The 'secret' reason to sell Tesla now

Forget about videos of car fires. Here's a little-known but much bigger threat to the automaker's bottom line.

By StreetAuthority Nov 5, 2013 4:34PM
Tesla Motors CEO Elon Musk drives a Model S at the Tesla factory in Fremont, Calif. on October 1, 2011 (© Stephen Lam/Newscom/Reuters)By Joseph Hogue                                                            

Everybody loves a lottery ticket. People will weekly put down their hard-earned money for a 1-in-175 million chance of being rich.

And that is the kind of fervor that has driven shares of Tesla Motors (TSLA) up more than 450% over the past year. Sure, the automaker is increasing production and profits are increasing, but there is nothing that can explain the surge in the stock price like good old-fashioned irrational exuberance.

For investors who got in at the ground floor in 2010, congratulations. For those that have recently bought into the shares and are hoping on another quadrupling, you may want to read on.

You thought the car fire was bad
Shares of the $19.6 billion company tumbled 10% in the two days after an Oct. 1 video showed a Model S on fire in California. CEO Elon Musk eventually identified the cause of the fire as a loose piece of metal from a passing truck that punctured the car's battery. The National Highway Traffic Safety Administration has said it will not investigate the incident, but shares of TSLA still have not recovered to their pre-video high.

Worse than the car fire, however, is the possibility that Tesla may soon see much of its gross profits go up in smoke.

Bloomberg West recently reported that the California Air Resource Board is re-evaluating its assignment of tax credits for zero-emission vehicles. These tax credits are given to automakers for each year to incentivize production of environmentally friendly vehicles that might otherwise not be profitable. The companies can then sell these credits or use them against their own taxes.

Tesla receives seven zero-emission vehicle credits for every car it sells and depends on those credits for almost two-thirds of its gross profits. At least three of those credits are tied to the ability to swap out the battery in its cars. The problem is that there are no battery-swapping stations available, and the California resource board is considering a change to its credit policy.

The fact that there are no battery-switching stations available for owners of Tesla cars means the credits are not fulfilling their intended purpose of industry change. One member of the California board noted that the credits are not intended as a "hypothetical" incentive, meaning that companies should not receive the credit if the batteries could potentially be swapped if there were the necessary infrastructure.

With a net loss of $152 million over the past four quarters, TSLA is grossly overvalued at 15.9 times sales. Remove a large portion of gross profits, and the sentiment in the shares could crash.

The California board delayed an announcement in October but said that a decision would be made by the end of the year, after which a 45-day public comment period would follow. Tesla management has said that the company can operate without the credits. That may be true, but an immediate loss of 25% to 60% of gross profits will certainly affect financials and stock sentiment.

I see the potential for a steep sell-off on any bad news. Even if the California board does not come down against the credits, the valuation in the shares does not leave much room for further gains. The risk-reward trade-off means investors are not being compensated for the possibility of a big drop.

Best-case scenario: Not good
The best outcome for Tesla would be if the resource board extended the current credit environment, presumably on the hope that battery-swapping stations would eventually be built. This means no sudden drop in profits for the company and possibly consensus estimates for earnings.

The Street estimate is for sales of $3.1 billion in 2014 sales and earnings of $1.72 per share. This represents a 37% increase in sales and a doubling of the company's profit margin to 7% from 3.5% in the previous year.

By comparison, Ford (F) has a margin of 4.4% and General Motors (GM) is able to eke out just a 2.9% profit margin. This would all be a pretty amazing feat but would still leave the shares valued at 94 times earnings.

But wait, it gets worse. At the end of last year, the company had 25 million stock options outstanding, with almost half (11.2 million) exercisable this year and the rest exercisable over the next couple of years. The highest exercise price on the options is $36.01, so they are likely to be exercised, diluting existing shareholders by nearly 17%.

Adding in the new shares, the company has to make 40% annual sales growth and maintain margins twice as high as competitors for the next several years just to justify its share price. At 2018 sales of $11.6 billion and earnings of $5.54, the shares would still cost a hefty 29 times trailing earnings, compared with an industry average of 14 times.

That is five years of everything going right -- and the shares would still be pricey.

Now if you consider what happens if the California Air Resource Board eliminates three of the seven tax credits that the company depends on, then you start to see how the whole thing could just fall apart.

Risks to consider: Shares are already down 13% from their high, but the stock has continually confounded the bears with new highs. The long-term upside to the company and its product may eventually justify the stock price, but I would not worry about missing out on upside for at least the rest of the year.

Action to take: Shares of Tesla have increased almost fivefold over the last year and trade at an eye-popping valuation. Whether the company loses any of its tax credits or not, investors may want to consider taking profits and avoiding the shares.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority
Nov 5, 2013 5:15PM

My only comment it is just amazing for state or federal government to act so quickly on some things and at a snails pace on others.

Look at NY it took over 10 YEARS to get past all the obstacles for constructing the replacement building for the Twin Towers.

Just goes to show if  governments truly wants to make changes they can do it in a damn short hurry.

Nov 6, 2013 3:11PM

Tesla is inflated by Obama using colluded  middlemen that get loans with no collateral from bailed out banks because owner is financial supporter of Obama.Also tesla has tax deduction for wealthy people

that buy tesla cars and zero emission carbon credits that should not because electricity in USA is 66% produced with coal and natural gas.also  li-ion batteries loose charge with time so they are not too efficient.Battery technology is still primitive but when battery charge density improves like 2 to 5 times from now big auto will massive produce ev and tesla wont be able to compete with production is scale economy industry .the bigger the lower your cost.Tesla is priced now as if it sells 2 million cars a year and with a profit of 1.5 billion a year.,reality is it sells less than 100k and zero profit so price must be $20 for all  possible growth

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