The world economy rebounded from the 2008 crisis by relying on emergency Central Bank programs of ZIRP, NIRP and QE. The stated goal of the emergency measures was to inflate asset prices with the hope the effects would spill over and drive Main Street growth. Well, the Fed certainly succeeded in inflating asset prices, the question now becomes can they remove the emergency measures without destroying the bubbles they inflated.
One of the negative consequences of ZIRP and QE is they manipulate honest markets with a flood of cheap money. As a result, zombie companies and questionable startups can flourish as investors are forced into risky assets as they searched for yield. As trillions of dollars were created with the printing press, they all had to find a home. This helped destroy market fundamentals and fueled a Wall Street run where nobody ever lost.
Tesla (NASDAQ:TSLA) was born into the greatest monetary experiment in the history of the world. The timing for the venture could not have been better, with government giveaways, easy money and the lowest interest rates in world history, it was the perfect time to be selling a story. However, as the economic fundamentals begin to change, Tesla, (with a current valuation of approximately $465,000 per vehicle sold) will go down as the poster child for the insanity of bubble finance.
As we read the daily back and forth on this forum, we are supposed to believe that as soon a Tesla can build and sell a few hundred thousand Model 3s per year, there will be nothing but blue clear sky ahead. However, if you look at the economic fundamentals driving the automotive industry for the last ten years, it is easy to see that now is not the time to place a bet that Tesla will be valued at $600,000 per vehicle sold in the future.
While numerous sectors of the economy have been artificially inflated by QE and ZIRP, the automotive market has reaped substantial windfall from 10 years of emergency measures. When the housing crisis blew up in 2008 Wall Street had an entire infrastructure built to securitize and sell mortgage loans. With that product seriously diminished, Wall Street had to find a new product to feed the beast. Apparently, auto loans fit nicely into the model.
Of course, we all know the story, if you can securitize the loans you can effectively eliminate the risk of lending to lower tier borrowers. If you can loan to lower tier borrowers, you can increase your loanable market and increase your yields. That is until the magnitude of losses overwhelms the extra income.
In addition to lending to the worst borrowers and pegging the interest rates to zero, how else can you drive the sales of more expensive cars? Well you loosen the terms of the auto loans of course. In a recent market study for the Denver Market, average Loan to Values for new car loans ranged from 93.55% to 125.25%. For used cars the average Loan to Values ranged from 111% to 170%! The more troubling fact was that the highest Loan to Values were being extended to subprime borrowers! Not only that, but the loan terms have been stretched to questionable levels for a depreciating asset.
In the same manner as LTVs, the longest loan terms are also going to the borrowers with the lower credit scores. With 100% + Loan to Values the norm and loan terms exceeding 60 months, it should be no surprise that the number of borrowers underwater on their loans is increasing rapidly.
However, auto sales have not just been driven by purchases. The easy money also drove up residual values and made auto leasing cheaper. As a result, 30% of new car purchases were leases in 2016. Herein lies the problem for the auto industry. The industry is cyclical it rises and falls due to economic and demographic forces.
The US auto industry has averaged about 14.7MM sales per year since 1978. The problem is as autos are a durable product and the replacement cycle is variable. In good times consumers may switch cars frequently and in bad times the decision to purchase a new car can and will be postponed. The use of incentives or abnormally low rates can pull purchases forward, but they cant increase true market demand.
Unfortunately, since the bottom of 2009 the industry has simultaneously employed every incentive in the book to increase sales. Rebates, cash back, 0% financing, $299/month lease for a $40,000 truck, 72 -month + loan terms, 125% + LTVs, all played a part in driving sales to 17 MM + for the last 3 years. Incentive spending has increased from $2,300 per vehicle in June 2011 to over $4,000 per vehicle in 2018. Yet sales turned over in 2017 and the hangover is about to commence.
In taking full advantage of the Feds emergency measures the auto industry has come to rely on emergency measures to sell cars. The problem is, even with no crisis, the explosion of leases will depress used car prices for years to come;
Regrettably, that is not the half of it, as interest rates return to normal all those buyers locked into 0-3% loans will be in no hurry to replace their vehicle. Those that would like to trade up will not be able to, as they took out a 150% Loan to Value on a 72-month term. In year 2, they are still so far underwater they will be stuck, as 100% + LTVs will have left the market. Those that bought more than they can afford will simply give the car back to the bank. This will further depress prices.
When banks start to get numerous cars back worth pennies on the dollar they will further restrict lending. As we saw in the housing crisis, fancy financing can bend the rules of economics, but they cant break them. The fundamentals will eventually return to a market dependent on emergency measures and the results will be catastrophic.
This brings us to Tesla. With an IPO in 2010 Tesla was born into an automotive golden age. US automotive sales grew from 12.7 MM vehicles in 2011 to 17.46 MM sales in 2016. Tesla has only existed in a market where the sales were growing annually. In addition, government loans and tax credits have served as a crutch to keep the company alive. Most importantly, ZIRP and QE have fueled easy money to keep Wall Street and the capital markets fully supportive of speculative ventures. However, as the Fed leaves the markets in 2018 the golden age will end.
Tesla will have to show they can exist in a hostile market with no need for additional capital to keep the lights on. Not only will QE dry up capital markets and perhap choke off Wall Street, but it will increase borrowing rates materially. In addition to the direct impact on Teslas income statement, it will also decrease the amount of people who can afford to buy a $50,000 + car.
So not only will Tesla have to navigate challenging capital markets and the fundamentals of the auto market deteriorating rapidly, but they will also be crossing the threshold to remove the federal tax credit for their vehicles. As if that was not enough headwind, numerous highly qualified competitors will be coming to market with the benefit of the tax credit.
As the daily chatter on this forum focuses on the build rate of the model 3, I suggest you might want to take a step back and look at the fundamentals that drove the capital markets and the automotive markets the last 10 years. Tesla may execute perfectly, but the economic tailwinds they have enjoyed since inception are changing rapidly. Before you wager that a valuation of $600,000 per sale is not unreasonable, you might want consider the fundamental economic drivers that allowed Tesla to be valued at $465,000 per sale.
Disclosure: I am/we are short TSLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short TSLA via long dated puts.