Disclaimer: This article is for educational purposes only and is not a recommendation to buy, sell or hold securities of any kind. This information does not constitute investment advice or an offer to invest or to provide management services. The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of Cognios Capital, LLC or any of its employees. Cognios Capital, LLC does not currently hold any long or short positions (in proprietary or client accounts) in the equities discussed herein.
Author's Note: This article was originally composed in April prior to the release of Tesla Motors' Q1 2014 results. On May 8, 2014, Tesla's stock declined 11.3% to $178.59 per share in reaction to the release and the stock has declined 29.9% since its closing high of $254.84 per share on March 4, 2014. The decline is likely attributable to two factors. First, high momentum stocks with questionable valuations have performed poorly in general and second, investors seem to be realizing that Tesla will need to invest significant amounts of capital into research & development and physical plant to achieve the lofty growth that analyst's project. This capital investment will likely need to be financed with significant equity, meaning that while the company may achieve impressive growth in nominal revenues and profit; on a per share basis the results would be diminished somewhat based on the amount of equity raised and the price at which that equity is raised.
Many comparisons have been made between the technology and social media equities of today and the dot com bubble of the late 1990s; however, there is one specific comparison of QUALCOMM, Inc. (NASDAQ:QCOM) in 1999 and Tesla Motors, Inc. (NASDAQ:TSLA) today that stands out based on similarity of the analysis and debate regarding the merits of each equity.
As a reminder, QUALCOMM is technology focused on wireless communications. QUALCOMM in 1999 was different from its technology and dot com brethren in that it was a real company with large revenues and meaningful profits.
In 1999, QUALCOMM attracted widespread attention due to its CDMA technology for wireless communications and the anticipated proliferation of mobile phones over the next several years. Many sell-side analysts fawned over the stock, and as a result, the stock gained 2,619% from December 31, 1998 to December 31, 1999. The resulting valuation metrics for QUALCOMM stock as of December 31, 1999 are as follows:
Many analysts recommended investors purchase shares of QUALCOMM on the basis of rapid anticipated growth. Note that there were some analysts that did not recommend the shares due to valuation, but these analysts were often thought to be obtuse, because remember in the late 1990s the prevailing wisdom of that day was, "things are different this time."
To justify the purchase of QUALCOMM shares, the favorable analysts used forecasted financial performance that extended very far into the future, often greater than ten years. The problem with this methodology is that analysts have a difficult task in forecasting financial performance one and two years out, let alone ten, and many times analysts will adjust the numbers in the forecast to justify the pre-determined recommendation. As the table below shows, QUALCOMM has been very successful at growing its financials since 1999.
With such impressive financial growth, one would expect stock price performance also to be impressive, but that is not the case. As of May, 2014, an investor that purchased shares at the close on 12/31/99 would have a meager 4.9% total return including re-invested dividends, assuming that investor had the stomach to hold the shares as they declined by as much as 87% in August 2002 (see the below stock chart).
Today, QUALCOMM's valuation is much more reasonable as can be seen in the table below, but the point is it took over fourteen years for QUALCOMM to grow into its 1999 valuation.
One interesting and important note, even as QUALCOMM has cumulatively generated over $51 billion in cash flow from operations and repurchased over $15 billion worth of stock in fiscal years 2000-2013, shares outstanding have increased to 1.688 billion as of April 21, 2014 from 1.320 billion (split adjusted) as of November 15, 1999. Why does this matter? As of March 31, 2014, the fully diluted market value of QUALCOMM's equity was $136.9 billion, 37% greater than the $100.1 billion that the company was worth on December 31, 1999, yet the per share value is essentially flat because the shares outstanding increased by 28%. The majority of the shares that QUALCOMM issued was as a result of employee compensation through options and restricted stock grants. While compensating employees with equity is not a bad thing, young companies, especially technology companies, tend to rely on equity compensation more so than large, established companies, and therefore a prudent investor should be cautious to account for dilution when evaluating such companies.
While QUALCOM and Tesla Motors operate in different industries, there are similarities between Tesla and QUALCOMM that may be instructive for the future. Like QUALCOMM, Tesla has engineered a tremendous product. Its cars attain the highest safety ratings as well as highly flattering consumer reviews. Much like QUALCOMM in 1999, the financial results of Tesla Motors would suggest that it is financially viable with positive cash flow from operations, but not yet profitable (see the table below).
Like QUALCOMM in 1999, the gain in Tesla Motors shares has been tremendous, returning 427% since December 31, 2012. Valuation data for Tesla Motors as of March 31, 2014 also looks elevated based on trailing twelve month financial performance.
Much like QUALCOMM, Tesla Motors has a strong following among analysts and many recommend buying shares at today's prices based on rapid future growth. Consensus analyst estimates run seven years out to 2020 on S&P Capital IQ and the table below compares the projected results to recently reported results.
Projected compound annual growth rates for Tesla Motors are higher than that of QUALCOMM from Fiscal 1999 - 2013, but note that the projected period for Tesla Motors is seven years while the comparison period for QUALCOMM is fourteen years. It is harder to maintain high growth rates over long periods of time as the law of large numbers becomes an ever increasing weight on growth.
What if Tesla Motors' stock price stayed the same into 2021 and it achieves the gargantuan growth that analysts forecast? The table below displays how the valuation metrics would look.
Obviously, the valuation metrics look better with the larger income and cash flow figures projected in 2020, but even these forward valuation metrics are not overly compelling and would be considered fair for a steady growth automotive company. Enthusiasts of Tesla Motors stock would argue that the company is a "tech" and will continue to grow at an accelerated rate, but by 2020 Tesla Motors' high growth will likely be in its past.
Dilution is also a looming problem at Tesla Motors. At December 31, 2013, the company had 22.6 million options outstanding with a weighted-average strike price of $26.70, which is equivalent to 19.7 million net shares based on the $208.45 share price on March 31, 2014. Tesla Motors also has $2.96 billion of convertible debt outstanding after issuing $2.3 billion on February 27, 2014. That debt is convertible into a total of 16.6 million shares and 5.0 million net shares based on the March 4, 2014 closing fifty-two week high price of $254.84. For reference, Tesla Motors had 123.2 million shares outstanding as of January 31, 2014, meaning that fully-diluted shares outstanding increases by 20% to 148.4 million based on the net share dilution from options and convertible debt at $254.84 per share.
This is the danger of extreme sudden stock advances; they often get ahead of the fundamental drivers of return. As a result, the sudden advance in return lowers future returns essentially by pulling forward or stealing those future returns into the present.
It took over fourteen years for QUALCOMM to retrace its 1999 price after investors figured out that the valuation was preposterous, even with the high growth that it achieved. A long term investor purchasing shares in Tesla Motors today should be prepared for below market average (such as the S&P 500) returns or even losses in the future, but who knows? Maybe it's different this time.
* Financial data sourced from public filings and S&P Capital IQ.
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. I have no business relationship with any company whose stock is mentioned in this article.