Jim Chanos made headlines for shorting a stock again this week, this time for predicting that Tesla Motors (NASDAQ:TSLA) could go bankrupt. Chanos is a well-known short-seller and has long been a thorn in the side of Elon Musk, taking a short position in SolarCity (NASDAQ:SCTY) last year (the stock is down 61% since then).
Short-sellers aren't always right about a stock, but even if you're bullish on Tesla Motors, it's worth understanding why someone may take the opposite position. And with 26.2 million shares sold short, it's worth listening to what Chanos is thinking.
Billions in funding are needed to meet growth targets
There's no question Tesla will need billions of dollars in additional funding over the next two years to ramp up the Gigafactory and Model 3 production. Elon Musk himself has said that Tesla will raise funds again this year after doing a capital raise in May.
Estimates vary on how much cash Tesla will burn building out production capacity, but Barclays puts the figure at $11 billion. And if you look at the free cash flow chart below and consider the rapid ramp in spending needed in the next two years to build the Model 3, that sounds reasonable.
This doesn't account for cash burn at SolarCity, which is a mystery right now. SolarCity could be a net cash generator if the solar business goes well, or it could burn through $216 million in a single quarter, as it did in the second quarter of 2016.
What's clear is that Tesla needs a lot of funding in the next five years to complete Musk's vision. And that's a baseline for any short case on the stock.
What happens if the market loses confidence?
If you're going to ask investors, whether it's debt or equity, for funding, you have to have their confidence. A loss of confidence means higher interest rates on debt and lower stock prices for stock offerings, which means more dilution for current investors.
In companies that need continual funding, the downward spiral can happen quickly if confidence wanes at all. And problems for Tesla really start to arise if confidence is lost, given its future capital needs. Here's how that could happen.
Tesla hasn't hit its own expectations
We know Tesla Motors has a history of missing incredibly optimistic production targets. The Model S and Model X were both late, and production targets have been missed on an almost quarterly basis. Those problems have been masked by growing excitement for the company's future and relatively small-scale production to date, but with Musk projecting 500,000 vehicles produced in 2018, the stakes are getting higher.
Being late in the Model 3 would mean cash from sales wouldn't come in as soon as expected, cash burn would increase beyond current expectations, and Tesla would require more funding from investors. If the delay (or quality problems) causes investors to lose confidence, we could see interest rates rise for debt and the stock fall, making raising capital very costly -- or even impossible, if conditions are bad enough.
These negatives are all hypotheticals, but the Tesla bull case is built on Tesla hitting all of its targets. It's also built on hypotheticals. And since we know Tesla is going to need billions in new funding over the next five years, the company needs confidence and for the stock price to remain high to fund growth. Chanos thinks there's reason to be skeptical.
The evidence Chanos is using to raise red flags
In an interview with CNBC, Jim Chanos laid out the reasons he's skeptical Tesla can hit its production targets, which he then thinks will result in lost confidence and a falling stock price. On top of the missed production targets, continual cash burn, risk from buying SolarCity, and losses selling a $120,000 car, he pointed out a few more concerns to think about.
Chanos thinks delays in the Gigafactory and Model 3 will allow competitors to leapfrog the company in both production and technology. General Motors (NYSE:GM) already did that with the $30,000, 238-mile range Chevy Bolt, and many more EVs are on the way from auto manufacturers. And battery plants being built in Asia, Europe, and the U.S. will add capacity and improve technology for batteries that could leapfrog the Gigafactory.
There's also been a flood of executives leaving the company. If those highest up at Tesla -- with the most to gain from its success -- are leaving, that's a red flag.
Finally, he's concerned about Tesla stock's cult following. He thinks it masks problems like financial losses, production delays, and improving competition. Eventually, if that following breaks down, or Tesla doesn't live up to expectations, the support could collapse, leading to a downward spiral.
Something to consider
I don't know if Tesla will be a great stock or not in the future, but it's important to understand both sides of the argument, especially in a stock that has so many strong opinions.
The short thesis Chanos and others are taking in Tesla is worth considering, whether it ends up being right or not. And time is the only thing that will answer all of the questions facing Tesla and its stock.
Travis Hoium has no position in any stocks mentioned. The Motley Fool owns shares of and recommends SolarCity and Tesla Motors. The Motley Fool recommends General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.