Unearthing Assumptions in Tesla 2020 Annual Report
Using Assumption Challenge™ to improve confidence in your investment thesis
If you have read the annual report for Tesla, I am sure the prominent part is the numbers section or as it is called Finances. The other area of keen interest for investors is management's discussion of the business. Different companies use different formats for this, but the best example is Warren Buffet's shareholder letter which set the standard for others and inspired the likes of Jeff Bezos to follow a similar approach.
In Tesla's case, we are not sure how much of it is written by Elon Musk himself, but he must undoubtedly approve it. Whether it is the Oracle of Omaha or the investor relations department, we know one thing for sure: humans write the report. Having people involved means that there is potential for all the good and bad that goes with human thinking.
In this issue, we will look at a technique called Assumption Challenge®, part of the Red Team Thinking toolkit. The name already gives it away; this technique aims to challenge your assumptions that went into the plan.
To challenge the management's assumptions, in this case, we have first to identify what these assumptions are. Let's take a look at the Tesla annual report of 2020 and specifically section titled Business. If you are a shareholder who cares about the company, you have likely read the report, but how do you evaluate its qualitative sections? Typically, the numbers sections are inherently binary and straightforward, but the qualitative areas are much less clear. Using the Assumptions Challenge™, we will come to meaningful insights where we might have just glanced over what we read because we don't have a framework for understanding and analyzing these sections of the annual report. So let's get to it.
We identified the Business Section of the Tesla Annual Report 2020 as an area we wanted to analyze. This is page 4-14 of the 10K (annual report 2020)
You may discover that you will unearth far too many assumptions when you do this exercise if you look at too broad of an area in the report. Thus you may want to narrow down your focus on a particular area where you feel it would be most critical. It will be your decision for you to make. In this example, we highlighted several assumptions across the business section.
We could have gone on for longer, but we stopped when we hit the 30 mark.
List out the assumptions. Again, this does not have to be a competition where you are rushing to see who can find the maximum number of assumptions. Ideally, focus on a particular area of interest and conduct the exercise. For example, within the Business section, you could focus only on the Sales and Marketing section.
So above is a list of 30 assumptions we were able to discover in a session which lasted an hour. The participants did get the report before hand and were asked to spend sometime reading and identifying but that was also not longer than an hour.
In the next step, we set priorities. We needed to determine which of these assumptions we wanted to analyze further. If you are doing this on your own, you choose the areas you feel unsure about for your investment thesis. In a group, doing a voting exercise is an excellent way to determine what is essential. There are whiteboarding tools like Mural, which allow you to vote even remotely. Depending on the availability of time, you can choose the top three assumptions or more. For our session, we choose just one, which is the following assumption:
Critical Assumption
“Superchargers stations along the route to allow Tesla vehicle owners the ability to enjoy quick and reliable charging”
Once we select the assumption that we want to dive into, we need to apply and answer the 7 key questions to reveal insights and threats impacting our assumption. The Assumption Challenge™ is a technique that we teach in the training course.
Below are the insights we surfaced by conducting this exercise for our chosen assumption.
We discover that Tesla is making this assumption based on their experience and is known as longevity bias; we assume something based on our previous experience.
We then ask if the experience is relevant for the assumption. Quick and reliable charging has worked on a smaller scale along the routes (this is what we are basing our experience on) but does that mean it will also work on a larger scale.
Next step, we ask ourselves what condition needs to be fulfilled for this assumption to become true. In this case, it is: We have enough superchargers providing us enough coverage.
Next, we explore if our assumption is true, will it remain true under all conditions. In this case, we realize there are a couple of scenarios when our assumption may not hold anymore:
1. If traffic volume hit extremes (for example, during a holiday season).
2. If the grid can not supply the required electricity.
Now, we have a more in-depth understanding of what possible threats are lurking out there for our assumption. We can monitor what actions the company takes to mitigate these threats—allowing us to judge if we want to stick to our original investment thesis or not.
We also look at the worst-case scenario; what if we are completely wrong about our assumption, then what will the impact be on the business. In this case, we identified two possible outcomes:
1. We could lose sales since consumers will not want to buy an electric car that won't charge fast, and it will slow their long trips.
2. The business is continuously investing, and return on investment is dependent on the fact that sales happen. Since we are already committing the capital upfront, our return would be negatively impacted if the fast and reliable charging assumption does not hold.
· We gave a percentage between 0-100% during the group session on our belief if Tesla will deliver on this assumption. We felt reasonably confident that they would be able to do it. So the group gave a score of 75%.
During the session as a group we gave a percentage between 0-100% on our believe if Tesla will be able to deliver on this assumption. We felt reasonably confident that they would be able to do it. So the group gave a score of 75%.
After working through the 6 key questions, we worked through a 7th question which focuses on revealing what, in this case, Tesla could already do to make sure that their assumption holds true as they expect:
1. They could define what "fast" means and be specific about it. The benchmark is how long a person is at the pump for a petrol car.
2. They could use simulations to determine critical chokepoints where more supercharger capacity may be needed when higher traffic peaks daily or seasonally.
3. Understand the user habits much better over the year to determine when most miles occur.
4. The obvious one is to continue to innovate on the battery technology; thus, charging time can be reduced.
5. Provide incentives and pricing strategies to discourage supercharging, so people develop habits where they charge at certain times or destinations.
It is incredible how we just had the business section of the annual report in our hands at the start of the session. By the end, just diving into a single assumption, we provided a detailed analysis, further insights.
If Tesla was doing this exercise themselves, they should consider implementing some of these strategies. If an investor has enough influence, he might get this passed along to Elon and his team.
But as a public investor, we have wholly unraveled this assumption and understand what Tesla needs to do to make sure it holds. We can monitor Tesla's upcoming reports and news to determine if they are following the path we expect. It is incredible what a simple technique such as Assumptions Challenge™ can do to make the plan better.
If you would like to learn and apply this technique, we have included a link below to register for our upcoming class. The Assumptions Challenge™ technique will give investors a compelling framework to improve their investment thesis and apply it to any of their investment decisions. In the coming months, I will be sharing a series of techniques from Red Team Thinking that investors can use in different situations.
Credits: I would like to thank the other Red Team Leaders who participated and contributed in this exercise: André Daus, Jacques Cosset and Remco van den Horst.