A critical analysis concerning the validity of the four central underpinnings supporting calls of overvaluation with regard to (TSLA) in recent weeks.
Please note. The following article is very long and aims to address each of the following concerns in detail.
- That all stocks are inevitably prone to a correction when they exhibit an unusually high Price to Earnings Ratio (P:E) and therefore the price of TSLA will inevitably fall.
- The term “overvalued” applied independently of any valid frame of reference. That is to say in case of Tesla, valuation metrics that differer from the metrics that apply to the traditional auto industry are inherently unreasonable or absurd.
- That Tesla’s faces competition that will catch up and overtake its current technological and engineering leadership and flood the market with cheap and credible alternatives.
- That the TSLA stock performance is indicative of a bubble.
1. The first assumption which can be characterized as the ‘what goes up must come down’ paradigm is readily dismissed in the case of Tesla.
In its simplest form there are two key components of a fundamentals-based valuation. Profits (actual or projected) and a profit multiple. The most simple and most commonly recognized metric is P:E or P/E. (Price to Earnings ratio). According to publicly available YCharts, at present the actual median P:E for the S&P 500 is 17.66 if this is to be considered the norm, then the divergence from the norm even amongst well established companies is enormous. $1 of Apple’s earnings currently trades at $12.98 while $1 of Amazon’s earnings currently trades at $3430.72. A simple observation of these numbers would appear sufficient to demonstrate that there is no inevitable connection of a stock price to any given P:E, not even over the relatively long term unless perhaps the stock in question can be defined as unexceptional.
The business of Tesla is anything but unexceptional both in general terms and in specific terms with regard to the auto industry. The scope of the Tesla undertaking while notionally incredible in scale, is clearly tangible in its execution to date and in the exactness of its published product launch and expansion road map. By comparison the supposed obstacles to Tesla’s continued execution of its road map are vague and intangible and include notions of competition on the horizon from unannounced products derived from unannounced sources. In 2012 following almost ten years of preparation, Tesla successfully unveiled both a disruptive vehicle and a disruptive business model that no traditional ICE vehicle manufacturer has proven to be equipped to compete with. Considering the scale of the market Tesla has entered successfully and the significance of its products to the lives of its customers and potentially the future landscape of the auto industry as a whole, it would be hard to argue that Tesla unexceptional and therefore prone to an ordinary P:E ratio.
A thesis that relies upon an inevitable (in other words 100% probable) correction in the value of TSLA to a typical P:E ratio for the traditional auto industry or the S&P 500 with respect Tesla is clearly in error.
There are literally hundreds of exceptional US stocks whose P:E exceeds the estimated 2014 forward P:E figure of 116.13 attributed to TSLA on the NASDAQ website. Note that Amazon is not even the highest on record, for example Salesforce (CRM) at 6720.75. Nor is a high P:E awarded only to new companies or even new tech companies. According to the link above, Wendy’s burger chain (WEN) established in 1969 trades at a P:E of 276 at the time of writing.
Given an ongoing critical mass of very high market confidence in Tesla (for very good reason) the TSLA 2014 forward P:E of 116.13 would appear to be relatively modest. In light of a continual stream of significant news and announcements that provide grounds for high and increasing confidence in both accelerating earnings and sales expansion (both for numbers and territory) as well as risk reduction bolstered by successive quarterly improvements in fundamentals, an expectation of an inevitable reduction in P:E awarded to Tesla would appear improbable and lacking any visible catalyst. For reasons covered below we would expect Tesla instead to continue to grow its fundamentals to meet and to exceed the expectations currently placed upon it.
As an adjunct, what we believe we can see is a rolling short interest in Tesla that is to a large extent driven by a flawed ‘inevitable correction thesis’ when in fact there is no such inevitability. Such a correction would be conditional at best and we believe the conditions for that currently show neither any visible nor any reliable prospect of being met.
September 4th 2013 Prof. Damodaran, famed for calling the top for AAPL in 2012 published a valuation exercise with a range of $60.84 to $74.71 with most reported weighted average figure of $67.12 based upon differing assumptions for the cost of capital applicable to the Auto industry sector and the Technology sector respectively.
To quote a section of introduction to the piece, Prof. Damodoran wrote:
“as a technology company in an otherwise capital-intensive, mature business (the automobile manufacturing business), it [Tesla] stands out.” In fact it does.
Reviewing media reporting and Internet commentary, it becomes clear that not only has this report been taken out of its academic context inappropriately, even within that context the headline $67.12 number was so heavily derived from false assumptions as to be dangerously misleading.
As a general observation, the Damodoran piece in common with many similar and derivative attempts raises suspicion by drawing analogies between Tesla and the industry Tesla is known to be designed to address by means of radical differentiation of both its products and business model.
From this starting point there naturally flows a litany of error: The falsely presumed difficulty in achieving high gross margins contrary to clear guidance that the same was visible on Tesla’s current accounts during the Q2 earnings call (a call that took place during Q3). Presumptions concerning industry-standard costs of capital of around 9~10% that conflict with early Q2 convertible bond sales at 1.5% cost of capital. The presumption of the typical need for external capital to replace cash burned in growing sales inventory and extending credit to a sales channel that is applicable to the auto industry and is not applicable to Tesla.
In reality, Tesla is not a text book case and treating as such will lead to problems in evaluating this stock as can be seen below. Instead of trawling through each error in turn, to address the matter of valuation conclusively it is sufficient to deal with just two.
Firstly a growth rate of only sixty fold in ten years time is clearly at odds with both guidance and the observable trend at least for the clearly foreseeable future. This is particularly true when revenues are derived from a 12 month base in which there is currently only data for six months (Q1 and Q2) containing trading approaching congruency with the now established business model, the prior six months being dominated by late stage startup activity and not the production and sale of vehicles. The foreseeable future in our opinion covers a period from the present until the full establishment of global sales of the Tesla Gen III that we see ramping from late 2016 through 2018. There is clear guidance to a 100% increase to circa 40,000 units in 2014 and a 1000% (ten fold) increase from 2013 figures to 200,000 units in 2017 (four years time). We think it is fair to suggest that with the combination of additional territory and a doubling of the product range (Model X) by early 2015 we can expect to interpolate an additional 100% compounding in 2015 leaving fair speculation only as to whether 2016 and 2018 through 2022 will continue to deliver annual compound increases in the order of 100% also. We think on the balance of probability this outcome is not only achievable but likely.
Secondly, cost of capital. There is no hard evidence or even any indication to suggest that Tesla will be unable to attract demand to keep pace continuously with growth at a 100% compound annual growth rate for many years to come. Simply put, demand has exceeded supply continuously and sales territories and brand exposure is expanding rapidly. In the case of heavy exposure to the brand as proven in California the sales density is much larger than in regions yet to gain exposure to the brand at equivalent levels. There is no visible obstacle to Tesla saturating additional territories with similar sales-densities over time based on experience accumulated in California. Neither is there valid concern for the source of cash for the roll out of production equipment and additional charging and service infrastructure at the same rate. The source of cash is inherent in the Tesla business model: Prepaid high-margin sales. There exists clear guidance that this rate of progress will be achieved on internal revenues, in other words without incurring cost of capital or dilution beyond that required for the attraction and retention of key personnel.
NOTE: For the avoidance of doubt, hereafter we will seek to delete an error of assumption with respect to cost of capital. This is a short hand for the arduous exercise of reconstructing the entire model which is not the aim of this piece. The author is fully aware than an entry for external cost of capital can be replaced with an estimate for the cost of retained earnings under various valuation strategies. However the concept of cost of retained earnings is materially different to the liabilities incurred in taking on debt for example, and is largely academic in a company that is not expected to pay dividends for the foreseeable future. Furthermore, cost of retained earnings does not affect forward cash flows as is the case with the actual costs faced by the business of raising capital externally. We do not feel therefore that introducing the construct of cost of retained earnings would aid in repairing a fundamentally flawed model in this instance. We are satisfied that simply deleting an error that serves to suppress valuation unreasonably is sufficiently illustrative for the purpose of this article.
The effect on valuation: Deleting the erroneous entry for [external] Costs of capital in Prof. Damodoran’s spreadsheet to 0% in 2014 through 2018 in order to respect guidance to growth on internally generated cash from sales produces a valuation of $200.56. This is before correcting additional clear errors of assumption.
Prof. Damodoran’s assumptions contained in arriving at a spread of estimates between $60.84 and $74.73 are as follows:
Note that following the May 2013 fundraiser which achieved $1.08bn USD we believe that Tesla achieved critical mass and with it the ability and intention to switch funding model from the sale of equity and the purchase of loan capital to a model that operates on internally genrated cash.
Following this round of funding CEO Elon Musk went on record to state that:
* Sales of the Model S were cash flow positive.
* That readying Gen III for production in late 2016 (on an order of magnitude increased volume of production when compared with Models S and X) would cost the company approximately $1 Billion USD.
* That this $1bn. capital requirement would be met by internally generated cash, in other words from sales of the Model S and the Model X, not from dilution and not from borrowings.
To reiterate, when deleting the cost of [external] capital figure in order to comply with guidance and with proper appreciation of the Tesla cash flow model for the period 2014~2018 (which is 0%, not 9.18% or 10.79%) Prof. Damodoran’s calculations yield a net-present valuation as at September 4th 2013 of $200.56. Not $67.12 as widely reported.
Tesla longs are often criticized for citing the excellence of the Tesla Model S as a rationale for defending the stock price. We would like to offer an explanation of the actual link between the car and the stock price as follows:
The Model S car is sufficiently desirable and sufficiently unique to be sold at strong gross margins while (most importantly of all) attracting a waiting list of customers willing to pay or arrange with lenders for Tesla to receive 100% of the sales price for each vehicle prior to the company incurring the cost of its production. The positive impact on Tesla’s cash flow by comparison to the economics of traditional manufacturing is the difference between night and day.
If there was an equally desirable alternative to the Model S at equivalent perceived value for money that could be browsed and purchased from a showroom at the customer’s leisure then the business model would be untenable. There is no comparable vehicle. The car yields both profit and generates cash, hence the value of TSLA.
As a result Tesla has been able to prove out its funding model and is consequently expanding across the globe. The principle is almost identical to customer willingness to pay and wait for the delivery of a gold iPhone 5s forgoing any number of perfectly functional smartphones that are available to purchase immediately (all of which able to make telephone calls, browse the internet, store and play music and send and receive messages). The prepaid waiting list for the iPhone 5s is only almost identical because Apple leverages its resources (risks its cash) to bank roll the up front cost of filling the sales channel prior to recouping capital and profits from sales.
Unlike Apple and unlike any other vehicle manufacturer approaching the scale of Tesla, Tesla’s core business is cash flow positive. Neither Tesla or its shareholders carry the cash risk to build inventory in anticipation of sales. Tesla’s books are devoid of any drain on working capital sunk into finished goods inventory more than a modest quantity of service loaners and demonstrators. Accordingly, the Tesla business model completely defies the capital constraints normally applicable to manufacturing, especially in the auto industry. Tesla’s business model also defies the economics traditionally applicable to retailing.
This cornerstone of the Tesla business model is so powerful and so counter-intuitive that it is worth a simple illustration for the sake of clarity: If Tesla was Walmart, this version of Walmart would be able to rely upon its customers to pay it up front, with profits, to stock the shelves with the goods they needed while the business focussed purely on growing its customer base and installing more shelves in the store.
Tesla also enjoys standard manufacturing credit terms from its suppliers. Tesla does not have to pay its suppliers for vehicle components before the money is in the bank for the finished vehicle. Tesla’s only capex burden related to manufacturing from now on is additional production plant and machinery (shelves in the analogy above) and in the case of NUMMI and Tilburg (Tesla Netherlands) the plant already exists. Additional machinery is a tiny fraction of the capital cost normally borne in manufacturing when compared to the cost of rapidly growing an inventory of finished goods. Hence to model Tesla based upon manufacturing industry norms as was the case with the Damodoran valuation is to miss the entire point of Tesla.
In the case of Tesla, traditional investment capital (the sale of shares) and a DOA loan (now repaid) was required from inception right up until a critical mass of R&D, production, sales and service infrastructure was achieved in May 2013 (alongside 3/4 $billion cash at bank).
Thereafter, the traditional role of investment and loan capital (providing working capital for growth) has been wholly replaced by the worlds largest implementation of what is ostensibly crowd-sourced funding. Working capital and growth capital is derived from customer reservations and cash released at the point of confirming vehicle configurations.
As a result the opportunity is available to shareholders to participate in profitable growth without the ordinary counterbalance of cash-flow constraint and dilution risk. This is the true differentiator of TSLA and the principle reason why in our opinion the stock is deserving of multiples in excess of those awarded to Wendy’s for example and certainly in excess of those awarded to the traditional automotive industry.
Note, under GAAP rules Tesla’s lease accounting program is accounted for as a source of interest free lending for working capital. Again the cost of capital to Tesla is 0%. In actual fact Tesla Financing yields Tesla a positive finance introduction fee.
Sales to capital rato.
Accordingly Tesla is entirely free to grow without burning cash. For that reason we not only refute the basis of Prof. Damodoran’s cost of capital assumptions, we also refute Damodoran’s industry-standard assumption of 1.41 sales to capital ratio. In the absence of capital sunk into finished goods inventory Tesla will be inevitably at least 100% more efficient than manufacturing industry norms in this regard i.e. at least 2.41 instead of 1.41. Correctly entering both the 0% cost of capital for 2014~2018 and a more realistic estimate of 2.41 for sales to capital ratio into Prof. Damodoran’s spreadsheet yields a valuation of $339.97. A figure that includes a c100% discount for execution risk at current pricing.
In summary, the much touted bearish notion that TSLA is overvalued is fundamentally wrong.
There is a frequently voiced conjecture that a chief concern for Tesla is that traditional auto manufacturers will catch up and overwhelm Tesla. We feel that is appropriate to analyze the validity of both of the premises contained within this argument.
Firstly the definition of catching up. On this point there appears to be a lot of common ground between Tesla bulls and bears: That is the premise that large traditional automobile manufacturers will one day produce a compelling electric vehicle at price point and in volumes that will severely curtail the available market for Tesla, confine it to a niche or otherwise put a stop to the exponential growth implied by investor confidence in TSLA.
It is critical to comprehension in light of this to note that it is accepted on both sides of the debate that there is no ICE vehicle in existence, nor is there an ICE vehicle envisaged that can compete effectively with Tesla’s present or planned models. To compete with Tesla or to hinder Tesla in any way in either entering the mainstream of the auto market or continuing to take an escalating market share where it currently competes will require the launch of a compelling electric vehicle by a traditional automaker. In other words the Tesla vision of the future of automotive is valid and by the same token, as the clear leader in electric vehicles, the future of the automobile market is already Tesla’s to lose. With regard to process of catching up, rather than seeking for obstacles facing Tesla in expanding into the market (there are none visible at present) it is more interesting to look at the obstacles facing the traditional automotive industry in an attempt to hinder Tesla.
There is only one area in which Tesla automobile technology has been considered less than superior to offerings available from high end Mercedes for example and indeed some parts of the electronics package available from Ford and others: Active collision avoidance, inadvertent lane change avoidance, active cruise and road surface detection. It would appear that instead of merely duplicating these systems, Tesla has chosen instead to leap frog the industry in this arena by establishing leadership in fully autonomous driving.
One of the problems facing the traditional auto industry in hindering Tesla, is that the company represents a ‘brain drain’ as a recruitment magnet for the industry’s best and brightest. It would be surprising for example if Tesla has not recruited some members of its autonomous driving research team from the auto industry leaving one or more competing manufacturer short of key persons in this field, just as Tesla had previously recruited the chief engineer of Aston Martin. This is in addition to Tesla’s location and credibility in Silicon Valley as tech company with respect to attracting the best and the brightest from the IT and software industries. The effect is further compounded by the presence of a technically literate CEO with a controlling interest in an engineering team that has a proven track record of building both vehicle and systems capable of docking an in-house designed spacecraft with the International Space Station.
In light of this, it would seem more credible that the technical leadership gap in every aspect of vehicle technology and engineering demonstrated by Tesla Model S is far more likely to widen in Tesla’s favor over time when contrasted with the capabilities on offer from the traditional auto industry, than to close over time. In other words the concept of the traditional auto industry catching up would appear to be less than likely considering Tesla is a comparatively fast moving target.
Furthermore despite the common acknowledgement that there is no possibility to hinder Tesla without focus on the task of competing with Tesla in its core and growing area of competence (electric vehicles) the traditional automotive industry is hide bound in a manner described clearly in the Innovator’s Dilemma by the economic imperatives imposed by a legacy business model and in particular, amortizing the value of a capital asset base geared towards ICE vehicle production. In other words Tesla can focus on owning the future of the auto industry without internal conflict of interest and with very little realistic prospect of meaningful hinderance in becoming fully established as a major player if not the major player in the production of passenger vehicles in the years ahead.
Finally Tesla’s lead in the actual production of electric vehicles has not only yielded a direct transfer of cash from the traditional automotive industry in the form of ZEV credits to assist Tesla in becoming established. Tesla’s first mover advantage has also allowed it to consolidate supply relationships with a top three of the world’s producers of technically and economically viable cells for automotive (Panasonic, LG, Samsung) and potentially the top four to include BYD. The traditional automotive industry will find itself many years late to the table when it comes to seeking volumes of similar supplies to compete with Tesla. When that time comes the remaining choice may well be between becoming a Tesla drive train customer or negotiating access to Tesla’s suppliers, with Tesla.
Any concern regarding the global production capacity of suitable cells is simply a barrier to entry for those seeking to follow Tesla. It is by no means a concern for Tesla. Tesla is the world’s only electric car maker that can point to existing demand and commit to a meaningful sales forecast to secure its cell supplies.
With regards to traditional automakers leveraging production scale to overwhelm Tesla’s future target market with low cost high volume electric vehicles, the battery cost data provided by GM to Barron’s Bill Alpert led directly to the questioning of Elon Musk on the economic feasibility of producing a $35,000 Gen III vehicle ‘in family’ with the Model S and with a 200 mile range and features to stand as an attractive alternative to a BMW 3 Series. In contrast to the concerns arising from GM’s data, Tesla has repeatedly given clear and unequivocal guidance that it suffers from no such anxiety regarding its ability to produce a mass market vehicle as described.
In summary, there is no competing vehicle in existence or visible on the horizon that could stand as a credible alternative to the Model S or the late 2014 Model X or the late 2016 Gen III (Model E). There has been an indication that GM will go to the drawing board with the goal of designing a 200 mile range low cost electric vehicle, although as yet GM has arguably never produced in evidence a vehicle to match up to a BMW 3 Series, let alone an accomplishment to compare in any way to a Tesla Model S and we understand that the Volt is already loss-making for GM despite a price point higher than that Gen III base price.
Nissan may return to the market with an electric Infiniti after withdrawing it indefinitely during 2013 citing unexpected advances in electric vehicles, without doubt from Tesla. The Nissan Leaf, the BMW i3 and many other low range or hybrid vehicles speak more of their respective manufacturers unwillingness to or inability to compete effectively. In the case of BMW we were told by the CEO that the development cycle for a new vehicle is seven years, effectively putting the company a total of seventeen years behind Tesla for the first opportunity approach the market with a desirable product having missed the mark with the i3. During the seven years remainder of that span we can see no reason for any doubt that Tesla’s rate of development in electric vehicles will out-pace the efforts of BMW and unlike BMW, Tesla’s developments stand firmly on a dramatic ten year lead and patent base relevant to the future of automotive accumulated since 2003. As it applies to BMW, so it goes for any attempt to contain the expansion of Tesla.
As an adjunct: It is worth noting that while superficially connected by target audience and the role of its products in transporting passengers via highways, Tesla is in a subtly different business than the business of traditional auto makers. (Subtle for example as the difference between fax and email, both of which convey messages electronically whereby one requires very specific third party infrastructure, a fax machine, and consumes a comparatively high value of supplies to perform its messaging function).
By including a very long range battery pack for low cost independent home charging and by providing access to free for life energy for long distance transportation, Tesla simultaneously addresses both the auto market and a segment of the energy market traditionally served by the oil industry and includes elements of the customer value proposition traditionally offered by both. We are not currently aware of any traditional automaker that is in the business of including energy for transportation (for example by owning gas stations or any equivalent to the Tesla supercharger network) as part the value proposition offered to its customers. That innovation both differentiates and belongs to Tesla.
4. Is TSLA a bubble? In a word, no. The underlying asset represented by the Tesla business is gaining ground exponentially without any valid or tangible cause for concern for future fundamentals in terms of growth or future cash flows. In fact simply correcting two clear errors of assumption in the valuation model provided by Prof. Damodoran of NYU indicates that a TSLA price of $170 discounts the net present valuation of TSLA based upon its prospects by almost exactly 100% while simultaneously underestimating growth prospects very considerably by analogy with an industry is not geared for rapid growth.
The exponential progress of the stock reflects the executed progress of the company both faithfully and with a large (100%) margin for execution risk. There is no comparable dilution-averse growth stock, certainly not within either manufacturing or the automotive sector. The recent announcements from Germany for example underline the point: The rapid roll out of the world’s highest per capita density of Superchargers with an upgrade from 120kW to 135kW. Rapid roll out of service centers within 100km of the majority of the population, free of charge localization of the Model S with optimization for Autobahn travel (estimate of 200km at full speed with Supercharger spacing to match), smart routing enhancements to navigation system to account for gradients and wind speed, browser upgrade, guidance that the company anticipates Germany to become the third largest customer base after the US and China and is investing in infrastructure and recruitment accordingly.
Note also, Model X reservations topping 8000 more than a year prior to launch, Model S sales expanding into Europe and Asia ahead of Q3 earnings with guidance to profitability and Q4 guidance to both profitability and 25% gross margins.
Far from being overvalued TSLA we believe TSLA is currently trading safely below 50% of fair valuation ahead of the company's first Quarterly Earnings Report as a fully established and profitable auto maker offering the market proof of both a large and widening lead in a disruptive automotive technology and simultaneously a disruptive business model, the proof of which will be evidenced in the absence of cash burn.
Furthermore, for growth investors we believe that holders of shares sold at IPO and subsequent rounds to fund the company to critical mass concluding in May 2013 will enjoy heavily de-risked and simultaneously profitable growth that is currently, and set to remain in the order of 100% compound annually to 2018 and beyond and to do so untroubled by fund raisers for working capital as would typically be the case throughout the hyper-growth of literally any other manufacturing enterprise but Tesla. In this regard we believe TSLA is profoundly unique.
It is perfectly natural to regard the progress of Tesla and its stock with incredulity. Rarely since the earliest days of General Motors disruption of the business of railroads almost one hundred years ago has a stock moved like this for valid reason. We believe this to be true of Tesla.
The opportunity on offer to the well informed investor is to take advantage of misplaced incredulity and tremendously bad modeling assumptions whenever that phenomenon appears ahead of a predictable announcement of significant good news. We believe strongly that TSLA ahead of Tesla’s Q3 earnings report is such an opportunity and hence we would look to target TSLA in the range of $210 post earnings.
Thank you for your time and attention. We trust that any assistance provided by this analysis has been a valuable return on a long read.Investnaire
A Commons Community, powered by Acquia