It's easy to dismiss Tesla's (NASDAQ:TSLA) investment prospects based solely on the exponential performance of its equity value in recent years. However, we'd like to reiterate our opinion that Tesla's equity, while speculative at current levels, is not unsupported by its future fundamentals. The company is trading just under $200 per share at the time of this writing, and this is within our estimate of the fair value range of the company. Let's dig into Tesla's cash-flow-derived intrinsic value estimate and run shares through the Valuentum style of investing.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a company's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Tesla posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. Though this is neither a 9 or a 10 (a "we'd consider buying" rating), nor a 1 or 2 (a "we'd consider selling" rating), it is still below average, suggesting that we won't be dipping our foot into the Tesla pool with respect to shares (at this juncture). However, let's dig into why it remains an important firm for our team to cover.
Tesla's Investment Considerations
• Tesla's strategy is to accelerate the world's transition to electric mobility with a full range of increasingly affordable electric cars. The Model S, the world's first premium sedan to be engineered from the ground up as an electric vehicle, began deliveries in June 2012.
• Tesla's stock volatility is not for the faint of heart. Shares have been on a roller coaster ride, and investor expectations have been ratcheted higher. At current levels, we view it as a very speculative play, though not unsupported by future fundamentals. We consider the magnitude of the upside in our uncertainty process as we do the magnitude of the downside.
• Tesla continues to transition to a mass production car company. At the beginning of the third quarter 2012, it was producing 5 cars per week. By the end of that quarter, it was making 100 cars per week. The company plans to consistently produce 400 cars per week and generate 25% gross margins.
• Tesla reached profitability in the first quarter of 2013 for the first time in its ten year history. During the period, the company exceeded its own targets for deliveries, while it significantly improved its gross margin. We were impressed.
• The firm experienced a revenue CAGR of about 158.4% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years. Though we expect the pace of growth to slow, primarily due to the law of large numbers, expansion will still be robust.
• The headlines of the company's first quarter results are worth repeating. It had record first-quarter Model S production of 7,535 vehicles, as it delivered 6,457 Model S vehicles, slightly exceeding guidance. The company posted a non-GAAP profit of $17 million in the quarter, or $0.12 in non-GAAP earnings per share. The firm continues to expand in Asia and delivered its first cars into China. The company is on track for more than 35,000 deliveries in 2014. Tesla is clearly executing well.
• The company has the support of the government in China thanks to a focus on cleaner air, and we think this will go a long way to supporting the firm's future growth in the country. Long-term, we think the emerging middle-class in China will largely be able to afford electric vehicles and probably in droves.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Tesla's 3-year historical return on invested capital (without goodwill) is negative and below the estimate of its cost of capital of 12.6%. As such, we assign the firm a ValueCreation™ rating of VERY POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We think it's very important to note that Tesla will transform from a value-destroying entity into a value-creating entity in coming years.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Tesla's free cash flow margin has been negative during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Tesla, cash flow from operations moved into positive territory from levels two years ago, as capital expenditures expanded about 10% during this time period. However, we think Tesla will begin to turn the corner on free cash flow generation in the years ahead, offering further support for our fundamentally-derived fair value estimate, which we address next.
Our discounted cash flow model indicates that Tesla's shares are worth between $126-$210 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The relatively wide fair value range is why we call the company speculative at this juncture. However, its current share price (just shy of $200) is within the fair value range, revealing that the company's price is fundamentally-supported. Even though shares are trading above the estimated fair value of $168 (the midpoint of the fair value range), there is no single-stock bubble in Tesla.
Our model reflects a compound annual revenue growth rate of 32% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 158.4%. Our revenue growth forecasts are supported by expectations of future iterations of Tesla's Model S/X (the X is expected in the Spring of 2015) and its growth efforts into Asia, where management is expanding as fast as possible. We think China will be one of its greatest long-term opportunities (especially since it has the support of the government). The Shanghai government recently announced that buyers of the Model S will receive free license places (a $10k-$15k value).
We're projecting a 5-year average operating margin of 16.9%, which is above Tesla's trailing 3-year average. Most of the profit improvement is back-end loaded during our 5-year discrete forecast horizon, meaning that we still expect relatively meager performance during the next couple years. As is common in many auto-maker's operations, as volume ramps, we would expect sales leveraging and increased production throughput to drive material margin improvement. We believe operating leverage is one of the most mispriced dynamics, and Tesla has a significant amount.
Beyond year 5, we assume free cash flow will grow at an annual rate of 17.5% for the next 15 years and 3% in perpetuity. For Tesla, we use a 12.6% weighted average cost of capital to discount future free cash flows. Our discount rate is significantly higher than the median in our coverage universe, and we think this adequately reflects Tesla's uncertainty with respect to its future cash flow stream (the negative growth rates reveal an inflection from negative to positive during the 5-year discrete period).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $168 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Tesla. We think the firm is attractive below $126 per share (the green line), but quite expensive above $210 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Tesla's fair value at this point in time to be about $168 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Tesla's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $241 per share in Year 3 represents our existing fair value per share of $168 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements - non-GAAP
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
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.