Last Monday, Workhorse (NASDAQ:WKHS) — a struggling electric van maker — posted a record $84 million loss. That should have stunned investors. The company could have manufactured its entire 2021 production volume of 1,800 vehicles, dumped them into the ocean and still have lost less money. Needless to say, it’s a massive warning flag for the future of WKHS stock.

Source: Photo from WorkHorse.com

For the past decade, Workhorse has struggled through amateur hour. Its founder, Steve Burns, left the company in shambles back in 2019. Now, new management has taken things a step further with one of the worst-timed convertible note issuances in corporate history.

With a subsequent $200 million deal, the company seems to be doubling down on that form of financing. Shareholders should balk — convertible notes are an easy way for managers to maximize the value of stock options while hurting long-run shareholders.

So, while Workhorse might still survive, here’s why investors should tread carefully.

WKHS Stock Is Burning Investor Cash

Years of underperformance have turned Workhorse into a cash hog. The electric van maker has an annual capacity of 60,000 vehicles, yet plans to make “substantially lower” than the previously projected 300 to 400 vehicles in 2020. In large part, that’s because the company has failed to bring high-performance electric vehicles (EVs) to market. For comparison, rival EV maker Rivian has already inked a 100,000-van deal with Amazon (NASDAQ:AMZN).

Meanwhile, Workhorse has struggled to fill its order books. Its largest customer — UPS (NYSE:UPS) — has only ever received around 1,400 vans from the fledgling EV maker. Since 2016, Workhorse has burned through about $158 million in free cash flow while generating just $18.7 million in sales.

Raising Money with Convertible Notes

To compensate for its huge losses, Workhorse turned to an expensive form of financing: convertible notes. Companies with poor credit and sagging stock prices generally issue these as a last resort. For example, Bank of America (NYSE:BAC) used a combination of preferred shares and warrants (which creates a similar outcome) to raise money during the 2008 financial crisis. Likewise, Tesla (NASDAQ:TSLA) issued convertible notes in 2019 after its shares dropped considerably.

But when a company’s stock price is high, management should avoid using these like the plague. That’s because they raise cash by issuing debt, costing the company precious equity if exercised. In other words, it’s the worst of both worlds. Yet, presumably no one told Workhorse executives to resist their investment bankers’ phone calls.

In July, the company issued $70 million of convertible notes, even after its shares had jumped from around $3 to $15. That mistake cost the company dearly.

To extinguish the $70 million in convertible notes, Workhorse had to issue 5.2 million new shares worth roughly $120 million. In total, the company lost $84 million that quarter — once you add in overheads and other costs.

WKHS stock investors should be enraged. Shares had only risen over 30% in the 90 days between convertible share issuance and extinguishment. But High Trail Capital — the convertible note buyer – walked away with a 71% return.

Lightning Strikes Twice — If You’re Too Dumb to Move

So, investors might have imagined that Workhorse learned its lesson — if your stock trades at over 3,00 times EV-to-revenue, you should be issuing new shares since they’re so desirable. Tesla has used this principle masterfully in order to raise billions of dollars cheaply.

Workhorse management, on the other hand, didn’t get the memo. On Oct. 14, the company issued another $200 million par value convertible note. As a result — if WKHS stock rises — the company will once again have to pay through the nose to settle the bill.

What’s more, if the company had merely issued $200 million worth of new shares, it would have diluted existing shareholders by less than 10%. That still would have raised enough capital to cover years of cash burn.

Why Won’t Management Learn?

Investors will eventually realize that Workhorse management doesn’t understand the meaning of capital allocation. For years, the EV maker has poured money into ventures that have gone nowhere. Embarrassingly enough, that included an octocopter helicopter called SureFly — they scrapped its maiden voyage at the 2018 Consumer Electronics Show (CES) after the company revealed it couldn’t withstand a mild drizzle.

Somehow, though, Workhorse seems oblivious to the amount of money it’s losing. Even without counting the failed share issuance, the company lost $2.25 million on sales alone. Meanwhile, executives have already earned $2.7 million in stock options for 2020.

Perhaps that’s the problem — no matter how good it is for the company, issuing WKHS stock to raise money will still dilute executive stock options. Convertible debt, however, won’t come back to haunt management until 2024.

Should Investors Short WKHS?

Short-sellers might feel tempted to shoot down shares of high-flying WKHS stock. But that doesn’t mean it’s a good idea.

Firstly, it’s a relatively crowded trade — loan rates for short shares are over 40%. Secondly, Workhorse also sits atop a massive EV craze. I’ve written before that the company could blow short-sellers out of the water with 300% gains. If you think over 4,000 times EV-to-revenue is ridiculous, what stops the company from being worth even more? Finally, Workhorse owns 10% of Lordstown (NASDAQ:RIDE) and much of the intellectual property behind that company’s Endurance pick-up truck.

In an ideal world, Workhorse would start channeling its massive wealth into high-quality research and development. It took the company’s rival, Rivian, almost a decade for its MIT-engineer founder to create a winning electric van. With $200 million in cash, Workhorse could mobilize far more resources.

But will Workhorse management ever wise up? The EV maker’s recurring convertible note problem doesn’t raise much hope. So, until they learn the importance of capital allocation, investors are better-off closing their wallets. If you can, sit back and watch WKHS burn even more cash.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.