Should You Follow This Hedge Fund Manager Out of Tesla Stock?

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David Einhorn, of Greenlight Capital, has been on the wrong side of the Telsa Inc (NASDAQ: TSLA) trade of late -- he's shorting the stock. That means he's expecting the electric-car maker's shares to fall despite the fact that they've gone up more than 70% so far this year.

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I don't think you should short the stock, but you might want to consider selling if you own it. Here's Einhorn's logic, along with some other issues you'd be wise to consider.    

A perfectly fine car

There's nothing inherently wrong with Tesla's cars. In fact, they are pretty impressive vehicles. And certainly the company's CEO Elon Musk is a visionary, constantly striving toward a future that is vastly ahead of today's realities. But these facts don't translate into Tesla being a great stock, especially after a massive price run-up this year.

For example, Tesla has lost money in each year of its existence. Right now buying Tesla is a bet that, someday, it will be a highly profitable company. And it'd better be, because the company's price-to-sales ratio is around 5.6 (you can't calculate a P/E for a company losing money). You can argue that this figure is down from the five-year average of 11.6, but it also happens to be way higher than those of more established carmakers such as Ford (NYSE: F) and General Motors (NYSE: GM). Both of those auto companies have price-to-sales ratios of about 0.3.    

Valuation, as it were, is my biggest concern with Tesla, and I'm not the only one. It may be the best car company in the world, but it's way too expensive.

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Einhorn's argument, however, runs a little deeper.

Burning cash

The hedge fund manager recently highlighted Tesla's cash burn as a key issue. There's a lot that goes into this, but one big reason for the spending is the automaker's efforts to mass-produce the Model 3, a car meant to appeal to customers who can't afford, or don't want to buy, Tesla's higher-end cars. On a recent conference call, Einhorn noted that Tesla is "expected to burn over $2 billion this year as it begins production of its Model 3." But, he warned, "It is currently only capitalized for the next three quarters."    

Which helps explain why Tesla just announced plans to sell $1.5 billion worth of debt. An optimist would see that and suggest Tesla has solved its cash problems. A pessimist would take a very different view. For starters, the debt is below investment grade, otherwise known as "junk." That's a statement about the company's financial strength and ability to pay investors back. If you don't like the idea of owning junk bonds, why would you own the expensive stock of a junk-rated company?    

And then there's all of the other debt the company has issued in recent years. At the end of the second quarter, long-term debt and capital leases made up around 60% of the capital structure. That's a lot of debt for a company that has never turned a full-year profit. But that's just a snapshot. Look at the graph below: Tesla has been on a debt binge. Sure, that $1.5 billion bond sale will buy the company some breathing room, but at some point this expanding bill will come due.    

Einhorn's concern appears to be pretty simple. Cash is the lifeblood of any business, and Tesla is still sending huge amounts of cash out the door, with some industry watchers suggesting it won't be cash flow positive until at least 2019. How long before debt investors get more concerned about being paid back? If that happens, Tesla's access to capital could quickly dry up (on both the debt and equity side), at which point the stock is likely to get less expensive, perhaps quite quickly.    

What could precipitate such an event? There's a host of options, including car sales not living up to expectations, operational difficulties, or problems elsewhere in the business (in solar power, for example). Overall, what you should be thinking about right now is the risk-reward equation presented by a money-losing and cash-burning company with an expensively priced stock.

Defying gravity

As it stands, valuation is enough to keep me out of Tesla stock. Einhorn, however, sees a catalyst that could lead to a stock-price decline. Essentially, Tesla can only burn cash for so long before investors start to question its future. And if the carmaker finds itself dealing with a cash crunch for any reason, look for that high valuation to fall as Tesla regroups.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Ford and Tesla. The Motley Fool has a disclosure policy.