EVs, Batteries and Tales From The Valley of Death
Today is the fourth anniversary of my blog on investing in the energy storage and electric vehicle sectors. Over the last four years I've penned 275 Articles and 45 Instablogs on topics ranging from technical minutiae to broad macroeconomic trends. Since most of my work focuses on challenges and risks instead of lofty and optimistic goals, I'm often derided as a curmudgeon who doesn't understand the dream. Truth is I've been a guide in the Valley of Death for over thirty years and while I love panoramic scenery, I can't overlook the dangers of old mine shafts, cactus patches and the poisonous critters that live in the valley. So I while occasionally gaze in awe at the majesty of the landscape, my big concern is always the next step.
The scary part is knowing that companies I praise rarely live up to my lofty expectations but companies I criticize always perform worse than I think they will.
Most companies that enter the Valley of Death don't emerge. For the fortunate few that do, the difficult times usually last longer than anyone expected. The single character trait all entrepreneurs share is unbridled optimism. The three character traits all survivors share are determination, focus and fiscal restraint. The following graph from Osawa and Miyazaki is a stylized view of the cumulative losses companies suffer as they transit the Valley of Death.
The next graph from the Gartner Group is a stylized view of the Hype Cycle, a well-known but frequently misunderstood market phenomenon that gives rise to extreme overvaluation during a company's early stages that’s frequently followed by a period of extreme undervaluation in later stages when the major development and commercialization risks have been overcome, cash flows are about to turn positive and stockholders have grown so weary of waiting for good news that they're willing to sell at distressed prices despite improving business fundamentals.
The graphs are not perfect overlays on a horizontal time scale, but they're close, and that's where the dangers lurk. The reason for the differences between the two graphs is a curious split personality of investment markets that was first described by Benjamin Graham who observed, "in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine." Stock prices always peak in early stages of a product launch because the dream is so beautiful. At the Peak of Inflated Expectations, the voting machine personality is firmly in control. When the day-to-day difficulties of building a successful and sustainable business become obvious prices begin an inexorable slide into the Trough of Disillusionment. As they reach the bottom of the trough, the weighing machine personality assumes control.
In combination, these graphs are the reason for Warren Buffet's oft quoted wisdom that "Investors should remember that excitement and expenses are their enemies, and if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful."
That's why truly successful investors who understand the Valley of Death usually follow one of two strategies:
- Venture capitalists buy during the Innovation Trigger and plan on selling during the Peak of Inflated Expectations.
- Vulture capitalists buy during the Trough of Disillusionment and plan on holding for the long term.
As I confessed above my record at predicting short-term success is spotty at best and many companies that I've praised over the last four years have been mired in muddle through survival mode for longer than I would have thought possible. With the sole exception of C&D Technologies, however, they've all survived and they continue to make solid business progress. Companies in the survivor group include Active Power (ACPW), Exide Technologies (XIDE), Maxwell Technologies (MXWL), ZBB Energy (ZBB) and my old teammates at Axion Power International (AXPW.OB). These companies have all had their ups and downs, but they've avoided catastrophic errors and grown their businesses through determination, focus and fiscal restraint. I continue to believe that all five will emerge from the Valley of Death as formidable competitors in their respective sub-sectors and provide market-beating returns for patient investors.
Turning to the other side of the ledger, my track record has been flawless when it comes to identifying companies that were riding the Hype Cycle but unlikely to survive the Valley of Death. Beacon Power, Ener1 and most recently Valence Technologies (VLNCQ.PK) were complete and utter failures that ended up in Chapter 11. Altair Nanotechnologies (ALTI) avoided a total loss by selling control to a Chinese company after its stockholders lost 90% of their value. A123 Systems (AONE) is on the deathwatch and seems unlikely to survive the year after watching its market capitalization shrivel from $2.3 billion in December 2009 to $123 million at yesterday's close. The one trait they all shared was an errant belief that the glory days would last forever and that bullish press releases could obviate the need for determination, focus and fiscal restraint.
Over the last several months I've become increasingly vocal about the risks Tesla Motors (TSLA) faces as it launches its first credible consumer product and begins a long and arduous trek through the Valley of Death. Adherents and advocates are certain that I don't understand the dream. Truth is I understand the dream perfectly but I know that no company can overfly the Valley of Death on the wings of a dragon. The only way through the valley is on foot in sweltering heat.
At March 31st Tesla had $123 million in working capital and $154 million in stockholders equity. Unless it slashed spending during the second quarter, its June 30 financial statements should show working capital and stockholders equity of roughly $65 and $85 million, respectively. At yesterday's close, Tesla's market capitalization was an eye-watering 45 times its estimated net worth, or about ten times higher than it should be at this stage in the company's development.
Tesla is entering the most cash intensive period in its business history where it will have to make cars instead of talking about them. Unless management acts quickly, Tesla will run out of cash this quarter. I was surprised that Tesla didn't close a substantial capital raise during the second quarter because its financial statements were looking so weak at the end of March. Now that we're two weeks into July with nary a peep about additional fund raising, I have to believe Tesla is facing difficult market conditions and significant investor skepticism over immediate execution risks that can't be overcome with happy talk. The potential investors have the upper hand in this particular waiting game because they know that Tesla is trapped between the rock of a down-round financing and the hard place of a going concern qualification on the Form 10-Q it has to file by August 9th.
The clock is ticking.
As a long-term guide in the Valley of Death I've been in that position before and know how the game is played. This is not an opportune time for retail stockholders who aren't paying attention to the carrion birds circling overhead.
Disclosure: Author is a former director of Axion Power International (AXPW.OB) and holds a substantial long position in its common stock.