In this article I will show that the current market price of Tesla (TSLA) is very much exaggerated, and incorporates a bet on extremely optimistic future growth and profit expectations. Consequently, Tesla is to be seen as a short candidate, mid-term or event-driven, whilst acknowledging that its share price currently still has a positive momentum, driven by the hype triggered by the introduction of Model S.
Comparison of fundamental metrics
Tesla is still considered to be a growth stock, which is a commonly used argument to justify lofty valuations. At current price levels, PE ratio on estimated 2013 earnings is about 290, while 2014 estimated PE ratio is about 96.
Table 1: Tesla's earnings forecasts
These PE ratios are impressively high. Table 2 gives an overview of PE ratios of some major car makers. Investors are currently willing to pay PE ratios of about 7 to 12 for established car makers, considering the cyclical business with periods of high profits and periods of low profits or even losses.
Table 2: PE ratios
Another metric with which the valuation of car makers can be compared is the Enterprise Value/Revenue multiple.
Table 3: Enterprise Value/Revenue multiples
As shown in Table 3, EV/Revenue multiples range from about 1 (although General Motors (GM) stands out at the lower end with a value of 0.32, which might be an indication of undervaluation) to about 1.4 . Tesla's figures are 9.6, based on the 2013 annual revenue forecast, and 7.1, based on the 2014 annual revenue forecast. That is about 7-times and 5-times the metric of BMW or Toyota (TM), respectively.
Usual valuation metrics, PE ratio as well as EV/revenue multiple, both obviously represent a bet on extremely optimistic future growth and profit scenarios for Tesla. In fact Tesla did a pretty good job to date, with revenues surging in the last quarters, driven by the introduction of Model S (see Table 4).
Table 4: Tesla's quarterly revenues
However, an investor will require the achievement of a reasonable valuation level within a foreseeable timeline. The question is: what does Tesla need to deliver in the future, in order to justify current share price. As Tesla is still in a growth mode, typical measures like PE ratio will not work properly. Thus I will refer to "net profit margin" as measure of future profitability.
Analysts forecast Tesla's net profit margins of 3.3% in 2013 and 7.4% in 2014 (see Table 1). How do these figures compare to profit margins of the peer group of car makers?
Table 5: Net profit margins of established car makers
Tesla currently focuses on the upscale car market (Model S average selling price is about 80,000-90,000 USD), which enables higher margins (but on the other hand limits the market size). Thus, a reasonable peer group might be BMW and Audi (note that Audi profits from synergies - platform strategy, procurement - within VW group) rather than the mass manufacturers VW, Ford (F) or General Motors. To take the cyclical business of car makers into account, it seems fair to refer to a 5-year average rather than a 3-year average. Let me add some more qualitative arguments (pro and con) with regard to Tesla's potential net profit margin:
- Tesla has less economies of scale in procurement, production and sales & marketing than its much larger competitors, so that its profit margin might also be lower.
- Tesla concentrates on just a few models (Model S, forthcoming Model X), which supports higher net profit margins. However, the planned "Gen III" Model E will be a smaller and cheaper car with a probably smaller profit margin.
- Tesla might achieve "first mover", premium profit margins, as Tesla's Model S (and probably Model X) will serve the upscale electrical vehicle market, while most competitors currently serve the medium and small electrical vehicle market and favor hybrid (instead of true electrical) cars in the upscale market.
Based on these considerations a long-term net profit margin of 5% to 8% for Tesla seems reasonable and achievable.
Now let's have a look on some scenarios. I acknowledge that the following calculations are far from a "scientific" business case, however I think these figures will give a good indication of what items Tesla needs to deliver with regard to growth and profitability in order to qualify as a sound, long-term investment.
I will model scenarios for 3 time frames: a 3-year scenario, a 5-year scenario and a quite long-term 10-year scenario.
A first scenario, which I have calculated, investigates which CAGR on revenue will be necessary over the next 3/5/10 years to achieve a target PE ratio of 15, which sounds reasonable for an established car maker. Results are shown dependent on different future net profit margins.
Table 6: Necessary CAGR on revenue
Given the current share price and a target PE of 15, Tesla needs to earn about 1.3bn USD at the end of the applicable time period in 3/5/10 years. If Tesla can achieve reasonable profit margins (marked yellow), then target revenue and necessary CAGR on revenue can be derived: if net profit margin is around 6%-7% at the end of the 5 (3/10)-year period, then target revenue needs to be 19.1-22.3 bn USD and the required CAGR on revenue has to be 56%-61% (110%-121% / 25%-27%) in order to achieve a PE of 15.
Having said this, we need to take into consideration that the scenarios above have been calculated assuming no change to current share price. In considering an investment, I would however expect some share price appreciation over time. Thus, under the same assumptions as outlined above, how do the figures look like if we expect a moderate 10% p.a. share price appreciation?
Table 7: Necessary CAGR on revenue when share price return assumption is 10% p.a.
Based on the assumption of a reasonable 6%-7% net profit margin Tesla needs to achieve yearly growth rates at the 71%-77% level over the next 5 years to be a worthwhile investment providing an annual 10% share price return. If we look at the 3-year period, Tesla needs to achieve 131%-143% annual growth; if we look at the long-term, 10-year period, Tesla needs to achieve 37%-39% annual growth. These are obviously high hurdles, considering that both high growth rates and high net margins are difficult to achieve at the same time. As shown in the table, a growth rate of 37-39% p.a. over the next 10 years would result in target revenues in 2023 of about 50-58 bn USD, which results in about 900,000-1,000,000 cars to be sold yearly at an average selling price of 55,000 USD (assumption: 60% Model E at 35,000 USD and 40% Model S/X at 85,000 USD). A growth rate of 71-77% p.a. over the next 5-year period would result in target revenues in 2018 of about 31-36 bn USD, which results in about 470,000-550,000 cars to be sold yearly at an average selling price of 65,000 USD (assumption: 40% Model E at 35,000 USD and 60% Model S/X at 85,000 USD).
Also we need to take into consideration that the scenarios above have been calculated assuming a constant number of outstanding shares. Achieving sufficient growth rates will need financial funding. Additional funding through issuance of additional shares will dilute EPS. Thus, absolute profit and consequently modeled growth rates then need to be higher to achieve the modeled target PE ratio.
In summary, Tesla needs to deliver steady, very high growth rates, while keeping a comparably high profit margin in order to justify an investment at current prices for an investor who expects a 10% p.a. share price appreciation and a target PE of 15. At the same time Tesla needs to manage the (national and international) growth from a technical and financial side and needs to compete with much larger, established car makers. Considering this I would argue that at current prices, buying Tesla shares represents a bet on extremely optimistic future scenarios for Tesla.
Deriving a reasonable share entry point
Finally, what could instead be a valid entry point for buying Tesla shares? Let's look at the 5-year period and a target PE ratio of 15, and additionally of 20 for those who are willing to pay a premium in expectation of an ongoing growth story beyond the 5-year period. And again we will expect a 10% p.a. share price appreciation.
Table 8: Tesla share price entry point
Select an expected future profit margin and an expected growth rate and the table will return a reasonable entry price for shares in Tesla. The higher the expected future net profit margin and/or the growth rates are, the higher the price which I am willing to pay for Tesla today.
The model assumes a 10% p.a. price appreciation, which is not too impressive in my view. This 10% p.a. price appreciation implies a comparably higher acceptable share price today, whereas a higher assumption regarding share price return results in a lower price which I would be willing to pay for Tesla today. Additionally I would prefer to have a certain margin of safety, as I am not inclined to risk overpaying my investment. Therefore, I prefer to select values for net margin and growth rates at the lower end of expectations.
Thus I would look into reasonable figures of 6-7% profit margin and 30% p.a. growth rate, which both still are ambitious from my view. That results in a price of 35-42 USD/share which I am willing to pay today, if I accept a PE ratio of 15 in 5 years, or a price of 47-55 USD/share, if I accept a PE ratio of 20 in 5 years. In these cases a 1% point change in profit margin equals a change of 12.1 USD/share (target PE of 15) and of 16.2 USD/share (target PE of 20), respectively. If I expect a higher than the 10% p.a. share price return then I would be willing to pay even less for Tesla today, e.g. a 15% p.a. share price return assumption results in a 20% lower "justified share price" today. We also see that current share prices of about 160 USD require an annual growth rate of about 70% over the next 5 years and a target profit margin of 7% to achieve a PE ratio of 15 in 2018.
There are a lot of risks for Tesla's business, which could harm future revenue and profit projections of Tesla. To name only a few (for more see TESLA MOTORS, INC., FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2013, p. 37-72):
- Subsidies for electric vehicles might be reduced or even abolished which would make cars more expensive for consumers
10-Q, p. 61:
The unavailability, reduction or elimination of government and economic incentives could have a material adverse effect on our business, financial condition, operating results and prospects.
Any reduction, elimination or discriminatory application of government subsidies and economic incentives because of policy changes, the reduced need for such subsidies and incentives due to the customer base of our electric vehicles, fiscal tightening or other reasons may result in the diminished competitiveness of the alternative fuel vehicle industry generally or our electric vehicles in particular. This could materially and adversely affect the growth of the alternative fuel automobile markets and our business, prospects, financial condition and operating results.
- Tesla grants a resale guarantee for customers of Model S and thereby inherits the resale price risk.
10-Q, p. 46:
The introduction of our residual value guarantee may result in lower revenues and profits and exposes us to resale risk to the extent many customers elect to return their vehicles to us and the residual values of these cars are below the guaranteed value.
- More competitors might release electric vehicles with aggressive pricing (as established car makers can subsidize prices across their model portfolio to a certain extent)
10-Q, p. 52:
The automotive market is highly competitive, and we may not be successful in competing in this industry. We currently face competition from new and established competitors and expect to face competition from others in the future.
The worldwide automotive market, particularly for alternative fuel vehicles, is highly competitive today and we expect it will become even more so in the future. Other automobile manufacturers entered the electric vehicle market at the end of 2010 and we expect additional competitors to enter this market. With respect to Model S, we face competition from existing and future automobile manufacturers in the extremely competitive premium sedan market, including Audi, BMW, Lexus and Mercedes.
Many established and new automobile manufacturers have entered or have announced plans to enter the alternative fuel vehicle market. In Japan, Mitsubishi has been selling its electric iMiEV since April 2010. In December 2010, Nissan introduced in the United States the Nissan Leaf, a fully electric vehicle, in 2012 Ford introduced the pure electric Ford Focus and plug-in hybrid Ford C-Max Energi and Ford Fusion Energi, and BMW intends to introduce the pure electric BMW i3 in 2013. In addition, several manufacturers, including General Motors, Toyota, Ford, and Honda, are each selling hybrid vehicles, and certain of these manufacturers have announced plug-in versions of their hybrid vehicles. For example, in December 2010, General Motors introduced the Chevrolet Volt, which is a plug-in hybrid vehicle that operates purely on electric power for a limited number of miles, at which time an internal combustion engine engages to recharge the battery pack.
Moreover, it has been reported that many of the other large OEMs such Daimler, Lexus, Audi, Renault and Volkswagen are also developing electric vehicles. Several new start-ups have also entered or announced plans to enter the market for performance electric vehicles. Finally, electric vehicles have already been brought to market in China and other foreign countries and we expect a number of those manufacturers to enter the United States market as well.
Most of our current and potential competitors have significantly greater financial, technical, manufacturing, marketing and other resources than we do and may be able to devote greater resources to the design, development, manufacturing, distribution, promotion, sale and support of their products.
- Need for more than expected service centers to ensure proper customer service (selling, maintenance, repair) results in higher costs and lower profit margin
10-Q, p. 58:
Our plan to expand our network of Tesla stores and service centers will require significant cash investments and management resources and may not meet our expectations with respect to additional sales of our electric vehicles. In addition, we may not be able to open stores or service centers in certain states.
Based on the considerations above I do not see a rationale for taking a long position in Tesla at current prices, which have run too far in the last months and are above a reasonable entry point. I recommend staying on the sidelines until the market offers a bargain price for Tesla shares, which from today's point of view should be significantly below 75 USD/share (note that 75 USD/share still implies a high EV/Revenue multiple of about 3, based on estimated revenues of 2,81 bn USD in 2014).
As long as Tesla's share price has a positive momentum, driven by the hype after the introduction of Model S, I would not recommend to take a short position immediately either, but to wait for a better entry point, e.g. if quarterly figures show weakness or general market conditions become weaker.