Stanphyl Capital letter to investors for the month ended June 30, 2020, discussing their short thesis for Tesla Inc (NASDAQ:TSLA) and other positions in several small-cap stocks.
For June 2020 the fund was down 3.9% net of all fees and expenses. By way of comparison, the S&P 500 was up 2.0% while the Russell 2000 was up 3.5%. Year-to-date 2020 the fund is down 7.0% while the S&P 500 is down 3.1% and the Russell 2000 is down 13.0%. Since inception on June 1, 2011 the fund is up 43.0% net while the S&P 500 is up 178.6% and the Russell 2000 is up 93.0%. Since inception the fund has compounded at 4.0% net annually vs 11.9% for the S&P 500 and 7.5% for the Russell 2000. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends. The fund’s performance results are approximate; investors will receive exact figures from the outside administrator within a week or two. Please note that individual partners’ returns will vary in accordance with their high-water marks.)
Our strategy during this economic depression is simple: own stocks that are cheap (typically on an EV-to-revenue basis) with great balance sheets and that are turnaround and/or acquisition candidates, and hedge that exposure by being short the very expensive Nasdaq 100 (via a short position in the QQQ ETF). Last month that strategy worked well; this month, poorly. Without that short hedge (and our relatively small Tesla short) the fund would have been up in June, but I refuse to be “naked long” one of the most overvalued stock markets in history as the economy enters a multi-year depression.
Those of you who think extremely low interest rates will put a floor under stocks despite the current no-growth environment may want to have a look at this paper from Verdad Capital, covering the 20 years since Japan’s BOJ initiated a zero interest rate policy. You’ll notice that despite those low rates there have been multiple massive draw-downs in stock prices, and that the best performing equity class by far was “small-cap value.” We’re well-positioned for both those events.
COVID-19 will have a terrible economic impact for several years, initially via altered behavior (crowd & travel avoidance) leaving the world in a severely depressed economy until there’s a vaccine widely available (hopefully in 12-18 months), followed by a still weak economy (relative to 2019) for a couple of years after that as the confidence necessary to start or expand businesses is slowly regained.
I thus wouldn’t want to own any business that’s overly consumer-facing or real estate-related (restaurants, theaters, etc. can’t make money if “social distancing” caps their capacity at 50%); instead we hold cheaply priced stocks involved with technology upgrade cycles that will happen regardless of how “the consumer” is doing—in fact, some of these companies (due to the 5G upgrade cycle) may benefit from the increased bandwidth requirements of working remotely, while others may do “just okay” but we’re buying them cheaply enough that (as noted above) I think they make terrific strategic acquisition targets in a world starved of “organic” growth.
Stanphyl's Portflio Holdings
Here then are the fund’s specific positions; please note that we may add to or reduce position sizes as stocks approach or recede from our target prices…
We continue to own Aviat Networks, Inc. (NASDAQ:AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in May reported a terrific Q3 for FY 2020, with revenue up nearly 14% year-over-year and a significant improvement in gross margin and operating earnings, as well as a reiteration of full-year guidance and expectations for growth in FY 2021 (beginning July). In January Aviat’s board (controlled by activist investor Warren Lichtenstein) appointed a new CEO and the accompanying press release made it quite clear (based on his experience) that he was brought in to dress up the company and get it sold. Aviat’s closest pure-play competitor Ceragon (CRNT) sells at an EV of approximately 0.6x revenue. If we assume $240 million in run-rate revenue for Aviat, $30 million of net cash and a $10 million valuation on a combination of $400 million of U.S. NOLs, $8 million of U.S. tax credit carryforwards, $212 million of foreign NOLs and $2 million of foreign tax credit carryforwards, we get an acquisition valuation of 0.6 x $240 million = $144 million + $30 million net cash + $10 million for the NOLs = $184 million divided by 5.4 million shares = $34/share.
We continue to own Data I/O Corporation (DAIO), a manufacturer of semiconductor programming devices. (Here’s a great recent overview published in Seeking Alpha.) We previously owned this stock in 2016 when we bought it in the $2s and sold it a year later in the $4s and $5s (it eventually ran to the $16s before collapsing, as it got way ahead of itself as new holders failed to account for its cyclicality), and now we’ve repurchased it in the $2s for another run. In 2019 (a year that without COVID would have marked a cyclical low for the company), DAIO did $21.6 million in revenue with a 58% gross margin. In April it reported its first COVID-19 affected quarter (Q1 2020), in which it did $4.8 million in revenue (still with a 58% gross margin) and ended the quarter with $13.8 million in cash and no debt. Using 2019’s revenue and valuing DAIO at 2x that cyclically low figure (this company is much more levered to customer technology cycles than economic cycles), then adding in $13 million of cash (after assuming $800,000 of COVID-related burn) makes this stock worth over $6.80/share.
We continue to own Amtech Systems, Inc. (ASYS), a manufacturer of semiconductor production and automation systems. Amtech recently sold its unprofitable solar divisions and is now a 38% gross margin company that does around $80 million a year in normalized (ex-COVID problems) revenue with around $4 million a year in operating income (again, ex-COVID) and around $44 million in net cash and over $80 million in NOLs. If we subtract $1 million from Amtech’s cash to account for two more quarters of “COVID hit,” then value the company at 1.5x revenue with $8 million for the NOLs, we get fair value of around $12/share. The biggest risk here (other than underestimating “the COVID effect”) is that management—which *is* acquisitive—blows that cash pile on something stupid!
We continue to own Westell Technologies Inc. (WSTL), a manufacturer of proprietary networking hardware products (here’s its latest corporate overview) which in June reported yet another lousy quarter, in this case Q4 of FY 2020 ending March 31st, with COVID-affected revenue down 14% sequentially and 36% (!) year-over-year. However, with $21.5 million in cash (estimated as of June 30th and inclusive of a forgivable $1.6 million PPP loan) and no debt, Westell has over five years of remaining cash runway to grow revenue and return to break-even (it’s projecting to do so in calendar year 2021), and obviously much more than that if it cuts the burn along the way. We continue to own Westell because it’s a $25 million/year, 33% gross margin business with an estimated $1.35/share in net cash that currently sells for a severely negative enterprise value. Assuming 15.81 million shares, an acquisition price (by a cost-eliminating strategic buyer) of just 0.5x revenue would (on an EV basis) be over $2/share. Preventing such an acquisition is that Westell suffers from a dual share class, with voting control held by moronic descendants of the founder who refuse to sell the company despite the stock’s horrible performance. However, I’m hopeful that someone will knock enough sense into their small brains to inspire them to salvage what’s left here, and thus walk away with at least something from what they’ve squandered. If they do the stock should be at least a double from here, and possibly more. In other words, it’s too cheap for me to sell but the board is too incompetent for me to buy more.
We continue to own Evolving Systems, Inc. (EVOL), a small telecom services marketing company that generates nearly $1 million/year in free cash flow on $26 million of 65% gross margin revenue. This company would make a great buy for a strategic acquirer, as $1.5 million/year in savings from eliminating the C-suite and cost of being a standalone public company would mean around $2.5 million/year in free cash flow. Thus, at an acquisition price of just $2/share (a nearly 100% premium to the current price) a buyer would be paying only around 10x free cash flow and 1x revenue. Also, management made clear on the May conference call that Evolving has been relatively unaffected by COVID-19 as it was already a highly decentralized business; thus the virus impact will be to draw out the sales cycle for new contacts, but shouldn’t affect revenue from existing ones.
We continue to own Communications Systems, Inc. (NASDAQ:JCS), an IOT (“Internet of Things”) and internet connectivity & services company (here’s the latest corporate overview), which in April reported a COVID-affected Q1 with revenue down 18% year-over-year (roughly in line with my expectations). Normalized (ex-COVID) run-rate revenue for this company is around $47 million a year (inclusive of $3 million from a small acquisition announced in May) with a gross margin in the low-to-mid 40%s. If we value JCS at 0.8x normalized revenue plus its $27 million of net cash (inclusive of the $4 million spent for the May acquisition and just under $1 million spent for a May partnership investment) and assume 9.3 million shares, we derive fair value of around $7/share. The company also pays a .02/share quarterly dividend and is in contract to sell its headquarters building for $10 million which, if it closes late this year or early next, will add another $1.07/share in cash to the balance sheet.
Finally on the long side, as central banks increase their money-printing to ever higher levels in order to fund multi-trillion-dollar annual deficits, we continue to hold a substantial long position in the gold ETF (GLD).
Tesla Short Thesis
We remain short Tesla Inc. (TSLA), which I still consider to be the biggest single stock bubble in this whole bubble market. The core points of our Tesla short thesis are:
Tesla has no “moat” of any kind; i.e., nothing meaningfully proprietary in terms of electric car technology, while existing automakers—unlike Tesla—have a decades-long “experience moat” of knowing how to mass-produce, distribute and service high-quality cars consistently and profitably, as well as the ability to subsidize losses on electric cars with profits from their conventional cars.
In 2020 Tesla will again lose money, as it has every year in its 17-year existence.
Tesla is now a “busted growth story”; revenue growth is flatlining while unit demand for its cars is only being maintained via price cutting.
In June, courtesy of Business Insider, we once again learned how much of a sociopath Elon Musk is:
Then, courtesy of J.D. Power, we again learned about the atrocious quality of Tesla’s cars; it ranked dead last of 31 brands surveyed:
And here’s a great graphic from Twitter user @clausMller17 clearly demonstrating Tesla’s blatantly fraudulent EPA range claims for its cars:
And as @TeslaCharts points out on Twitter, Tesla is no longer even a growth company:
In May, faced with a shortage of demand in an increasingly competitive (see the many links below) electric car environment during an economic depression, Tesla cut prices across the board. Nothing’s more amusing than seeing this giant stock promotion of a company continue to add capacity (expanding its Chinese factory while supposedly breaking ground on brand new factories in Texas and Germany) in order to desperately try to maintain an image of “limitless demand” as it continually slashes prices to unprofitable levels (excluding its unsustainable emission credit sales and accounting fraud) just to utilize its existing capacity.
In April Tesla reported $16M in Q1 “earnings” thanks entirely to the sale of $354M in 100% margin emission credits that disappear after next year when other automakers no longer need to buy them as they’ll have enough EVs of their own. Additionally, Tesla’s earnings are typically inflated by around $200M/quarter from its ongoing warranty fraud (here’s an excellent Seeking Alpha article and another one in Fortune explaining some of this), so adjusted for these two factors the company would have lost over $500M in Q1, while free cash flow was minus $895M. This is not a viable business.
In addition to the typcial quarterly warranty reserve fraud, Musk may generate a Q2 profit by recognizing part of $600 million in non-cash (it’s already on the balance sheet) deferred revenue from its fraudulently named “Full Self-Driving” (the capabilities of which offer nothing of the kind), thereby turning yet another a money-losing quarter into one showing paper profits. Meanwhile, God only knows how many more people this monstrosity unleashed on public roads will kill, despite February’s NTSB hearing condemning it as dangerous.)
Meanwhile, a terrific chart from Twitter user @fly4dat illustrates how Tesla’s EV market share (the pink line below) in Europe (the world’s most competitive EV market) continues to erode as new competition arrives; this foreshadows what will soon happen to Tesla worldwide:
And for those of you looking for a resumption of growth from Tesla’s upcoming Model Y, demand for that car is reportedly disastrous. This is unsurprising, as it will both massively cannibalize sales of the Model 3 sedan and (later this year and in 2021) face superior competition from the much nicer electric Audi Q4 e-tron, BMW iX3 (in Europe & China), Mercedes EQB, Volvo XC40 and Volkswagen ID.4, while less expensive and available now are the excellent new all-electric Hyundai Kona and Kia Niro, extremely well reviewed small crossovers with an EPA range of 258 miles for the Hyundai and 238 miles for the Kia, at prices of under $30,000 inclusive of the $7500 U.S. tax credit. Meanwhile, the Model 3 will have terrific direct “sedan competition” later this year from Volvo’s beautiful new Polestar 2, the BMW i4 and the premium version of Volkswagen’s ID.3.
And if you think China is the secret to the resumption of Tesla’s growth, let’s put that market in perspective even without the coronavirus problem: prior to a recent 10% sales tax exemption Tesla was selling around 30,000 Model 3s a year there, and “the story” is that avoiding the 15% tariff and that 10% sales tax will allow it to sell a lot more. There’s also a $3600 EV incentive available (which will be reduced over the next two years), but China just cut to 300,000 yuan the maximum price allowed for an EV to get it; Tesla is thus slashing its Model 3 price from 323,000 yuan to qualify and will now make little-to-nothing on the car, and thus all volume increases will be profitless. Meanwhile the rule of thumb for the elasticity of auto pricing is that every 1% price cut results in a sales increase of up to 2.4%. If we assume a 2.4x “elasticity multiplier,” domestically produced Model 3s that are 40% cheaper (than the original price at the 30,000/year sales rate) would result in annual sales of just 59,000 (40% x 2.4 = 96% more than the previous 30,000), meaning Tesla’s new Chinese factory would be a massive money-loser vs. its initial 150,000-unit annual capacity and the 500,000/year capacity it will supposedly have in 2021. Even if we were to increase the previous sales rate by 150% to 75,000 cars a year, it would be massively disappointing for Tesla bulls and the factory will be a huge money-loser.
Meanwhile, sales of Tesla’s highest-margin cars (the Models S&X) will be down by over 50% worldwide this year vs. their 2018 peak, thanks to cannibalization from the less expensive Model 3 and direct high-end competition (especially in Europe and China) from the Audi e-tron, Jaguar I-Pace, Mercedes EQC and Porsche Taycan, with multiple additional electric Audis, Mercedes and Porsches to follow, many at starting prices considerably below those of the high-end Teslas. (See the links below for more details.)
Meanwhile, Tesla has the most executive departures I’ve ever seen from any company, including in June its VP of Business Development; here’s the astounding full list of escapees. These people aren’t leaving because things are going great (or even passably) at Tesla; rather, they’re likely leaving because Musk is either an outright crook or the world’s biggest jerk to work for (or both). And in January Aaron Greenspan of @PlainSite published a terrific treatise on the long history of Tesla fraud; please read it!
In May Consumer Reports completely eviscerated the safety of Tesla’s so-called “Autopilot” system; in fact, Teslas have far more pro rata (i.e., relative to the number sold) deadly incidents than other comparable new luxury cars; here’s a link to those that have been made public. Meanwhile Consumer Report’s annual auto reliability survey ranks Tesla 23rd out of 30 brands (and that’s with many stockholder/owners undoubtedly underreporting their problems—the real number is almost certainly much worse), and the number of lawsuits of all types against the company continues to escalate-- there are now over 800 including one proving blatant fraud by Musk in the SolarCity buyout (if you want to be really entertained, read his deposition!).
So here is Tesla’s competition in cars (note: these links are regularly updated)…
AUDI E-TRON GT FIRST DRIVE: LOOK OUT, TESLA (available 2020)
GM & Honda to Jointly Develop Next-Generation Honda EVs Powered by GM Ultium Batteries
And in China…
Here’s Tesla’s competition in autonomous driving…
Here’s where Tesla’s competition will get its battery cells…
Panasonic (making deals with multiple automakers)
Northvolt (backed by VW & BMW)
Most car makers will use those battery cells to manufacture their own packs. Here are some examples:
Here’s Tesla’s competition in charging networks…
And here’s Tesla’s competition in storage batteries…
So in summary, Tesla is about to face a huge onslaught of competition with a market cap approximately 2.5x that of Ford, GM and Fiat Chrysler combined, despite selling around 400,000 cars a year while Ford, GM and Fiat-Chrysler sell 5.4 million, 7.7 million and 4.4 million vehicles respectively. Thus, this cash-burning Musk vanity project is worth vastly less than its $200 billion market cap and—thanks to nearly $30 billion in debt, purchase and lease obligations—may eventually be worth “zero.”
Thanks and stay healthy,