oil below $20 a barrel

The Energy sector of the S&P 500 makes up 2.8% of the index, according to the S&P website.  This is another way of saying that none of us as investors need to have an opinion about oil and gas production, which makes up the lion’s share of the sector.

Last weekend Saudi Arabia and Russia, with a fig leaf provided by the US for Mexico’s non-participation, led an oil producers’ agreement to cut production by around 10 million barrels daily.

Prior to the meeting, crude had rallied from just over $20 to around $23.  Right after, however, the Saudis announced price discounts reported to be around $4 barrel for buyers in Asia.  Prices were reduced by a smaller amount in Europe but went up for US customers–apparently at the Trump administration’s request.  That sent crude prices into the high teens.

Why is this the best strategy for Saudi Arabia?

The commonsense answer is that Riyadh thinks it’s more important to secure sales volumes than it is to be picky on price.  This is at least partly because the world output cuts reduce, but by no means eliminate, the oversupply.  So there are still going to be plenty of barrels looking for a buyer.  Another reason is that since demand has dried up the Russian ruble has dropped by 20%.  That’s like a 25% local currency price increase for Russian crude, meaning lots of room for Moscow to undercut rivals.

investment implications

The most leveraged play to changes in oil prices is oilfield services.  Companies that specialize in exploration–seismic services, drilling rig firms–are the highest beta, firms that service existing wells less so.  During the oil price crash of the early 1980s, however,  drilling rigs were stacked for a decade or so.  On the other hand, oilfield services firms are the ultimate stock market call on rising oil prices.

Given that US hydrocarbon output and usage are roughly equal, the country as a whole should be indifferent to price changes (yes, it’s more complicated, but at this point we want only the general lay of the land) rather than the net winner it was 15 years ago.  However, within the country oil consumers normally come out ahead, while oil producers are losers.

Typically, the resulting low gasoline prices would be a boon to truckers and to commuting drivers.  The first is probably still the case, the second not so much.

The bigger issue, I think, is the fate of the Big Three Detroit auto producers, who are being kept afloat by federal government policies that encourage oil consumption and protect high-profit US-made light trucks from foreign competition.  While nothing can explain the wild gyrations of Tesla (TSLA) shares, one reasonable interpretation of the stock’s resilience is the idea that the current downturn will weaken makers of combustion engines and accelerate the turn toward electric vehicles.

Personally, I’m in no rush to buy TSLA shares–which I do own indirectly through an ARK ETF.  But it’s possible both that Americans won’t buy new cars for a while (if gasoline prices stay low, greater fuel economy won’t be a big motivator).  And the rest of the world is going electric, reducing the attractiveness of Detroit cars abroad, and probably making foreign-made electrics superior products.

If there’s any practical investment question in this, it’s:  if the driving culture in the US remains but the internal combustion engine disappears, who are the winners and losers?

 

 

 

 

 

 

 

 

Tesla (TSLA): dreaming and reverse engineering

As I’m writing this, TSLA’s market cap is around $160 billion, with the stock up 50%+ over the past week and having more than doubled in a flat market over the past month.

I have no real idea what’s behind the move  …desperate short covering?  …glitchy trading AI feeding on positive price momentum?  It looks crazy, though.

My thoughts:

–conceptually at least, we’re now living in a post-fossil fuel world.  This is much more evident in, say, Europe than in the US.  (The current administration here is clueless.  It actually favors the most heavily polluting fuels and is fighting industry efforts to keep US-made auto relevant in world markets through increasing fuel efficiency.  If this were a century ago, we’d be backing firewood.)

–the trickiest part of a car to make and maintain is the internal combustion engine.  Substitute big batteries and suddenly building is easier, manufacturing costs go down and you don’t need an extensive dealer network for sales and service.

Tesla is the leading brand name in electric cars.  There’s also some evidence that the manufacturing problems that plagued TSLA are now behind the company.

–we’re still in the “dream” or “concept” stage of TSLA’s development, so it’s very hard to gauge what the company is worth.  On the other hand, we can ask ourselves what the current share price implies must be already factored in, as follows:

—-let’s say that the market for automobiles is 100 million units/year, with 25% of those in China and 20% in the US.  Suppose TSLA can capture a 1% market share over the next few years.  That would mean manufacturing 1 million cars.  Let’s pluck numbers out of the air and say that they’ll sell for $40,000 each and have an after-tax margin of 20% (using margins is bad–never do it–but we’re just dreaming here).  That’s $8000 each, or $8 billion in total.

—-the point of this reverse-engineering is to see that the stock is now trading at 20x that annual earnings figure (market cap =$160 billion).  To buy/hold the stock at this point one would have to believe that the future for TSLA is better than I’ve just described.

—-how could that happen?:  the margin number I’m using is very high in conventional auto company history; there’s the issue of creating a network of charging stations to serve the cars; there’s also a (less important, I think) question of usability of electric cars in colder climates.  The biggest unknown, in my opinion, is how large a lead TSLA has on other would-be electric car makers.

Primary competition will likely come from Europe, where whose diesel emission cheating scandal has wrecked the market for conventional cars, thereby accelerating the move toward electric.   Their biggest impediment–ironically, a major point in favor of TSLA, is the backward-oriented posture of the administration in Washington.

On the other hand, given that TSLA has manufacturing operations in the two largest markets, maybe a 1% market share is too low.  Again, I have no idea.  But I think that’s the bet buyers today will be making, whether they realize it or not.

my $260 price target for Tesla (TSLA)

A regular reader recently asked how I arrived at $260 as a price target for selling TSLA, which many of you will know I have been trading alongside my younger son for a while.

 

To some degree, I’ve regarded TSLA in the way I would look at any growth stock.  That is to say, I look for signs that the company can grow faster than the market expects and/or would sustain an above-average expansion pace for longer than the market believes.

I then try to use the company’s financial information, plus government, trade association and individual competitors’ data to project an income statement and flow of funds statement for several years into the future.

In TSLA’s case, reliable data are scanty.  In addition, the company’s own projections of its production capacity and sales have not been anything to hang your hat on.

 

Typically, and for a stock I would consider as a core part of my portfolio, I would try to make a projection that I believe to be reasonable, or perhaps mildly aggressive, and would reassess as/when the stock reaches the future target price that projection would lead me to.

In the case of TSLA, however, I did something different.  I decided to make an extremely optimistic projection, one I thought would leave the shares at least temporarily overvalued–and which would serve as a sell signal.

 

This is what I did:

–I decided to make my projection based on 2018 earnings, since I don’t think anyone has the faintest idea of what earnings for years farther in the future will be

–I took the TSLA production forecast, which has proved consistently too optimistic, of 500,000 cars during 2018 as a given

–I decided that most of these cars would be Model 3s, where the average selling price indicated in preorders is about $42,000, as another given.  To account for a small portion of more expensive models, I rounded the average selling price up to $50,000

–I examined other publicly traded auto companies worldwide.  The highest pre-tax margin I found (yes, although this is a dangerous shortcut, I did use margins) was Porsche, at 15%.  I assumed that TSLA would achieve that margin in 2018, even though I think the figure is substantially too high

–I assigned a financial reporting tax rate of 25%, which is probably too low.  That gave me net financial reporting profits of $2.8 billion, and earnings per share of $17.10

–I decided to apply a price earnings multiple of 15x to the earnings number, even though auto companies typically trade at single digit valuations.  I don’t think TSLA should trade at the 20x+ multiple that an IT stock would merit, so 15x seemed about right.  That gave me a valuation, based on 2018 earnings of $257–which I rounded up to $260.

 

As we can clearly see from a TSLA chart, the stock blew through my $260 target in March-April as if it weren’t there.  It peaked, for now, at least, at $386–leaving an embarrassingly large gap between me and it.

 

Where did I go wrong?

The obvious place is in the PE multiple.  The prevailing market view would seem to be that 2019 earnings will be, say, $25/share, and that it’s safe to be factoring anticipated earnings for two years from now into today’s stock price.  Another way of saying the same thing, one which I think must be TSLA bulls’ belief, is that TSLA is this decade’s Amazon (AMZN)

That may well be correct.  Personally, I’m uncomfortable making the bet, though.  One thing experience does tell me, however, is that, barring a total corporate collapse, the stock is highly unlikely to get back to the $180 – $200 range that has marked the lows over the past couple of years.

a bad day for Tesla (TSLA) shares

First, let’s put yesterday’s negative price action for TSLA–down by 7%+–in context.  Prior to yesterday, the stock had risen by 75%+ since the opening bell in January.  So a down day–or even a down few weeks–shouldn’t come as a shock.

What happened yesterday:

–TSLA reported 2Q17 results.  Profits were hurt by another production foulup–a shortage of batteries this time–that prevented the company from churning out cars at a higher rate.  The good news is that the problem was solved intra-quarter and shouldn’t affect results for the second half

–TSLA also said it intends to be churning out 20,000 Model 3s a month by the end of the year and 500,000 in total during 2018

–two negative analyst reports were released, arguing that TSLA is substantially overvalued.  Reasons:  plateauing demand for older models, increasing competition from other auto companies and TSLA’s less-than-perfect production experience.  Goldman Sachs says it now thinks the stock is worth $180 a share (down from $190 previously)

–Volvo announced it intends to become a exclusively a hybrid/electric car company in 2019; Baidu announced it will give its autonomous-driving car technology away for free in return for usage data.  Takers include a bunch of other Chinese carmakers + Ford and Daimler

my take

–I sold my last shares of TSLA at $260, based on the idea that this is the highest price I can reasonably conceive of TSLA trading at during 2018, assuming the company does indeed make and sell 500,000 cars.  I guess that’s my bottom line

–the negative reports are good news in the limited sense that they imply the authors’ firms see no possibility of future investment banking business from TSLA.  Maybe their negative analyst stance in the past has already ruled them out.  But emphatically underlining the fact suggests to me they think TSLA needs no further funding to carry out its production plans

–the possible turn to significant profits being earned in 2018 is a mixed blessing.  On the one hand, say, $5 a share in earnings for the company, with the promise of more to come in 2019 is better than the current situation.  On the other, the emergence of earnings–and of a more easily predictable future–means an end to the “dream” of unparalleled riches that many early-stage-company investors routinely harbor with any of their stocks.  For a certain percentage of “dream” stocks, the minute the earnings begin to arrive marks the peak in the stock price.  A minerals exploration company that owns a single orebody peaking the day the mine opens is the stock example.  Euro Disneyland is another.

Tencent (700:HK) now owns 5% of Tesla (TSLA)

The Chinese internet conglomerate Tencent filed a 13G form with the SEC yesterday, fulfilling its legal requirement to declare 5% ownership of a publicly traded US firm–in this case, TSLA.

Filing a 13rather than the better-known 13D indicates Tencent intends to remain a passive investor rather than seeking a voice in TSLA operations.

According to the filing, Tencent acquired its 8.2 million shares (at a cost of $1.8 billion) both by participating in TSLA’s public offering on March 17th and through market purchases.  Tencent reached the 5% level on March 24th.

When I first heard of the stake, it struck me as peculiar that Tencent would make open market purchases, in which the money goes to third parties, rather than arranging for a private placement of stock from TSLA, in which case all the money would go to fund TSLA.  Looking at the 13G a little more closely, however, I realized that Tencent’s total cost implies an average acquisition price of $219 a share, meaning Tencent has been patiently accumulating shares at lower prices.  Now I’m thinking that Tencent took part in the recent offering to provide some financial support to TSLA–and then rounded its position up to 5% during the following few days in order to file a 13G that publicly declares its backing.

the TSLA offering

The TSLA offering raised about $1.3 billion, through an issue of $400 million in common stock plus $1 billion minus in 2.375% convertible five-year notes.  The conversion price is $327.50, a 25% premium to the stock price at the time of issue.

The notes are convertible, at the option of the holder, but, practically speaking, only if they are trading at a 30% premium to conversion value.  To my mind, though, they represent a much better deal than fixed income investors have gotten in prior TSLA offerings.  This seems to me to imply that these buyers see much greater credit risk with TSLA today than they have in prior years.

Tesla (TSLA) raising funds

Last week TSLA announced that it is raising $1 billion in new capital, $750 million in convertible notes due in 2022 + $250 million in common stock.

The offering itself isn’t a surprise.  TSLA has been chronically in the situation where analysts can see a point on the near-term future where the company could easily run out of funds.  This is partly the lot of any startup.  In TSLA’s case, it’s also a function of the firms continuingly expanding ambitions.  Elon Musk has been saying for some time that TSLA will will need new capital, too.

What is surprising, to me at least, is that the offering is not bigger   …and, more significantly, that the stock went up on the announcement.

To the first point, why wouldn’t TSLA give itself some breathing room by raising more money?  Of course, it’s possible that the small size is a marketing tactic and that the underwriters will soon announce that, “due to overwhelming demand,” it’s raising the size of the offering to, say, $1.5 billion.  Otherwise, I don’t get it.

To the second, this is just weird.  TSLA shares rose by a tad less than 30% in the first six weeks of 2017 and have been moving more or less sideways since.  So the idea that investors are willing to buy the stock can’t be surprising positive news.  And I don’t see the plus in some commentators’ claims that the market is relieved the offering isn’t larger.  I think the market should be mildly concerned instead.

Something else must be going on.

The only thing I can think of is that Wall Street is beginning to believe that electric vehicles are going to enter the mainstream much sooner than it had previously thought.  At the same time, the Trump administration’s intended moves to make it easier for American car makers to sell gas guzzlers for longer may result in Detroit remaining stuck in the past, paying less attention to electric vehicles.  So market prospects for TSLA may be improving just as competition from the “Big Three” may be weakening.

However, that alone shouldn’t be enough to propel a well-known stock higher in advance of an offering.

 

 

 

what a good analysis of Tesla (TSLA) would contain

A basic report on TSLA by a competent securities analyst would contain the following:

–an idea of how the market for electric cars will develop and the most important factors that could make progress faster or slower.  My guess is that batteries–costs, power/density increases, driving range, charging speed–would end up being key.  Conclusions would likely not be as firm as one might like.

–TSLA’s position in this market, including competitive strengths/weaknesses.  I suspect one main conclusion will be that combustion engine competitors will be hurt by the internal politics of defending their legacy business vs. advancing their electric car position.  The ways in which things might go wrong for TSLA will be relatively easy to come up with; things that could go right will likely be harder to imagine.

–a detailed income statement projection.  The easy part would be to project (i.e., more or less make up) future unit volume and selling price.  The harder part would be the detail work of breaking down unit costs into variable (meaning costs specific to that unit, like labor and materials, with a breakout of the most important materials (i.e., batteries)) and fixed (meaning each unit’s share of the cost of operating the factory).  An important conclusion will be the extent of operating leverage, that is, the degree to which fixed costs influence that total today + the possibility of very rapid profit growth once the company exceeds breakeven.

There are also the costs of corporate overhead, marketing and interest expense.  But these are relatively straightforward.

The income statement projection is almost always a tedious, trial-and-error endeavor.  Companies almost never reveal enough information, so the analyst has to make initial assumptions about costs and revise them with each quarterly report until the model begins to work.

–a projection of future sources and uses of cash.  Here the two keys will be capital spending requirements and debt service (meaning interest payments + any required repayments of principal).  Of particular interest in the TSLA case will be if/when the company will need to raise new capital.