Elon was in a bad mood. The latest Tesla earnings call for Q1 2018 was one for the books. You may have read various reports on how Elon Musk berated Wall Street analysts for asking “boneheaded” questions that were “not cool”. He went on to give an unknown Youtuber the bulk of the remaining time on the call. I must admit that the Youtuber’s questions were much more interesting. But I think the sell-side analysts had legitimate questions too. Look, normally I’m not one to sympathize with “the street”. But in this case, they have a point. Tesla does have a problem. It’s spending too much cash on production of the Model 3, based on expectations that it can sell a certain number of the car in the next few months. If it doesn’t meet its target, it may run out of cash, at which point the company will need to go out and raise more cash to keep the lights on and the factories running. Of course, I don’t think Tesla will have a problem raising cash from the debt or equity markets. But that’s not a good situation for existing bondholders or shareholders. Either they get burdened with more debt or their ownership of the company gets diluted. Elon’s response to that might be: “well even if you get diluted in a company that’s growing astronomically, you shouldn’t complain”. Fair point. But shareholders must entertain the idea that Tesla may not grow astronomically. Bondholders are being paid a coupon for the risk of default and sub-par recovery. When that risk increases, they get nervous. The likelihood of Tesla failing to grow and filing for bankruptcy is probably very low, but it’s not zero.
Where I agree with Elon Musk is this: Many earnings calls are full of boneheaded questions about specific cost line-items or various accounting assumptions that have very little to do with the economic reality of the company. And these questions are often too myopic. They focus on the next quarter or the rest of the year. “Street Analysts” do this to fill out their valuation “models”, which are multi-tab spreadsheets that are linked to each other, to arrive at a specific price target that they can slap on a report. I have price targets too. But I don’t use multi-tab spreadsheets. I don’t need them. I don’t need to know whether gross margins will be 15% or 15.5% next quarter. All I’m looking to do, and all the giants of investing like Buffett are looking to do, is to estimate a maximum price we’d pay for an asset. If you’re an analyst, and your thesis is based on minutiae like trends in gross margins over 2 quarters, then you’re not an investor. And if you’re not an investor, why should you be given special status on these earnings calls?
Anyway, back to the Youtuber. He asked Elon Musk about using Tesla’s charging stations as a Moat. He asked (and I’m paraphrasing), “why not use Tesla’s extensive charging network as a Moat by not allowing competition (like a BMW or an Audi) to use your network?”. Great question. Musk’s response created a bit of a stir:
"First of all, I think moats are lame…They're like nice in a sort of quaint, vestigial way. But if your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation. That is the fundamental determinant of competitiveness."
Fair enough. I can’t disagree with what he said. But as a long-time subscriber of Intelligent Investing, I was surprised. Something wasn’t jiving. I’ve learned from Warren Buffett (and others) that I should look for companies with Moats.
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
-Warren Buffett, Berkshire Hathaway Shareholder Letters.
"Being a low-cost producer is an incredibly important moat," he responded, while conceding that "Elon may turn things upside down in some areas…I don't think he'd want to take us on in candy”, Buffett joked.
He’s been saying this all along. Over the years, Warren Buffett has used a lot of real estate on his legendary Berkshire Hathaway shareholder letters on Economic Moats. Some people call it “barriers to entry”. But that’s not an accurate description. Barriers to Entry (in the Michael Porter sense) is a stationary concept. The traditional thinking of Competitive Strategy didn’t entertain the idea the barriers break down and must be renewed. I’ll get to this in a bit. But whether we’re talking about Moats or Barriers, the point is the same: If a firm has a competitive advantage, it must have some mechanism to protect it. Here’s Buffett saying it better than I ever could:
“The key to investing,” [Buffett] explains, “is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”
- Robert Hagstrom from The Warren Buffett Way
It took me a day to realize this: It looks like they disagree. But I think they’re pointing to the same thing. That is: Moats are not permanent. They don’t last. They must be widened – constantly. And the way to do that is to innovate – constantly.
Offense is the best defense.
No Moat between them
If Elon and Warren met in a bar, they’d agree with each other. They might even like each other. How can you dislike Uncle Warren? What Elon’s saying is that a company must innovate to beat competition if it wants to survive. Simply putting in place some sort of protection is NOT going to ensure survival. Even pharmaceutical patents don’t last forever. But I’ll take the liberty to add some subtext: It’s true that a company cannot stop innovating if it wants to survive over the long-term. But it takes time to innovate. It takes time to come up with a markedly better product or a markedly cheaper product. It takes time to divert money and effort from an existing product to a new product (or an improved product). If the competitive advantage of a company is “low cost”, there must be a way to galvanize that advantage for some extended period of time before competition catches up. And competition will catch up. That’s inevitable. That’s the law of competitive destruction.
Moats just delay the inevitable – competition catching up and dampening the incumbent’s Return-on-Capital. A Moat buys time. And the more time an incumbent has, the easier it is to innovate and out-fox its competitor. I have argued that Tesla’s Moat is its Gigafactories. They have 2 now. There’s a 3rd one coming up in China. The plan is to build both cars and batteries at the same Gigafactories. That’s a Moat. The sheer scale of it will drive costs down, through economies of scope and scale. And it will facilitate osmosis between the “car department” and the “utilities department”. But this Moat won’t last. Some Chinese company will replicate this idea within a couple of years. But even if it buys Tesla a couple of years, it’s a good head-start. If Tesla reinvests in its business to widen this advantage – maybe build another Gigafactory or learn something from its existing one to make it leaner and meaner – the advantages will compound. It’ll get harder for a competitor to eat away at Tesla’s returns.
In simple terms, here’s the deal: if you invest $1 million to build a product that sells for $10 per unit, how many would you want to sell? At least 100,000, right? Then you would breakeven (assuming no variable costs and ignoring time-value of money). Ideally, you’ll like to sell many more over a longer period of time. But if your product is easily replicable and can be produced in Timbuktu for half the cost in a month’s time, you might not be able to sell 100,000 units. You may not have enough time to do it. The return on your capital invested will then be negative. To make it positive and to keep it positive, you need some sort of a Moat. You need time. That’s what Warren looks for. That’s what Elon has at the moment. This is what Jeffrey Williams (someone who taught me to appreciate this ethereal subject called “Strategy”) calls “Economic Time”. How long are a company’s cash flows protected from the barbarians at the gate?
The Youtuber’s suggestion – that making the network of charging stations exclusive could be a Moat – is a logical one. But Elon knows that’s not a reliable Moat. Charging stations will spring up everywhere whether Elon makes the Tesla network exclusive or not. The Youtuber suggested that it would take competitors years to install a network. Not really. Look at what Ionity and Green Lots are doing already. Other car companies are all in on this. It won’t take years.
The Charging Station network is not a Moat. I think that’s what Elon meant. Churning out sexy electric cars that are reliable, at record speed, is a Moat. It’ll take a while for Daimler or BMW or Audi to catch up to that. For starters, they don’t have Gigafactories yet. That’s a massive head-start for Tesla. Here’s Elon at the last earnings call in February 2018.
“The competitive strength of Tesla long-term is not going to be the car; it's going to be the factory. We're going to productize the factory. And really, this is a lesson that is kind of obvious in history because the Model T wasn't the product, it was River Rouge. The Model T was a very simple car. Anybody could have made that car, but not anyone could make River Rouge, and that's really what will ultimately – what will be Tesla's long-term competitive advantage.
We'll have a great product. So a great design, great engineering the products itself in the vehicles and autonomy and all that sort of stuff. But the factory is going to be the product that has the long-term sustained competitive advantage, in my opinion.”
Tesla’s competitive advantage will be fortified by their factories. That’s the Moat.
Also, Volatility is a load of ****
Something else that Elon said made me smile:
“…So really the point is, like, people get too focused on, like, what's happening in the space of a few weeks or a few months. This is an old maxim of investing, you should not be focused on short-term things, you should be focused on long-term things. We have no interest in satisfying the desires of day traders. I couldn't care less. Please sell our stock and don't buy it…I think that if people are concerned about volatility, they should definitely not buy our stock. I'm not here to convince you to buy our stock. Do not buy it if volatility is scary. There you go.”
This was his answer when an analyst asked him about giving frequent updates on production volumes, to alleviate the fears of stockholders who might get spooked by volatility. The response from Elon was classic. I won’t harp on the fact that volatility is a flawed concept of risk, but I will leave you with these gems from Buffett:
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”
Amen to that. Focus on the underlying economics of the company – the Castle, the Moat and the Generals. Focus on its competitive advantage, the durability of that competitive advantage, and whether the company has the right Management team in place to widen that Moat.
Elon gives a nod of approval. Buffett nods back. Enough said.