November 11th, 2018 by Zachary Shahan This is a repost from two years ago. The story is more or less the same today. The original title was, “What goes on in the minds of auto execs?”
I’ve had a lot of fun recently while highlighting 50 “tips” for slowing the electric car revolution and writing about what the end of gasmobiles could look like, but the discussions left some people scratching their heads. Why would automakers conscientiously try to delay a switch to electric vehicles? Why would they not try to create attractive electric cars once they were shown how popular Tesla’s models have been?
I’ve written about this plenty of times before, such as here, here, and here. The short summary is this:
A transition to electric cars threatens the “financial health” of conventional auto companies. Many shareholders would be pissed to see so much investment in gasoline car technology “wasted.” Executives who built their careers on engine expertise would become much less valuable. Automakers would have to shift much of their business strategy, operations, factories, and workers. They’d be tossing many highly valued patents & knowledge down the drain.
However, that’s all just a simple summary. It hit me that a more detailed theoretical rundown would help more people to visualize the problem — to understand why BMW is trying to compare the 330e to the Model 3 in advertisements, why Ford is boasting about rangeon a plug-in hybrid that has only 22 miles of electric range and is advertising its cars using Captain America, why most electric models sold in the US aren’t available in most US states, why no automakers other than Tesla have cars with superfast charging, why Chevy isn’t creating this car (which a consumer designed) and BMW isn’t creating this one (which a consumer designed), why Fiat’s CEO told people not to buy the Fiat 500e, why Toyota is still hyping hydrogen, etc.
With the long preface out of the way, let’s dive into a thought experiment.
Numbers (… Fake Ones)
I’m not going dig through decades of investments from big auto companies, but below are some fake numbers from automaker “Bord” to play with in order to get rolling….
- Bord has 84 factories
- $84 billion has been invested into these factories
- 18 of these factories (~21%) are engine factories
- 6.5 million Bord vehicles were sold in 2017 for $150 billion in revenue and $7 billion in net income
- Bord had a 6.5% automotive gross margin in 2017
Essentially, Bord is making 6.5 million vehicles a year ($150 billion in revenue, $7 billion in net income) using factories that it put $84 billion into (with $17 billion going into the engine factories alone). After adding in cash used for other overhead, operations, etc., Bord walks away with a healthy little profit each year and sends some of that back to investors.
The Groundbreaking Q4 2018 Bord Shareholder Letter
Now, let’s say that Bord’s CEO sees that electric vehicles are the future, that they’re already essentially competitive, and that the most logical thing for the long-term health of the company is to switch to electric vehicles fast. Mr. Constable C. Smuggins, CEO of Bord, tells shareholders in a shocking quarterly letter:
We are planning to switch over 100% to electric vehicles in the next 3–5 years. We would do it sooner, but it takes time to create these new EV models and ramp up battery production capacity. Doing it later would be stupid, because people won’t want to buy our gasmobiles in 5 years when compared with our electric vehicles or other automakers’ electric vehicles.
Unfortunately, this means that our engine factories (which we put $17 billion into) are soon going to be useless. Well, the land and building shells will still be useful, but nothing we currently have or do inside will be. These factories will have to be completely revamped to produce batteries and electric motors. In order to do that, we will need to invest another $17 billion. Actually, we will need to invest $33 billion on top of that $17 billion for additional battery factories in order to keep producing the same number of vehicles we sold in 2017. This is a good thing, because we will have a competitive advantage in the industry from our $50 billion worth of battery factories. Don’t worry about us choosing the right batteries and manufacturing machines, though — we’ve got this.
Our other factories will need to be reworked to support the many new models we are introducing based on new electric powertrains. That’s another $50 billion.
We have a cash balance of $50 billion. Quite a lot, eh? Unfortunately, that’s clearly not enough to cover this quick transition. (If we could somehow spread the transition outby 2–3 decades, that would be much easier, but we don’t see that as sensible.) So, we will need to borrow a lot of money, and we are going to cut off dividend payments for several years. No worries — we’ve got you covered in 2025 or 2030, and we know you are long-term investors who also care about humanity and want to see a quick transition to clean technology that helps to stop costly and horrendous global warming, so we’re sure you won’t bail on us.
To be honest, though, we don’t know a lot about batteries and don’t have experience making compelling electric cars, so we hope we don’t screw up too much while pouring $150 billion into this. (Oh, did I mention that we need to do some massive staff re-training, R&D, set up new supply chain partnerships, license new tech, and acquire a bunch of patents?) By the way, yeah, um, our thousands of engine-related patents are basically useless now, so we’re just going to toss them in the trash.
I know you’d rather get a few more dividend payments before we jump in, but frankly, everyone in the industry sees the light and is now going to do this, so we have to get moving fast.
Yeeeeah. … Most shareholders of GM, Fiat Chrysler Automobiles, Ford, BMW, Nissan, Daimler, Toyota, Hyundai, and Honda wouldn’t be thrilled to hear such plans, and many would try to stop the move. (Volkswagen is getting away with something slightlyapproaching this thanks to the pickle it landed in by being a massive cheater and liar. Lucky VW!)
Overall, the question is: If you’re in the shoes of these large automakers, how do you dump your huge investments (sunk costs) and competitive advantages (which are centered around the internal combustion engine) in order to jump head first into a new technology? How do you tell shareholders that you’re going to go from making billions of dollars a year in profits to borrowing money for several years? How do top executives who built their careers on engine expertise suck it up and say that it’s time to retire the old dirty beast under the hood? Tough questions.
I know I demonize automakers a lot for doing a horrible job on their EV efforts and promotion, but it’s not really about demonizing them — the goal is to push them into a better approach, and to help inspire other consumers to do the same. But when you look at the challenges they face, this simplistic idea becomes less potent. That leads into a topic for a coming article — how I think these companies can and should proceed. First, though, I never got to the main question in the title: “What goes on in the minds of auto execs?”
Who the hell knows? These people vary in personality, career focus, and culture quite a bit. How much they understand that electric cars are the future, how much they understand the existential threat electric cars present to their businesses, how much they consciously think through the finances or run spreadsheets on the matter, how much they care about global warming and air pollution, and how much they genuinely try to delay an electric car revolution probably vary a great deal.
November 12th, 2018 by Peter Forman (aka Papafox)
For years now, Tesla has enjoyed a market capitalization sufficient to distinguish it as one of America’s 500 most important publicly traded companies. The missing ingredient for Tesla’s inclusion in the granddaddy of all indexes, the Standard and Poor’s 500, has been consistent profitability. Now that Tesla has shown a profit of more than $300 million in Q3 of 2018 and its CEO Elon Musk predicts continued profitability ahead, inclusion in the S&P 500 index is extremely likely in the not-so-distant future. Let’s look at this event’s implications for Tesla and its stock price, plus consider the likely timing of such a move.
When a company has been added to the S&P 500 index, that event marks a definitive move from a status of startup to arrival as one of the most significant businesses in the United States. Such a mark of distinction surely is not necessary with many inhabitants along the coasts and with young people in general. For them, the company already reigns as an aspirational brand. As for the majority of the country’s population who haven’t yet awakened to things Tesla, the legitimacy of S&P 500 inclusion can at least serve as a nudge towards acceptance.
The biggest effect upon Tesla from an S&P 500 inclusion will likely be seen in the form of stock price appreciation. For many companies, S&P 500 inclusion results in a modest bump upwards in stock value, something along the lines of 5%. This increase comes as funds that are indexed to the S&P 500 acquire shares of the new company in order to reproduce the index’s contents. As you would expect, that buying bids the stock price higher. In a recent instance of S&P 500 inclusion when Twitter was added to the index, we saw a nearly 5% jump in the stock price on the day inclusion was announced, and then over the next two weeks Twitter added of total of about 20% to its stock price. That’s not counting the likely considerable front-running of the S&P 500 announcement when it became clear to speculators that Twitter would likely be added to the index. Without a great deal of research, it’s difficult to isolate how much of the pre- and post-announcement climb was specifically due to inclusion in the S&P 500 index, but it’s likely quite a bit more than the one-day 5% rise from being added to the index.
Consider, too, the effect of more shares of TSLA being bought and then more-or-less permanently held by funds mimicking the S&P 500 index. These shares are not going to be reduced in numbers as a recession approaches or threatening news appears on the horizon (which can happen with holdings by typical institutional investors when they see the need to transition to a more bond-heavy mix of securities). The net effect would be one of added stability to the stock price during negative times. These shares held by the index funds reduce the availability of shares to buy, but demand for buying has not been reduced, and from a simple supply and demand standpoint, there will be added pressure for price appreciation as Tesla grows and the stock price inevitably rises with that growth.
As with Twitter, Tesla will likely gravitate toward the high end of stock price appreciation from inclusion in the index. Below is an explanation of why we come to that conclusion.
First, there’s the general volatility of Tesla’s stock (TSLA) to be considered. Next, figure in the effect on tens of millions of shares sold short, and finally consider the effect of TSLA’s very high ratio of outstanding option contracts compared to its number of shares.
A great contributor to the volatility of Tesla’s stock is the difficulty in assigning it a value. Tesla is presently growing at more than 50% per year, which makes determining a value on its present performance an exercise in gross underestimation. Thus, analysts figure theoretical profits that Tesla will be producing in a future year and then apply discounts to arrive at a present value of those future profits. Ask a short seller what Tesla will be worth a few years from now and a likely response would be “zero.” Ask a bullish investor, such as ARK Invest’s Catherine Wood, and you’ll receive an estimate as high as $4000 a share, depending upon whether Tesla is one of the first companies to achieve fully autonomous driving. That’s quite a range! Small changes in expectations through good or bad news can sway the public’s opinion greatly within this range, and so Tesla trading includes massive swings.
With short sellers holding more than 30 million shares of Tesla’s stock, there is typically a significant reaction when good news sends the stock price higher. In many stocks, shorts tend to enter positions when the stock is near a local high, when the stock price is most likely to be overvalued. They are then most likely to sell when the stock price is depressed and likely undervalued. This sell high/buy low strategy can be profitable and it adds a certain level of stability to the stock trading by buffering the climbing when the stock is heading too high too fast and providing a softer landing as the stock price approaches a likely bottom. Rather amazingly, Tesla shorts often do just the opposite. When TSLA is near a low and a new piece centered around fear, uncertainty, and doubt (FUD) comes out, new shorts pile into the stock, egged on by the “Tesla is a zero” mindset that suggests that the company is going to go bankrupt and you want to get in while there’s still some value left in the company. Inevitably, the stock price rises when the dire warnings fail to materialize and this new batch of short sellers takes a painful elevator ride upstairs until they either depart their positions on their own initiatives, are forced out through margin calls, or hold on with the hopes that a reversal is coming soon.
Tesla is presently at a price where any further increases yield additional margin calls for the shorts and higher numbers of shorts buying to close their positions, which reinforces more stock price increases and additional covering. Any sizeable positive catalyst to send the stock price higher only speeds up the processes of shorts buying to cover and that buying adding additional appreciation to the stock price. Inclusion in the S&P 500 index would definitely be such a catalyst.
Consider, too, the effect of huge numbers of outstanding options. While Tesla has about 172 million shares of stock issued, only about 127 million shares are actively traded (the float). Now, compare these 127 million shares with existing put and call options, which presently number more than 2 million contracts. Since each contract is for the equivalent of 100 shares, that’s the equivalent of more than 200 million shares of TSLA trading in options, a much higher number than the actual shares of Tesla being actively traded and a much higher percentage of options to shares than most other stocks. Tesla’s volatility is of course the reason why so many options are traded in its stock. These two types of securities, stocks and options, influence each other. The stock price movements determine which options win and which lose, naturally, but the system works the other way around, too. When Tesla’s stock moves higher, the brokerage houses that sold Tesla options hedge their bets by buying shares of TSLA in a process known as delta hedging. Thus, any rise in the stock price typically begets more rise as the delta hedging keeps the option sellers from exposing themselves to unnecessary risk.
Combine these three factors and you have an extremely volatile mixture. The lack of a clearly defined TSLA valuation sets the stage for great volatility.
When the stock price goes up, its upward movement is accentuated not only by short sellers buying shares to cover their positions, but also by the delta-hedge buying by the sellers of options. Each factor reinforces rather than opposes the movement of the other and you have what can be called a dynamically unstable situation.
Of course, all these factors work together in precisely the opposite direction when the stock price is heading downward, which is why a catalyst such as FUD can be so powerful for depressing the stock price. If you take a look at Tesla stock’s trading in 2018, you will see the stock routinely bouncing like a ping pong ball from one natural top (the upper Bollinger band) down to one natural bottom (the lower Bollinger band) and then repeating itself with these massive price swings.
The problem with short sellers just waiting for the next down cycle to cover is that a fundamental change has just occurred at Tesla: the company has entered what may well be a period of prolonged and persistent profitability. With such a fundamental change in character, many experienced traders expect the stock price to break out and rise above the recent trading ranges and establish itself as a company with a significantly higher priced stock. In other words, that expected reversal might not happen as the stock instead heads higher, possibly much higher.
If there are no big surprises in Tesla’s future, the timing for Tesla’s S&P 500 inclusion date can be roughly estimated as follows: The Standard and Poor’s 500 index looks for a net profit in a company’s most recent 4 quarters. Tesla’s losses in Q1 and Q2 of 2018 were significant enough that they are not likely to be cancelled out with Q3 and Q4 profits. Instead, it will be the Q1 2019 performance that will likely qualify Tesla for the index because one unprofitable quarter from 2018 will be dropped (Q1) and replaced with a more favorable quarter (Q1 of 2019) in the calculations. Thus, the math looks excellent for S&P 500 inclusion after the results of Q1 2019 are released in late April or early May.
Once those numbers are present, the S&P 500 decision-makers may take some time to determine which company will be exiting the index, but once that task is completed, we should hear of Tesla being included in the index. The market is forward looking, and you can expect some funds to be picking up TSLA early in order to avoid the higher cost of acquiring the stock right after the announcement, and of course speculators will do the same.
Tesla’s inclusion in the Standard & Poor’s 500 index during the first half of 2019 will only add to a growing list of the company’s accomplishments. Model 3 should have achieved a stable production rate at a noticeably higher number by that time, Model Y should be revealed, the significantly faster hardware for Tesla’s autopilot suite will be coming online, and we’ll see substantial progress with the Shanghai Gigafactory by then. All in all, the middle of 2019 should be an exciting time for Tesla owners and invest.
