There Is Safety In Disruption: A High-Level Tesla Valuation

Dec. 2.13 | About: Tesla Motors (TSLA)

We live in a new economy -- we know this because our neighbours might be professional Youtubers, Instagram celebrity influencers, teenage content-curating millionaires, 20-something infrastructure-building (coding) billionaires, etc. The best, brightest, most creative people in their fields, are able to do powerful things on their own as a result of remarkable new technologies; and old guard gatekeepers are left feeling sabotaged. We see it even within organizations. In many industries, some of the most important and performance-affecting individuals are the social media strategists and corporate personality designers. A lot of labor value is leaving the domain of the experienced and intellectual, and is entering the hands of the naive and innovative. It's a creative-destructive economy on a level Joseph Schumpeter likely never dreamed.

If we can say anything for certain about the future, it's that things are going to be different. So, please don't use standard metrics/methods for valuing companies without qualitative spoonfuls of salt each time you do. The business landscape is treacherous, and one of the biggest trends is the erosion of value of complacent incumbents. I'm a hunter of this value.

Introduction

This is actually a follow-up piece to an article I wrote last December titled "No Money To Be Made Shorting Tesla But Lots To Lose." Some people know that my broker statements are littered with expired (formerly) out-of-the-money Tesla (NASDAQ:TSLA) call options leading up to the publication of that article. It was a last attempt to capture the squeeze before I ran out of cash after seven months. In an extremely high-level model (a good way to beat "a market with a microscope"), I calculated a 10x expected return on investment -- ascribing just a 10% probability of a historic short squeeze occurring. The actual outcome of the strategy continued would have been somewhere between 20x and 80x total investment, depending on my timing of the last batch of calls (and given that put buying on the way up, would have quenched my desire to sell).

All boasting aside, I've been patient in the writing of this second Tesla article. But two market developments have pushed me over the edge:

1. One is the market's -- new this year -- willingness to envision future scenarios where ultra high-tech electric vehicles are a significant mode of transport. In my opinion, the most paramount factor in the ignition of the Tesla short squeeze was a gradual extension of the market's collective time horizon. I say this because, simply put, virtually no meaningful fundamental change occurred between the time of my article in December and the start of the explosion in April. In fact, one notable thing that did happen barely moved the needle:

This realization about a shifted time horizon has drastically affected my current fair value and the model to follow. It's been a profoundly important lesson, recognizing that markets really can be that inefficient. This all coming after a brief stint as a short-term bear around $90 (I no longer swing trade).

2. Since the market has now decided to use recent "product issues" as an excuse to turn Tesla's chart into the parabola initially expected (did we also contract the time horizon?), I now have a wonderful margin of safety for my thesis going forward with current value of $15.3 billion ($125 a share), instead of the $24 billion sticker price I was watching two months ago.

A High-Level Model

I'm not going to focus on telling the most compelling disruptive tech story you've ever heard. Lots of folks have done that over the past six to seven months (though it's pretty clear the bears have been running the show again lately). The purpose of this article is to try and value the "unvaluable" and to do so, I'll be using some interesting techniques. I say "high level" not in terms of complexity, but in terms of perspective. I hope to position our line of sight in such a way that we can see the real Tesla value proposition. For this company, in this new economy, it's a necessity to see things as far and wide as possible.

As Glenn Abrett would agree (one of my favorite people to follow on Seeking Alpha) and many professional analysts seemingly disagree: The only way to properly value a company with extreme diversity in potential outcome is probabilistically. That is, defining numerous possible scenarios and assigning odds to them (I think there might be some lessons to learn from actuaries and the insurance business when it comes to tech valuation). When Aswath Damodaran, an obviously brilliant finance professor at NYU's Stern School of Business, recently valued Tesla at just $67 under "optimistic" assumptions that it would become as large as Audi in terms of revenue, he simply overlooked plausible scenarios where high-tech, pure-electric, connected and advanced software-automated vehicles become a really big deal. This is what the market had been doing before the squeeze (albeit, more audaciously/recklessly so). Professor Damodaran later conceded that there are possible scenarios that are quite a lot more optimistic than his model allotted for. These are scenarios where Tesla is:

  • The Ultimate Disruptor (defining an incomparable new paradigm of success for an automaker; from another industry, cite Apple's (NASDAQ:AAPL) outsized share of smartphone profits)
  • The Powertrain/Battery Master (OEM/supplier for the industry -- especially considering its intellectual property as industry forerunner)
  • The First Mover (with a self-burgeoning "ecosystem" resulting from its proprietary supercharger network, established first)

It's actually problematic to just list these possibilities separately; these are not mutually exclusive outcomes. More than one could be true of Tesla's future, and thus they are a tremendous boon to a scenario-conscious valuation.

DCF and Matrix Analysis (Bypassed)

The broadest view we can take as to be certain we're not missing anything integral to the Tesla story is to make projections regarding: 1) the expected size of the auto manufacturers industry (I'm going to make an appropriate change to this number, as we should be considering the additional "white swan" value Tesla carries as a disruptor of several other industries. For example, the petroleum/fueling industry, the utilities sector, the audio-visual content industries (with connected cars and those big touch screens), the auto parts industry, the auto dealership industry, the automation industry, the mass transport industry -- i.e., possible stake in Musk's Hyperloop.), 2) the electric market within it, and 3) Tesla's share of that market.

Instead of running a DCF analysis and attempting to predict year-to-year growth rates in cash flows (which I believe is an impossible task), I'm going to head straight to the end vision of where I reason Tesla's position to be within the 2028 competitive landscape. After making some conservative assumptions in regard to share dilution from employee stock options and additional capital raises, I'll then calculate a fair value while leaving some room for you to have your own opinion. I've chosen the year 2028, because I believe after 15 years the place of electric vehicles in our lives will be well-defined.

A) Future Electric Vehicle Market Size (2028)

Qualitative scenarios for the electric market range from broken economics/broken social contracts/broken(or dangerous) technology/broken governments = no electric vehicle market, to clear economic benefits/sustainability-culture/tech and safety superiority/government incentives turned to strict regulations = electric vehicles becoming the dominant mode of transportation. Please feel free to challenge my assumptions here and adjust the model.

I did my best to use conservative numbers. Every skeptical person I've asked has agreed that less than one-third (31.75%) of the auto market seems to be a very reasonable figure representing average percentage size of the EV component 15 years out. Could be more, could be less -- but this is the expected number, or totality of all scenarios weighted by their odds.

Early Buyout Potential Ignored

One interesting thing to note: if this is an accurate gauge of the future of the EV market, and is or becomes what other automakers are projecting (in secret), then Tesla again has a floor in its stock price under the assumption that other automakers will want to acquire it. I'm just guessing we're close to that buyout price presently, around $15 billion (I said $6 billion to $8 billion in my last article when it was trading under $4 billion).

So, we have significant downside protection that I'll actually ignore in the model. I'm including a 25% chance of zero electric market in order to stay conservative, but, in reality, under nearly every scenario where a black swan doesn't bring a very quick end to the entire EV market -- this "capped bottom" is appreciable, with upside yet to be determined.

B) Tesla's Share of Electric Market Profits (2028)

Assume share of profits = share of market capitalization in the long run, and assume electric market operating profits, at base, are equivalent to ICE market (except where otherwise noted).

Please feel free to argue, but 21.5% seems like a reasonable average share of profits for the creator, builder and establisher of a possible new paradigm -- especially considering Toyota (NYSE:TM) holds ~20% of the market capitalization of the existing automaker industry.

C) Automotive Industry* Size in 2013 (Market Cap)

*Disruptable Market Size

Since it's quite possible that Tesla will gain a much fatter profit margin and chomp on significant additional revenues because of the way it disrupts other industries (for example, removing well over 50% of the automotive-purposed petroleum sector from customers' wallet spend), we need to accommodate for disruptable market size. This figure should be appreciably larger than the $1 trillion auto manufacturers industry alone.

My Limitations

I don't have access to high-quality data or the time and expertise I wish I had. So for this article I can't gain a proper grip on the complexities surrounding just how Tesla might benefit from disrupting the energy and utilities sectors. (This article, however, does outline some very unique and significant possibilities arising from a Tesla/SolarCity (NASDAQ:SCTY) joint initiative. They are putting Tesla battery technology to use, potentially in very profound ways. I suggest taking a look and considering it as added margin of safety.) However tempted I am to speculate, I'm going to exclude these markets from the disruptable figure entirely. What I will do, though, is use their exclusion as justification for the inclusion of the entire auto parts and dealership industries. This is actually very reasonable in isolation as Tesla is vertically integrated to a much greater extent in comparison to its ICE competitors -- producing far more of its own parts in-house and owning its own distribution and service network.

One more assumption I am making is that equity markets are efficiently pricing the auto industry's future growth and risks (i.e., cars as a service, urbanization trend, mass transport innovation, global development). So I'm only assigning 2.5% for "normal" inflation.

Disruptable Market Size in 2028 = 1.362 trillion x 1.025^15 = $1.973 trillion

Valuation

Expected Disruptable Market Size = $1.973 trillion

Expected EV Market = $626 billion (31.75% of Disruptable Market)

Expected Tesla Market Cap = $135 billion (21.5% of EV Market)

Expected Tesla Market Cap in 2028 = C x A x B = 1.973 trillion x 31.75% x 21.5% = $135 Billion

Dilution

Number of shares in 2013 = 122.59 million

Number of shares estimated in 2028 = 157.59 million (assume 25 million in employee stock options and 10 million from additional capital raising)

Expected per share price in 2028 = $856.65

A discount rate of 10% offers us a present value of $205.07. This, in contrast to current market price of $125.32.

I believe I've adjusted quite conservatively for company-specific risk and also for reward. Using a very normal required rate of return gives us a rather large margin of safety between current stock price and modeled value. But you can play with these numbers all you like.

Conclusion

As slow-moving incumbents prepare for a new era by holding firmly to the past (with incremental changes), Tesla Motors persists in the creation and development of the future of personal transportation. Since businesses are often built on stories in both consumer markets and labour markets, it will do so with effortless brand promotion and -- in fantastic positive-feedback form -- an ever-expanding pool of the most brilliant and talented people on the planet.

Buying into disruption might be safer than you think. Personally, I'm not satisfied with the earnings security of a lot of companies, in and out of the auto manufacturing business, knowing that a company like Tesla exists. Expect disruption. If you can find it at the right price, there is safety there.

Disclosure: I am long TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.