That Didn't Take Long (And Yet, the Market Still Doesn't Care)

That didn't take long (and yet, the market still doesn't care)... Tesla's dubious business model falters... No comparison to Mercedes-Benz... Software gigafactories don't exist... This trendy stock is more like Tesla today than ever... The week of the 'unknowable when' continues... Don't ignore all these examples...

Well, the 'unknowable when' sure got here quick...

Recall that in last Friday's Digest, I (Dan Ferris) pointed out that electric-car maker Tesla's (TSLA) latest quarterly results featured two questionable sources of profitability...

1. Bitcoin trading
2. Selling regulatory credits to other carmakers

I warned Tesla shareholders to be careful. And although I didn't predict its day of reckoning, I did clearly imply that such an "unknowable when" was inevitable. After all, without regulatory-credit sales, Tesla wouldn't have shown a profit for the past six quarters.

Maybe instead of the 'unknowable when,' we should've called it the 'unknowable Wednesday'...

That's because Tesla's regulatory-credit business took a major hit on that day this week...

In short, one of the bigger companies buying Tesla's credits announced during its first-quarter earnings call on Wednesday that it won't need to buy them anymore after this year.

Stellantis (STLA), a Netherlands-based carmaker, formed in January through the merger of France-based PSA (which owned the Peugeot brand) and the multinational Fiat Chrysler Automobiles (which owned the Chrysler, Dodge, Fiat, Jeep, Maserati, and other brands).

Before the deal, Fiat Chrysler was one of the largest buyers of Tesla's regulatory credits. But now, PSA's electric-car division is under the same roof as Fiat Chrysler... which means the latter business will no longer need to buy the credits from Tesla.

Stellantis said it will save roughly $360 million per year by not having to buy the credits in Europe. Roughly two-thirds of that amount – $240 million annually – went to Tesla... Fiat Chrysler was one of Tesla's biggest credit buyers, paying $2.4 billion for them since 2019.

On Wednesday's call, Stellantis Chief Financial Officer Richard Palmer said...

Frankly, the fact that we won't have the cost of credits in Europe is just a net positive.

Eliminating $360 million in expenses without losing a single penny of revenue definitely qualifies as a "net positive."

Of course, on the flip side, it's a 'net negative' for Tesla...

Based on last quarter's profits of $533 million, Tesla's annualized profits equals roughly $2.1 billion right now. So Stellantis' $240 million in regulatory-credit payments per year amounts to roughly 11% of Tesla's annualized profits.

That doesn't sound like a big number. But as I noted at the outset, without selling credits, Tesla wouldn't have been profitable in any of the past six quarters. Go figure... Losing money selling cars and making it up selling credits isn't a sustainable business model.

As you might expect with Tesla, though, the market didn't respond to the negative news...

The company's stock closed down a mere 0.4% on Wednesday. That's simply a random share-price movement that could happen on any given day for no reason whatsoever.

Of course, Tesla shareholders have never cared about profitability. To them, profit is an antiquated measure of business performance. They only care about the twin gods of vision and growth.

It's a solid bet that Wednesday's news didn't change Tesla founder Elon Musk's vision of a planet full of self-driving electric cars that only kill a few people every year.

And Tesla's revenue jumped 74% last quarter over the same period in 2020. So vision and growth are both solidly on track, and Musk's thesis remains intact – credits be darned.

But here's the big problem for Tesla...

It isn't merely that Stellantis won't need to buy any more regulatory credits.

It's that the credits are designed to incentivize all car companies to earn them instead of destroying their bottom lines by having to buy them. The credits are a tax... and avoiding this tax is as simple as either building or acquiring an electric-car business.

That's how they're supposed to work... They penalize car companies for not producing electric cars.

So how long will it be until the rest of Tesla's regulatory-credit revenue disappears as other carmakers get into the electric-vehicle ("EV") market and earn their own credits?

As I've said before, making cars is a highly capital-intensive, highly competitive, economically sensitive, low-margin business. That won't change just because the engines in Tesla's cars don't run on the cheapest, most abundant transportation fuel ever devised.

Tesla has no special intellectual property that prevents other companies from imitating any aspect of its business. At some point, all of those other companies can – and will – buy all the same robots for their factories, make or buy similar batteries, make or buy the same software, and produce products at least as good as Tesla's.

It's already happening. All the major car companies are making EVs...

I've driven the top-line Tesla Model S. It was a very nice car that accelerated like a rocket... But it's nowhere near as luxurious as the new Mercedes-Benz EQS.

And why should it be? Mercedes has been synonymous with luxury for nearly a century.

There's nothing proprietary about putting an electric motor with a giant battery pack in a car... but there is something absolutely inimitable in the minds of car buyers about the Mercedes brand name.

Multiply this effect by every major car company on Earth... and Tesla starts to fade into the noise of a market every bit as competitive as the market for cars with internal-combustion engines.

After last Friday's Digest, a reader e-mailed us to say that I was wrong...

He argued that Tesla is really a software company, not a car company.

Well, in the table below, I've listed Tesla's gross and pretax profit margins compared with those of software giant Microsoft (MSFT) and carmaker Toyota Motor (TM).

You tell me... Which company does it look more like?

And maybe that reader didn't see Tesla's most recent earnings release, which featured pictures of its absolutely gargantuan factories under construction in Germany and Texas...

You don't spend billions building multiple "gigafactories" to make software. To do that, you build a lush campus where your software engineers sit around in beanbag chairs being creative, play table tennis, and get free gourmet meals and child care.

You build gigafactories and fill them with expensive machines (and maybe some expensive people) to turn – increasingly expensive, thanks to inflation nowadays – raw materials into cars.

Tesla bulls will no doubt point out that the stock is a 13-bagger over the past two years... It has outperformed just about everything but bitcoin and surgical masks in that span.

Bulls are focused solely on the pleasant sight in the rearview mirror... though even that backwards-looking mindset now requires blotting out the recent 25% drop from its January 25 all-time intraday high of $900.40 per share to today's close of $672.37 per share.

That type of recent price action strikes me as a stock that investors might be falling out of love with... possibly permanently.

Here's the bottom line when it comes to future expectations in Tesla's stock...

If I'm right about the regulatory credits, then Tesla's financial results will soon become a purer reflection of its ability to make and sell cars at a profit. And the lack of profitability will eventually disappoint even the most cluelessly optimistic Tesla shareholders.

At roughly 200 times last quarter's annualized profits, Tesla bulls have zero room for error... With this sky-high valuation, their most optimistic projections absolutely must come true.

Tesla needs to start selling tens of millions of cars soon. (It's making about 600,000 per year now.) And even more important, it needs to be pulling this big increase off at a profit that doesn't include selling government subsidies to other companies or trading bitcoin.

Tesla shareholders right now believe they're holding a sure thing... But in reality, they look more like an insurance company betting that another earthquake will never hit in California.

The "unknowable when" for Tesla's business model arrived Wednesday. Can the unknowable when of the stock trading far below its current exorbitant valuation be far behind?

Keyboard cowboys... please feel free to tell me how wrong I've been about Tesla so far – as long as you also point out that I absolutely nailed the vulnerability of a subsidized business model, as well as the fact that the market has fallen out of love with the stock.

Speaking of falling out of love with a stock...

This must be the week of the 'unknowable when'...

In the September 3, 2019 Digest, I called Peloton Interactive (PTON) "the Tesla of exercise equipment" because...

There's more cachet than genuine benefit to owning one. And yet, I bet showing off your stationary bike won't feel nearly as good as flashing a Rolex, an Apple Watch, a Tiffany bracelet, or a fancy electric car.

Now, also like Tesla, Peloton's products have proven far more dangerous for users than anticipated. On Wednesday – coincidentally the same day Stellantis said it would no longer be a reliable source of Tesla's profits – the "unknowable when" came with a vengeance for Peloton...

The exercise-equipment maker recalled all 125,000 of the $4,295 Tread+ treadmills that it has sold to date due to safety concerns. According to the recall notice, Peloton has received 72 reports of adults, kids, pets, or objects being pulled under the back of the Tread+ treadmill – including a 6-year-old child who died in one incident earlier this year.

Meanwhile, all of the nearly 6,500 units of the Tread (Peloton's other treadmill) were also recalled because the console – the part with the TV – can become detached. It could fall off the machine while it's operating, posing a safety hazard for users. The company said it has had 18 reports of screens loosening and six reports of them falling... but no injuries so far.

The Tread+ came out last November, but the Tread has been out since 2018.

Most important... Peloton will issue refunds for all of its treadmills.

Peloton's stock closed down nearly 15% on Wednesday, the day of the recall announcement...

It closed today at $83.81 per share – down about 50% from its peak in mid-January.

Back in September 2019, as longtime readers will recall, I likened buying the stock to a dare such as eating live cockroaches...

Remember the gross-out TV show Fear Factor, where guests were challenged to do crazy things like climb into a box full of snakes or eat live, giant cockroaches?

That's where we are now in the market: It's the "Fear Factor IPO" market, where investors have to buy into crazy new stocks. Those who require profits are labeled cowards.

Exercise-equipment maker Peloton smells like a typical Fear Factor IPO.

The stock went public later that month and closed its first day of trading at around $25 per share. It soared as high as $171.09 per share during the day on January 14 of this year, as the company rode the "stay at home" mania in the wake of the COVID-19 lockdowns.

But thanks to the massive recall, Peloton now faces a big problem...

Based on numbers in the company's press release on Wednesday, it looks like refunding the purchase price of all the Tread and Tread+ treadmills would cost at least $553 million.

I don't know if the recalls would also include shipping costs to send the treadmills back... And I don't know how much the mishaps will cost Peloton in legal settlements either.

Let's be optimistic for Peloton shareholders and assume the company gets off easy...

We'll imagine that the whole episode will cost no more than $600 million. Peloton earned just shy of $3 billion in revenue over the past 12 months. The refunds from the recalled treadmills would effectively reduce that to about $2.4 billion – or around 20% lower.

But beyond that, the jury is still out...

How much have the recalls damaged the brand? Will Peloton ever sell another treadmill again? Maybe instead of avoiding just Peloton's products, folks will avoid all treadmills.

Six people have died in accidents involving the possible failure of Tesla's autopilot. The company has recalled thousands of vehicles.

But new Tesla buyers don't seem bothered, as the company reported a 74% rise in sales last quarter. Maybe Peloton will survive this debacle and continue to grow, just like Tesla.

With all these negatives, and the stock still trading at 147 times pre-recall earnings per share, once again... just like with Tesla, the very most optimistic outcome absolutely must happen to justify a bullish view of the stock at current prices. There's zero margin for error.

Peloton's recalls, potential legal settlements, possible brand damage, lack of profitability, ballistic 2020 share-price trajectory, and a valuation that could only be justified if there's never another syllable of negative news reported on the business...

This is exactly what a bursting bubble looks like.

Anybody who had money in the stock market back in 2000 to 2002 knows that feeling.

That reminds me... An exchange-traded fund ("ETF") manager that we warned you about in February – and again in March – also has that "bursting bubble" look to it these days.

We'll leave you this week with one more 'unknowable when' moment...

We're talking about ARK Investment Management, of course.

Earlier this year, we were skeptical about the future performance of the firm's innovation-oriented ETFs – including its flagship ARK Innovation Fund (ARKK). In February, we pointed out that every ARK ETF was on a ballistic trajectory, but that in the stock market...

There's always a "What next?" to answer. And what's next is a horrendous crashing sound in the vicinity of ARK's ETF offerings.

The ARK Innovation Fund soared 150% in 2020... thanks to the performance of Tesla (its largest position, at 10% of the ETF's assets) and stay-at-home stocks like Zoom Video Communications (ZM), Roku (ROKU), and Teladoc Health (TDOC) in its top 10 holdings.

ARKK peaked five days after our Digest warning in February. It now trades roughly 31% below its 52-week high due to the poor performance of Tesla and other top 10 holdings.

(Keyboard cowboys, again... I'm not saying I called the top, but I don't mind if you say it.)

Investors don't like the price action, and they've increased their bets against the fund...

Put option volume on the investment hit 190,000 contracts on Wednesday... That's the highest level in six weeks and the fourth-highest level ever. Plus, the fund recently logged six straight days of outflows – the longest streak since its 2014 debut.

When bubbles pop, they tend to wipe out all the excesses and then some... It's always enough to destroy investors' hopes that it was "different this time."

During the dot-com mania, the Nasdaq Composite Index went ballistic starting in 1998... peaked in March 2000... and eventually crashed back to its 1996 level.

A similar crash could take the ARK Innovations Fund back to its 2017 level (the year it rose 85% and started looking manic) to less than $30 per share. That would be more than 70% below its current level. (The fund closed today at $109.68 per share.)

In other words... is the top of the Great Bubble already behind us?

Fortunately, I don't need to know the answer. I only need to tell you what I would do...

Prepare for the bubble's inevitable burst by avoiding all the Teslas, Pelotons, and ARKKs out there. And make sure you're ready for a lot more "unknowable when" moments to arrive soon.

The good times won't last forever... They never, ever do.

New 52-week highs (as of 5/6/21): ABB (ABB), AbbVie (ABBV), American Financial (AFG), Altius Minerals (ALS.TO), American Express (AXP), Brunswick (BC), Berkshire Hathaway (BRK-B), Brown & Brown (BRO), CVS Health (CVS), Quest Diagnostics (DGX), Dow (DOW), Eagle Materials (EXP), Expeditors International of Washington (EXPD), Comfort Systems USA (FIX), Home Depot (HD), Huntington Ingalls Industries (HII), Hershey (HSY), iShares U.S. Home Construction Fund (ITB), JPMorgan Chase (JPM), LGI Homes (LGIH), 3M (MMM), MasTec (MTZ), Annaly Capital Management (NLY), Oshkosh (OSK), Invesco High Yield Equity Dividend Achievers Fund (PEY), VanEck Vectors Russia Fund (RSX), Travelers (TRV), Trane Technologies (TT), United States Commodity Index Fund (USCI), Valmont Industries (VMI), Consumer Staples Select Sector SPDR Fund (XLP), and Alleghany (Y).

In today's mailbag, feedback on C. Scott Garliss' Thursday Digest... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"How the Fed can kill the [Melt Up]... Only one problem with [this] observation.

And the Fed isn't seeing the risky loans it saw during the housing crisis over a decade ago. As a result, it's confident the current boom in the industry doesn't present any risks to the economy.

"The Fed didn't see the risky loans during the housing crisis either, at least not until we all saw it which was too late.

"Right now the Fed can't see real inflation despite truckloads of data every day affirming it in every corner of the economy.

"The Fed only sees what it wants to see, which is too often true of those sitting atop a mountain of one sort or another. The Fed's confidence is propped up by its inherent blindness of convenience.

"That could change a lot of outlooks." – Paid-up subscriber John C.

"Excellent Digest by Garliss, except I think he forgot to incorporate two perspectives...

"First, the Fed has said they will let inflation run above 2% to make up for all the years it spent below 2%. If so, their reaction will be slower (besides, they need to inflate debts away).

"Second, the debt/balance sheet problem is now so much bigger and therefore the negative reaction to tightening will be much quicker. The Fed may not even be able to discuss tightening, let alone begin implementing.

"In other words, I think he needs to include in his calculus the current extremes that we face. It would be good to hear his thoughts on these." – Paid-up subscriber Jon W.

C. Scott Garliss comment: Jon, thanks for taking the time to send a message.

I haven't forgotten about the Federal Reserve's comments on inflation. The central bank said it wants to see inflation sustained above 2% before changing its policy on interest rates.

That doesn't necessarily mean it will let inflation run above 2% for the same amount of time that it has remained below 2%. Former Fed Chair Ben Bernanke introduced that target in 2012 after the financial crisis. And the Fed has basically never achieved that target since then (except for a brief period that doesn't really matter in the larger scope).

While I'd love to think the Fed will let inflation run hot for just as long as it has been cold, I believe that's going to be impossible...

One of the major issues for the central bank is the longer rates stay low, the more the system grows used to it – and dependent upon it. A whole generation of people has now graduated from college without knowing anything other than low rates when it comes to borrowing.

When we took out the mortgage on my home in 2004, it was for 30 years at 5.875%. Everyone told me how incredible that interest rate was because it was super low on a historical basis. But of course, we've since brought that rate down to 3%. And when my dad started his own business building houses in the 1970s, interest rates were closer to 20%.

The longer the Fed waits on raising rates, the more of a shock it will be to the system... Because the longer it goes on, the harder it will be to get away from it. And it needs to rebuild its weapons arsenal. Otherwise, it will be worse when the next crisis strikes.

In terms of the balance sheet, the Fed needs to prepare for another rainy day as well.

But we must remember... it's not going to sell the bonds it owns outright. When it stops buying new bonds, it will keep reinvesting the proceeds from the maturing ones. We're talking about $8 trillion (the size of the Fed's balance sheet)... That's a lot of money. But at some point, the true test will come when the central bank simply lets its holdings mature and doesn't reinvest the proceeds.

In the process, it will have removed the largest buyer of bonds from the market. It won't be there to keep interest rates down. That could very well lead to a taper tantrum.

At the end of the day, this doesn't mean the Fed will be successful raising interest rates once more or winding down its balance sheet... But it's going to have to try.

And history will decide whether these policies are the best for everyone or not.

But my overall point is... by using this knowledge to our advantage, we can better prepare so we have less to worry about when the next disaster strikes. Thanks again for writing in.

Good investing,

Dan Ferris
Medford, Oregon
May 7, 2021