Few stocks have garnered as passionate a following of supporters and detractors as Tesla Motors (NASDAQ:TSLA). With a 344% return in 2013 it was one of the best performing stocks of the year and recently a very optimistic Morgan Stanley analyst's article sent the stock soaring to record highs of $258 and a $31 billion market capitalization.
Tesla skeptics point out that the company only sold 22,477 cars in 2013 which means that the market is valuing each car sold at $1.38 million/car in 2013 and $838,000/projected car sold in 2014. This simple metric does seem to indicate that Tesla is ridiculously overpriced. However, let's compare how other car makers are priced in terms of market cap/car sold.
|Manufacturer||Market Cap/2013 cars sold||Tesla Premium||Operating Margin|
Thus, we see that Tesla seems to be valued 233x more than GM and 37x more than Toyota (NYSE:TM) (the world's biggest and most valuable car company). However, there are 3 reasons why I believe that Tesla deserves a premium over these more established automakers. These reasons are better operating margins, an objectively better product and the optionality that goes along with the leadership and innovative genius of Tesla co-founder and CEO Elon Musk.
Highest Operating Margins in the Industry
According to the last earnings report Tesla achieved an operating margin of 25% and the company guided to 28% operating margins for 2014. In the last investor presentation, the company stated that Model X sales are to begin in Q4 of 2014. The Model X is to be a CUV based on the Model S and include double motor all-wheel drive. It seems reasonable to assume that the price of this vehicle will be higher than that of the Model S. Since SUVs and CUVs are higher margin products than sedans let's assume a slight improvement in the company's overall operating margin to 30% in 2016. With the cheaper Model E coming in 2017, 2016 will be the last year of pure higher margin Model S and Model X.
30% operating margins would be 3x higher than that of Toyota and so it seems clear that Tesla deserves a premium to Toyota's valuation/car.
Best Car Ever Made
Reason two that Tesla deserves a premium over industry leader Toyota is that its cars are objectively better. Toyota has built its empire on pretty much one thing - reliability. Toyota's cars are not the safest, most beautiful, best performing or most comfortable but Toyota's are the most reliable. But Tesla's cars have no moving parts other than the electric motor. There are no valve timing belts to break and no filters or oil to change. There is essentially no maintenance to be performed on a Tesla. This means that there is a good probability that Tesla is now the most reliable car company in the world. We'll have to see what 2014 JD Power and Associates initial quality study shows but Toyota might lose its one advantage.
If Tesla can take that crown from Toyota; then it will have a car that is: more beautiful, more comfortable, (no engine means more space for storage and passengers), safer, (the Tesla Model S is the safest car ever tested by the NHTSA) and whose running costs are much lower. This is not only because there is essentially no maintenance to perform on a Tesla, but because charging your car at night is equivalent to filling up your tank with $.75/gallon gas. Compare this to the average price of regular, $3.44 and you can see that your fueling costs will be 78.2% lower in a Tesla.
In addition, consider this: In 2013 the Tesla Model S won 9 awards including Consumer Reports proclaiming it the best car they have ever tested, achieving a score of 99/100. Take a moment to consider this fact. In 2003, Tesla was founded in Silicon Valley. 10 years later it produced what is arguably the best car ever made. Imagine if Tesla can bring this caliber of quality and excellence to the Model X, the Model E and all the other models they will produce going forward. If each Tesla model is the most reliable, the most comfortable, the safest, the best performing, in its segment then there is no limit to how successful sales can grow. In that situation, the sales will be strong and market will correctly assign Tesla a premium to other car makers such as Toyota. I'll explain how large of a premium in a second but first I must cover one other premium I think Tesla deserves. This premium is the most important as it includes all the potential for market disruption that the company brings to the table.
Optionality and Elon Musk
Motley Fool's David Gardner penned the idea of "optionality" the idea that a company can morph into an entirely new company expanding beyond their original business model in exciting and profitable new ways. In 1996, Mr. Gardner recommended Amazon.com (NASDAQ:AMZN) arguing that CEO and founder Jeff Bezos was an innovator and disruptor who could sell far more than books. Today, Amazon has expanded to selling everything from office supplies and groceries to cloud services and soon to be 30-60 minute drone delivery of small packages.
This concept of optionality is what the Morgan Stanley analyst was focusing on when he raised his price target on Tesla to $320. While I think that analyst focused on the wrong things, his general idea was correct.
Investors in Tesla today are paying a major premium for Elon Musk, the CEO and co-founder of the company. Mr. Musk is the co-founder of PayPal, SpaceX and sits on the board of Solarcity (NASDAQ:SCTY). He is an innovation dynamo (and allegedly inspiration for Robert Downey Jr.'s portrayal of "Iron Man"). Mr. Musk at 42 is still in his prime with many decades of innovation in front of him.
What the Morgan Stanley analyst was talking about when he made his admittedly pie-in-the-sky utopian proclamations (he literally stated that Tesla would usher in a "utopian society" within 20 years) is that Tesla can become far more than a simple electric car company.
Where the analyst went wrong was assuming that autonomous cars will be the key to Tesla's future. Rather the most obvious optionality for Tesla is two areas.
Optionality One: Battery and Electric Systems
In 2009, Daimler bought a 10% stake in Tesla and in 2010 Toyota bought $50 million of stock at Tesla's IPO. Both Companies have licensing arrangements with the company.
"The upcoming Mercedes B-class EV, which goes on sale in 2014, will feature a Tesla powertrain. Toyota, meanwhile, gave Tesla a $100 million contract to supply the electric motor, power electronics, battery, gearbox and software for the new $50,000 RAV4 EV. "
One of the main arguments Tesla skeptic's use against the company is that larger OEMs such as Toyota, GM and Volkswagen will easily crush the fledging upstart once Tesla proves the viability of electric cars.
There are three problems with this argument.
The Prius Effect
In 1993, Toyota was concerned that higher fuel prices would cause consumers to demand high mileage cars. So it launched a $1 billion R&D program and in 1995 revealed the prototype Prius at the Tokyo auto show and launched the vehicle in 1997 in Japan. In 2000, sales went worldwide and today the company has sold over 4 million units and total Toyota hybrid sales of 6 million.
Meanwhile, in the 1990's, Detroit's big three were given $1 billion in taxpayer funds to come up with their own high mileage hybrids through the "Partnership For A New Generation Of Vehicles".
The results were a trio of hybrids: the GM Precept, Ford Prodigy and Chrysler ESX3 who got 82, 72 and 72 MPG, respectively. None of the Detroit big three brought any of these cars to market arguing that hybrids were too expensive and that there was no consumer demand for them.
When the Prius, by 2005, had proved a major success, with sales surpassing 1 million units, history recorded that GM (NYSE:GM), Ford (NYSE:F) and Chrysler dusted off these 3 amazing hybrids (with mileage far superior to the Prius) and crushed the young, fledging upstart with their far superior technology. Today, the Toyota Prius is a mere footnote in history while the GM Precept rules supreme among hybrids.
Oh wait, that didn't happen. Despite the amazing success of the Prius, neither GM, Ford nor Chrysler were able to effectively compete with Toyota's first-mover advantage. Honda (NYSE:HMC) tried to compete with the Insight but recently announced that it was discontinuing the brand due to low sales. To date, no company has been able to effectively challenge the dominance of Toyota's Hybrid Synergy Drive (Prius makes up 40% of global hybrid sales). The company's first move advantage built out of far sighted innovation and risk taking means that the Toyota Prius will remain triumphant when it comes to hybrids.
Just as we saw Toyota bet big and win huge with the Prius, Tesla represents a potentially as big, if not bigger opportunity. The benefits of electric cars vs regular cars are undeniable:
- Electric cars are 90% efficient vs 20% for regular cars
- Maintenance on an electric car is non-existent. Take the maintenance on the now defunct GM EV-1. "Garages stating that they bring in the electric cars in every 5,000 miles, rotate the tires, refill the windshield wiper tank and send them out again."
- Cost to run: according to the EPA, a model S that drives 24,000 miles/year costs just $700 in annual electric bills.
- Environmental benefits: electric cars can be run off of clean energy, such as the Tesla Super Charger stations, many of which are solar powered.
- Performance: Electric motors have instant maximum torque which allows for amazing acceleration.
- Space: As seen in the Tesla S, when a car maker designs the car without an engine and the battery and motor in the floor of the vehicle, the amount of space available for passengers and cargo is amazing. The Tesla S has 31.3 cubic feet with all seats up and 58.1 cubic feet with rear seats folded.
- Safety: With all the added room for crumple zones (no engine, just a front trunk to collapse and absorb energy) the Tesla Model S is the safest car ever tested by the National Highway Traffic Safety Administration.
What this means, is that at some point in the future nearly all cars will be electric and right now Tesla is the undisputed king of electric cars. It has the most advanced technology that big competitors, (such as Toyota and Daimler) are choosing to license and buy from Tesla rather than pour billions in R&D into a competing system.
Let's talk about R&D for a second. This is how much Tesla's competitors are spending to develop competing models.
Toyota Prius: $1 billion
GM/Ford/Chrysler hybrids: $1 billion, tax payer funded
Chevy Volt: $1.2 billion
Nissan Leaf: $1.4 billion
Tesla Model S:$650 million
As one can see, Tesla spends the least on R&D yet develops the best product. Not convinced? Consider the following battery costs for today's EVs.
Industry average per kWh: $650
Nissan Leaf: $375
Tesla after Gigaplant goes online in 2020: $182 or less (Elon Musk is quoted as saying "at least 30% savings in battery costs")
Meanwhile, big traditional automakers like Toyota and Hyundai (OTC:HYMTF) are investing hundreds of millions of dollars into fuel cell vehicles with a goal of being able to sell 5,000-10,000 in the US, in 2015 at a cost of $50,000. With a range of 310 miles (Tesla is close to 300) and requiring 3 minutes to refuel the car is going to likely lose money for Toyota and waste its R&D resources.
This is because fuel cell vehicles are already inferior to electric vehicles and they haven't even arrived yet. Tesla has designed the Model S's battery pack to be switched out in 90 seconds for a cost of $60-$80 which is the cost of a tank of gas. Meanwhile hydrogen stations, which are rare, cost $3/gallon equivalent for hydrogen and take 3-5 minutes to fill up.
Fuel Cells, Main EV Competitor, Have No Future
The only benefit that fuel cells had over electric cars was in their refuel time.
FCV: 3-5 minutes to refuel at $3/gallon equivalent
Tesla S: 90 seconds to refuel at $3.43/gallon equivalent
A hydrogen economy requires massive infrastructure buildup of special pipelines, hydrogen producing stations and storage facilities. The estimate cost of this infrastructure is $200 Trillion.
Electricity is everywhere. The aging electric system will have to be rebuilt and reinvested in to keep the lights on and economy functioning. A smart grid will cost $338-$476 billion over 20 years but will deliver $1.4-$2 trillion in economic benefits. In other words, the hydrogen economy is an economically untenable fairytale while a smart electric grid is inevitable.
The point of the above presentation is to show that the automotive Goliaths that Tesla is supposedly going to be crushed by are not as mighty or frightening as initially presumed. Toyota, Nissan and GM are spending billions of dollars on competing systems that are more expensive, less efficient or in the case of fuel cells, economically not viable. Meanwhile, Tesla is focused like a laser on the final automotive end game, electric cars. Hybrids are great and will make Toyota lots of money, but plug-in hybrids offer even better fuel economy. Plug-in Hybrids are great but electric cars are the end state of automotive technology. The company that perfects EVs will own the automotive future.
In ten years, when Tesla has proven the superiority of not just electric vehicles but their electric technology in particular what is more likely? That big OEMs such as Toyota and GM will spend billions of dollars on R&D and will take 5-10 years to bring a decent competing EV technology to market? Alternatively, these companies seeing that Tesla's battery packs and electric control systems offer the highest performance at the lowest price could simply outsource them from Tesla (as Toyota and Daimler have already done).
Here is the first major optionality for Tesla - the licensing of its electrical systems to other OEMs to use in their electric cars. 10-20 years from now if Tesla keeps on innovating in this space its technological lead in batteries and electrical management systems could remain strong. Then, Tesla will primarily be an automotive systems supplier. The recently announced Gigafactory, which is to be completed by 2020 at a cost of $4-$5 billion, will be capable of producing enough Tesla Branded battery packs for 500,000 cars. To put this in perspective - the output of this single factory (to be built in the US and provide 6500 jobs) will be greater than all the battery production in the world today. This kind of audacious long-term strategy is what Mr. Musk is known for and why Tesla trades at a well-deserved premium to automakers such as Toyota.
Optionality Number 2: Electrical Infrastructure for EVs
Tesla is building a network of superchargers along America's busiest highways that are capable of recharging a Tesla S to 80% within 40 minutes and full within 75 minutes. Some of these will be able to swap out the battery pack in just 90 seconds at a cost of $60-$80. As of early 2014, the network covers 80% of the US population. The network will be complete, covering 98% of the population, by the end of 2015. This charger network is several times faster than any competing system. What's more is for owners of the Model S with an 85 kWh battery back the superchargers are free of charge for the life of the vehicle. This is pretty amazing technology made more so by the fact that Tesla will soon have all supercharger stations powered by solar energy courtesy of Solarcity (another Musk company). The benefit of being solar powered is not purely for environmental reasons. In the event of a large scale blackout like the ones that hit the Northeast in 1965 and 2003 the Tesla supercharger stations would still work. In fact, Elon Musk recently mused, "even if there's a zombie apocalypse, you'll still be able to travel the country on the Tesla Supercharger network."
This brings us to the second large optionality for Tesla, opening up the supercharger network to all compatible EVs. Remember that Toyota and Daimler are buying their EV components from Tesla. Imagine the monetization potential if these vehicles could charge, (for a nominal fee) at these supercharger stations (with power free from the sun). It would be the equivalent of a network of high margin gas stations. If Tesla succeeds in becoming the main supplier of battery and electrical components to future EV makers, then the networking effects become massive.
What I mean by networking effects is that initially competing car makers would buy Tesla sourced batteries and electrical systems because they are cheaper and better than developing their own. However, because these non-Tesla EVs are compatible with the supercharger network, customers of Toyota and GM EVs would be delighted to learn they could benefit from this impressive system.
The supercharger infrastructure and its compatibility with non Tesla EVs could become a major selling point for Tesla's competitors. Suddenly, other automakers, such as Honda, find that customers would not buy an EV from them unless it's supercharger compatible. That requires that Honda either build out their own supercharger network, a redundant and hugely expensive affair, or just buy their EV components from Tesla, which are cheaper and better performing than the components they could make themselves.
Suddenly, Tesla's competitors become its partners. This means suddenly that expensive supercharger network (that would have to be expanded massively to accommodate millions more non Tesla EVs) becomes a huge asset. The sheer size and scope of the infrastructure cost to compete with Tesla (once they have a 5+ year head start) becomes economically nonviable. It becomes within every automakers best interest to save money and maximize sales by sourcing Tesla EV systems. This creates not just a massive economic moat around Tesla but creates enormous residual income. Suddenly Tesla is the world's number one automotive equipment supplier and the world's largest high margin "electric gas station" operator. It could earn far more sales and profits from these two optionalities than they could selling cars, though they will undoubtedly gain strong market share in the automotive space as well.
These are just the two most obvious optionalities and are the kind that Mr. Musk has talked about himself. Part of the premium Tesla is trading at today is because of innovations that reside within Mr. Musk's head that he is patiently working on and has yet to reveal.
Despite the optimistic view I have painted thus far, Tesla is a company that does face risks both as a company and an investment.
1. Market Valuation/Momentum risk: The stock has been one of the best performing investments of the past year and nearly all its movement has been a momentum play. The general market's 30% return in 2013 (one of the strongest ever) greatly helped with this performance. In the event of a market correction Tesla stock may fall fast and far regardless of the fundamental performance of the company.
2. Headline risk: The recent spate of Tesla Model S fires and the investigation launched by the NHTSA, could give people the wrong impression about the safety of Tesla Electric Cars. Though conventional cars are far more flammable, given they carry 10-15 gallons of explosive fuel onboard, media hysteria over Tesla fires could hurt sales. Thus far it hasn't but future media coverage may turn against Tesla in this area.
3. Execution risk: Thus far Tesla has executed very well on its growth strategy. It has been able to consistently put up results beating its guidance and each time it does the stock rallies. In the future, raised expectations could result in great results but market disappointment.
Also, the supercharger network mentioned as one of Tesla's key assets is also a challenge to build out. The company is not just targeting the network to cover 98% of the US population by 2015, but is also building similar networks in Europe and Asia. The logistics and costs involved in a global network of superchargers is formidable and any hiccups in execution could hurt faith in management's ability to execute on Mr. Musk's grand vision.
4. Timing Risk: The long-term dominance of electric cars is certain (fossil fuels will eventually run out making gasoline cars impossible) but the exact timing of when electric cars achieve mass market adoption is not. Right now Tesla is supply constrained and guiding for 35,000-40,000 sales in 2014. However, its possible that end demand for the Model S might peak at 40,000-50,000/year. Perhaps the general car buying public just isn't ready for mass EV adoption and Tesla's future will be constrained as a niche player. After all, according to Elon Musk, Tesla won't be able to offer a 500 mile range in its cars until 2018. Range anxiety will decrease as EV ranges increase but some people will demand that EVs have range superior to regular cars before they purchase one.
Valuation and Future Returns
This brings me to my original point. Tesla deserves a premium to traditional automotive companies such as Toyota. However, how much of a premium? How can we value a company whose potential for profit seems limitless but so hypothetical and far into the future? Let's use Toyota to see if we can model Tesla's current fair value.
Toyota trades at 1.15x sales and has an operating margin of 9.8%. Since Tesla will have a 30% operating margin in 2016 (due to maximized efficiencies out of Model S and Model X production lines), let's give Tesla a P/S of 3.45 which is proportional to its massive profitability.
Next, we need to account for Tesla's superiority of products over its competitors. I feel that a 25% premium is fair given that Tesla's cars are so superlative (the most reliable, the safest, the most comfortable, the most beautiful, and the best performing). This premium gives us a P/S of 4.31.
Finally, how do we value the incredible innovative genius of a man who seems to be bent on solving all the world's greatest problems within his lifetime? Again, I think a 25% premium is fair. Applying this to our previously adjusted P/S ratio we get a total P/S of 5.4. This is down from the current 15.43 P/S at which Tesla trades.
That is the premium I think Tesla deserves to trade at in 2016. In 2017 will be the introduction of the more mainstream Model E which will come with a lower price and lower margins. To determine the value of the company in 2016 we need to model how many Model S and Model X cars Tesla can sell.
According to the company's 2013 end year investor presentation, Tesla is anticipating a 55% increase in sales in 2014 to about 35,000 vehicles. These will almost be all Model S's since the Model X will just be starting production. Currently, the Model S is supply constrained which means we do not know the true demand for the vehicle because Tesla sells all it makes. However, it seems reasonable to assume that by 2016 at least 50,000 model S's/year will be sold and I'll model the same number for the Model X SUV. I base this assumption on the fact that the most popular Porsche (another premium performance brand) model is the Cayenne SUV.
This gives us a base of 100,000 vehicles sold. However, with strong growth of stores in Europe where gas is $8/gallon and the cost to refuel a Tesla is 12x less than a gas car this might prove conservative. The company has just now started to focus on Asian sales which could provide a sufficient kick to sell 75,000 Model S and 75,000 Model X's in 2016. This is my high-end estimate and represents a doubling of Model S sales in 2 years off of the increased 2014 amounts.
To model total revenues we compare the estimated 100-150K units sold to the 35,000 expected sold in 2014. Using this and the estimated $3.63 billion in sales in 2014, I estimate $10.4-$15.6 billion in sales in 2016. Then, applying my P/S multiple I get a market cap of $56.2-$85.8 billion. This represents an 81-169% potential upside by the end of 2016 and gives us a 3 year price target of $468-$693/share with a mean target price of $581/share.
To determine the fair present value of this projected growth, I discount by the stock market's long-term, (1871-2013) compound annual growth rate, of 9%.
This gives us a present day fair value of $330-$489 which is an average of $410/share. This represents a 41.8% potential upside in 3 years - an equivalent to 12.3% CAGR. That is 37% better than the market's historical return. Coupled with recent technical analysis this gives a strong buy signal.
The technical signals on Tesla are as clear as they come. The signals are bullish across the board, with a recent Bullish Engulfing candlestick pattern and absolutely no resistance above the current price. Unfortunately, there is only moderate support at $177; meaning that, should unexpected bad news hit or the market undergo a general correction the stock would take a pretty strong hit. However, that would only give long-term investors a chance to acquire more shares at a much better price.
Despite its incredible one year run, I strongly feel that the fundamental strength of Tesla (which lies in its award winning products and best in class management) warrants a strong buy, even at these record levels. I estimate a short-term (3 years) CAGR of 12.2% from the current price. After the introduction of the more mass market Model E, I anticipate even stronger 15 year performance (a topic for another article).