Tesla: The Exuberance Of Disruption

Feb.24.14 | About: Tesla Motors (TSLA)

Prior to Tesla's earnings release, even many Tesla (NASDAQ:TSLA) bulls were calling its stock overvalued and warning of a potential pullback. The day following the release, Tesla was up 8.4%. Tesla illustrates the futility of applying traditional valuation metrics to a company as fundamentally disruptive (of the auto industry) as Tesla. The exuberance of Tesla investors is not irrational, but rooted in disruption.

Technologically Conservative Bears

The nature of technological disruption and its effects on technology businesses is an ongoing narrative thread of my articles on SA. One of the things that has struck me from reading comments on my articles is how little consensus there can be about the nature of a given disruptive technology, even years after the disruption commences.

Here's a case in point that hopefully will be embraced by most readers as illustrative. When the Apple (NASDAQ:AAPL) iPhone was introduced, it featured a touchscreen UI that, while most recognized it as clever, was also declared to be a "non-starter" for most consumers, who it was claimed would still prefer a physical keyboard. This went on for years. As late as early 2010, Microsoft rolled out the Kin mobile phones, targeting the youth market, and touting its physical keyboards as "essential". And we all know what a huge success the Kin was.

There's a certain technologically conservative mindset that never gets disruption and can live in denial seemingly forever. For these people, the only future they can contemplate is one that mirrors the past. At the end of calendar Q3 2013, Tesla bears very much reflected this technological conservatism, and there were plenty of them. Some of the more prominent were:

John Petersen, "Dissecting Tesla's ZEV Mythology", which was intended as a rebuttal of my article "Tesla Cars are not an Environmental Abomination".

Ashraf Eassa, "Tesla: Learn from the Mess"

Don Dion, "Tesla May be Out of Gas and Electricity"

Regarded Solutions, "Tesla Fundamentally One of the Worst Stocks to Buy at the Current Price"

Why Battery Electric Vehicles are the Future of Automobiles

Even though SA blogger sentiment turned predominantly in favor of Tesla towards the end of Q4, I get the impression that many don't quite believe in the BEV and are Tesla fans because Tesla has become a popular momentum play. Here's why BEVs are the future:

1) Energy Efficiency: UCLA released a study demonstrating that for comparable weight and size vehicles, a battery EV was more energy-efficient than a hybrid and much more than a conventional gasoline vehicle. This was the conclusion reached by comparing mathematical models based on the Nissan Versa (GAS), Nissan Leaf (BEV), and Toyota Prius (hybrid). The UCLA analytical models factored in all energy costs of manufacturing, transporting, operating, and disposing of the vehicles, so there were no "hidden" energy costs.

In my "Tesla Cars are not...", I extended UCLA's analysis to include the Tesla and a Mercedes E350 for comparison purposes, and found that the Tesla was the more energy-efficient. I specifically made this comparison because Petersen was asserting that Tesla-class BEVs were an environmental abomination because they weren't as energy-efficient as a Nissan Versa or Leaf. But the comparison with the much smaller, lighter, less luxurious Nissan cars was unreasonable. No one with $70,000 to spend on a car would buy a Leaf or Versa. It's certainly preferable for those who can afford it to buy a Tesla rather than a gasoline-powered luxury car.

Energy efficiency almost always wins in technology markets, especially in today's world of limited energy supply.

2) Future Battery Innovations: Petersen was particularly scathing in dismissing the prospect of future Lithium battery innovations that could increase their energy storage capacity. Not all of the current research will pan out, of course, but much of it is promising.

The most important research I've come across, and probably the most practical to implement in the near term, was disclosed in a paper by a research group at Northwestern University, led by Dr. Harold Kung. The group reported fabricating and testing a lithium ion battery with 4x the energy storage of today's lithium batteries, while having long life.

The results of the Kung group have been duplicated by other groups and continue to be an active area of research. The group's results illustrate that the energy storage capacity of current lithium ion cells is not limited by "fundamental physics". Increasing the storage capacity of the batteries is the most promising path to a lower-cost BEV. If you double the storage capacity of a battery you halve the number of cells required in the battery pack, more or less also halving the size and weight of the pack.

Does the cost of the pack also get cut in half? Not necessarily, but the cost of manufacturing probably does come down significantly. It's in the context of lithium battery innovation that the Tesla Gigafactory needs to be understood. It's questionable whether the Gigafactory could achieve sufficient economies of scale to cut the cost of batteries in half, if all it's doing is making the same type of batteries currently made by Tesla supplier Panasonic. But I doubt that's the plan, and I'll be looking forward to Tesla's upcoming presentation on the Gigafactory that was promised at its earnings call.

The prospect of a higher-capacity lithium ion cell in mass production is probably what has drawn the widely reported interest of Apple and the meeting of Apple's M&A Chief Adrian Perica with Tesla last year. I doubt that Apple wants to buy Tesla or that Tesla wants to sell. Musk admitted at the earnings conference call that a capital infusion would be necessary in order to bring the Gigafactory on line in three years, and a joint venture with Apple would provide that.

3) Superior User Experience: Electric vehicles provide a superior user experience because they are quieter, cleaner, and more reliable. Tesla also argues that they are safer. Certainly Tesla has a great safety record so far, even with the widely reported battery fires. The recommendation of Consumers Union and the high ratings in its Tesla ownership satisfaction survey certainly tend to confirm the superior experience.

4) A Mature and Efficient Fuel Delivery Infrastructure: If we think of electricity as the "fuel" of BEVs, then their advantage becomes very apparent compared to hydrogen-powered fuel cell cars. The national electrical grid provides an economical and safe delivery system for BEV "fuel" that is already in place. The Supercharger stations take advantage of this infrastructure for a relatively modest capital investment.

Why Tesla is the (Near) Future of Battery Electric Vehicles

Even when a company disrupts an industry with an innovative product, financial success of the company is not assured. Palm is a good example. I look for factors that can serve to protect the company from competition in the nascent stage of the disruption:

1) A Deep IP Portfolio: Tesla has amassed in the past few years an extensive patent portfolio covering virtually all aspects of its BEV, clearly applying lessons learned from the Roadster. The innovations are almost too numerous to mention, but let me highlight a couple of the most important:

Motor efficiency: Not all electric motors are created equal, and Tesla patents provide its motors with torque and efficiency advantages compared to Tesla's competitors. These innovations make the Model S more efficient, while offering a high-performance driving experience.

Battery management: Tesla Supercharger stations charge a compatible Model S at about 10 times the rate of a conventional electric vehicle. This is only possible because of Tesla-patented innovations in battery charging and thermal management. Put a competitor's electric vehicle on a Supercharger, and their battery packs would probably explode.

Tesla's patent portfolio encircles and protects its products in much the same way that Apple surrounded the iPhone with patents covering all aspects of the touchscreen UI. Not all the patents may hold up, but it's enough to keep competitors tied up in litigation for years. Based on Tesla's patent portfolio, I doubt that any car maker on the planet could duplicate the Model S without significant infringement.

2) Superior Design and Engineering: I get the impression that Musk has an eye for quality in engineering and design in much the same way as the late Steve Jobs. For only the second car the company has produced, the Model S is a remarkable achievement. This ability to lead the design and engineering of such a product is not something many CEOs of technology companies have.

3) Innovative Marketing: You might ask, "What Marketing?" Tesla doesn't advertise, and PR stunts such as the Hyperloop have dubious value. Tesla has made the most important marketing decision that any nascent car company could make: it's chosen to abandon the incumbent dealership franchise system in favor of company-owned stores.

The traditional dealerships have probably the greatest impact on customer satisfaction and also the most negative. Within the existing franchise system, there really is no way to change that, as GM found out with its ill-fated Saturn brand. The problem with the dealerships is that their margins on new car sales are razor thin, and as a consequence, they make most of their money on repairs. This means that dealerships are incentivized to ply customers with unnecessary and expensive repairs, which exaggerates the perception of unreliability.

Tesla has fought the dealership system in states where it's legally mandated and protected. This is clearly in the best interests of Tesla and consumers. Tesla has realized that an important part of the automobile user experience is the dealer experience.

4) Financially Sound: Although financial metrics aren't good predictors of share valuation, obviously investors have to pay attention to Tesla's financials. I'll tread lightly in this area, since Tesla's earnings report has already been extensively discussed, but I want to comment on Tesla's non-GAAP reporting.

Normally, I mistrust non-GAAP reporting, which companies in financial trouble often abuse as a means of disguising losses due to restructuring. Tesla's not in that position. Tesla's non-GAAP revenue and earnings mainly exclude the effect of lease accounting and stock-based compensation. Tesla's latest SEC 8K shows that even including lease accounting, with only stock-based compensation excluded, Tesla posted operating income of $11.8 million.

GAAP revenue growth for the quarter was impressive at 42% sequentially to $610.8 million, while the GAAP operating loss shrank from $30.5 million to $13.3 million. Tesla is clearly on a growth trajectory and is managing its capital and operating expenses reasonably.

Opportunities for Investors

Tesla has set a very ambitious sales target of 35,000 Model S deliveries for the year and a ramp-up of production capacity to 1000 vehicles/week by the end of the year in order to accommodate production of the Model X SUV. Operating expenses may rise more than expected in order to bring the Model X into production, and Model S sales may not meet expectations. Under these circumstances, even non-GAAP earnings may dip into the red. Tesla investors should regard this as a buying opportunity, as I intend to.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.