Tesla’s trillion-dollar takeaway
Most of us may not know Michael Burry. Among the savvy stock investors, both in India and abroad, he is a known Cassandra. Like the princess from Greek mythology, whose prophecies were true but she was never believed, Burry’s accurate warnings about the 2008 Financial Crisis, and Great Recession, were ignored. He made money from it through the Big Short,’ and became famous. In his new Substack newsletter, Cassandra Unchained, he hopes to take on the tech giants, and the mystique of Artificial Intelligence (AI).
In a recent blog, Burry guns for the tech giants, which use stocks and shares to compensate founders, CEOs, and senior executives. Tesla’s CEO, Elon Musk, whose trillion-dollar compensation got 75 per cent votes from the shareholders, is among them. Palantir and Amazon are the other names he highlights as these firms dilute their shares through such measures. According to Burry, Tesla’s stock is “ridiculously overvalued,” and that too “for a good long time.” This is because of the adverse impact of stock-related salaries. It distorts the way the shareholders perceive profitability, and valuations.
Not just the senior executives, even mid-level managers receive stocks as rewards to boost compensation packets. This is through the issue of new shares which, obviously, increases the number of shares, or equity capital of a firm. The existing shareholders, therefore, continue to own less of the equity each year than they did in the previous one. In the case of Tesla, reveals Burry, the share count increases by 3.6 per cent each year. As per his approved trillion-dollar future package, Musk is likely to get tens or even hundreds of millions of shares, which may double his stake to nearly 29 per cent over the years. This will reduce the ownership of the others.
Since stock market valuation is based on the multiple of price-to-earnings, the latter reduces if the number of shares go up each year. Thus, for valuation to remain high, or go up, the multiple constant needs to rise. This may create a divergence between a firm and its peers. Obviously, innovative, and investor-friendly firms enjoy a higher multiple compared to their competitors. It can be, say, 20x while the average figure for the industry or sector is only 10x. But share dilution has an indirect impact, which is not related to present performances, sentiments, or future expectations.
Burry shares a chart that depicts how “this steady dilution (of shares) can erode a company’s value, especially over long periods.” He adds that this dilution is “certain to continue.” Many experts see stock-based income as a step in the right direction. It forces senior executives to adhere to a timeline, and specific milestones. It encourages the senior executives to think of the shareholders, and firms first, as their futures are linked to both. Musk’s trillion dollars are tied to Tesla attaining specific market cap, and annual revenues. His income will fall short if the milestones are not achieved.
However, experience shows that the reverse may also be true. CEOs and founders may feel the pressure to show better performances to line their pockets, and resort to illegal and semi-legal shortcuts. They hope that the irregularities will come to light long after they have quit, or monetised their stock holdings. The legendary Jack Welch was known to massage the quarterly earnings of General Electric to avoid expectation surprises and shocks to Wall Street. Internet firms, and dotcoms routinely misguide analysts, and shareholders to paint a rosier financial picture.
In addition, the dilution of the shares is not adjusted through stock buyback. For example, if the number of shares go up because of stocks given to the senior executives each year, the firm can buy back shares from the market using its cash reserves, to balance the equity capital. This will preserve valuations, which will not be adversely impacted due to bloating equity bases. Even if a firm cannot buy back the shares each year, it can do so every few years to rein valuation sanity. This, of course, does not happen in most cases.
A broader critique by Burry pinpoints how the stock options, and stock-based compensations are accounted for in the balance sheets. He claims that many tech firms remove these from the “adjusted” earnings, and financial results. Look at it from a normal perspective. Stocks are part of the salaries and, hence, they need to be shown as incurred expenses. Since, they are not included on the expenditure side, they boost the profits. More importantly, stock-based payments are regular and recurring features, and give a false picture regularly. Tech giants “routinely benefit from this practice because it makes their financial performance healthier than it truly is.”
Stock options, and stock payments are a genuine cost to the shareholders, and happen at the latter’s expense. They can never be, in the words of the legendary Warren Buffet, be treated as optional footnotes. Based on such arguments, Burry proposes, and concludes that “when the real cost of stock-based compensation is fully considered (on valuations and profits), Tesla’s valuation looks much less defensible than its headline numbers suggest.” According to media reports, Tesla’s share price dipped slightly after Burry’s newsletter, although the scrip stood six per cent higher this year.
In the recent, there were concerns about the valuations of tech stocks. A recent agency report states that while earnings of tech stocks as a percentage of S&P 500’s collective earnings are down, the former’s share in market cap is at an all-time high. In the third quarter of this calendar year, tech firms accounted for just under 21 per cent of the earnings, down by two percentage points compared to three quarters earlier, the share in market cap rose by a percentage point to just over 31 per cent. This raises worries that share prices of tech firms are “further removed from underlying profit trends.”
Nasdaq Composite Index, a tech-heavy one, trades at a forward P/E (price-to-earnings) of more than 29, which is above its 10-year average, and higher than S&P 500, which includes diverse stocks. In both cases, the expectations are that AI will deliver results in the future, and push up the profits of the tech firms. Recent results by Nvidia exceeded the street’s expectations, and nullified concerns about AI-driven valuations. Yet, some experts contend that these factors cannot fully explain the stretched valuations. One needs to see how the ‘Magnificent 7’ tech stocks perform in the future.
