$2 Zip Ties

Tesla is run by a visionary leader, Elon Musk, who is a graduate from the PayPal Mafia to start three companies that have billion dollar valuations. Solar City has a $6.5b valuation, it’s rumored that SpaceX is raising financing at a $10b valuation, and Tesla currently trades at a market cap of $32b.

Advancements in all three of these companies are very important to alternative energy innovation, models of energy efficiency and space exploration (for Space X the ability for relaunch of a rocket which would be needed to explore Mars) and a good thing for a more progressive society. There are three reasons that I believe Tesla stock is advancing at a pace that might be unsustainable and a sensible stakeholder should consider the following three items:

Resale Value Guarantees

In 2013 the Company began offering a resale value guarantee to all customers who purchased a Model S. Under the program the customer has the option of selling the vehicle back to the Company for a period of 36 months for a pre-determined resale value. It’s another quirky accounting method that allows the Company to gross up the balance sheet and then amortize both the sale and cost of sale over the 36 month period through lease accounting. The disparity between the asset and liability that will eventually need to be expensed through the income statement is currently ~$150m. This also resulted in a 2013 increase in a deferred revenue of ~$270m, and without this add-back the Company would have once again reported a negative cash flow from operations, which they have done since inception.

Patents

Musk recently announced that they were taking down the patents that sit on the wall of their lobby in Palo Alto. He praised their internal decision as a benefit to all car makers in the industry that Tesla wanted to encourage innovation for electric vehicle manufacturing to address the carbon crisis. While he is correct that there is a carbon crisis I think Musk failed to acknowledge or disclose that he needs the big car manufacturing companies to adopt the electric model to help build out the infrastructure (charging and super-charging stations) required for sustainability in the market place. Right now they are going at it alone and that is reflective in their free cash flow. As we pointed out earlier that without their one time accounting add-back for the Resale Value Guarantees they would have reported yet another negative cash flow from operations and that would have resulted in $250m or more in negative cash flow for each of the last three years. In the first half of 2014 alone the Company has reported negative cash flow in excess of $250m. Is the patent decision a sign of Musk’s true entrepreneurial spirit or a cry for help? The capital infrastructure is being funded by suspect investment banking convertible notes (http://www.sec.gov/Archives/edgar/data/1318605/000119312514084484/d686051dex101.htm) and not by internally generated free cash.

http://www.teslamotors.com/blog/all-our-patent-are-belong-you

Final Straw (or Zip Tie)

And Finally. The Company recently announced that they were extending their warranty on the Model S to eight years and infinite miles. Musk said that this should be viewed as the Companies belief that they produce the most reliable cars on the road but comes on the back of two negative consumer reports. Including one from Edmunds that had a very extensive list of services required over their 17 month test drive (worth a look in the review below, there are about 28 issues) resulting in a conclusion from Edmunds that it will be hard for them to recommend buying the car. The spin is on though over at Duetsche Bank who has a $310 price target on the stock that the cars will be recalled for a $2 zip tie to be installed on the drive train costing $400 per replacement. The estimate that if half of the Company’s 39,000 cars built to date require this warranty fix they will only take a $7-$9m hit to future earnings. The sensible thing to do would be to compare that thought process with how Musk is internalizing the reality of the Edmunds reports and what the real impact of future warranty costs might do to consumer demand without an all out infinite mile protective measure. That’s not a typo, the Duetsche analyst actually chalks up the 28 issues in the Edmunds report to a $2 zip tie.

http://www.edmunds.com/tesla/model-s/2013/long-term-road-test/wrap-up.html

A final note and food for thought

In Q2 2014 Tesla delivered 7,579 cars whereas GM delivered over 2.5m. Tesla has a market cap of $32b and GM has a market cap of $55b. Do the math.

Have another look at the picturesque story in the Edmunds report where the driver was able to stop off on the beautiful Highway 1 on the California coast and then think about being late to your kids soccer practice and in need of that charger. A successful electric car company is absolutely crucial to the carbon footprint crisis were are in, but the problem needs a Company like GM to address it.

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Netflix and the Usual Suspects

Netflix (NFLX) reported second quarter earnings last week. While Wall St. focused on their earnings per share I believe there are a few other items worth considering that go beyond their print of $1.15 per share – which puts them a shade under a price to earnings multiple of 100-1.

Usual Suspects

The usual suspects are out with their price targets on NFLX. Most recently JP Morgan came out with their price target of $500. I question the motives of a JP Morgan price target of a price to earnings ratio of ~115-1. The Company has shown growth slow down dramatically with quarter over quarter revenue slowing to 5% growth. The Company has accumulated negative free cash flow over the last 2.5 years of $65m. I believe free cash flow is an important metric for an equity stakeholder to show a pathway to an actual return on investment.

I suspect that JP Morgan has ulterior motives in their $500 price target. Could it be that they want to maintain a good standing with the Company to generate significant fees and commissions for their investment banking division? Look no further than the recent bond offering led by JP Morgan and Morgan Stanley (the Usual Suspects). There was a recent case where Morgan Stanley issued bonds to Tesla Motors. It has been reported that Tesla requested to be indemnified from a “smoking gun” email related to the pumping of Tesla’s stock price target by Morgan Stanley in front of this bond offering. The inherent relationship conflict of investment banker and sell side analyst is very evident here with both of the Usual Suspects.

http://www.sec.gov/Archives/edgar/data/1065280/000119312514037000/d671121dex101.htm

http://www.teslamotors.com/fr_CA/forum/forums/morgan-stanley-upgrades-stock-then-underwrites-convertible-offering

At least a common stakeholder should be able to call into a quarterly meeting and ask about any such conflict of interest or maybe get some insights onto how the Company views their negative cumulative free cash flow. Or can they? I tried to dial-in to their most recent investor call only to find it being held on YouTube with two investment banking moderators lofting up softballs to management. Odds that one of the two was an investment banker representing the Usual Suspects….

GAAP

Since I didn’t have a chance to ask management on their investor call about a few accounting questions that a sensible stakeholder may have – I decided to outline a potential accounting issue here. NFLX has become a streaming content delivery service. As such, a streaming content obligation is incurred at the time a Company signs a license agreement to obtain future titles. Once a title becomes available a content liability and corresponding asset are recorded on the balance sheet. The Company then amortizes the cost of this content using management estimates as to when the viewer will actually be viewing the show. A quick example is NFLX licensing the content rights to Breaking Bad from AMC. A streaming content obligation is incurred when the Company signs the rights from AMC. When they make Season 1 available they book the cost of that to the balance sheet and then amortize it over the estimated period for which the customer will watch the show, to match the revenue coming in from the customer with the expense of them watching Season 1. The content library is stated at the lower of cost or net realizable value. As of their latest reporting period the Company reported a content library asset of $4.1b and a content library liability of $3.2b. The company will have to credit their asset account and debit an expense account to true up managements estimate and this will have a negative impact on earnings, possible to the tune of $900m. The sheer nature of the accounting treatment being used where management uses such estimates should cause a sensible stakeholder to ask some questions.

Supplier Holdup

Lastly, the business model of NFLX as an over-the-top (OTT) service provider, should be discussed in the context of justifying a price to earnings ratio for where the stock trades today. NFLX is subject to Supplier Holdup as a majority of their content is obtained from a supplier. NFLX serves as the middle man between the content producer and the consumer. Also notable in the recent JP Morgan $500 price target report was the hype around licensing of Smurfs 2. While I don’t claim to know much about the Smurfs series I can suggest that their parent company, Sony Entertainment, can “holdup” the Company through content acquisition cost increases. By all means, since NFLX is simply pushing the content over the internet for free*, Sony Entertainment could simply choose to do it themselves, increase their pricing regime or distribute through another OTT offering (https://www.google.com/webhp?sourceid=chrome-instant&ion=1&espv=2&ie=UTF-8#q=smurfs+2+streaming). Supplier Holdup is a complicated topic but is covered in a recent blog post by Tren Griffin who understand the issue well:

http://25iq.com/2013/06/12/wholesale-transfer-pricing-and-the-free-parking-business-model/

*OTT at this scale isn’t truly free and a lot of people point to net neutrality as a benefit to NFLX. While they to have some OTT benefits, when you use 35% of internet capacity as NFLX does, you will have to pay interconnect and peering fees.

Netflix is a revolutionary company and will likely be viewed from a historical perspective as the Company that helped break up the bundling in the television market. I am just not sure that a Sensible Stakeholder would want to own the stock given the items outlined above.