In this briefing:
- Tesla–The Struggle to Stay Afloat in 2019
- Olympus Corporation (7733 JP): Overvalued with Too Many Controversies
- Growing MVNO Market Share in Japan Looks Positive for Evolving Entrants like Rakuten (4755 JP)
- The GER Weekly EVENTS Wrap: Pinduoduo, Softbank, Healthscope, M1, and Near-Term M&A Catalysts
- Subaru: Continuing Quality Issues and Employee Suicide Point to Sustainability Issues
1. Tesla–The Struggle to Stay Afloat in 2019
Profit Warning for Q4 2018 and Q1 2019: Two Fridays ago, Elon Musk warned that Q4 profits came in lower than Q3’s, despite an 8% QoQ rise in vehicle sales during Q4. He also announced a 7% cut in Tesla’s workforce, as Tesla is now facing “a tiny profit” in Q1 that will be achieved with “great difficulty, effort and some luck”. These are extremely bearish comments from a perennial optimist like Musk. If true, however, it kills the growth story at Tesla. And with the average 15% price cut of the Model 3 in the US and 17% in China, it also shows that Tesla may have misread the demand environment for its high-priced electric sedan.
Model 3 Demand in the US has Clearly Been Exhausted: September 2018 saw peak monthly sales of 22,250 units in the US, which fell to an average monthly rate of 18,039 units in Q4. There are no more wait lists for the Model 3 at current prices: Tesla’s website says delivery can be made in under 2 weeks. In the January 18th profit warning, Musk admitted that Tesla must now sell its lowest-end version for $35,000 from May, or see production fall. At this price, Tesla’s Model 3 probably just breaks even, by our estimates.
Weak Model 3 Launch in Europe: It was hoped that the Model 3’s European launch this March would make up for waning demand in the US. But since opening up configurations for reservation holders on December 7th, Tesla only received 13,773 orders, which is a whopping 24% lower than recent monthly sales in the US. Musk was forced to open up configurations to non-reservation holders, but this led to only 2,436 extra orders over the following 2 weeks. In the US, Tesla opened up the Model 3 floodgates to non-reservation holders 12 months after launching the car. In Europe, it took less than 4 weeks.
No Hopes for Tesla in China Either in 2019: Tesla’s registrations in China for October and November 2018, combined, fell by 72% YoY and overall auto demand is weakening there. Musk proclaimed that Tesla would start production of the Model 3 in Shanghai by 2019-end. The factory site is a barren plot of land (see Figure-5). It took VW 23 months to build its latest factory in China and Toyota’s new Alabama plant will require 28 months. Why should we believe that Tesla only needs 11 months?
Watch the Competition for Tesla in 2019: Tesla will face true competition this year for its first time as 4 new European EVs hit the market. During Q4 of 2018, Jaguar’s new I-Pace outsold Tesla’s Models S and X, combined, in the Netherlands–Tesla’s number two market after the US. Audi’s e-Tron SUV–due out next month–had over 20,000 orders as of December 7th last year. Porsche’s new Taycan–a powerful rival for Tesla’s Model S–has sold out its first year of production, with most orders coming from Tesla owners. The Models S/X provided 50% of automotive gross profit in the 2H of 2018, by our estimates. A fall in volume will heavily impact profits.
Spending Will Spike in 2019 and Lead to Negative FCF: Tesla was able to squeeze out a profit during the 2H of 2018 largely because of suppressed spending on R&D and infrastructure. In order to roll out the new Shanghai plant and bring the new Model Y to market, both capex and R&D must rise significantly in 2019. Our list of “spending needs” (see Figure-1) shows that capex should nearly double to $4.5bn in 2019. Including debt obligations and payables, Tesla’s total cash needs in 2019 come to $9.3bn, which is over twice its equity. A highly dilutive public share offering appears inevitable.
Why 2019 Could Be the End of Tesla: Tesla proved in 2018 that, even with higher sales volumes and lofty pricing for the Model 3, it could only attain an estimated 2H operating margin of 1.7%, excluding environmental credits, one-offs, and stock-based compensation. 2019 will be incredibly harder as 1) Tesla faces stiff competition for the first time since its inception; 2) a lower-priced Model 3 will not generate enough profit to cover falling profitability of the Models S/X; and 3) most significantly, a steep rise in capex and R&D will lead to higher losses and negative FCF. Tesla may need a bailout by a deep-pocketed suitor this year. But this could only occur at a much lower share price.
2. Olympus Corporation (7733 JP): Overvalued with Too Many Controversies
Olympus Corporation is currently trading at JPY4,525 per share which we believe is overvalued based on our EV/EBIT valuation. The company generates nearly 80.0% of its revenue from its Medical Business where it is the global market leader for gastrointestinal endoscopes. Despite Olympus’ market share and technology leadership, the segment has been hit by investigations related to its duodenoscopies and has been fined for violating safety regulations. In addition, the Medical Division is also subject to several bribery-related investigations by the US Department of Justice and could risk losing its market share if the allegations are proven given the industry is highly competitive. Meanwhile its Imaging Business which offers cameras and lenses, is operating in a contracting market, where the segment continues to see declining revenues and is loss making.
To add to all of the above, the company is under scrutiny for governance-related issues such as lack of board diversity as well as poor corporate culture. On the positive side, the management has announced a plan to transform its business, including appointing three new (non-Japanese) directors to its board, all due to the pressure from its largest shareholder ValueAct Capital. The Management has mentioned that they will be proposing one of the partners of ValueAct as one of the three new directors at its shareholder meeting in April 2019, which is encouraging. However, that being said, we are yet to witness any tangible improvement in the way the company has conducted itself since the exposure of its accounting fraud in 2011 and has not been able to stay free of controversy. Hence, in our opinion the hefty premium at which the shares are currently trading is not justified suggesting to us that the potential turnaround in governance quality is being priced in too fully at this point. It is uncertain what other skeletons may be in Olympus’ closets and it seems premature to afford the stock a premium valuation.
3. Growing MVNO Market Share in Japan Looks Positive for Evolving Entrants like Rakuten (4755 JP)
In the latest data, MVNOs (mobile virtual network operators) have reached 7.0% market share of Japan’s main 3G and LTE (4G) services with over 12m subscribers.
Government support remains robust for the MVNOs. Mr. Suga, the Chief Cabinet Secretary, has suggested that MVNOs, in all forms, should expand to 50% of the market in the future.
As Rakuten (4755 JP) prepares for its full MNO (mobile network operator) service launch later this year, the Rakuten MVNO services continues to execute well, taking market share and building a formidable foundation of subscribers. Rakuten is now Japan’s largest MVNO by customer numbers. We expect Rakuten will struggle to make a reasonable return on its MNO on a standalone basis, but it may strengthen the company’s overall ecosystem and create enough synergies to add positive value to the group.
4. The GER Weekly EVENTS Wrap: Pinduoduo, Softbank, Healthscope, M1, and Near-Term M&A Catalysts
In this version of the GER weekly events wrap, we assess the recent lock-up expiry for Pinduoduo (PDD US) which may have led to a short squeeze. Secondly, we assess the debt tender for Softbank Group (9984 JP) which may be supporting the equity. Finally, we provide updates on bids for M1 Ltd (M1 SP) and Healthscope Ltd (HSO AU) as well as update a list of upcoming M&A and equity bottom-up catalysts.
The rest of our event-driven research can be found below.
Best of luck for the new week – Rickin, Venkat and Arun
5. Subaru: Continuing Quality Issues and Employee Suicide Point to Sustainability Issues
Our thesis on Subaru has maintained for some time that margins were inflated due to under-spending and that these costs would surface in one form or the other over time.
As it turns out, the costs were incurred through recalls as Subaru downgraded its FY OP guidance from ¥300bn to ¥220bn on 5 Nov. What continues to concern us is the constant stream of negative news flow on quality and sustainability-related issues. While the latest announcements do not imply excessive direct costs for the company, they continue to raise the question of whether corners were being cut and thus create doubt about the formerly excellent and still very high OPMs generated by Subaru.
We remain negative on Subaru as we expect margins to remain under pressure and believe top line may stagnate or shrink over the next one to two years.
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