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Why Would This Aerospace Company Survive?

By Jim Gillies – May 12, 2020 at 3:39PM

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The global pandemic has taken a huge toll on the aerospace industry, but this company’s business model puts it on a better footing.

In this episode of Industry Focus: Energy, Nick Sciple chats with Motley Fool analyst Jim Gillies about some recent interesting stories. They discuss Warren Buffett selling airline stocks and Elon Musk's Twitter antics. Jim talks about digging deeper into companies' financials. They also take a look at bankruptcies and an aerospace player on stronger footing than most, and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 7, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Joining me today to break down some of the most interesting stories in energy and industrials this week is Motley Fool analyst Jim Gillies. Jim, welcome back on the show.

Jim Gillies: Glad to be here. Thanks, Nick.

Sciple: That's great to have you on. We've got some great topics queued up today. I sent out a Twitter poll this week asking what folks wanted us to talk about, and the winners were that we would discuss Warren Buffett selling his stake in the airlines and the latest in Tesla (TSLA -1.10%) earnings and Elon Musk Twitter antics.

Let's start off with Buffett first. I know you've been following Warren Buffett and Berkshire Hathaway (BRK.A -0.06%) (BRK.B -0.95%) for a long time, actually met him in person a couple of times. When you heard that Buffett was selling his entire airline stake across all four of the major airlines, almost 10% holdings in all of them, what was your first reaction?

Gillies: This is not great for airline stock valuation going forward. I actually felt very seen, very heard, if you will, because we've been doing a lot of Fool Live publications and other venues, and a question that comes up all the time, because of the way stocks reacted in March, was what do you think about airlines? You know, everyone's looking for bargain-hunting. Which is an inherently good instinct, I think, you want to buy things when they're on sale. So, people looked at airlines and they had the imprimatur of the Oracle of Omaha, of Warren Buffett and, you know, "Oh, he owns 10% of all of them and wow!" And now they're down 50%, 60%, 70%, maybe we should jump in here.

And I've been saying for a while now, folks, the world has changed for airlines. I believe the airlines are going to continue flying. The flag carriers will be flying. But the equity, the current shares, may go to zero. These companies may go into some form of a bankruptcy, a preplanned bankruptcy, a Chapter 11 where the existing equity is wiped out, the previous debt holders become equity holders and we, kind of, go on from there. Or it may be functionally equivalent, where the government shoves money into these things over time but they put in so much money, they end up owning so much of it that it becomes functionally equivalent.

So, if you pull up a stock chart, say, of AIG or Citigroup coming out of the global financial crisis in '08-09 you'll see that the effective price of those stocks is still down +95%, +99%, they never technically went bankrupt, but you might as well -- I mean, if you are a shareholder from before that, you don't notice the difference.

So, with all of that said, when Buffett comes along and he says, "We sold all of our holdings in all four." And he basically said, it's because the equity may not be worth anything even if these businesses survive. You know, like I said, I felt very seen. You know, I'd come to the same conclusion he had. But my first thought was actually, what about all these poor investors who have coat-tailed Buffett over the years?

Now, I'm a Berkshire Hathaway shareholder as are, indeed, many, many Fools. So, you know, on a look-through basis, yeah, I'm a little bit damaged by this, because he bought it at much higher prices than he sold them at. But in addition to that, there's a phenomenon called coat-tailing, where you find someone whose ideas you respect and you see what they're doing, it's like, "Oh, you know what, I'm not going to buy Berkshire Hathaway, but if it's good enough for Buffett to do, I'm going to go chase and do what he just said."

So, you know, how many people bought airlines because of the Buffett imprimatur? How many people in the wake of this, kind of, quick flash crash we had or [...] but, you know, we had one-month 30% drawdown, how many people in that drawdown were like much the people we've seen coming forward on these Fool Live broadcasts saying, well, you know, "Oh, the airlines are down 70%," and, "Oh, Buffett, Warren Buffett owns 10% of these, this must be a great time for me to get in at a lower price," not perhaps thinking that Buffett might change his mind.

And that's one thing I really admire about Buffett, even though he took a loss here and he said, "This was a mistake, I made a mistake." And the best part I think about this, yes, we lost money and that's fine, but when he recognized the world had changed, he didn't sugarcoat it, he didn't try to double-down to maybe make the mistake look less egregious, he basically said, "No, I've made a mistake, I need to take my medicine, I'm done, I'm out, finished."

Sciple: Yeah, a lot of points raised there and I agree with many of them. I think this instinct that a lot of folks have to buy up their losers' average down is counterintuitive. You should be buying your stocks that are winners, that have succeeded, that your thesis has been proved out on. And those stocks where your thesis has been disproved, as Buffett has said he thinks has happened in this case, maybe it's time to sell.

One of the things you talk about coat-tailing and following these guru investors, and one point a lot of people have raised in response to Buffett selling the airlines is that, hey, you as an individual investor are positioned differently from Warren Buffett. This is someone who's 89 years old, has a bunch of other operating businesses that are going to be affected by what's going on, as well as an insurance company. Maybe his perspective on the business is influenced by all those other things. And the investment is more attractive, maybe for you as an individual investor than it would be for Buffett. You don't agree with that argument at all?

Gillies: I don't agree with that at all. Look, Buffett is not unaware that he's 89 years old, Buffett is not unaware that his time heading Berkshire Hathaway and his time on the stage is coming to a close; it's not coming soon, I hope, you know. And I've been a Berkshire shareholder for -- coming up on -- 20 years, I think. [laughs] And I was hearing this argument back then, you know, it's like, "Oh, he's 70 years old, he can't stay there forever." Well, two decades later, here we are.

But he has long said, look, Berkshire is built to survive me. He says, I think the stock will go up when I exit the stage; I will take the other side of that bet, I think the stock will probably go down the day he decides to leave or leaves without deciding to leave. But he has said, he has built his life's work on long-term thinking, the long-term survivability and viability of this business. I would argue Berkshire, with Buffett in charge or not, has a longer time horizon than I have, because Berkshire, we hope, will be around when I'm off the stage as well; forget Buffett.

So, no, I really think that the big issue here is, he sees either actual bankruptcy or, as I said earlier, functionally equivalent to bankruptcy. I think he believes the equity of one or more of these could be severely/permanently impaired and, you know, he knows he doesn't have a time machine to go back and not buy those.

I mean, he knew that he was already getting some attention because two of the -- he owned 10% of all four, two of them -- I believe it was Delta and Southwest, it's either through buybacks or whatever -- they were actually above 10% threshold. And when you're above the 10% threshold as an exterior investor, you have to file with the SEC to let people -- because you could be putting some influence on these things. So, in early April, I believe it was, news came out, the forms were filed that showed that Buffett and Berkshire had sold down below the 10% threshold for those two airlines. And at the time it's like, OK, well that's probably not positive, but we don't know the full extent of what that is. Like, all we know is he now has all four airlines below 10%.

But did he stop there? Did he sell them all off? Did he sell a bunch off because maybe he's going to make a run? I thought perhaps that Berkshire Hathaway may go after what I consider the best run of the four and that would be Southwest. I thought it's possible, here's Berkshire which has added, you know, railroads in the past and has energy and has this wide swathe in cross-section of American business, you know, I thought it might look kind of nice, that maybe an airline might fit in nicely there. And I thought, well maybe he's taking a run setting up to take a run at Southwest.

Turns out, he's like, "No, I've made a mistake, I'm out entirely." And he had to have known that that was not going to be received terribly well on Wall Street on main street, but he did it anyway because he believes this was the right thing for Berkshire Hathaway and Berkshire Hathaway's shareholders.

Sciple: Yeah, I would say, you know, this is probably -- you've been following Buffett much longer than I have -- probably the most, I wouldn't say it was bearish, but tepid on the markets that I've seen him.

Gillies: Yes. And actually, that is something. And I'm going to say this against the backdrop of as of this recording the Nasdaq is now up for the year. So, in spite of that flash crash, that March crash we had, the Nasdaq is now up for the year, it seems that any number of we'll say high valuation, high multiple, often cash-anemic, if not cash-burning companies are hitting new highs daily.

One thing I found, as you say, he was very tepid and my concern, and I've voiced this in other places, was that here is the man, who, if he didn't coin the phrase, "Be fearful when others are greedy, and be greedy when others are fearful," he certainly has become popularized with it.

He has similarly said things like, "When it starts raining gold, we want to be outside with wash tubs not teaspoons." Okay, so this is what he said. What did he do? Well, what he did was, in the first quarter he was a net seller of stocks, he bought a little bit of Berkshire back; got rid of some airlines. And as we went into April, he was much more of a seller in stocks; all of the airlines.

He was building cash, he already had $128 billion on the books of Berkshire Hathaway, and ended the quarter with $137 billion. He didn't make an attempt; he wasn't greedy when others were fearful. And I don't know if you remember, Nick, but people were pretty damn fearful in March. You know, he wasn't greedy and he didn't run outside with wash tubs when it was raining gold. And to be honest with you, that gives me a little bit of pause.

Sciple: Yeah, I couldn't agree with you more. I still think we see these -- it's Thursday, right? We had the latest unemployment numbers coming down, there's another 3 million unemployed folks.

Gillies: There are now more people unemployed in the U.S. then we have people here in Canada, that is a mind-numbing statistic for me. My entire country is unemployed in your country.

Sciple: That's an insane stat, you know, to see here put that way. And then to see, you know, the market is rocketing up, that disconnect is difficult. Bringing it back around to, kind of, the airlines and the liquidity situation they're in. We led off the show talking about how a lot of folks are excited, they see these stocks selling off, you know, +50% and they want to jump in. And we've told a story here today, based on what Buffett has said, he agrees with this, that these were companies that, you know, very well the equity could be wiped.

Is there anywhere, when you look around this space, given this environment, that you might be excited to jump in related to aerospace?

Gillies: Sure. So, we've already, kind of, stuck the fork in the airlines. And look, we don't obviously know the future, they may ultimately get something worked out or whether this softens beforehand or whatever, but you know, I'm obviously not interested in the airlines.

I'm similarly, I'm looking at -- obviously, Boeing has had their issues, the 737 MAX issues before all of this happened. Similarly, Airbus over in Europe was saying -- you know, I think that's a bit of hyperbole, frankly, but the CEO was saying things like, "Look, we have to all pull together or we could lose the company." Well, when both halves of the worldwide duopoly for airplanes are in trouble, I mean like, I'm not interested there either. But I'm thanking you for teeing this up for me here.

Because do you know, Nick, do you know -- I think you might know, because we may have talked about this. Do you know who the world's largest buyer of airplanes is, of light passenger liners?

Sciple: You know, I wouldn't have known before yesterday when you told me, but, Jim, what is it?

Gillies: It is an aircraft leasing company called AerCap Holdings, AER, I believe, on the New York Stock Exchange. They are the world's largest -- but, I mean, it's not one of the airlines, it's these guys. And these guys buy planes and then lease them to airlines around the world. They have relationships with 200, I believe, airlines around the world. 70% of their business is with the U.S. majors and the China-Asian majors.

Now, who is going to get the bulk of the support from governments? And right now so far, governments around the world have pledged somewhere on the order of $100 billion to prop-up their respective airline industries. The CEO of AerCap on this week on their conference call said, we actually think it could go to $200 billion. And you know, what's an extra $100 billion between friends, really?

But in the case where the airlines go into a preplanned bankruptcy. And what I mean by bankruptcy is not they will cease to exist, OK, that they will stop flying and we're done. This would be preplanned. I have a book on the bookshelf behind me, which you can't see me right now, but there's a book on my bookshelf called Air Monopoly. And Air Monopoly is the story of the last time that Air Canada, Canada's flagship carrier, went bankrupt. Now, Air Canada is still Canada's flagship carrier. Air Canada is quite often the start and end of any search. If you need to fly in Canada and fly to the States, fly to Europe, that's usually where we start looking, with Air Canada. And yet, their equity was wiped out entirely in the 2002-2003 era in the wake of September 11th and SARS, basically.

That could very much be the fate of a lot of airlines around the world, but yet, they're still going to keep flying. And when they do, they're going to need planes, and so AerCap buys the planes and places them with the airlines.

What could also happen is, as governments around the world shove capital into these airlines to keep them running, on the other side of this, these airlines are going to be looking to shed costs, to get out of government financing. We saw that in the global financial crisis with the banks, when the banks had all this capital shoved into them by the governments, and they paid these things off as fast as possible, because you don't want to be beholden to the government, frankly, regardless of what country you're in.

And so, if that is the case then they are going to be looking to shed capital costs, like, say you know, I don't know, buying planes. Planes are expensive. If I don't have to buy a plane, if I could just get you, the leasing company, to buy the plane and then I'll lease it from you, and, yeah, my payments are going to be larger than -- you know, it's more expensive to buy a car on a seven-year loan, Nick, right, than to take advantage of all the bells-and-whistles and pay cash for it upfront. They're not going to care because they can get by leasing planes that'll free up more capital internally, maybe to get the governments off their backs.

So, I actually think that this brave new world we're in now, I do believe air traffic will come back perhaps faster than people expect. And I would point to China where AerCap has some, as I mentioned earlier, AerCap is around the world, they have most of their businesses China, Asia and U.S. majors.

China in January was running 15,000, 16,000 flights per day. Now, there's Chinese New Year's around there, so you expect elevated travel, like, U.S. Thanksgiving. By February, they were down to about 4,000 flights per day. Country is lockdown, coronavirus pandemic, so, I mean, the traffic is way down. They're now back up, they are now back up in the 10,000, 11,000, 12,000, flights per day range. They've passed through the worst of it and they're now back on the way up.

Assuming that that is the similar pattern to what we're going to have in North America and Europe, that speaks to A. AerCap surviving; and I've said, AerCap, I think, it was about a $70 stock three months ago. It was about a $15 stock one month ago. It's now, I think, in the high-$20s, like, I mean, they got hit pretty hard.. Like, they are being very explicit in, "No, no, we're a survivor." And I was quipping a little bit maybe two or three weeks ago, it's like, you know -- and full disclosure, I ended up buying some shares here, but I was quipping that in two years, this is either a zero or it's a triple. Because I mean, it was a triple three months ago, or it was triple the price three months ago. So, even if things get back to where they are.

But they are exceptionally well-run, they focus on new technology. I think it's something about 16% to 20% of airplanes around the world are the so-called newest of new technology. Aircraft's fleet, it's close to 60%. They're average lease still has 7.5 years to run, they've got no slots to place planes now anyway. They're working with all their clients. They've got banking relationships with 120 banks that help finance and things. So, I really like this company as my play. If I'm going to play in the airline space and the aircraft space, I kind of want to be in the leasing area rather than the actual airplanes.

Sciple: Yeah, just to underline one of the points you highlighted earlier on bankruptcy. We spent a lot of time on this show, we talked earlier about, there's a decent chance that some of these airlines could go bankrupt. And what happens in a bankruptcy? The current equity gets wiped and the debtholders, people with residual claimants on the company usually end up with the assets. And as the company who owns the planes that the company flies, AerCap owns the companies [planes] (sic) and leases them back to the airlines. They can just take the planes back in bankruptcy. If these airlines disappear and demand for air travel returns in a year or two down the line, they're the ones who are going to have these valuable assets, while these airline stocks that are out today, that equity very well could be wiped. And at the end of the day you want to own these assets.

And when you look at the financial position they're in, I mean, I was really impressed with management's earnings call. I mean, they really, in a fairly direct straightforward way, laid out everything you would want to know as a shareholder in a really logical, easy-to-follow way, which I really appreciated, especially in a time like this.

Gillies: Yeah. No, exactly. If anyone listening has access to conference call transcripts, this was a master class I thought, their most recent call. Where, yeah, they say, hey, yeah here's how we're going to get through this and why. And, you know, they carry some leverage. You have to understand when a leasing company -- it's almost like a bank, you know, or any kind of financing company, debt is raw material, so financing is raw material for these guys. They turn debt into these assets, these planes.

One of the points that they've made, I don't remember if it was the most recent conference call or if it was from an investor's conference a month or so ago, one of the things that said, it's like, guys, airlines go bankrupt all the time, this is not our first rodeo, like, we have taken planes back from bankruptcy filing lots of time, many times in the past. Okay, it's a bit more elevated now, and? You know, there's nothing going on right now that, again, admittedly, in more isolated terms, are more sporadic and spaced out, that they've not seem to, that they've not seen before, but they have seen this before.

And you know, so I mean I like to stat -- you know, we have seen a couple of airlines already go down, Air Mauritius, you know, we all fly Air Mauritius on a regular basis, Virgin Australia, they've both, I believe, entered bankruptcy protection. Norwegian Airlines, it's not bankruptcy technically, but they've worked out a deal with all of their creditors and the government, including AerCap as well.

But, Nick, 2019, before all of this unpleasantness, 2019, how many airlines went bankrupt around the world?

Sciple: That's a great question. I don't know. More than I would think, right? Where travel was rocking-and-rolling all-time highs. So, how many went bankrupt?

Gillies: 23.

Sciple: There you go.

Gillies: They have seen this before, in fact, it is possible -- I'll throw this out there as something people can bang over my head when I'm wrong later -- it is possible there were more airline bankruptcies in 2019 than will happen in 2020, because 2019, as you just said, air travel was rocking-and-rolling, so that's a sign of bad management or whatever, right? Whereas in 2020, anyone who runs into trouble is going to be throwing themselves upon the mercy of the government largesse, which again we mentioned, $100 billion so far, maybe could go as high as $200 billion. We might get more bankruptcies last year than this year, which is a somewhat silly thing to say maybe, but I think it could happen.

Sciple: That's a bold prediction. Alright, you all, if you aren't into airlines, you want something more exciting, on the back-half of the show, we're bringing all the excitement with Elon Musk and Tesla.

Gillies: You've got a weird definition of excitement, man. [laughs]

Sciple: Alright, folks, if you were bored on the first-half of the show, I think we've got some excitement here. For folks who have listened to Elon Musk's interview, a second interview with Joe Rogan, he said, he thought Warren Buffett's job must be pretty boring. Well, we're going to talk about a little more exciting company here, Tesla earnings last week.

And you look at the headline numbers, really pretty impressive, third straight quarter of positive GAAP net profit, the first-ever profitable first quarter that they've had and they had record first quarter production and deliveries. Jim, when you look at those numbers, obviously, some pretty impressive headline numbers, what do you take away from the quarter?

Gillies: Sure, they're impressive headline numbers, now you are comparing it to Q1 last year, which was not great. So, I'm going to state my bias upfront, so people can tune out now if they want to. I am not a believer in the Tesla story, I think that the best-case scenario is some of the facts are being played fast-and-loose with at the best of times. So, I'm going to just leave it out there.

The headline numbers look great. And my job -- and this is not a Tesla thing, this is my job regardless of what company I look at. So, I could give you a long list of companies where I never trust the numbers that are given to me in a press release, ever, for any company. I always have to go in and dig and what have you. And that's how you decide, is this actually better than expected, is it worse than expected.

So, with Tesla, one of the things that immediately jumps out. So, yes, they delivered a $16 million GAAP, Generally Accepted Accounting Principles, profit. Fantastic. Okay. They have a small part of their business, not as small as it usually is, but they have a small part of business where they sell regulatory credits. These are credits that have been created because they have green vehicles, other vehicle makers who have less green vehicles, need to buy credits, need to show a certain amount of green production, they maybe can't or don't do it themselves yet. We'll talk about competition maybe some other time. And so, they can buy credits from Tesla. Green zero emission credits.

And Tesla has been selling these credits every quarter, you know, that is the regular part -- it's not a big part, you know, when you're doing $5 billion, $6 billion on top-line car sales, what's $150 million in emission credits, that's not a big deal.

But it is 100% gross margin. So, this is about the most profitable thing you can have. But, hey, again, you know what, Tesla has got them, they can sell them, that's not a problem, that is perfectly legal, perfectly acceptable and I'd be angry as a shareholder if they didn't sell them. But the average that they've been doing for the last five or six quarters, I think is in about the $150 million to $175 million range, ballpark.

Sciple: Yeah, that's about right. I mean, the recent high before this had been Q1 of 2019, so.

Gillies: Sure. Which was the desperation quarter for them, it was a very bad quarter last year, same quarter. Okay. Average $150 million to $175 million the last, say, six quarters. This quarter, they sold $354 million, that by itself -- and you know, again, the so-called profitability, the thing that the people are hinging on is $16 million. Well, OK, you know what, I'm going to have a hard time not reporting a GAAP profit if I'm selling $354 million worth of 100% gross margin credits.

If they had just sold their average -- so, let's say they sold $200 million instead of $354 million, higher than their average for the last three quarters, this company is reporting a +$100 million loss. Okay. So, they did not make a profit because of their car business, which is what they are, they are a carmaker. They did not make this profit because of their solar business, you remember SolarCity that they acquired because it's integral to the success of Tesla going forward. Their installed megawatts went down this quarter. No, they posted a GAAP profit because they sold something that can't be repeated.

And the other thing is, too, is that their tax rate, their effective tax rate for the quarter was what, 2% or 3%? Like, I don't know what chicanery they're pulling on that. But, you know, we used to look at IBM, you know, everyone knows IBM. IBM for years was castigated, rightly so, for managing their earnings and bragging every quarter, we're going to have $20 per share in this kind of look through earnings yaddi-yaddi-yadda. But they were manipulating, they were buying back stock, they were manipulating their tax rate, they're pulling all kinds of crap. And Wall Street, at one point just said, you know what, like, you guys are just, you are playing accounting games to show these profits, so we're just going to stop listening to you.

And to this day, like, IBM is trading at what? 9X earnings, 10X earnings? It's still a massive company with a massive name, but you know, the analyst community got wise to the chicanery being pulled. And so, you kind of look at this this year, it's like, eh, super-low tax rate, sale of one-time items or some other stuff, puts-and-takes that I would question, but those -- you know, like, they had one factory last year, they had two factories this year. Operating expenses went down, that's a good trick.

Sciple: So, Jim, yeah, I see the criticism on, it's a $16 million GAAP profit, but for any amount of regulatory sales, essentially, they're not going to show a GAAP profit. I think one question I have for you though is, Musk said on the conference call, following up that X regulatory sale, they had 20% auto gross margin. You know, they are showing some progress on getting cost controls under way, that sort of thing, I mean, is that encouraging for you or what's your view there on that part of the business?

Gillies: Yeah. No, I would say actually, you better get it over 20%. But, yeah, no, I would say, yes, that is encouraging. I haven't done a deep dive into the components of gross margin, but on the surface I'm willing to accept that, yeah, we got the 20% and it's good.

And I'm going to actually say this too, again, maybe I'm showing my particular style of analysis and investing. Okay, so you reported GAAP profit. If I told you, Nick, that I don't care about GAAP profit, I don't; I care about some very specific things. But you know, I happen to employ a chartered accountant in my house. And when I say employ, I mean she's my significant other. And she has reminded me on many occasions -- we once had a two-hour elevated discussion, we'll call it, about the proper way to treat deferred taxes.

So, that's the kind of excitement you get around my house. But she has told me multiple times, you know, pounded into my thick skull, I can show whatever profit you want me to show, like, that's not the issue. You know, I can make the statement and I can show you what you want. I want to talk about cash flows, I want to talk about what is the actual health of the business, because GAAP profit is one thing, but cash flows tell a very different story here in Q1.

Sciple: Okay, what stories the cash flows tell you, Jim?

Gillies: It's less enthusiastic. So, they had a $16 million GAAP profit; fine. The first thing I'm going to point you to is what's called cash flow from operations. So, the third financial statement, you got your income statement, you got your balance sheet, I suppose you got your statement of shareholders' equity, but no one pays attention to that. And so, the third one is the statement of cash flows.

And the statement of cash flows is delineated into three sections: operating cash flows, investing cash flows, financing cash flows. Operating cash flows, how much cash you make from running your business. And the way you calculate operating cash flows is you start with GAAP profit. So, you take the number at the bottom of the income statement and that's the top number on the statement of cash flows. And then you add and subtract all of the noncash charges and all the other sources and uses of cash in your operations to come up with your cash flow from operations number.

Since you're starting with the number from the bottom of the income statement, you're starting, OK -- there's all kinds of earnings quality books you can get out there, there's Thornton O'glove's Quality of Earnings, there's Hewitt Heiserman, It's Earnings That Count, there's all kind of cash flow numbers from Mulford and whatever.

The general, quick rule-of-thumb is that operating cash flow, because it starts with net income, with GAAP profit and then you are adding back non cash charges, like, depreciation, like, amortization, like, stock-based compensation, operating cash flow should be higher than GAAP profit. It is not uncommon to see a company turn in a GAAP loss and yet on an operating cash flow basis, they're positive. You know, there's all kinds of SaaS companies out there right now who have very large bills in terms of stock-based compensation that gets taken off on the GAAP profitability numbers, but because it's a noncash charge against the cash flow, it gets added back on the statement of the cash flows.

So, what you want to see is, for higher quality earnings, higher earnings quality, operating cash flow should be higher than net income. Tesla Q1 reported GAAP profit of $16 million. Do you like to take a stab of what their operating cash flow was, Nick? Was it positive or negative, do you think?

Sciple: It was significantly negative.

Gillies: It was significantly negative, it was about -$450 million to -$500 million, I believe. I think it's negative -$454 million or something. But the point is, it's not higher than GAAP profit.

Now, my question that I would turn around is, what is the incentive to report a GAAP profit and a negative cash flow number?

Sciple: Well, to show a profit, of course.

Gillies: Okay. So, what we're saying by that, is to show a profit; you're correct. But how profitable is it? And why do you need to show a profit? Are you assuming that most people, most analysts, most investors don't read past the word "profit?" I mean, that may be true, but that's kind of sad if it's true. Like I said, I don't care about it. I go straight to cash flows and look at what's going on there.

But then, the next question I would ask you is, why? Because, again, we have a GAAP profit, we add back amortization, we add back depreciation, we add back stock-based compensation. All of which are not exactly insignificant for Tesla. And we still end up with negative cash. Why is that, Nick?

Gillies: I think you're going to tell me, Jim, why don't you tell me? Stop the suspense. The suspense, it's killing me.

Gillies: Okay. Well, the first thing is, so Tesla's history is they backload their quarters, right? So, in a quarter, you know, the first month of the quarter is pretty mundane, the second month of the quarter is pretty mundane, they maybe sell 10% to 15% of whatever they're going to sell in a quarter, or "deliver," I should say, I shouldn't say "sell." They deliver maybe 10% to 15% in the first couple of quarters or first couple of months in a quarter each.

And then there is an inevitable push, last. So, at the end of 2019 there was that big, massive push in December. So, October was meh, November was meh. And suddenly December, we're going to just jam all the cars out.

And, in fact, what we see in the last few quarters is, there's always some sort of a miraculous leaked email that's come from Elon to staff. I mean, it's quite remarkable it happens every quarter, where, you know, "Hey, let's all hands on deck and if we do that, we have a shot at a record quarter," and all this wonderful stuff. And so, they jam, like, 70% of the deliveries in the quarter in the last month.

Didn't get to do that this quarter, did they, because the world is in pandemic shutdown and so we didn't have that mad rush at the end. So, one of the reasons why their cash flow is negative is because they've got a bunch of unsold cars sitting around on the balance sheet. So, they build them. I believe they said production was about 102,000, they delivered about 88,000 to 89,000. So, about 14,000 cars are just sitting there.

Remember that, next time you hear however -- Tesla is built custom, by the way. So, that's one reason. That's cash; you've got cash sitting in that inventory. So, that inventory is going to have to be liquidated and you would hope that they would liquidate it this quarter. So, they'll be selling and they'll probably be marking down a few parts [...].

Sciple: Well, and their factory is closed, right? So they're not producing, right? So, they're naturally going to sell down, any sales they give is going to be out of that inventory.

Gillies: Sure. Again, remember that next time you hear someone tell you that all Teslas are custom built. So, that's No. 1. So, that's something that will and should reverse, I would hope, this quarter and I think it will. We've already had some signs of that in certain places, Great Britain, where there is some inventory liquidation, not a lot yet, and we won't really know until this quarter is in the books, but that's one thing they're going to have to be doing.

The second thing is they have just shy of $1.3 billion in receivables on their balance sheet. That is a bit more problematic. Because, Nick, have you ever bought a car?

Gillies: I have not, thankfully.

Sciple: Oh, darn! Yeah, no, I'm not a big car guy either, but usually when you buy a car, the dealership would like its money today. If I'm going to buy a car, I bought a new car about 11 months ago, and before I get my car, I have to hand them a cashier's check, "Here is your check," so I paid. And so, why are there all these receivables on Tesla's balance sheet? And this is a question, because if I'm paying cash before I take the car, how do we have a receivables balance of -- you know, it's been averaging about $1.3 billion for the last five or six quarters.

And people far smarter than I have been asking this question publicly, saying, "Why is this?" And the explanation that's been coming out of Tesla has not been clear and it's not been consistent. One time it's, "Well, because the quarter ended on a Tuesday or on a Sunday, and so, you know, we can't get the books cleared by then." But there's been multiple reasons given and yet, you know, this is kind of a little bit odd that we have high elevated receivables.

Like, if they were able to liquidate those receivables. Let's say, take back, go from $1.3 billion to, say, $900 million next quarter, that's $400 million in cash that would come into Tesla and would just, you know, obliterate my entire argument here, frankly, but yet it doesn't happen. Why is that? If you can figure it out, please email me, [email protected], I would love to hear it, because you will be doing a service to the analyst community, because so far Tesla has been very tightlipped on that.

The other thing about Tesla is, you know, when you look at their cash flow is, what the whole thing with running to end of quarter is, you know, ramming about 70% of your cars at the end of the quarter has been able to do, is it allows them to keep cash on their books through quarter's end, so the balance sheet is just a point in time, right? The balance sheet is close the business on the last day of the quarter.

And so, on the balance sheet you find out their accruals and their accounts payables on the right-hand side of the balance sheet, the liability side of the balance sheet. And Tesla, by ramming all their sales toward the end of the quarter, what they're able to do is they're able to push-off their payables until the start of the next quarter -- remember when I said it's fairly mundane, whatever. And Tesla has been doing this for a while.

So, they said they had about $8 billion in cash, on their most recent balance sheet, I believe, $8.1 billion, I think; somewhere in there. But that is not what they have throughout the quarter in its entirety. And the way we know that is we can --

Sciple: Elon Musk said that that happens in a deposition, so we can trust him.

Gillies: Well, yes, but, I mean, he isn't saying that in the quarterly conference calls, Nick. And, look, again, there are so many things that in isolation actually aren't really red or even yellow flags, but when you have all of these things that are piling on top of each other, the flags do start waving a little bit. So, like, look, when you get your credit card bill -- I'm asking a question that maybe you're going to completely detonate me here -- but look, if I get my credit card bill and it says, I pay in three weeks, do I pay it that day or do I schedule my payment for like the day before its due?

Sciple: Day before its due, for sure.

Gillies: Yeah. Like, I'm not going to give you my cash three weeks early, I'll give it to you a day before its due. So, there's no sin in doing this, right? But when it becomes repeatable and it's -- and so, what you end up -- and they always focus on their cash at the end of the quarter, but they distinctly will not answer questions about, well, what is it inter-quarter? So, all kinds of companies as they're reporting here in the middle of the coronavirus pandemic, people are really interested in, how's your balance sheet, how's your liquidity, can we talk about that balance sheet again, kind of thing, right? I mean, this is something that's on everyone's mind with everyone's company.

Tesla wouldn't answer the question. They just blew right past it. I assure you, they might have had $8 billion at the end of Q1, but they had +$4 billion in payables due at the end of the same quarter. It's a good bet that, you know, $1 billion or $2 billion cash went out the door within a week after quarter's end to go and try to tamp down some of the payables there.

I'm of the opinion that Tesla likes to spin a narrative, and you know to an extent, we all like to spin a narrative about how well we're doing. You know, what else is Facebook and Instagram -- looking good on the gram, you know, we're telling a highly stylized account of our own lives.

But this is a case of, they don't have $8 billion in cash now. With -- apparently, as of this morning, we saw some news stories come over Bloomberg, apparently Shanghai is closed, at least for a day or two on parts issue. That's fine. You can't get cash out of China anyway. So, any cash in that $8 billion is domiciled in China, you can't use it for Tesla in Fremont, Tesla North America. Add in the payables they've had in there, add in the fact that auto sales cratered in the month of April. I happen to believe that Tesla is going to need to raise capital again, which is kind of an odd thing to say for a company with $8 billion in cash on the books, but I think they're going to have to raise capital again before the second quarter is reported. Could be wrong, but that's my expectation.

Sciple: Right. So, we've raised a lot of second-level concerns drilling into the cash flow statement, drilling into the way they're carrying some things on their balance sheet from the point-of-view of accounts receivable. I know all these auto companies are going to struggle as production is shut down. What could the company report that would, kind of, unwind these concerns in the numbers? Like, so what would, kind of, unwind these concerns that you have, if you saw the company report some new facts?

Gillies: I want to see the receivables come down and a good, honest explanation of why that is. I would like to see the inventory come down with this quarter, I would like to see -- again, don't much care about GAAP profit. So, don't try to impress me with GAAP profit, because it doesn't impress me. Give me cash flows, cash, cash, cash, cash. You know, I'm very one-track mind, very boring there. And again, this actually is not a Tesla issue, this is every company. I want to know how your cash and how your financing and how your liquidity is going, and add the balance sheet in.

I would like to discuss -- sounds paradoxical perhaps, there are a lot of companies who in the middle of this coronavirus are reporting their quarters, there's a lot of companies with a lot of bad stuff that's been happening to them. And we understand why.

We've shut the economy down in the first world somewhat willy nilly, of our own volition to fight against this pandemic. It's OK if things have gone bad for you in this quarter, we are understanding. What went wrong at Tesla this quarter? Every other car company in the world is reporting, and I know, they're not a car company -- of course they're a car company. But like, they're going to claim that they are more of a technology company. But stop with the superlatives, you know. I mean, about a year ago Elon said something about, every Tesla will be a robo-taxi, full self-driving, it'll be making money while you're asleep, they'll be driving -- I mean, I guess it has to be sanitized, but whatever, he didn't know about the pandemic, so we will cut that one some slack. There will be a million robo-taxis on the road this year, how many are on the road, Nick?

Sciple: I mean, well, zero.

Gillies: Rough estimate. Zero?

Sciple: Zero. That's a whole another show, that's a whole another rabbit hole we can go in, but yes.

Gillies: Oh, no, but where I'm going with that is, you know what? It is OK to have had some things go wrong this quarter and the coming quarter. I almost think that, you know, admitting to a degree of fallibility, admitting to a degree that, hey, some things aren't working out for us because of this, that or the other thing. We know it's happened in the past, privately, you know, there've been times when Musk has said, you know, they were weeks away from bankruptcy when they had a $50 billion market cap or something like that. That would concern me if I was a shareholder there. [laughs]

We know they've said things privately, but there's never -- I mean everything publicly is always so amazing and too good to be true sometimes. Maybe I'm a deeply black-hearted cynical human being, and there are probably some arguments for that point. [laughs] But you know like, show a little Achilles' heel and you'll go further with me; how's that?

Sciple: That's fair. You know, every company has some incentive to hold them in their best light. I do say on the narrative side, we've talked for a long time on Tesla, the company. So, we won't have a ton of time to go into the story, but it was interesting, you know, we called out some concerns on their earnings, but generally their earnings were positively received by many of the observers.

But then, coming over the top we had another Elon Musk Twitter rampage, I think is the only way to describe it, tweeting that "Tesla stock price is too high IMO," [in my opinion] tweeting that he's going to sell all his physical possessions, tweeting all the lyrics to the Star Spangled Banner. So, throwing that in the context of what were pretty impressive earnings in the context of what's going on here. [laughs]

Have you ever seen anything like this from a public company?

Gillies: No. That should concern you. If the best you can come up with is, well, that's just Elon being Elon. Okay. When was the last time the CEO of Starbucks pulled that stunt? How about the CEO of Home Depot. Like, I want my CEOs to be boring and focused on their business, I don't want -- again, this is not a Tesla issue, but if he wants to do this, you know, we have to -- like, Steve Jobs, you know, the late CEO, Founder of Apple. Of course, Steve Jobs never met a camera he didn't like, right? Like, Steve Jobs liked a little bit of drama, liked a little -- like, he did. And he got himself in trouble a couple of times. When was the last time you saw Tim Cook saying, oh, my stock price is too high? The current CEO of Apple. The CEO of Shopify, Canada's largest company now, the CEO of Shopify, you know, he likes the limelight a little more than perhaps some people might want to acknowledge. And I say that as a shareholder. But this was just strange.

And what's worse. Okay, fine, you want to text, you want to tweet out the lyrics of Star Spangled Banner? Sure, whatever, have fun. You want to tweet that you're going to sell all your worldly possessions? Also, that's fine, like, if he's got several multi million-dollar houses, I would argue that since there was a very publicized news story, I think, last-third of 2018 where he took out very large mortgages against these houses, it may be arguable he already doesn't own them, you know, it's mainly owned by the banks. But again, you know, like, that's fine.

But the one thing there that should give you pause, the one thing was him saying, our stock price is too high. That is arguably a violation of the consent decree that he signed with the SEC after the $420 funding secured debacle, which cost him $40 million, by the way, $20 million for him, $20 million for Tesla, which he reimbursed.

There is a reasonable argument to be made that the CEO just tweeted material information and without any oversight, without the so-called Twitter-sitter, which is the unfortunate euphemism that maybe came out with the consent decree. But the company has said, Elon on Twitter is how we are communicating to investors. So, no press release, no 8-K, whatever. Okay, the CEO of the company just said their stock price is too high. I haven't seen a great explanation as to why he did that, I think he could face enforcement from the SEC again; we'll see. But it just seems reckless and a little bit silly, frankly.

Sciple: Yeah, I'll tell you my perspective on it, and I, kind of, have two minds on it, part of me feels like you do, you know, this is ridiculous, this is a person. And [laughs] I went to law school, I'm a lawyer, you know, I can pull out my bar card out of my wallet for you. To just thumb your nose at your SEC settlement for the second time, right, because we have the amendment, this is currently the amended settlement, I mean, it's just beyond the pale. But then there's another part of me, which I'm sure a lot of people feel this way too, they're just numb to this, right? There's this new craziness all the time for Musk and really all over Twitter, right? There's this nonsense all the time and part of you just wants to just say that this is craziness. Why should I pay attention to this?

And I think that concerns me as well, because I'm someone who really pays attention to this stuff and really cares about capital markets and corporate governance and all of that sort of thing and if I'm starting to feel this way, then that just shows how our perception is slipping somewhat in what we expect from our public figures. And you know, that's a whole other conversation of why that maybe.

Gillies: That's a whole other conversation, [laughs] one that would get us both in trouble, I think. Yeah, there's just so much and it is just coming so straight and it's almost like, the criticisms I have of Tesla's quarter, the financials, I'm trying to keep it on the company itself. And again, I have no position, I'm neither long, nor short. I have been, both, long and short in the past, but I have not had a position for pretty much a year.

It's just like, why am I ... like, Tesla is by far the most fun company to follow, but it's just exhausting, and by the time -- like, the criticisms I raise about the financial numbers, what's coming out of Tesla, I'm not the only one that noticed them. People far smarter than me were posting in various investing blogs and coming up on Twitter and various places around The Fool and what have you. I mean, I'm not raising anything new. But by the time Elon went on this tweet storm, you forgot about those criticisms, you're like, "Oh, good Lord! What's he doing now?" And you start seeing people coming out, they're saying, "Oh, well, you know he's under a lot of stress," "Oh, he's got another baby coming," and he did, congratulations, you know, as a father myself and as a fan of children, congratulations Elon.

But, you know, it's just, what is going to come next? And look, I'm a really boring investing guy. As I mentioned earlier, I like cash flows, you mentioned earlier about adding to your winners, not your losers. I might argue there's an argument for doing both at certain times, you certainly don't add to every winner, you certainly don't add to every loser, but tie it to valuation. And I've done the valuation work and I've tied lots of valuation work on Tesla.

You know, if you accept, and I know a lot of people don't accept this, but if you accept that Tesla is a car OEM, they're a car company, at least in part and at least in their most important parts; because you know, go look at what the revenue is made up of, it's cars; cool cars, but cars. If you then look at what every other car company valuation is, and you then give Tesla every benefit of the doubt and then you look at their valuation, it is an order of magnitude higher than everybody else's, like it's way beyond pale.

And, again, I know Elon is getting a nice pay package this week as his incentive thing is going to kick in for market cap. Part of me is wondering if that is what's been maybe keeping some things afloat? I don't know. But just from a just a boring valuation perspective, maybe I lack of vision, I'll accept that criticism, but this does not add up, and that's why, for me, I just kind of sit back and go -- I can raise flags and you can own it, you can not own it, that's fine. But my job as an analyst, I mean, I'm literally not doing my job if I don't raise flags where I see it regardless of which company it is.

Sciple: Alright, Jim, last question, we ran super-long, discussed a lot of great stuff for the listeners. I have to kind of ask this question, I know a lot of people listening are going to be asking it, the super high valuation. I mean, Amazon was super-valued for a really long time. Shopify super-valued for a really long time. A lot of really great winning companies, why would you say that rational doesn't apply in this case at this time?

Gillies: I would say to you, first off, Fools, I encourage you to go back through the financial holdings or the financial statements of Tesla. And you go just to the cash flow statement and you go to the cash flows from financing activities. How much money have they raised and with what frequency? And I will give you a hint. It's a lot, and you compare it to Amazon, since you brought up Amazon, Nick, go do this for both companies in their first 10 years of being public. And chart the first 10 years Amazon raised capital through financing, that is, new equity and new debt placement, and chart it against Tesla, and you tell me what you see.

And what you will see is a relatively flatline over time from Amazon, and a steady-line up into the right for Tesla. They are continually raising capital even this far into their journey as a public company. That's No. 1, that this is not even remotely like Amazon, because Amazon has been self-funding for a good long time.

The second thing is Amazon, at the height of the credit crisis, that would be the dearth or the trough -- no, at the height of the tech bubble, because I'm old enough that I was doing this back when, you know, the internet us going to change the world and e-toys and e-pets and e-this and e-that. And Amazon is this money-losing book company on the Nasdaq and it's never going to make any money, unless you listen to David Gardner, so, which I hope some people did.

Amazon at its height, I believe got to -- I don't have the spreadsheet open here or any of our things we use to track these things -- but I believe it got up to about 30X sales, at its height in, like, '99, early 2000. Within a year or two; and it fell about 90% from its high it reached in '99, 2000. It was down to about 4X to 5X sales, and I think it might be as low as 2X sales on a valuation basis, and since then it has generally ranged between 2X and 5X sales for +20 years. I think today, it's at one of its higher multiples to sales than it's ever been in that era, and I think it's still under 5X sales.

So, we won't pick on Tesla anymore, because, you know, frankly it's kind of boring, we've done that. But let's pick on Shopify, Canada's largest company, let's go after them for some fun.

Shopify, now the largest company in Canada, is trading at about 48X, 49X, somewhere between 45X and 50X sales. That should scare you, that should that frighten you as an investor; and I am an investor in Shopify.

Sciple: Me too.

Gillies: Yeah, you too and practically everyone else in The Fool. That should frighten you because there is so strong -- when we bought it originally in one of the Canadian services, we bought it at about 9X sales in June 2016. And there's a lot of growth that's assumed in that price. And what ended up happening, as we go back now, I believe we bought in June '16. So, we had Q1 2016 in the books, where we're looking backwards. We're buying it at 9X sales, whatever the last 12-month.

If you look at the price today and the way that the growth has gone, the price we paid there was, I think, we're now below 1X sales, because the sales has done this, it's gone skyrocketing. So, that was a case of, OK, well, we paid up for growth, not as much you're probably paying up for now, but we paid up for growth, the growth happened, the valuation, it grew into its valuation. This is the classic "grow into your valuation" story.

Same deal Amazon, I think we can call it after +2 decades, Amazon turned out to not be some pitiful little bookseller, Amazon turned out to be a logistics company to get you anything, anytime, anywhere. The growth manifested, grew into its sales; Amazon is good.

Now, let's go back to Tesla. I wasn't done picking on them. Go back to Tesla, Tesla mentioned the cash flow from financing. And again, I could be wrong, but I believe you're going to see yet another capital raise, probably a convertible debt offering, probably on the order of $2 billion sometime within the next month. So, there's a stalking horse people could tell me I'm wrong on when we get to July and nothing happens.

You have the financing arm there, but also, when I said Shopify, when I said Amazon grew into its valuation; Shopify nosebleed valuation, I'm not sure I'd be paying 48X sales today quite frankly, my cost basis is a lot lower than it is today. And I'm telling you right now, I will exit probably some of my position if it stays where it is today, if I have, I could stop talking about it and things like this.

Tesla, how are they growing? Their most recent quarter or most recent year-over-year period, I believe, it's about 15% grower. And this year, the last, really, four quarters includes the Model 3 launch and I guess the nascent launch of Model Y that really hasn't done much, whereas the 12 months previously ending in Q1 2019 doesn't include the Model 3 really, it includes some Model 3, but not a whole year.

And it's 15% growth. How does Tesla's grow? So, Shopify has grown, Amazon has really grown; how does Tesla grow to support the current valuation? Because Model Y isn't going to do it, are we going to launch another ... what's coming out? The Model S and Model X are in decline, that's fine, you know, cars have a natural lifespan. The 3 is out there, but it's a lower price point; the Y is out there, but it's lower price point. So far, minuscule sales.

Cybertruck, the Semi, the Roadster 2, like, these are not ...

Sciple: ... like, require additional vehicle launches to take place.

Gillies: But those things, I just mentioned, those will not be the massive growth engines that they need to grow into their valuation. And so, I ask again, what will be? Because if you look at the actual growth on the financial statements, Tesla is not getting it done to the valuation they need. And again, I have no position, folks. I hope you are listening and with the spirit of what this is intended, which is, think about what you own and you should do this with every -- if you want me to do a deep dive on what's wrong with Shopify and, you know, the stock that I own, I'll be happy to do that too. I ask this question with any company I look at, any company I own.

This would concern me if I were a Tesla shareholder. The growth is not necessarily there to the extent you're going to need for this to support this valuation. And I honestly hope it does manifest and that they're able to do something that I don't envision, because that would be good for shareholders and there's lots of shareholders among Fools.

Sciple: Yeah, I think the big wild card out there and the things you just mentioned, and I generally agree on the auto ramp. The big wild card out there, a lot of folks would call out will be autonomy and that's a whole another show. I have my own skepticism there.

But, Jim, thanks as always for coming on the show, sharing your thoughts. I know we ran long on this one for the listeners, but hey, we got a lot to talk about. We got Warren Buffett and Elon Musk in one show. I mean, heck, there's too much to talk about here. Thanks for coming on.

Gillies: I have been known to prattle and so thank you for putting up with me Fools and thank you, Nick, for inviting me on.

Sciple: Yeah. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for making us sound so nice. For Jim Gillies, I'm Nick Sciple, thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Jim Gillies owns shares of AerCap Holdings, Amazon, Apple, Berkshire Hathaway (B shares), and Starbucks and has the following options: short June 2020 $36 puts on Twitter, short January 2021 $150 puts on Apple, and short January 2022 $175 puts on IBM. Nick Sciple owns shares of Apple, Facebook, Home Depot, and Shopify and has the following options: long June 2020 $100 puts on Tesla, long January 2021 $100 puts on Tesla, and long January 2021 $50 puts on Tesla. The Motley Fool owns shares of and recommends Amazon, Apple, Berkshire Hathaway (B shares), Delta Air Lines, Facebook, Home Depot, Shopify, Southwest Airlines, Starbucks, Tesla, and Twitter and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), long January 2021 $120 calls on Home Depot, short January 2021 $210 calls on Home Depot, short June 2020 $205 calls on Berkshire Hathaway (B shares), short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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