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Tesla Bankruptcy Chances Increased Exponentially With The Capital Raise

March 20, 2017


 - Tesla communicated Model 3 ramp to investors ahead of the capital raise has disastrous consequences.


- The small raise means Tesla will run out of money during a bad Model 3 ramp and make it difficult to get future raises on advantageous terms.


 - On the current path, we believe there is a better than 50% chance Tesla will be reorganized in the next 12 to 24 months.


"If you think your IQ is 160 but it's 150, you're a disaster. It's much better to have a 130 IQ and think it's 120." - Charlie Munger



In a stunning call with investors, Elon Musk, Chairman of Tesla (NASDAQ:TSLA) apparently communicated to investors that the company expects to have first cars with largely production tooling in about 1 to 2 weeks. Setting aside any Reg FD issues, we believe that this call, along with the size of the planned capital raise has fundamentally changed the risk profile of Tesla.


According to Mr. Musk, based on its experience with Model S and Model X, the company is going to skip the beta testing phase and jump straight to "release candidates". Musk believes Tesla can do this because of "advanced analytical techniques". These techniques, Mr. Musk believes, have made the Model 3 design significantly higher quality compared to Model S and Model X.


The company apparently is focused on production tools and process to quickly ramp Model 3 manufacturing.


Because Model 3 was designed for manufacturability, the company believes that it can skip through key steps in traditional automotive testing process. The company expects to directly move to "Release Candidates" and start manufacturing products in the July/August timeframe.


Based on Musk talk, one would think that automobile manufacturers with much better reputation would also skip past beta testing phase and get to market more rapidly. But, as you can see from Toyota, that is not the case. New cars need to go through intense reliability and life time testing before they become production worthy.


If Toyota, which tops the charts on reliability and durability, needs to test then what makes a company like Tesla with sub-par reputation in reliability and serviceability think that they can skip testing and go straight to production?


We suggest two answers: staggering ignorance and hubris.


Mr. Musk, with his software background, appears to have recently learnt the concept of Design for Manufacturability and has been throwing around this buzz phrase a lot lately. But, this is a very old concept for anyone who has been involved with manufacturing for any length of time. The DFM concept is many decades old and has been augmented by various other concepts such as Design for Testability, Design for Reliability, Design for Durability, and Design for Serviceability. Based on how Tesla builds its cars, we would not be surprised if Tesla management is not even aware of these concepts. Proof of Tesla's subpar record can easily be found in the poor serviceability and reliability ratings that Tesla vehicles have gotten over the years.


What Tesla management also does not seem to realize is that, in manufactured products, the cost to fix an error increases by about an order of magnitude at each step of the product life cycle. Evidence exists in many different industries that if an error caught at concept phase costs about $0.10 per unit to fix, then:


- An error caught in the design phase could cost about $1 per unit to fix

- An error caught in the test phase could cost about $10 per unit to fix

- An error caught in the production phase could cost about $100 per unit to fix

- And, finally, an error in the field could cost $1,000 per unit to fix.


To avoid catastrophic losses and to improve ROI, manufacturers use many different methodologies to catch the errors early in the process. While manufacturers strive to address as many problems as possible in the design phase, for complex products, it is impossible to catch all the errors in design phase.


Beta testing (also referred by other names) is the phase where manufacturers make rigorous attempts to find the problems with their designs. This is the stage where manufacturers do extensive all weather, accelerated lifetime testing on newly minted products to work out the kinks. Vehicles are put through thousands of hours and tens, if not hundreds of thousands of miles, of abuse to identify problems. This beta process typically takes about a year for new automobiles.


Let's look at Tesla's schedule. Let's assume that Tesla builds these bogus "release candidates" one to two weeks from now. Let's further assume that the company immediately starts testing the vehicles effective April 1st. This will leave Tesla with three full months of testing - April, May, June - before the first set of Tesla Model 3 production kits start showing up at the factory. Can Tesla catch the problems in April/May/June and switch parts out if it finds problems and re-order the parts in time for the first production cars? We doubt it.


This is more so for Tesla because Tesla lacks extensive product testing grounds that the larger players have access to. If anything, to get to test to the same extreme limits, Tesla would have to test its products longer than its peers to make up for this disadvantage. If not, Tesla products will be at a disadvantage in the form of lower reliability and durability.


We are skeptical that Tesla can reach an acceptable quality level, let along world class quality level, well in to 2018.


Longs who believe Tesla can achieve its production schedule should consider the following:

- Tesla Model S, multiple years in to production, still has middling reliability and there are customers still complaining of problems even on the newly minted 2017 vehicles. If this is the status with a car that has been in production for years, where is the evidence that gives Tesla any confidence that it can cut out the beta testing phase?


- Consider that 4 out of past 5 quarters the company cited a manufacturing problem of one kind of another to justify missing guidance. All of this on mature Model S (and in some cases the newer and less robust Model X). Why will the company have a better track record with a brand-new Model 3 design?


- Tesla has still not delivered functional AP 2.0 software product that was announced in October and promised for December. We are skeptical that AP 2.0 will meet the company's specs this quarter or even the next quarter. Why should the investors trust that the "analytics" of Tesla will enable a car that can completely skip testing?


- The company has been in perennial beta on AP 1.0 until that feature was discontinues in favor of AP2.0. Can Tesla get the current Model 3 past beta stage or will it have to discontinue the product before it ever reaches production?


Based on the above, and the many missed benchmarks by Tesla over the years, does it sound like this company is ready to manufacture a high-volume car? That too by skipping a phase of testing?

We do not believe so.


To the extent that there are investors who still think a bet on Mr. Musk makes sense in spite of the overwhelming evidence to the contrary, consider this additional point:


- This is not just a bet on Tesla but the entire supply chain. Automotive industry is filled with stories of suppliers not coming through. Most stories never make it to consumers but some make big headlines due to high profile recalls. Ever heard of Takata air bag recall? Takata seatbelt recall? Toyota floor mat recall? Ford Transmission recall of 1980? Ford ignition switch recall? GM ignition switch recall? These problems occurred in spite of extensive testing.


Let's say, on the path to a glorious failure, the untested Model 3 is going to be built and shipped to customers. Who are these customers?


In the early stages, per Tesla guidance, these will be Tesla employees. Effectively, Tesla is taking its early purchasers, i.e. Tesla employees, for suckers, for guinea pigs. It is one thing to pawn off Model 3 kind of buggy expensive experimental product off to high profile Tesla investors but do the more middle class Tesla employees need to be subjected to this kind of experiment?


Let's set aside the employees. What does this type of testing schedule mean to Tesla and investors?


We submit that the chance of the so called "advanced analytical techniques" catching all the problems is "0" and there are only two likely outcomes from this Model 3 manufacturing adventure:


- Tesla will put a buggy model 3 out that will swamp Tesla infrastructure and create humongous losses and customer issues leading to massive capital needs to fix the problems. Some problems could even necessitate new tooling which can lead to massive delays. All of this will lead to heavy stockholder dilution or even a Chapter 11.


- Tesla will put a buggy Model 3 out that will lead to injuries and deaths on the road leading to even bigger problems including recalls, lawsuits, and possibly a Chapter 7 for the company.


In a hypothetical case, let's imagine a big problem is identified in the second quarter of ramp that requires a production halt. Tesla could be in a situation where it reached a run rate of 5,000 cars per week. If production must be halted for a quarter, this could easily be a $2B working capital problem. On top of that, imagine the field repairs to all the cars already sold.


The risk that Tesla is taking here by skipping a testing stage is huge and the chance of success with the approach Tesla is taking is next to nil. With the approach articulated by Mr. Musk, we are not really talking about chances of success but gradations of failure.


In this context, the very small raise that Tesla is about to wrap up becomes very significant. By not raising enough money when it can, the company is exposing itself to have to go back to capital markets when the whole world (except for a few diehard fans) gets to know that there are serious problems with Model 3 ramp.


These problems could have been more limited with extensive testing and a slower ramp. But, that is not the path Tesla is choosing.


The faster the company ramps, the bigger the capital needs and the less a chance of recovery. It is because of these reasons the we now believe that Tesla is better than 50% probability candidate for bankruptcy in the next 12 to 24 months.


We expect to start seeing a rush for the exits rapidly as the Model 3 ramp fiasco unfolds.

Given the risk profile, why professional money managers are long this stock is a mystery.



Based on the events surround the capital raise, here are our predictions about Tesla:


- We expect Model 3 deposit holders to start running away from Tesla in droves as Tesla's testing methodology becomes more widely known. Who would like to pay $40K+ for a product that is 99%+ chance of being a lemon? And if a reservation holder is at the back of the line, there is not much of a chance that they will even get their $1000 deposit back in a Chapter 11.


- We predict that Tesla has a better than 50% chance of being reorganized in a Chapter 11 in the next 12 to 24 months.



Our View: Sell Short

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