The Mythology Of Tesla's Valuation

| About: Tesla Motors (TSLA)

I admire Tesla Motors (NASDAQ:TSLA) and wish the company all the best, but I strongly believe that its shares are greatly overvalued. As an investor, whenever I see that the market values a company several times more or less than my own assessment, I always ask two questions: What are the other investors missing? And, when are they going to realize that their expectations are wrong?

Comments to my first article and other articles on Tesla helped me get an answer to the first question. Tesla valuation rests on three myths.

Myth 1: There is an unlimited demand for Tesla cars

To Tesla aficionados it does not matter that "traditional" car makers are pushing a 50 mpg barrier with their new gasoline-powered cars at very attractive price points, that they expand their lineup of luxury hybrid cars and prepare to launch luxury electric vehicles, or that Toyota (NYSE:TM) and Hyundai (OTC:HYMLF) plan to introduce fuel cell cars to the market in less than two years.

They assume that tens of thousands of people will switch to Tesla next year, despite the fact that the other cars in the same price range are bigger, more powerful, have a longer range, can be refueled in minutes and serviced anywhere, and offer more features and luxury touches than Model S. For a similar price, you can get a new Mercedes S550, which has 33 percent more passenger volume than Model S, accelerates faster than Model S despite being much bigger, and offers a host of features that Tesla owners can only dream of. You may think that a hot-stone massage or the system to filter, ionize and perfume the air in the cabin are just gimmicks, but they do attract a lot of potential buyers. And how about these features:

The S-Class' "smoothness" is due in no small part to the near Jetsons-level of high-tech involved in its suspension and safety systems. Using integrated radar sensor and stereoscopic camera technology, Mercedes-Benz has advanced its brake-assist technology with what it calls Cross Traffic Assist -- the system can spot crossing traffic and pedestrians and enhance the driver's brake input accordingly. This carries over into Mercedes' Night View Assist Plus, which alerts the S-Class driver to crossing animals or pedestrians in dark conditions via a night-vision image displayed on the instrument panel.

Still not impressed? Let's continue:

Pulling together the Adaptive Dampening system and the Airmatic suspension, Magic Body Control is put into play when the Road Surface Scan detects bumps or potholes in the road ahead. The boast from Mercedes is that in mere milliseconds, Magic Body Control can adjust the suspension so that you never even feel rough spots in the road, and the truth is that it works miraculously well...

(Source: Editorial review on MSN Autos)

It is no surprise that when Tesla bulls drum up their sales projections, they prefer to compare Model S to Chevy Volt, rather than to Mercedes S550. This is not how most buyers in the $90k+ car category view it.

As a side note, I especially enjoy the discussion of miles-per-gallon for a car in this price range. I picture rich folks boasting about their zero-emission Teslas on board of their yachts and jets. Over 600 private planes flew into New Orleans for this year's Super Bowl, burning a few thousand gallons of fuel each. The private jet industry employs 1.2 million people in the U.S. alone, in case you are wondering how many potential Tesla customers fly private. Private jets have access to over 5,000 airports in the U.S. - compare that to 25 Superchargers. Tesla has a lot of work to do if it wants most of its customers to live closer to a charging station than to an airport.

Model S does attract even the super rich, because it is rare and different. This exclusivity appeal will quickly diminish as the number of Teslas on the road grows.

While Model S is a very good car and Model X is a promising concept, their target market is too small to support Tesla's valuation. Therefore, most of the future growth for Tesla is expected from the Gen III vehicle, which is going to face even tougher competition with dozens of models in the $35-40k price range. Customers are much more price sensitive at this level, and while they claim that "saving the planet" is high on their list of priorities when asked about it in different surveys, in reality they are not willing to pay for it. Doron Levin summarized it nicely on CNN Money:

It's hardly a surprise that a handful of wealthier consumers, with three or more cars in their garage, are buying Teslas and may show an interest in the Cadillac ELR. But without breakthroughs in battery technology that lower prices, extend range, and improve power, it will be a while before the average Josephine spends her hard-earned bucks on a car whose main virtue is that it doesn't burn fossil fuel.

Tesla will have to make a lot of concessions to cut the costs and price of its cars in half, and it remains to be seen how competitive their new vehicle is going to be.

Despite all of these uncertainties, Tesla bulls keep coming up with wild revenue projections. Adam Jonas of Morgan Stanley expects the company to increase its sales by 30 times in 7 years, and by 60 times in 15 years, and even this staggering growth justifies only $149 per share.

It takes a special kind of ignorance to make a projection stretching 15 years forward, based mostly on sales of a car that does not even exist yet. Even if each of the assumptions behind this forecast is highly probable, on a 15 years horizon, the distribution of possible outcomes for Tesla revenues ranges from $20 billion to $0.5 trillion. Following Mr. Jonas's DCF logic, this is akin to saying that Tesla shares should be worth somewhere between $30 and $600 per share today.

Not to be outdone, Craig Irwin from Wedbush Securities upgraded Tesla stock after conducting a survey of potential customers:

Survey data was supportive for significant Gen III mass market potential in the $35k-$45k price range. In a survey of 892 respondents, we were pleasantly surprised that over 20% of respondents indicated they would "absolutely consider" driving an electric vehicle (vs. 65% "maybes"), and 19% were willing to pay a $5,000 or greater premium for a 90% improvement in fuel economy.

Mr. Irwin boosted his forecast to 300,000-500,000 units sold in 2017. Think about it: Mr. Irwin expects a specific company to sell at least 300,000 units of a specific car model that no one has even seen, just because a few people promised to consider driving an electric vehicle. Stock analysts often pull their forecasts out of thin air, but this is a sleight of hand that I have not seen since the dot com bubble days. I can't help quipping that 70 percent of BlackBerry (NASDAQ:BBRY) users promised to upgrade to a new BlackBerry 10 phone less than a year before the company announced that sales of new devices almost evaporated. Analysts were expecting BlackBerry to sell tens of millions of new devices.

There is no reliable way to prove that the expectations of Tesla bulls are realistic, but it does not even matter if they are. The key here is that there is a possibility that the current expectations are way too optimistic, and this possibility is not reflected in a stock price.

Nobody knows for sure what the price of oil is going to be, which car models will be popular, and how fuel cells would compare to batteries in cost and efficiency 15 years from now - to name just a few important variables. If projecting a long-term demand was easy, there would be no BlackBerries, only Apples.

Any comparison of Tesla with Apple (NASDAQ:AAPL), by the way, means that Tesla is grossly overvalued. After the success of iPhone became obvious, Apple shares were trading at P/E multiple of 50. This ratio came down quickly afterwards. Tesla is trading at P/E multiple of 300 right now, or 100 based on the next year earnings projections.

Myth 2: Tesla can make cars more efficiently

The idea that Tesla can beat companies like Toyota or Volkswagen in manufacturing efficiency is a fantasy. It is simply too small. Elon Musk himself admitted that it is hard for Tesla to get the same terms from suppliers as they extend to the bigger manufacturers. Over time, as Tesla increases production, this handicap will get smaller, but it is not going to turn into an advantage any time soon.

It appears, though, that many Tesla fans believe that the company has a unique production system with an army of robots doing all the work. These fans, obviously, never visited a modern assembly line somewhere in Germany or Japan. In 2008, it took Toyota and Chrysler 30.37 man-hours to build a car at their North American plants. At approximately $55 per man-hour, including benefits, labor costs total $1,670 per vehicle for Toyota. Currently Tesla spends 300 man-hours per car - 10 times more than the dinosaurs that Tesla fans are quick to deride. Over time, this number will go down. Even if Tesla does find a way to reduce the man-hours in half compared to the "traditional" manufacturers (which I think is extremely unlikely), it will gain only 2-3 extra percentage points of gross margin.

Apparently, at this point many Tesla employees are not happy, which means the company may have to increase pay or offer better benefits to keep the best workers.

Tesla is also making a big mistake by going international at this very early stage of its development. I understand that Norway offers unique incentives for plug-in vehicles, but Norway's population is smaller than the number of people who live within 40 miles of Tesla's headquarters. Was it worth the distraction and extra capital? Why the company would take orders from China before fulfilling orders it already received from Germany? Why take orders from Germany before meeting the demand back home? I am sure there are logical answers to these questions (for example, the management understands that the real demand in the U.S. is much smaller than what investors expect), but this international rollout at such tiny production levels is not going to help their bottom line.

Tesla investors routinely assume that the company will maintain 25 percent gross margin and 10 percent net margin going forward, as if there is absolutely no possibility that the actual results fall short of these numbers. No car manufacturer in a million cars per year club was able to maintain its profits anywhere near that level.

The assumption that Tesla will be able to reach and maintain such margins is not supported by any evidence, and the possibility of lower margins is not reflected in a stock price.

Myth 3: Tesla can do no wrong

According to Elon Musk, there would be no Tesla today if the CEO of Daimler did not extend it a $50 million loan in 2009. It is ironic that a company, which is supposed to overthrow the old giants, survived thanks to a guy who Tesla fans would not hesitate to mock as a representative of the "old guard."

I am sure that Mr. Musk, a very smart man, knows how many challenges lie ahead. Tesla investors, on the other hand, assume that there will be no bumps on the road. I can name dozens of things that can go wrong and totally derail Tesla's progress. There is a chance that Tesla will go bankrupt within the next 10 years: a zero probability of bankruptcy means that a company can borrow money cheaper than the U.S. government, which is obviously not the case for Tesla. At this point, none of the execution risks are reflected in the current stock price.

When will the bubble burst?

Tesla easily exceeds the first threshold for a good investment opportunity: there is a large group of investors that hold on to several notions that are either downright unrealistic, or contain a large degree of uncertainty which is not reflected in the stock price. This leads us to a second criterion of a good trade: timing.

Shares in Tesla attracted many trend-chasers, who do not care much for a bright EV future. An intraday drop of 17 percent over the past two weeks is a very good indicator that the stock price is primarily driven by this group. This bodes well for a major correction that may be sparked by an otherwise insignificant event. On the other hand, the myths supporting Tesla valuation remain intact, so any pullback in price is likely to be met with a new wave of buying from the true believers.

At some point, the stock will go all the way down to a $30-60 level. This ultimate slide is unlikely to happen soon, unless there is a major correction in a broader market, which results in panic or margin-call selling of all bubble stocks. Absent this market-induced price adjustment, the short-sellers will have to wait patiently for the delays in production ramp up, the first signs of a slowing demand for Tesla cars, the introduction of successful models from its competitors, a decline in Tesla gross margins despite its growing revenues, or any other possible or unforeseen event that dispels at least one of the myths that currently prop the stock. This awakening period may take anywhere from 4 to 24 months.

In the short-term, I would watch carefully when Tesla reports its latest results on November 4. Investors in Tesla are doing a very good job of pumping up the expectations, setting up the company for a disappointment even if it beats its own forecasts but fails to match the whisper numbers. I recommend being very cautious going short into the earnings announcement, but I would certainly be ready to pound on any whiff of bad news.

Disclosure: I am short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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