In a previous article, we presented a more or less bullish take on Tesla (TSLA). However, we did have our doubts about Tesla, as we had said in that article as well. In this article, I am going to discuss some of the doubts I have about this company.
The Electric Vehicle (EV) market constitutes a very small fraction of the total US auto market. Outlook for the market looks gloomy, due mainly to the lack of infrastructure support for plugin battery recharge stations, and the power system supplying electricity to these stations. At present, the market caters to only a few people, owing to this being a niche technology with expensive installed battery. The industry has been struggling to make a significant mark. Companies like Coda Auto went bankrupt, and Fisker Auto laid off people to avoid bankruptcy.
Here is an EV company, Tesla, that surprised the stock market with its impressive Q1 FY13 performance, beating market consensus and the company's own figures; this was mainly due to its award winning Model S sedan. Sales clocked $562 million, up 83% qoq, and posted profit of $11.2m for the first time in its history of 10 years. Gross margin too doubled to 17% from 8% qoq. Share price rose by over 177% since the result announcement.
We believe that the stock is over-valued and over-blown with unfettered enthusiasm, and that this stock rally will be short lived and it will eventually come down, reflecting the reality in its fundamentals. Although in the short term Tesla seems to be in a good position, we remain cautious in the mid to long term. Nobody knows what future lies ahead for EV, but we would like to highlight a few things investors should consider. There are many uncertainties and challenges Tesla has to overcome in order to make a mark and establish itself as a stable and profitable company.
EV market to grow at a slow pace: The US EV market is very small, constituting 0.08% of total auto sales in 2012. Outlook for the EV market continues to remain weak in the years to come, owing to some serious concerns. US macro-economics are improving but it is still not good enough for customers to take the risk and invest in a niche technology. When cash is short - and although this is an exaggeration for Tesla - people do not want to end up with a lemon.
In spite of being a green technology, lack of solid infrastructure is hindering EV market growth. This includes infrastructure like plugin recharging stations and power plants to support these stations. Due to limited recharging stations, EV owners have to wait for long hours for a battery that requires frequent recharging. The US would need many more nuclear power plants to supply electricity to these stations.
Another concern is pricing. EV is too costly for a normal customer - it just does not make sense to invest in a technology that is maturing sooner than the rest of the world. This is ironic, but since the world can't keep up with it, Tesla gets stranded, to use an analogy, sometimes in the middle of the desert, with a gas station right next to you that does not have a charging option for an electric vehicle.
Unless and until these concerns are addressed, the outlook would remain bleak. JD Power and its partner LMC Automotive (hyperlinked above) has forecasted EV market share to be only 0.47% by 2015. President Barack Obama's target of introducing 1 million EVs on American roads can be achieved if the US Government builds the necessary infrastructure.
We have live examples of companies struggling (see the Daily Telegraph link above). Startups like Coda Automotive which turned bankrupt, failing to make a mark, and Fisker Automotive which laid off 75% of its workforce in order to avoid bankruptcy. Well established companies like Chevrolet/GM had cut production of the Volt in 2012. If EV manufacturers want to play in this niche market for a long time, they have to build strong R&D to introduce a solid battery which could run more miles and do with only a quick recharging. Also they should make EV affordable and accessible. We believe this could be possible once the technology matures and competition intensifies, but that would take years to come.
Tesla's solid sedan: Tesla is getting a lot of attention these days thanks to its newly launched Model S sedan, which in terms of looks, performance with dashing design, and well-crafted interiors beats most other products in the market. This is evident from the Consumer Reports magazine's review which assigned 99/100 points to Tesla. Q1FY13 volume of sedan S sales grew to 4,900, 400 units more than guidance, and raced ahead of well established giants like General Motors' Volt and Nissan's Leaf. Q1 FY13 earnings of $561m went up from $30m yoy, beating the market as well as company guidance. This made the market happy, sky rocketing the stock price to around $88, an upside of around 166% since the Q1 results announcement. We believe this market-euphoria based stock run is short-lived and will soon subside, reflecting the stock's fundamentals.
Weak financials: No doubt the model S gave Tesla a good start, but looking at Q1 results, Tesla still looks weak. Credit sales of circa $68m (12% of total sales) boosted the reported revenue. Gross margin and EPS stood at 5.7% and -0.49 respectively, excluding credit sales, even though numbers improved from last quarter. Tesla already has high Debt/Equity of 2.3; and has raised $1,100 million through convertible notes at 1.5% and conversion premium of $124.52 to repay a 2009 Energy Department loan of $460 million. If the stock does not reach $124.52, which we strongly believe to be impossible considering that the stock is already trading at a very high price, $640m ($1100m-$460) would sit as debt, worsening the D/E ratio.
Gross margin is going to be a critical factor. To achieve the gross margin target of 25% (excluding credit sales), Tesla has to face challenges from two fronts: first in consistently increasing sales, and second in reducing fixed cost by way of component cost reduction and improved manufacturing and logistics efficiency in the quarters to come.
The Model S sedan-dependent Tesla could face resistance from well established and stable competitors like GM's forthcoming model Cadillac ELR and Fiat's 500e. Toyota (TM) too is working to launch an EV product soon. These launches could dampen Tesla's sales if they prove to be better than the sedan S.
R&D cost declined by 23% from Q4FY2012 as reported because of the absence of higher expenses associated with the Model S. We believe in order to stay in the market, Tesla has to keep on introducing new and improved products with a solid battery, which could last longer before needing a quick recharge. That would mean R&D cost going up, hurting margins in the long run. SG&A has been increasing and is expected to increase further in line with increased efforts for pushing volumes. These two cost factors could drag EPS down in the coming quarters.
Short squeeze: Short squeeze is to be partly blamed for the stock's overvaluation. Short sellers are bound to buy back the stock at a higher price to reduce their losses. The stock is squeezed down 27%, from 47% before the results. We believe once the stock factors in short squeeze the price would start to fall.
Recommendation: We believe the stock is overblown as based on the CMP, It is selling at high multiples to its EPS. We believe the price will start correcting in coming trading sessions in the absence of short selling and the current euphoria. In a niche technology driven sector, it takes years for a company to establish a brand with stable profitability. Tesla is yet to show positive EPS and ROIC to demand such valuation.