David Trainer (03:08):

On the flip side, it works for something like a Peloton where we’ll say, “Look, if the margins go from terribly negative, equal to the average of all their profitable peers and they grow a consensus rates for the next few years and 10% compound annual after that, and the stocks were six bucks.” Those aren’t necessarily so much price targets as they are ways to really, I think, shine kind of the light into the darkness of valuation and say, “This is what the stocks worth if this happens.” It gives people the opportunity to calibrate their expectations around whether or not they think that is a reasonable scenario or not.

Clay Finck (03:46):

That definitely makes sense. You often see these people with these high growth, high flyers, they’ll say, “If revenues continue to grow at 40, 50%, then it’ll be worth a trillion dollars someday.” And you just hear some of these ridiculous things. One thing I noticed in your research is that you put such a heavy emphasis on economic earnings. Walk us through why that is. And maybe paint a little bit of a picture for what economic earnings are.

David Trainer (04:15):

I was fortunate when I kind of grew up into the business. One of my first jobs was executive compensation consulting. And in that job we went to boards of directors and said, “Look, whatever you do, don’t pay executives based on accounting earnings, because you can grow accounting earnings while running the business into the ground.” You need to look at economic earnings, also known as EVA. And the most important element within economic earnings is return on invested capital. And I’m not the only person that talks about that. That’s Buffet, that’s Miller, that’s Mauboussin. That’s everybody talks about return on invested capital. Because at the end of the day, understanding how much cash flow the enterprise generates relative to how much capital’s gone into it is super important.

David Trainer (04:53):

And that’s kind of what I grew up in the business understanding. Like day one, it was like, “Oh, by the way, don’t rely on accounting earnings.” That was something that came very intuitively and naturally to me. I was very skeptical when even when I was in school, a limited amount of finance exposure you get in undergrad to this idea that we were like doing discounted cash flow models on net income. There’s no attention to the balance sheet. And then I went to Wall Street and I was very fortunate to have Michael Mauboussin as my first boss and mentor. Al Jackson is his boss and they were big believers in the EVA. We were effectively creating our own brand, a more generic brand, right? The EVA brand specific to the Stewart guys, right? But it’s the same thing as economic earnings. Economic earnings is just the general name for EVA.

David Trainer (05:39):

We were building an entire research business around the world, around this superior measure of profits. And it’s superior for one main reason, Clay. It’s more comprehensive, right? What you get with all these other measures. And the farther they get away from economic earnings, really the more narrowly focused they are. Gap earnings, pretty good on the income statement. It has a lot of unusual gains and losses in it. That’s a problem. The taxes are therefore messed up and you got no accounting for the balance sheet really. So it’s a narrow view. The farther you move even from that, whether it’s pro forma or Wall Street, the views get even more narrow because they leave more and more out. The idea is that they’re leaving out what they don’t want you to know.

David Trainer (06:21):

stock-based compensation is a great one. “Oh, poof. That doesn’t matter to me as an investor.” Of course, it does. If you’re giving away the ownership in the company that I have an ownership of and you’re basically diluting me, I need to know about that to the extent we can assign a dollar value that even if it’s approximate, it’s better than a zero. Think about economic earnings. It’s just a much more comprehensive. It’s the full view. It’s like going to the doctor and saying, “Well, I want to understand how well I am.” The doctor just looks in your ears and makes a diagnosis based on that. That’s pro forma earnings, right? Gap earnings is just looking in your eyes, right? Economic earnings is a full body physical.

Clay Finck (06:59):

You talk about stock-based compensation. I’d like to dive a little bit deeper into that. Maybe you could help me understand what are some red flags when it comes to stock-based compensation. Maybe some obvious ones to me would be very high compensation for the CEO and the execs when they’re deeply cash flow negative. Whereas that might be acceptable if they’re deeply cash flow positive. So maybe what are some red flags we should look for when it comes to stock-based compensation or maybe just executive compensation overall?

David Trainer (07:29):

I think too much emphasis on stock-based compensation is a little bit scary and a red flag. A lot of times it’s helpful with startups because they don’t have cash, but there is a cost there. And whenever it’s a large amount, it tends to suggest that people aren’t really taking it seriously as a real expense. And then when you have big compensation packages like we’ve had with Tesla and a few other companies like Avaliant, what happens is you… As well intentions as those compensation package might be, they tend to create a little bit of too much of a short term focus on jacking up the stock price so that they can see windfall, huge cash windfall, profit windfall, wealth windfalls. And that may be good for the CEO in the short term.

David Trainer (08:13):

I think what we’re seeing with Tesla is it’s going to be bad in the long term, right? They shot the moon early on. They transform the car industry, but what’s left? I think we’re going to find out that the emperor in many ways has no clothes here. And Musk is going to continue to walk away as the richest person in the world, right? That’s not a good thing. Avaliant is a case study where the executives were compensated by stock for a bunch of stuff or largely by stock and did all kinds of things to boost the stock price near term. And that business really did run into the ground.

David Trainer (08:44):

Look, anytime they’re also trying to tell you that it shouldn’t be a real cost, that’s a red flag. Anytime someone tells you, Clay, if you’re funding their business and they come back to you and tell you, “Oh, that thing I spent your money on, we don’t count that as an expense,” that’s a red flag. I mean, investors need to realize, managers, executives are spending their money. Those are the agents of your capital. They come back to you and start playing with the profitability numbers in a way that helps them get compensated better or in a way that doesn’t accurately represent the money that’s come out of your pocket or come out of the company’s pocket, that’s a big red flag.

Clay Finck (09:20):

You mentioned Tesla and Elon Musk there. We’re going to get to him a little bit later. But I wanted to talk about something. That’s kind of been on my mind when it comes to just value investing. Oftentimes when I look at some stocks that look to be attractive on a multiple basis, I can get deterred away if their top line is flat, meaning that the revenues aren’t growing for the company. Why might these types of companies be worth considering even though there are many other great companies out there that have strong earnings, but they also have that revenue growth potential and long growth runway ahead?

David Trainer (09:57):

Yeah, look, I mean, we always want high growth, profitable businesses achieve valuations. I think what matters most here, the real way to answer this question, Clay, is to first understand the expectations in the current stock price. Because investing at the end of the day is identifying stocks where the market has profit expectations too low. You want to buy those. And you want to sell or short stocks where the market’s expectations for future cash flows are too high. That’s what matters most. And importantly, cash flows or economic earnings matter most, right? Because if you’re growing the top line at a great rate but your return on the invested capital is below your cost of capital and your economic earnings are negative, you’re actually accelerating the rate of which you destroy shareholder value. Peloton, Robinhood, Coinbase, great examples. Not so much Coinbase because they did get the profitability for a little while. Peloton ever did. The faster they grew, the faster they destroyed value.

David Trainer (10:55):

And really in many ways the same is true for Tesla. They’ve got gap profitability, but the free cash flow has been largely negative. Take away regulatory credits and the margins really aren’t that good. Especially a lot of these hyped up IPOs in the last few years, these have been negative economic earnings companies. And so the faster they grow, the less profitable they are. The more unprofitable they become and the more value they destroy. And so it’s really about understanding the expectations for future cash flows. And so what we’ve seen in a lot of those high flying stocks was that the expectations for future cash flows were completely blind. They were super high. Blind to the fact that the company wasn’t profitable already because I think too many investors would believed the pro forma numbers, which cut out all kinds of expenses in an effort to make the company seem profitable whether it was profitable or not.

David Trainer (11:42):

We did the work on a Coinbase or a Robinhood or a Peloton. What we found is that the expectations for future cash flows, and Tesla for example too, were extraordinarily high to the point where they implied highly unrealistic market share gains. We’re always trying to tie the future cash flow expectations back to something that’s practical and easy to understand. So for example with Tesla, when it was trading at 1,200 bucks, that implied that Tesla was going to own 120% of the entire electric vehicle market by 2030. They’re going to sell more cars than the entire electric vehicle market was expected to be, okay? That’s high expectations, right? Peloton had similar market share gains bake into its stock price. So did Spotify. The list goes on and on. Absurd. And so what we would say, “Well, if you were to back down from where the market is and assume something a lot more reasonable, then the stock is worth X.” And that would be sort of an example of a target price.

David Trainer (12:37):

Now to your point, Clay, on what do you do with companies whose revenues are no longer growing or even declining. There, again, you start with the market’s expectations for future cash flows. And if the market’s expectations for future cash flows are super, super low, well then you might have a situation where even with flat revenues they’re going to continue to generate more cash flow than what the market expects. In which case it could be too cheap. But you always got to be careful. It could be a zombie company, right? It could be cheap for a reason because it’s going out of business.

David Trainer (13:11):

RadioShack is a great example, right? Where the returns on capital were still good. The margins were great. Cashflow was great because they were selling off inventory, closing stores. The valuation implied the profits were going to permanently decline by 80%. Well guess what? It went bankrupt. They did decline by 80% or more. Those situations where you… Look, there’s no substitute for doing the diligence and making sure that you’re not stepping in front of a train here because the business is going away.

Clay Finck (13:40):

Let’s talk about a case study your team recently did. You wrote an article titled Focus on Fundamentals in Stormy Markets. You compare these two businesses and their stock price performance. The two businesses were CarMax and Carvana. Both are growing businesses, but the performance between the two has been drastically different over the past few years. Walk us through this case study.

David Trainer (14:08):

The main thing for Carvana versus CarMax was like Carvana was growing, but not profits. That was a company that at parentally, I think, negative margins. They’ve never earned a single dollar, a profit. We felt like in the markets where they had experienced all of their “growth,” and again growth in quotes because it’s not growth honestly if it’s just top line growth. To me, that doesn’t count always. If you can’t grow top line without growing bottom line, then again you’re accelerating your shareholder value destruction. When we first were negative on Carvana a long time ago, years ago, we pointed out that they had already really fully saturated the high density markets, Atlanta and other big cities, right? They needed that kind of exposure. I mean, everyone does. Those are scale businesses. There’s not a lot of margin in used cars. If that’s a surprise to you, then you need to think about kind of some of the research you’ve put into it.

David Trainer (15:07):

But yeah, there’s not a lot of margin in used cars. There’s a lot of competition. And if Carvana had been able to generate a positive return on invested capital or generate any free cash flow while expanding into the larger scalable markets, we thought that their prospects for ever generating cash flow were very, very low. Not to mention the fact that they’d lack the dealership model, which is where you’re getting most of your inventory on trade-ins. They have to go onto the market and buy those at auction every time, which is a good model when you can be selective. It’s a bad model when that’s where you got to get all your cars.

David Trainer (15:39):

And so now Carvana’s been out there buying, I think, used cars in the all time highest market for used cars. The prices are ridiculous. I think someone just told me the other day. They got a new car and I think they… Yeah, one of our analysts here, Hunter Anderson, he traded in his car. I think he had it for a few years. He got more than he paid for it.

David Trainer (16:00):

Anyway, what’s the dichotomy? Carvana looked like a sexy business model. When you looked behind the curtain, it wasn’t sexy. It wasn’t making any money. And really had no competitive position to make money. Then you flip over to CarMax and other firms, all of which were adopting this paperless sales model, but who had this legacy advantage of being able to gain inventory to sell used cars on the trade-in model, which is huge, also giving people the ability to come in and see and touch a car. It’s kind of a big purchase to make without ever seeing and touching. Look, I bought cars on Carvana. I had two in a short turnaround. I had to send a couple back because they had scratches and stuff was broken when I got it that I didn’t see. And by the way, you still got to sign a lot of paperwork when you go pick it up.

David Trainer (16:49):

And so the Carvana was not sort of this blissful perfect purchase experience. Firms like CarMax had presence, established presence that was money making. They were cash flow positive. They were making economic earnings. The expectations baked into the CarMax stock price were really low. I think they had expectations for little to no profit growth. Whereas Carvana, stock price had expectations that it was going to equal or exceed the market share of CarMax with profitable margins. That it had yet to achieve.

David Trainer (17:22):

Pulling it all together here, with Carvana we saw what we call really bad risk reward. And at New Constructs were about risk reward, bad risk reward, really high expectations for future cash flows and a super competitive market with no cash flows, and what we believe to be very low prospects for ever generating cash flow. That’s bad risk reward. The market’s out there, selling at a price that implies this company’s going to do magical things. Bad risk reward. CarMax on the other hand, generating a ton of cash flow with expectations for little to no cash flow growth. That’s good risk reward. The hurdle that the company has to clear in terms of cash flow growth to justify the current stock price, super low. It’s therefore reasonable to expect that the market will likely readjust its expectations upward when the company’s cash flows exceed the expected cash flows.

Clay Finck (18:12):

Maybe just to play a little bit of devil’s advocate here. I just looked at some of Carvana’s numbers. Their revenue was 2 billion in 2018 and grew to 12 billion in 2021. And as you mentioned, cash flow negative and it’s market caps around 4 billion. Is there a case to be made that they’re sacrificing cash flows today to achieve that growth and potentially have those cash flows in the future that they can reap off of a very large revenue base?

David Trainer (18:46):

Yeah, you can make that argument. A lot of companies do. And I think a lot of people believe that. But at the end of the day what matters, Clay, is how much of those future cashflow expectations already baked in the stock price. If the stock’s already given them credit for that, there’s no upside in buying it because effectively the market has awarded them a value, commensurate it with doing exactly what you just said.

David Trainer (19:08):

So then the real question is, “Okay, well how much credit am I willing to give this company? How much of a turnaround opportunity? How much of what you said is true? We’re sacrificing the year term cash flow to generate long term cash flow. We’re the next Amazon,” right? Everyone’s the next Amazon. I caution people in believing that they’re going to be many more Amazons. Those are once in a generation type companies. Not every company’s going to be the next Amazon. But to your point, yes, it’s absolutely possible that Carvana at some point will become cash flow positive. The question is, how cash flow positive is the stock price already give them credit for? And would you agree with that?

Clay Finck (19:44):

Yeah, definitely a fair point. In relation to a company like CarMax, for example, how many years of earnings and positive free cash flows does a company need for it to be considered stable and consistent in order to project that going into the future?

David Trainer (20:03):

Again, I think that’s a subjective question. Everybody has a different expectation for that. I mean, I think you’d want to see at least one year, a couple years string a little positive free cash flow. I don’t think Carvana has anything close to that. This is one of our zombie stocks because they’re terribly free cash flow negative. They’re burning a lot of cash. They don’t have a lot of cash on the books and therefore could run out of cash before they raise new capital. And if they raise new capital, it’s going to be a lot more expensive.

David Trainer (20:31):

For example, they issued 3.3 billion in senior unsecured notes in April of this year at an interest rate of 10.25%, where their prior, I think, debt issuances were closer to 4.9%. That’s the bad situation to be in. How much cash flow do you need in order to trust the company’s cash flows are sustainable? I have a hard time answering that. I would kind of come back to, well, I would just want to make sure that I always buy stocks where the market’s expectations for future cash flows are lower than mine. CarMax today is trading at a price that implies its cash flows will never grow. They’ll stay the same as they are. That to me seems, again, if you’re especially looking at pair trade, I’d be long CarMax, short Carvana because CarMax’s expectations for future cash flows are super low. Carvana’s expectations for cash flows are still quite high, right? To justify, when we wrote our last report on Carvana, it was at 25 bucks a share. I’m not sure where it is now, but this is just written a couple weeks ago,

Clay Finck (21:32):

22.

David Trainer (21:33):

22? All right. So 25 is close enough, but the math is they got to improve their profit margin to 3% based on a negative 1% to this point and grow revenue 15% compounded annually for the next seven years. That’s what they got to do to justify 25 bucks a share. In that scenario, they’d reach 34 billion in the year 2028, which is 106% of the trailing 12 months revenue of CarMax and over 128% of AutoNation. The stock price is implying they’re going to be bigger than both CarMax and AutoNation and start generating positive margins at the same time, right? So they’re going to take huge amounts of market share while also improving margins. Something rarely done in the history of the world. Usually it’s one or the other, right? And that was your thesis, right? They’re sacrificing near term cash flow to take market share and eventually be profitable. It’s just hard to do.

Clay Finck (22:29):

Your firm has also been super vocal about calling out these zombie companies. We haven’t talked too much about this on the show. So could you walk us through what exactly a zombie company is?

David Trainer (22:42):

It’s a company that has been burning a lot of cash flow, competitively very poorly positioned. So prospects for future cash flow are very low. They don’t have a lot of cash left on the books. So they’ve got maybe less than a year, maybe six months of cash flow burn left before they’ve got to either raise new capital, which in today’s environment is really expensive and difficult to do, or go bankrupt.

David Trainer (23:09):

What we saw during the super easy money fed days and all this fiscal stimulus that we’ve seen over most of the last 10 years was money was so cheap and available that you had a lot of bad businesses getting funded. Private equity firms were just looking at the top line. Well, that’s all changed. You hear all the talking heads in private equity talking about unit economics and generating cash flow and top line growth isn’t enough anymore. A lot of the businesses that we’re able to get away with generating top line growth with no profitability and no prospects for profitability can’t do that anymore. Raising money to support these unprofitable businesses is just getting a lot tougher. And some of them may not be able to do it. We call those zombie stocks.

Clay Finck (23:50):

Do these types of companies pose any sort of risk to the overall financial system? Or what are your thoughts on that? Because I keep hearing how a lot of companies even in the S&P 500 are zombie companies.

David Trainer (24:05):

I feel like there’s a lot of great big companies out there that are going to kind of keep the overall market from, I think, crashing too much. That said, you never know how sentiment is, right? I mean, the pendulum tends to swing too far in each direction. And it swung way up there from the irrational exuberant side the last several years. A swing to the downside is not out of the question for sure. But a lot of the S&P 500, for example, is dominated by Microsoft and Facebook and Apple and Google. These are really big profitable companies that aren’t going to go to zero anytime soon. There are a lot of other ones though.

David Trainer (24:41):

How much systemic risk there is in those stocks? That’s hard for me to say, Clay. I think there’s more than maybe people think, especially when you throw crypto in there. I think a lot of people borrowed money to invest in stocks, or they put too much money in stocks and crypto because it was so easy and everything went up and it was buy the dip and it was hot oil and it was diamond hands and all these things that I think will end up enriching a lot of institutions and really making a lot of individuals much poor because so much of that investing was done without any attention to fundamentals.

David Trainer (25:15):

I’m not here to say fundamental should be 100% of what you do. It just shouldn’t be zero. Have some risk management in your process. You’re welcome to make bad bets on a fundamental perspective, but at least know that it’s bad so that you can have some risk management around that and understand that when things start to turn against you, you better sell. You better sell fast. Otherwise, you’re going to be left with nothing. And I think a lot of people just took a lot of risk. And when that starts to unwind, I think we could see really a lot of selling and a lot of pressure across the market that could lead to some pretty big declines.

Clay Finck (25:48):

Let’s get back to talking a little bit about Tesla. I enjoy bringing on just a variety of viewpoints on the show. We’ve talked about a little bit about the bull case on the show in previous episodes. So I like to hear a little bit more about your opinion on why you’re a Tesla bear and maybe talk a little bit about what their cash flows have looked like maybe the past year or two.

David Trainer (26:10):

Yeah, I think the free cash flow of the last year or two is negative 1.2 billion. Tesla’s a great example of expectations analysis, expectations investing. At 1,200 bucks, the stock price imply they were going to own 120% of the electric vehicle market. Those expectations are too high. I think in our last report, where are we now? It’s 700 bucks. We do a bunch of scenario analysis on this, which is, I think is kind of cool where we look at multiple levels of market share to give you a sense of what makes sense. But really at the end of the day, what it comes down to is, “Hey, what’s the implied market share based on the current valuation?” And from there you can back into, “Well, how many cars they have to sell?” And from there to justify that valuation, to justify that market share. And then how many factories they got to build, to build that many cars to achieve that market share to justify that valuation?

David Trainer (27:02):

And what you realize when you just do that math is that it’s ridiculous. Not going to happen. And they’re not doing it by the way. They would need to be adding, I think, 500,000 cars of capacity every six months, or at least every year. No, it’s more like every six months over the next several years in order to get to the 7 or 8 million or 15 million kind of vehicle level that you need to get to, to justify… Well, that was 1,100 bucks to share. But you get the idea, right? Even if you’re just looking to get to 7 or 8 million cars, you got to be building a lot of factories. And they’re not. They’re not. They’ve got three or four now. I think almost all of them are at least partially or fully offline. It’s not happening. The company’s losing market share. Losing it, not gaining it.

David Trainer (27:50):

Remember to justify that thousand bucks a share so they got to get to over 100%? We’re not trending well in that direction. The bottom line, it’s been really difficult for Tesla to scale up. And I don’t know that they will. I don’t think that they will. I think the competition from the incumbents has arrived and it will continue to eat away at the great lead that Tesla had. And hats off to Elon Musk and to Tesla for changing the market. Spent a lot of capital, Clay, spent a lot of money proving EVs. That’s money that the incumbents didn’t have to spend. And then the incumbents can get to wait until they can produce EVs at a profit or at scale, which is what they’re doing, right? I think the Ford EVs, the Mustang, immediately profitable. The F-150, immediately profitable because they can build it at scale in the beginning. And the Fast Follower strategy has been a smart one for decades.

Clay Finck (28:42):

You’ve been beating the drum on the market being a discount mechanism of future earnings. And I’m sure there are a lot of smart people on the bull side and I’m sure they’re not projecting 120% of the EV market or the electric vehicle market owned by Tesla. They might push back and say, “Well, Tesla has plenty of assets that aren’t producing earnings today, but very well could be behemoth in the future.” Call it maybe something similar to what AWS was to Amazon where it was not any part of their business in the previous years, but now it’s one of their main drivers of earnings.

Clay Finck (29:21):

And for Tesla, that might be their battery technology or maybe insurance or some sort of ride sharing service, or maybe even use or utilize some of the data they’re collecting in their vehicles. Just throwing out some ideas. I’m by no means a Tesla expert. Not a shareholder myself. But it’s all about sort of expectations where you’re not seeing that earnings today and to bet on that for the future is really just a gamble. Whereas the bull side maybe has done deep research on it and they truly believe that Elon’s going to be able to pull this out of his back pocket and make it happen.

David Trainer (29:54):

No, I agree. We’ve addressed those other business opportunities in multiple reports. Battery technology, bottom line, Tesla’s no longer the leader, hasn’t been for a long time. You’ve got a lot of big companies, even countries, building out battery technology that’s very competitive, is good or better than Tesla’s. They lost the lead on the battery fund for a long time. Insurance. Insurance is a joke, Clay. Look, insurance is a tough business. They don’t have that much data. And they just actually admitted in one of the FSD investigations that they don’t actually have the infrastructure to collect as much data as they say they’ve been collecting for their own FSD project, full self-driving by the way. There’s been a variety of other businesses, but insurance like… There’s some big companies doing insurance and they’re doing it well. And Tesla’s not going to be able to compete with those.

David Trainer (30:39):

They still don’t have enough vehicles. And by the way, GM for the OnStar has been collecting a ton of data on that front as well. It’s not something that Tesla has a monopoly on. And by the way, GM’s got a lot more cars out there and a lot more miles for collections. The insurance one, that one’s kind of a joke. Battery, I could tell people would think that because they were a leader in battery. They’re not anymore. And let’s talk about full self-driving. Not a leader there. I think they’re ranked amongst the bottom of the pack at this point, right? And you’ve heard Elon Musk himself even say Tesla’s worth a lot of money if they can solve full self-driving. Might be worth zero if not. That’s a direct quote from him. Recent as well.

David Trainer (31:17):

A lot is riding on full self-driving for a lot of people, a lot of firms. Apple’s doing it. GM’s doing it. Google’s doing it. They’re spending a lot of money on this because it’s a huge potential revenue stream. Don’t get me wrong. Do I think Tesla’s going to be the firm that solves it? I do not. That’s my opinion. I think Elon Musk has been great at selling it, but when you look at all the stats, surveys, and the research, GM is in the lead. Google, Apple, they’re all way ahead of Tesla had been falling behind. Part of the problem is that when Tesla moved away from LIDAR into cameras only, a lot of people don’t believe it can be done without LIDAR, I think. And all the other firms, they’ve got a combination of those sensors, more sensors. Musk made some sacrifices for appearances on the car that I think really handicapped their ability to be successful with full self-driving.

David Trainer (32:08):

I’m afraid that there’s going to potentially be some bad news when these investigations come out and they find that autopilot was engaged or autopilot was automatically disengaged moments before collision so as to avoid any liability. There’s just some stuff that I think long term as we look at the real story of Elon Musk, I’m just not inclined to trust as much as other folks on that front. I feel like it was a potentially a bit misleading to continue to pump his stock when it was that overpriced, because he’s not the one losing, right? It’s a lot of individuals that don’t know any better. It’s a big grift, and I don’t like that. Same with the Dogecoin stuff. Started getting into that stuff. It’s grifting. It’s taking advantage of folks. And that to me is a sign of potentially a character issue. That means you need to step back, be careful.

Clay Finck (32:58):

We talked a bit about the zombie aspect where some companies may not even have the earnings to pay off the interest on their debt. And when interest rates rise, that only becomes more and more of an issue. How dependent is Tesla on that external financing and will higher interest rates put pressure on them? I guess if their stock price is really high, they would be able to sell stock instead of get financing via taking on a loan. So can you share thoughts on that?

David Trainer (33:29):

Great question, right? And they’ve sold a lot of stock in some high prices here recently, right? There’s a lot of cash on the books and not a lot of debt for Tesla. Yeah, free cash flow. I misspoke before. In the trailing 12 months, it’s a negative 358 million. In 2021 fiscal year, it was negative 2.9 billion. 2020, negative 1.1 billion. In 2019, positive 2.6 billion. That was a year they cut back R&D and a lot of other stuff. 2018, negative 1.9 billion. 2017, negative 7.4 billion. All in, I think you’re looking at about negative 10 billion over the last five years in free cash flow.

David Trainer (34:16):

And then let’s see, cash on the books. Yeah, they’ve got around at least 15 billion. They could get at least another five years in them. And that’s excess cash. I think the actual… Yeah, they’ve got closer to 18 billion just pure cash on the books. Yeah, that can last them a while. Musk has been really good at selling stock. And so again, that’s all part of, in some cases, the grift. 6.8 billion in debt. 6.9 billion in debt. So not that much relative to what? 18 billion in cash. Over the last five years around 10 billion. They’re not so much a zombie company because they’ve got that big cash store on the books that can fund them for a while.

Clay Finck (34:59):

When I look at just on a stock screen or a stock filter just searching Tesla, I see actually positive free cash flow. So I’m curious what sort of adjustments you’re making to say that their cash flows are actually negative and diluting shareholder value?

David Trainer (35:17):

Yeah. You got to be really careful with these screeners and the data you get out there. The free data is free for a reason. It’s not good. It’s not scrubbed. We’ve specialized in scrubbing it. We built technology for the last 20 years to scrub data at scale, which is very difficult to do because you have to read these footnotes and look at the income statement, balance sheet, cash flow statement. And I think because of technologies like ours, the world is waking up to the fact that, “Oh, we can’t trust those numbers that we get from FactSet or Yahoo Finance or any of them.” But it all comes down to what I said in the beginning, right? If you’re going to look at fundamentals, you need to do the full body physical, the full company physically. You need to look at everything.

David Trainer (35:53):

The differences between our cash flows and shortcut or traditional legacy measures of cash flows tend to fall into a couple of buckets. Number one, unusual gains and losses that are buried on the income statement bundled in the other line items that people miss. This is what in particular the Harvard Business School and MIT Sloan professors focused on when they show that our measure of core earnings was superior materially so. About 20% difference between our number and your average S&P 500 company number. Much bigger in the smaller caps. So it’s a big material number. Other things, stock-based compensation often gets left out of most companies, cash flow numbers, off balance sheet debt, off balance sheet financing gets left off. A lot of the working capital stuff can be… It just depends. Because a lot of people are looking at EBIT. There’s so many different ways of measuring free cash flow. People will kind of attack us a lot or, “Oh yeah, you’re measuring free cash flow wrong.” I’m like, “Well tell me what the official right way is.” Everyone’s doing it differently.

David Trainer (36:56):

I can tell you hand on heart that I believe ours is the most comprehensive and useful. And we’ve got many flavors of it. Some people want to exclude acquisitions, but the core numbers based on a clean net operating profit after tax and a change in invested capital, we do that. We do a version of the free cash flow to equity holders only, free cash flow excluding acquisitions. Those are the main buckets of things that’s different from other people. We’re looking at more than just CapEx.

Clay Finck (37:26):

Over two years ago, you had a conversation with Preston and Stig on their show and you talked all about Disney. I’d be curious to get just a brief, maybe quick update on and maybe Disney’s business performance over the past few years and how they’ve weathered through the pandemic and adapted.

David Trainer (37:45):

Yeah, Disney’s definitely struggled. We were projecting with Disney was a quicker return to profitability. What we’d seen over the years when they made big acquisitions, that the return on invested capital would dip, as it does within a big acquisition, but the return or the bounce back and return on invested capital was really fast because Disney has a superior content creation and content monetization platform. In comparison, in contrast, Netflix has a very weak content monetization platform. They’ve got one way to monetize content, through streaming. And that’s not worked out so well. Netflix is a big negative free cash flow company as well. People don’t realize that, right? And that’s another one. “Oh, if we just build it big enough, eventually we’ll have enough customers and we’ll be profitable. And then all our problems will be solved.”

David Trainer (38:32):

Now that’s not really working out that way because guess what? Producing content is expensive and you need to have multiple ways to monetize. And that’s something that Disney has. And by multiple ways to monetize, I’m talking about multiple channels of distribution whether it’s streaming, whether it’s movies, whether it’s DVDs, whether it’s cartoons and syndication. And you’ve got merchandising and it’s a big one. And you’ve also got theme parks. Let’s face it. COVID and travel and all that, it was really hard on Disney. And so the return to profitability has taken longer, especially when you’ve got to compete with companies like Netflix and others that can use cheap capital as a weapon. To borrow a term from Bill Gurley, using capital as a weapon. That was what a lot of the private equity firms were allowing companies to do by funding them extravagantly when they were not making any money.

David Trainer (39:21):

Netflix, a clear example of a company that was able to use capital as a weapon or operate at a big negative cash flow loss for a long period of time. That’s difficult on companies like Walt Disney that are more rational. They don’t have that privilege. Their investors expect them to make money. It’s been tough, but do I think Disney’s going to win the long term? Absolutely. I think their library of original content is much deeper and their ability to monetize is much, much better. They’re already still way more profitable than Netflix. I think before the Fox acquisition, I think Disney was making around 10 billion a year in free cash flow where Netflix was burning that much, right? I mean, it’s a tale of two very different businesses. Yeah, if they can just get back to approaching historical levels of profitability, Disney’s got a lot of upside.

Clay Finck (40:11):

Man, you bring up such a good point right there. The phrase using cheap capital as a weapon kind of just had this aha moment for me. I think it’s made investing a little bit harder than it might have been prior to the years of artificially low interest rates. For example, you have a company like Uber just doing a full on attack on the taxi driver industry because they’re able to every single ride sharing service that they’re performing is operating at a loss. Same thing with Lyft.

David Trainer (40:45):

Right.

Clay Finck (40:45):

And then I think of a company like Airbnb doing a full on attack on the hotel industry and hospitality. And now you have many people complaining about the fees on Airbnb or the higher prices on Uber and Lyft and it’s like, “Okay. These artificially low interest rates can just throw an industry all out of whack and confuse investors and confuse consumers as well and frustrate a lot of people along the way.” So I really like that point you bring up.

David Trainer (41:11):

I think it’s incredibly important because the worst part about it, Clay, it’s not just confusing. It’s waste of capital, right? How many billions did these companies spend just to no avail, right? Uber and Lyft, still not profitable, right? And they had to change their internal KPI away from adjusted EBITDA, because adjusted EBITDA doesn’t actually represent profitability. Aha. Goodness gracious. That’s the world we live in. That’s news. Oh, a major publicly traded company that came out at a 40 billion valuation or whatever it was. Oh it took them five years to say, “Oh yeah, that number, we’ve all been telling you that we’re targeting, it doesn’t really actually translate into profits.”

David Trainer (41:47):

The real issue is opportunity cost here, Clay. If that capital that was burned on overpaying salaries and executives and a business model that ultimately isn’t really going to work, you can only sell things below cost for so long. If that capital could have been deployed into good companies that were actually going to create wealth, create shoulder value, we as a society enjoy higher levels of growth and prosperity. Instead, this capital is wasted on Wall Street fees, outsize executive compensation, money taken from the pockets of many, pennies from the pockets of many into the pockets of few. It’s a bit of a tragedy. And that’s part of why I feel like a lot of these business leaders, Elon Musk and from the heads of these companies, other companies, whether it’s SNAP or Lyft or Uber or Robinhood and Coinbase, they bear some responsibility for hoarding and stealing huge amounts of capital to benefit themselves personally at the expense of society when it’s at that scale.

David Trainer (42:45):

Wall Street’s in the front of the row on this one too, right? I mean they’re setting the stuff up, right? I mean, come on. A lot of these IPOs have really turned out to be jokes. And look, Wall Street makes money either way, right? They get hundreds of millions of dollars of fees on these IPOs. It’s good for them, but it’s bad for society. And I want people to understand that that’s a big part of what drives New Constructs every day. Our mission is to improve the integrity of the capital markets by informing people the truth about fundamentals. Again, fundamentals don’t need to be 100% of what you do. It shouldn’t be zero. And if you have a little bit of risk management in there, a little bit of an eye on what’s going on with the fundamentals, it’s just going to keep you from getting blown up or help you avoid the blowups. Because at the end of the day, stock market is a capital allocation mechanism.

David Trainer (43:30):

The purpose of the stock market is to allocate capital to its highest and best use. When we take this huge amount of resources and we burn a bunch of it, we give it away bunch to people who are buying big managers or flying around on jets, that’s taking away from society’s ability to be more prosperous and grow the pie. And that’s a big part of what we’re about. We want to help people invest intelligently and then therefore grow the pie here in the United States and around the world so that civilization moves forward in a more productive way.

Clay Finck (44:00):

I think my big takeaway from today’s conversation is just be a little bit careful about the numbers you see out there. So David, such a good conversation. I had a lot of fun. Thank you so much for taking the time for our audience to join me today. Before we close out the episode, I want to give you the handoff to New Constructs, what you guys are working on and anything else you’d like to share.

David Trainer (44:22):

Yeah. Thanks, Clay. It’s been a lot of fun. I love these kinds of conversations. I think it’s helpful for people to hear it from someone who’s not your sort of traditional talking head, doesn’t have an ax to grind or a product to sell. I’m not a banker. I’m not a consultant. We are purely focused on honest, reliable research. We genuinely want to help people be more informed. I think you’ll see that on all of the research that we publish on our site. We’ve got long ideas, danger zone ideas. We’ve got subscriptions starting at as low as 999 and going to 10,000 or plus a month, depending on the type of customer you are. We serve a wide variety of customers. Most of our business is institutional. Some of the biggest names in the business paying us for our data that they can trade systematically to generate alpha because it’s so unique. And all of that powers the rest of our research.

David Trainer (45:10):

I think in a world where there’s so many whiz bank tools around there about how to better organize the existing information, maybe it’s time to go back and just look for a better source of information in general. And that’s what I believe we provide, a better measure of profitability and valuation to make more informed decisions and to provide, I think most importantly, a source of research that people can really trust.

Clay Finck (45:34):

Well, David I’ve really enjoyed this. I’ll be sure to link your info in the show notes for those interested. Thanks a lot for joining me again.

David Trainer (45:41):

My pleasure. Thank you, Clay.

Clay Finck (45:43):

All right. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. If you’ve been enjoying the podcast, we would really appreciate it if you left us a rating or review on the podcast app you’re on. This will really help us in the search algorithm so others can discover the show as well. And if you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There you’ll find all of our episodes, some educational resources, as well as our TIP Finance tool that Robert and I use to manage our own stock portfolios. And with that, we’ll see you again next time.

Outro (46:20):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin and every Saturday We Study Billionaires and the financial markets. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or broadcasting.