Analyses and investment views

Tesla and its shares

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Tesla and its shares

When we wrote the text on Tesla bonds earlier this week, we were a little worried whether it did not have too narrow a focus and whether people would find it interesting. We were very pleasantly surprised, therefore, by the number of comments, shares, and reactions to which this text has given rise. Consequently, we decided to write another piece about Tesla, this time from the viewpoint of an equity investor.

At the outset, we want to say that we are not in any way trying to disparage Tesla. Their cars are beautiful, we are fans, and we wish it success just the same as any other company. We have no investments in the company ourselves and only endeavour to explain why investors should avoid its bonds as well as its shares. We originally chose Tesla because it is a well-known company with a relatively simple business model and because it is practically a textbook example of incorrect market valuation. If we had written about Havila Shipping, for example, few people would probably have known what we were talking about.

So, back to Tesla. Tesla is primarily a manufacturer of automobiles. Its other activities – the solar and storage businesses – are small in revenue terms, and therefore Tesla will in future be more of a standard automobile manufacturer. It designs and produces cars. It buys the individual components from dozens of suppliers, among which the largest are Panasonic (batteries) and Fakuta (motors). Tesla occupies two firsts among important car manufacturers: It is the smallest in terms of production (currently on the order of 100,000 cars per year), and it has the highest loss per car manufactured.

Tesla’s backers may object that these facts are irrelevant because the company has a vision that it pursues tenaciously and future profits are most important. That may be true, but… as stated in a humorous observation that we recently came upon, “Vision without numbers is just sniffing glue.” So let’s take a look at whether Tesla’s future profitability course can justify today’s share price. Let’s put some numbers on the vision.

Tesla’s vision involves mass production of cars. Let us say that 1 million cars sold per year can be regarded as mass production and that it will take Tesla 7 years before it gets to this volume (ten times the current production). A million cars can mean revenues somewhere on the order of USD 50 billion. The automotive business is brutally competitive and profit margins are under unrelenting pressure. Let us be very optimistic and assume that Tesla, for which production is its long-term weakness, manages to set its margins equal to those of BMW, which is at the top of the industry in this respect. In such case, its net margin can be around 6%. This would mean a profit of USD 3 billion.

At 1 million cars sold per year and in the third decade of its existence, Tesla will probably be priced as a “mature” automotive company. The shares of such companies trade today on the order of 5–8 times net profits (BMW, Daimler, GM, VW). Again, let us be generous and assign a premium to Tesla and consider a P/E of 10. This would give it a market cap of 30 billion. Tesla is not a software or technology company or a disruptor. It is an automotive company, and its business faces the same conditions as do those of other automotive companies concerning capital requirements, returns on capital, and industry cyclicality. It must therefore be priced as an automotive company. A P/E of 10 is more than enough, too, considering that at a million cars produced and the considered profit Tesla’s debt will probably be more than five times its annual profit, and that is a lot for an automotive company.

Getting to a million cars sold per year, however, requires large investments. Cars are not software – their production requires a high level of tangible assets. When we look at how much other automotive companies have had to invest into their factories to be able to make their cars, we estimate that Tesla will need to invest something on the order of USD 10 billion into further production in order to be able to make its million cars somewhere. In addition to that, it will need to obtain more capital to cover the losses it accumulates before that time, as well as more capital to cover such of its operational needs as inventories, work in progress, and materials.

In total, we estimate this would take USD 20 billion which Tesla does not have. Because Tesla has large debts even now, most of the new capital (we estimate USD 13 billion) will have to come in the form of subscribing new shares. Even in case investors are able to continue tolerating the growing losses and subscribe to new shares at the current high share price, Tesla will have to issue at least 38 million new shares. Today, Tesla has 167 million shares outstanding. We need to add to this more shares already issued in the form of options, additional such shares issued in the future, and potential conversions of convertible bonds to shares. This brings us to somewhere around 220 million shares outstanding in 2025.

At that time, as stated above, Tesla’s profitability would value the entire company at 30 billion. That is USD 136 per share in 2025. If investors require Tesla’s shares to provide them with a return of 10% p.a. (which, by the way, is low considering the risk they are taking), a Tesla share would have to cost USD 70 today. Its present price is USD 347.

We have assumed in this exercise that the following five conditions will be true:

1. Tesla will have demand for 1 million cars per year (on the whole realistic).
2. Tesla will be able to make that many cars (a daunting challenge).
3. Tesla’s margins will get to the top level in the industry (low probability).
4. Investors will be willing to subscribe to more and more shares for the current price of USD 347 (most difficult to predict, as this could change at any time).
5. Over the future seven years, there will be no substantial recession and the markets will be willing continuously to provide Tesla with new capital (difficult to say, maybe 50:50?)

Moreover, all these five conditions would have to be satisfied at the same time. If one of them is not met, then even the price of USD 70 is not justified. We believe the probability of fulfilling all five conditions is much lower than 50%.

Tesla’s success also depends on a number of other circumstances: subsidies to both consumers and its own production; rapid development of electric car sales generally, including the supporting and currently almost non-existent infrastructure (time is against Tesla); the capabilities of its suppliers, etc. In addition to all of that, its technological advantage is smaller than it seems and is steadily diminishing. Tesla has the fewest patents among the big automotive companies even in areas that are crucial to it. Moreover, it has made its patents available to other users free of charge. This may show that it does not place much value in them. It is trying to establish dominance in a field where no one ever has managed to do so. A more probable scenario is that if Tesla remains a stand-alone company it will face existential problems during the coming five years.

This is the point at which many readers may object – if all this were true, then why do the shares cost USD 347 apiece? We can think of three reasons:
1. Investors take pleasure in supporting Tesla’s vision by investing in its stock and they do not mind the risk that they may lose most of their money. No one can blame them for this, as everyone decides what to do with their own money.
2. Investors have concluded after a detailed analysis that Tesla’s profitability will be so high that its shares are cheap today. The problem is that we have seen at least 30 analyses of Tesla and we cannot say that even one would convincingly explain how the current price could be regarded as low.
3. Investors do not think much about what they are doing. This may not be as aggressive a conclusion as it might seem…

If we say the fundamental value of Tesla shares is one-fifth the present price, that does not mean the price will begin rapidly decreasing tomorrow. Rather, the shares’ value has a gravitational pull on their price over the long term, and over time value will draw the price toward itself. Holding Tesla shares at the current price of USD 347 is extremely risky.

Benjamin Graham was known to remark: “The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” We believe that describes our thoughts about Tesla. On the other hand, it is very, very difficult to explain the current price of Tesla shares as cheap by means of a rational and number-based analysis.

To show that we can be more than just negative, our next contribution will show what we think is a good investment.

Invest with care!

Daniel Gladiš, 20 August 2017

P.S. This document expresses the authors’ opinions at the time of its writing and is intended exclusively for educational purposes. It is not an investment recommendation. Our estimates and projections of the future may be, and probably will, contain errors. Do not rely on them but use your own common sense and your own analyses when making investment decisions.

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