Jim Chanos Talks Tesla and Kidney Dialysis

I’m a great admirer of Chanos and I always try to learn something when I hear him speak. Here, an inter interview produced by Bloomberg. Two of the topics discussed, among others, were Tesla and the kidney dialysis industry.

To watch the interview, click here.

Below, two parts of the interview, the first one with a few words from Jim Chanos on the kidney dialysis industry (emphasis added).

*THE KIDNEY DIALYSIS INDUSTRY*

[12:45] Joe Weisenthal: Alright, to move it back from politics and theory for a second, I noticed you said there in your answer that you’re focused on some companies that may be in trouble with the potential rollback of the essential health care benefits. So, can you give us some insight into some specifics? Who’s vulnerable to a theoretical rollback there?

Jim Chanos: One area we would really focus in on, there’s only a handful public place, is the kidney dialysis business. I think that business is really heading for difficulties.

JW: Oh, we have a chart here of some different public companies…

JC: Oh, what a coincident.

JW: …in kidney dialysis. Amazing how that happened.

JC: There’s three of them, and I should say here that any companies that you either see a chart of or I mention, either intentionally or inadvertedly, you should assume that we are short that stock. Disclosure now done. And so, the kidney dialysis business is interesting because we have Obama care exchange insurance officials on record saying that kidney dialysis is almost single-handedly breaking the exchanges. Blue Cross of California has said that for every single kidney dialysis patient they have, they need 3,800 healthy lives to cover it. It is amazingly expensive, but not in the way you would think. In the way these companies have prospered, in a weird way, is they’re actually trying to push Medicare and Medicaid patients – where the reimbursement is much lower – into Obama care, and where they get two to three times the reimbursement rate, and under the essential health benefits factor, they gotta provide it. And so, taking an elderly person who’s on Medicare, why would they go into Obama care, right? It would costs them, an elderly person, a fair amount of money. Well, they get third parties to pay a big chunk of the premium, the former charities. And guess who donates to some of those charities? And so this is one of these sort of rent-seeking behaviours that I think is gonna go by the wayside. And I think these excess returns… one of those companies that you had up there actually has a slide in their investor dec that said 90% of their business is Medicare/Medicaid and that loses money. Ten percent of their business is commercial and that makes a 110% of their operating profit.

JW. So everybody can go search for that…

JC: Yeah, they can go search for one of those three companies. I think they quite figure it out.

Scarlet Fu: So has that gained momentum? Do you hear other people pressing the company on that? How that doesn’t seem to make sense?

JC: Well, there was a wonderful… I can’t mention networks, I know it’s no good on Bloomberg. But there was a wonderful Sunday night weekly news show on a cable network, chaired by a British guy, that actually did a 15 minutes segment about one of these companies about a month ago, and we were stunned when we saw it. We had no idea that anybody else cared. But they did a pretty good job at walking you through exactly what an issue this is.

So for all investors out there interested in the kidney dialysis industry, and for example DaVita Healthcare Partners (Ticker: DVA), a Berkshire stock investment, this might be something to dig deeper into to see whether Jim Chanos and his Kynikos is on to something here or not.

Following the chat about the kidney dialysis business is a discussion about Tesla, a company Jim Chanos has been talking about publicly before.

*THE TESLA AUTOMOBILE*

[15:49] SF: Let’s move on to another company that you have spoken publicly about which is Tesla. And as I imagined…

JC: Who?

SF: Tesla. T-S-L-A.

JC: Okay.

SF: The company is holding its annual shareholders meeting right now, so they’re probably applauding themselves for their five-year return. If you look at a chart…

JC: They’re probably launching themselves to March right now…

SF: Perhaps, perhaps. The stock has somewhat launched itself. It’s gone from less than $30 five years ago to more than $350. That’s a return of more than 1,000 percent despite the absence of consistent profits and incredible cash burn. So, Joe and I were talking about this, we know you’ve been public on Tesla for some while. What would it take for you to throw in the towel? What would have to happen for you to throw in the towel and say “I give up on this short, this is not gonna work”?

JC: I think that have to see the company actually begin to make money selling products. And I should point out that we were also short Solar City that he bought in. That one worked out a little better than Tesla. So, the fact of the matter is, that this is a company that, as you pointed out, burns a lot of cash and we think they’re gonna be burning close to 750 million to a billion a quarter for the next handful of quarters. It has not finished its Gigafactory, the batteries are made by Panasonic. But most importantly it has its big test ahead of it; the Model 3. It has been loosing money selling $120,000 cars, but it hopes to make money selling a $35,000 car, which we think it will be a lot more than that. You have an executive departure list, the only one I’ve seen longer in the last two years is Valeant’s. There just people are leaving left, right and center.

SF: It’s a freight train…

JC: Well something… I mean, I don’t know. They’re certainly… they’re not waiting around for the company of the future, the stock price notwithstanding. And so we’ll see. I mean the car is supposed to go into production in July. They’ll be competing with real companies in 2018. I noted with some interest as I got here the opening remarks by Mr. Musk were talking about transforming to an energy company, an energy solution company or something like that. So he’s trying to reposition the company as something other than an automobile company. But it is an automobile company with a money-loosing solar roof company subsidiary. In addition he’s got to raise a lot of money. Rule of thumb is it takes about 50 cents in capital for every dollar of automobile revenues. So if he’s gonna be doing a 500,000 Model 3’s and 100,000 of the Model S’s and Model X’s, he’s gonna need something on the order – that’ll be thirty some billion in revenues – he’s gonna need about another ten billion in capital to do that, and he’s gonna need it soon. So the Teslarian should just embrace themselves cause they’re gonna get the chance to buy a lot more stock or convert here I suspect in the coming months.

JW: What’s the most likely way, in your view, in which the Tesla story ends? Is it something that in the Model 3 doesn’t live up to the high…

JC: He actually starts making money. That’ll be what ends it.

JW: No, but I mean like in terms your thesis becoming validated. Would it be more of a sort of an investor strike, as in conditions changed, there’s a market downturn, people aren’t able to fund the…

JC: If the Model 3 isn’t gonna be popular, that’s gonna hurt, right. That’s the one everybody’s waiting for, the one that the average person who can’t afford an S or X and wants to be part of the Tesla revolution and if the car is a lemon I think that will be a problem. […] But at the end of the day he’s gotta make a car for the masses that is successful, so that’s what we’re gonna watch.

Some takeaways from the above talk that you may want to consider putting into your investor’s toolbox are:

  1. Are all customers contributing proportionally to the company’s profits?
  2. What’s the downside to the business from any current or future regulatory changes?
  3. How much capital is needed to support future growth (capital to revenues ratio)?
    • Who will provide the capital – debt or equity holder (any dilutive effects on current shareholders)?
    • Will the company be able to raise the capital needed?
    • How long is the business able to keep on going without further capital contributions?
  4. Does the industry in which the business operates make it possible for companies to gain and sustain any sustainable competitive advantages?

Disclosure: I have no position in any stock mentioned.

Elon Musk: Going Public vs. Staying Private

“I think that’s the single best piece of advice: constantly think about how you could be doing things better and questioning yourself.”

—Elon Musk

Living in the Future, Learning From the Past

I just finished reading Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future, written by Ashlee Vance. The book is about Elon Musk and his entrepreneurial life, and the different businesses that he’s been involved with during the last 20 years; Zip2, X.com/PayPal, SpaceX, Tesla, SolarCity and Hyperloop.

Let’s start out with a recap of Musk’s different businesses, just to get some understanding about what he’s done.

Zip2. Founded by Elon Musk in 1995 when he was fresh out of collage. Originally called Global Link Information Network, and later renamed Zip2. A web software company, “a primitive Google Maps meets Yelp.” Zip2 was acquired by Compaq in 1999 for $307 million.

”The Zip2 idea was ingenious. Few small businesses in 1995 understood the ramifications of the Internet. They had little idea how to get on it and didn’t really see the value in creating a website for their business or even in having a Yellow Pages–like listing online. Musk and his brother hoped to convince restaurants, clothing shops, hairdressers, and the like that the time had come for them to make their presence known to the Web-surfing public. Zip2 would create a searchable directory of businesses and tie this into maps. Musk often explained the concept through pizza, saying that everyone deserved the right to know the location of their closest pizza parlor and the turn-by-turn directions to get there. This may seem obvious today—think Yelp meets Google Maps—but back then, not even stoners had dreamed up such a service.”

X.com/PayPal. Musk made $22 million from the sale of Zip2, of which almost all of it was invested in his next venture, a start-up called X.com. Musk co-founded X.com in March 1999, an online financial services and e-mail payment company. A year later on X.com merged with Confinity which had a money transfer service called PayPal. After the merger the company came to focus on the PayPal service, and was then renamed PayPal.

PayPal was acquired by eBay for $1.5 billion in 2002. From the profits made by Musk from the deal, he invested $100 million into SpaceX, $70 million into Tesla, and $10 million into SolarCity.

In the book Musk briefly discusses the lack of understanding that he sees regarding PayPal’s business model, and why he thinks that PayPal is worse today than it was before (emphasis added).

“I’ve thought about trying to get PayPal back. I’ve just been too strung out with other things. Almost no one understands how PayPal actually worked or why it took off when other payment systems before and after it didn’t. Most of the people at PayPal don’t understand this. The reason it worked was because the cost of transactions in PayPal was lower than any other system. And the reason the cost of transactions was lower is because we were able to do an increasing percentage of our transactions as ACH, or automated clearinghouse, electronic transactions, and most importantly, internal transactions. Internal transactions were essentially fraud-free and cost us nothing. An ACH transaction costs, I don’t know, like twenty cents or something. But it was slow, so that was the bad thing. It’s dependent on the bank’s batch processing time. And then the credit card transaction was fast, but expensive in terms of the credit card processing fees and very prone to fraud. That’s the problem Square is having now.”

“Square is doing the wrong version of PayPal. The critical thing is to achieve internal transactions. This is vital because they are instant, fraud-free, and fee-free. If you’re a seller and have various options, and PayPal has the lowest fees and is the most secure, it’s obviously the right thing to use.

When you look at like any given business, like say a business is making 10 percent profitability. They’re making 10 percent profit when they may net out all of their costs. You know, revenue minus expenses in a year, they’re 10 percent. If using PayPal means you pay 2 percent for your transactions and using some other systems means you pay 4 percent, that means using PayPal gives you a 20 percent increase in your profitability. You’d have to be brain dead not to do that. Right?

“So because about half of PayPal’s transactions in the summer of 2001 were internal or ACH transactions, then our fundamental costs of transactions were half because we’d have half credit cards, we’d have that and then the other half would be free. The question then is how do you give people a reason to keep money in the system.

“That’s why we created a PayPal debit card. It’s a little counterintuitive, but the easier you make it for people to get money out of PayPal, the less they’ll want to do it. But if the only way for them to spend money or access it in any way is to move it to a traditional bank, that’s what they’ll do instantly. The other thing was the PayPal money market fund. We did that because if you consider the reasons that people might move the money out, well, they’ll move it to either conduct transactions in the physical world or because they’re getting a higher interest rate. So I instituted the highest-return money market fund in the country. Basically, the money market fund was at cost. We didn’t intend to make any money on it, in order to encourage people to keep their money in the system. And then we also had like the ability to pay regular bills like your electricity bill and that kind of thing on PayPal.

“There were a bunch of things that should have been done like checks. Because even though people don’t use a lot of checks they still use some checks. So if you force people to say, ‘Okay, we’re not going to let you use checks ever,’ they’re like, ‘Okay, I guess I have to have a bank account.’ Just give them a few checks, for God’s sake.

“I mean, it’s so ridiculous that PayPal today is worse than PayPal circa end of 2001. That’s insane.

None of these start-ups understand the objective. The objective should be—what delivers fundamental value. I think it’s important to look at things from a standpoint of what is actually the best thing for the economy. If people can conduct their transactions quickly and securely that’s better for them. If it’s simpler to conduct their financial life it’s better for them. So, if all your financial affairs are seamlessly integrated one place it’s very easy to do transactions and the fees associated with transactions are low. These are all good things. Why aren’t they doing this? It’s mad.”

SpaceX. Space Exploration Technologies Corporation, better known as SpaceX, was founded in 2002 by Musk. SpaceX is an aerospace manufacturer and space transport services company. Musk’s goal is to create technologies to reduce the costs of space transportation, and also to enable the colonization of Mars.

”SpaceX would build its own engines and then contract with suppliers for the other components of the rocket. The company would gain an edge over the competition by building a better, cheaper engine and by fine-tuning the assembly process to make rockets faster and cheaper than anyone else. This vision included the construction of a type of mobile launch vehicle that could travel to various sites, take the rocket from a horizontal to vertical position, and send it off to space—no muss, no fuss. SpaceX was meant to get so good at this process that it could do multiple launches a month, make money off each one, and never need to become a huge contractor dependent on government funds.”

Tesla. Originally incorporated in 2003 by Martin Eberhard and Marc Tarpenning, Tesla manufactures and sells electric cars. Musk got involved in Tesla during the 2004 investment round, after which he also joined the board as chairman. Later on in 2008 Musk was appointed CEO of Tesla. Tesla’s initial public offering was on June 29, 2010. The IPO was priced at $17 per share. As of July 27, 2016 the stock is trading at $229.

Click image below to enlarge summary of Tesla’s financial key ratios from Morningstar.com as of July 27, 2016.

Tesla_Key_Ratio_Morningstar

Check out Tesla’s Investor Relations to read more.

SolarCity. Musk provided the initial concept and financial capital for SolarCity, which was then co-founded in 2006 by his cousins Lyndon and Peter Rive. Musk remains the principal shareholder and chairman. SolarCity’s stock first traded on the public markets on December 12, 2012 at $8 per share. As of July 27, 2016 the stock is trading at $27.

SolarCity business overview from 10-K for fiscal year 2015:

SolarCity’s founding vision is to accelerate mass adoption of sustainable energy. We believe solar power can and will become the world’s predominant source of energy, and that we can speed widespread adoption of solar power by offering products that save our customers money. We sell renewable energy to our customers at prices below utility rates, and are focused on reducing the cost of solar energy. Since our founding in 2006, we have installed solar energy systems for over 230,000 customers. Our long-term agreements with our customers generate recurring payments and create a portfolio of high-quality receivables that we leverage to further reduce the cost of making the switch to solar energy. (Source: 2015, 10-K)

Click image below to enlarge summary of SolarCity’s financial key ratios from Morningstar.com as of July 27, 2016.

SolarCity_Key_Ratio_Morningstar

Check out SolarCity’s Investor Relations to read more.

Hyperloop. A concept for a high-speed transportation system billed as “a new mode of transportation, … a large-scale pneumatic tube like the ones used to send mail around offices,” and “linking cities like Los Angeles and San Francisco via an elevated version of this kind of tube that would transport people and cars in pods.”

”Musk had been thinking about the Hyperloop for a number of months, describing it to friends in private. The first time he talked about it to anyone outside of his inner circle was during one of our interviews. Musk told me that the idea originated out of his hatred for California’s proposed high-speed rail system. “The sixty-billion-dollar bullet train they’re proposing in California would be the slowest bullet train in the world at the highest cost per mile,” Musk said. “They’re going for records in all the wrong ways.” California’s high-speed rail is meant to allow people to go from Los Angeles to San Francisco in about two and a half hours upon its completion in—wait for it—2029. It takes about an hour to fly between the cities today and five hours to drive, placing the train right in the zone of mediocrity, which particularly gnawed at Musk. He insisted the Hyperloop would cost about $6 billion to $10 billion, go faster than a plane, and let people drive their cars onto a pod and drive out into a new city.”

So, let’s move on and see what Elon Musk wrote in an email sent to all SpaceX employees about going public.

Thinking About Public Markets, and a Few Other Things

Back on June 7, 2013, Elon Musk sent an email to the employee’s of SpaceX, in which he discussed the issue of going public, and why it probably is better to wait with this part. The mail is an interesting read because it shows some of Musk’s own thinking about this IPO issue. Excerpt below from the book (emphasis added).

From: Elon Musk
Date: June 7, 2013, 12:43:06 AM PDT
To: All <All@spacex.com>
Subject: Going Public

Per my recent comments, I am increasingly concerned about SpaceX going public before the Mars transport system is in place. Creating the technology needed to establish life on Mars is and always has been the fundamental goal of SpaceX. If being a public company diminishes that likelihood, then we should not do so until Mars is secure. This is something that I am open to reconsidering, but, given my experiences with Tesla and SolarCity, I am hesitant to foist being public on SpaceX, especially given the long term nature of our mission.

Some at SpaceX who have not been through a public company experience may think that being public is desirable. This is not so. Public company stocks, particularly if big step changes in technology are involved, go through extreme volatility, both for reasons of internal execution and for reasons that have nothing to do with anything except the economy. This causes people to be distracted by the manic-depressive nature of the stock instead of creating great products.

It is important to emphasize that Tesla and SolarCity are public because they didn’t have any choice. Their private capital structure was becoming unwieldy and they needed to raise a lot of equity capital. SolarCity also needed to raise a huge amount of debt at the lowest possible interest rate to fund solar leases. The banks who provide that debt wanted SolarCity to have the additional and painful scrutiny that comes with being public. Those rules, referred to as Sarbanes-Oxley, essentially result in a tax being levied on company execution by requiring detailed reporting right down to how your meal is expensed during travel and you can be penalized even for minor mistakes.

YES, BUT I COULD MAKE MORE MONEY IF WE WERE PUBLIC
For those who are under the impression that they are so clever that they can outsmart public market investors and would sell SpaceX stock at the “right time,” let me relieve you of any such notion. If you really are better than most hedge fund managers, then there is no need to worry about the value of your SpaceX stock, as you can just invest in other public company stocks and make billions of dollars in the market.

If you think: “Ah, but I know what’s really going on at SpaceX and that will give me an edge,” you are also wrong. Selling public company stock with insider knowledge is illegal. As a result, selling public stock is restricted to narrow time windows a few times per year. Even then, you can be prosecuted for insider trading. At Tesla, we had both an employee and an investor go through a grand jury investigation for selling stock over a year ago, despite them doing everything right in both the letter and spirit of the law. Not fun.

Another thing that happens to public companies is that you become a target of the trial lawyers who create a class action lawsuit by getting someone to buy a few hundred shares and then pretending to sue the company on behalf of all investors for any drop in the stock price. Tesla is going through that right now even though the stock price is relatively high, because the drop in question occurred last year.

It is also not correct to think that because Tesla and SolarCity share prices are on the lofty side right now, that SpaceX would be too.

Public companies are judged on quarterly performance. Just because some companies are doing well, doesn’t mean that all would. Both of those companies (Tesla in particular) had great first quarter results. SpaceX did not. In fact, financially speaking, we had an awful first quarter. If we were public, the short sellers would be hitting us over the head with a large stick.

We would also get beaten up every time there was an anomaly on the rocket or spacecraft, as occurred on flight 4 with the engine failure and flight 5 with the Dragon prevalves. Delaying launch of V1.1, which is now over a year behind schedule, would result in particularly severe punishment, as that is our primary revenue driver. Even something as minor as pushing a launch back a few weeks from one quarter to the next gets you a spanking. Tesla vehicle production in Q4 last year was literally only three weeks behind and yet the market response was brutal.

BEST OF BOTH WORLDS
My goal at SpaceX is to give you the best aspects of a public and private company. When we do a financing round, the stock price is keyed off of approximately what we would be worth if publicly traded, excluding irrational exuberance or depression, but without the pressure and distraction of being under a hot public spotlight. Rather than have the stock be up during one liquidity window and down during another, the goal is a steady upward trend and never to let the share price go below the last round. The end result for you (or an investor in SpaceX) financially will be the same as if we were public and you sold a steady amount of stock every year.

In case you are wondering about a specific number, I can say that I’m confident that our long term stock price will be over $100 if we execute well on Falcon 9 and Dragon. For this to be the case, we must have a steady and rapid cadence of launch that is far better than what we have achieved in the past. We have more work ahead of us than you probably realize. Let me give you a sense of where things stand financially: SpaceX expenses this year will be roug[h]ly $800 to $900 million (which blows my mind btw). Since we get revenue of $60M for every F9 flight or double that for a FH or F9-Dragon flight, we must have about twelve flights per year where four of those flights are either Dragon or Heavy merely in order to achieve 10% profitability!

For the next few years, we have NASA commercial crew funding that helps supplement those numbers, but, after that, we are on our own. That is not much time to finish F9, FH, Dragon V2 and achieve an average launch rate of at least one per month. And bear in mind that is an average, so if we take an extra three weeks to launch a rocket for any reason (could even be due to the satellite), we have only one week to do the follow-on flight.

MY RECOMMENDATION
Below is my advice about regarding selling SpaceX stock or options. No complicated analysis is required, as the rules of thumb are pretty simple. If you believe that SpaceX will execute better than the average public company, then our stock price will continue to appreciate at a rate greater than that of the stock market, which would be the next highest return place to invest money over the long term. Therefore, you should sell only the amount that you need to improve your standard of living in the short to medium term. I do actually recommend selling some amount of stock, even if you are certain it will appreciate, as life is short and a bit more cash can increase fun and reduce stress at home (so long as you don’t ratchet up your ongoing personal expenditures proportionately).

To maximize your post tax return, you are probably best off exercising your options to convert them to stock (if you can afford to do this) and then holding the stock for a year before selling it at our roughly biannual liquidity events. This allows you to pay the capital gains tax rate, instead of the income tax rate.

On a final note, we are planning to do a liquidity event as soon as Falcon 9 qualification is complete in one to two months. I don’t know exactly what the share price will be yet, but, based on initial conversations with investors, I would estimate probably between $30 and $35. This places the value of SpaceX at $4 to $5 billion, which is about what it would be if we were public right now and, frankly, an excellent number considering that the new F9, FH and Dragon V2 have yet to launch.

Elon

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article.I have no positions in any stocks mentioned.