to pick up Tesla shares in the low 300’s for quite some time.

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Disclosure: I am/we are long TSLA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.