Tesla: 4 Reality Checks For Bulls To Consider

Jul.16.14 | About: Tesla Motors (TSLA)

Summary

Tesla is a speculation, not an investment.

Elon Musk openly admitted Tesla was overvalued just nine months ago, when the stock price was much lower than today.

All bubbles ultimately pop and Tesla will be no different.

most obstacles to Tesla becoming a dominant automaker are outside of Elon Musk's and the company's control.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities--that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future--will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street--a community in which quality control is not prized--will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

-Warren Buffett, Berkshire 2000 Shareholder Letter

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-Headlines regarding Tesla, February 2014 (see here and here)

Far be it from me to take a cynical view of Tesla Motors (NASDAQ:TSLA) and its current stock valuation (for which, see my prior articles here and here), however some time has passed since I last looked at Elon Musk's publicly-traded vehicle manufacturer that bulls believe will bring about "utopia on earth," aka Tesla. Therefore, I thought Seeking Alpha readers might appreciate an update on my views regarding the company, especially since Tesla's stock price has recently suffered a "melt up" back into the low 240s as recently as July 1st, from the 200 level when my prior articles were published. In accordance with that belief, I hereby present four "reality checks" for longs to consider when deciding whether to buy, hold or sell Tesla shares at current market levels:

Reality Check #1: In the Long Run, Valuation Matters

It is axiomatic that the intrinsic value of any company is equal to the present (or discounted) value of the net cash that its shareholders will be able to take out of the company (if any) over the course of its existence. This applies to candy manufacturers (such as Hershey Company (NYSE:HSY)), software makers (such as Oracle (NYSE:ORCL)), beverage companies (such as Coca-Cola (NYSE:KO)), insurance companies (such as AIG), homebuilders (such as PulteGroup (NYSE:PHM)), and, yes, even carmakers such as Tesla (and no, "disruptors" are not exempt from the rule). It is extremely unlikely, however, that the discounted value of Tesla's free cash flow over the life of the company will ever amount to anything remotely close to the recent high market cap of $30 billion.

All things considered, $30 billion is an extremely large number. In fact, only about 160 companies in the S&P 500 have market caps over $30 billion (see data here); thus, Tesla's peers at that market cap include heavyweights like Raytheon (NYSE:RTN), WellPoint (NYSE:WLP), Norfolk Southern (NYSE:NSC), Reynolds (NYSE:RAI) and Travelers (NYSE:TRV), not exactly startup companies. In order for Tesla to justify that valuation, it will need to generate free cash flow far in excess of $30 billion, because one needs to discount Tesla's future stream of free cash back to its present value using an appropriate discount rate. Using a conservative but appropriate discount rate in the range of 15-18% (due to the highly uncertain prospects for any startup taking on an entrenched industry), Tesla will need to produce future free cash flows along the lines of the following in order to justify a $30 billion market value (let alone any appreciation from that level, which would require even better financial performance than presented below):

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

After 2028

FCF by Year ($MM)

0

50

100

150

300

600

1200

2400

2800

3200

3500

3600

3600

3600

3600

175000

Cumulative FCF ($MM)

0

50

150

300

600

1200

2400

4800

6400

9600

13100

16700

20300

23900

27500

202500

Click to enlarge

Yes, that's correct, in my valuation model, in order to justify a $30 billion market cap, Tesla will need to generate approximately two hundred billion dollars ($200,000,000,000) in free cash flow over its existence, mainly because the consensus, even among bulls, is that the bulk of Tesla's cash flows lies far in the future. Now, to put it mildly, $200 billion is a huge amount of cash flow. In order to generate $200 billion in FCF, Tesla will need to sell roughly 58,000,000 vehicles at ~$35,000 per vehicle with an operating margin of 15% or roughly 87,000,000 vehicles at ~$35,000 per vehicle with an operating margin of 10%. In either case, this produces $300 billion in operating income, or $200 billion in after-tax net income (note that this also assumes that net income should generally approximate FCF over long periods of time-in other words, that capex and depreciation should be generally equivalent over time, although in reality capex will likely exceed depreciation due to inflation, thus making the Tesla valuation case even more challenging). In order to sell this many vehicles, however, it would take Tesla between 145 and 218 years(!) once its annual run rate for sales becomes the expected 400,000 vehicles per year. I'm sure most Tesla investors take a long-term view, but are bulls really willing to wait until the year 2232 for their investment thesis to prove out?

Note also that the entire present value of FCF in the above chart for the years 2014 to 2028 equals just a small portion of Tesla's current market cap (perhaps 20% to 25%); thus, approximately 75% to 80% of Tesla's market cap depends on FCF for periods that are a minimum of 15 years in the future. Can anyone really know what a startup company like Tesla will look like even 5 years from now? I highly doubt it. And looking 15-20 or more years out, it is basically impossible to predict how Tesla will fare. Note that this also assumes that Tesla does not engage in any net equity issuance from now on, which simply will not happen (indeed, shares outstanding have climbed from 115MM to 124MM in just the past year). Certainly, one can be sanguine about any company's future, especially with a visionary "serial disruptor" CEO such as Musk, but investors should ask themselves exactly how likely it is that this FCF scenario will actually play out in reality.

Reality Check #2: Elon Musk Openly Admitted Tesla was Overvalued Just 9 Months Ago

Tesla investors love to put CEO Musk on a pedestal, acting as if he can say and do no wrong… except on the issue of Tesla's stock valuation. When it comes to this topic, Tesla bulls have an extremely hard time dealing with the fact that Musk stated the following just 9 months ago:

The stock price that [Tesla has] is more than we have any right to deserve

At the time Musk made this statement, Tesla's stock price was approximately $45 to $50 below current levels and $70 below the highs seen in the beginning of July. When confronted with this inconvenient reality, Tesla bulls generally have one or more of the following responses: they get angry (the "emotional" response); they dismiss the fact by stating that "things have changed since then" (the "attack the underlying premise" response); they claim the quote is taken out of context and that Musk somehow didn't mean what he clearly stated (the "redirection / obfuscation" response); or they simply refuse to acknowledge the quote (the "bury your head in the sand" response).

Three of the four responses obviously don't advance the bull case whatsoever; only the second response ("things have changed") could potentially have some merit in this respect. So, have Tesla's valuation metrics really changed so much in the past year that Tesla could go from being overvalued at ~$173/share ($21B market cap) in late October 2013 to undervalued at ~$222/share ($27.5B market cap) currently? In order to make this case, some combination of the following must have occurred during that period: Tesla's future expected cash flows must have drastically increased; the dates that Tesla's cash flows are expected to be realized must have gotten materially closer to the present; and/or the discount rate used to reduce Tesla's cash flows to their present value must have materially decreased. I don't believe, however, that any of these has occurred since last October. On the first and second points, Tesla has not materially altered its future business plan from that presented a year ago. Just as in mid-2013, the company still expects the Gen 3 vehicle, which will produce the vast majority of its future profits, to cost around $35,000 and be on the road by 2016 (see here, here and here). Nor has the expected date of initial operation for the gigafactory gotten closer, which would indicate that future Gen 3 cash flows could be nearer than previously expected. In fact, groundbreaking for the gigafactory has actually been pushed further out in the past few months (see here and here).

Thus, only a material decrease in the discount rate could justify an increase in the expected DCF for Tesla. However, it would be unreasonable to materially decrease the discount rate applicable to cash flows lying three or more years in the future and dependent on a massive ramp up in Gen 3 vehicle production, when Tesla has yet to take any concrete steps to insure that these cash flows will actually be realized on the expected timeline. Even the cash flows for future years' sales of the Model S do not deserve a lower discount rate, as these increasingly appear to be highly dependent on temporary "pops" in deliveries resulting from Tesla entering new geographic markets, such as Norway and China. The downside of being a startup and a "disruptor" is that such a company deserves a high discount rate unless and until it becomes part of the industry "establishment." For Tesla, this still lies many years in the future (if ever).

Reality Check #3: Bubbles Inevitably Pop

Every bubble that's ever existed has had its ardent defenders. Such defenders exist because bubbles feel incredibly rewarding to those reaping the benefits… until they pop. And they inevitably will pop; it's not a question of if, it's merely a question of when. As Warren Buffett states in the quotation above, "Nothing sedates rationality like large doses of effortless money." Tesla bulls have made massive amounts of effortless money over the past year, thanks to Elon Musk, Adam Jonas and the other promoters of the Tesla "story." As a consequence, rational thought on the part of bulls has gone completely out of the window. Any news story regarding the company, no matter how minor, is now latched onto to justify Tesla's absurd market valuation. For an example of this, see Tesla bulls' reaction to the announcement that the company is not going to enforce its patents going forward. Normally, the failure to enforce a company's IP would be a large negative for its valuation; however, because the announcement came from the "visionary" Musk, bulls immediately label it a bold and genius decision. In addition, when confronted by evidence that Tesla is massively overvalued, bulls often reply with some version of the non sequitur "I heard the same argument when the stock was $[insert lower price]". Clearly, bulls have no willingness to acknowledge that the Tesla bubble exists and may be in its final stages.

But, as Buffett also says in the quote above, "a pin lies in wait for every bubble." Just as the South Sea Bubble and the Dutch Tulip Bubble deflated, so too will the Tesla stock bubble. Tesla-ites, of course, will deny it all the way down ("nothing to see here, move along folks"). They say a picture is worth a thousand words; sometimes a chart is as well (with Tesla, I believe we are rapidly moving towards the end of the "mania" phase):

Reality Check #4: Most Obstacles to Tesla Becoming a Dominant Player in the Auto Industry are Completely Outside of CEO Musk's and the Company's Control

Tesla and CEO Elon Musk can only control what they can control. Tesla bulls seem completely oblivious to the fact that what lies within Musk's and the company's control is fairly small in comparison to what remains outside of its control. And in my opinion, the latter, much more than the former, will dictate where Tesla's stock goes long term. The following is just a partial list of such items. Bulls should consider these very carefully before dismissing them as "irrelevant," "FUD," etc.

  • Government regulation of motor vehicles and diminishing subsidies for EVs
  • Development of fuel cell vehicles as competitors to EVs
  • Increase in fuel economy of internal combustion engine vehicles
  • Price wars among OEMs and their effect on the prices that Tesla is able to charge for its vehicles ("you're only as smart as your dumbest competitor")
  • Future development of gas prices versus electricity prices
  • Increasing introduction of HEVs and EVs by other OEMs to compete with Tesla's EVs
  • Urbanization of young people in the United States (less drivers, more people dependent on mass transit for transportation)
  • Ability of third party suppliers to provide Tesla with adequate supply of parts for its vehicles, especially when the Gen 3 vehicle ramp up occurs
  • Interest rates and their effect on the affordability of leased vehicles
  • Prices for used Teslas in the secondary market and the resulting liability that may be incurred by Tesla due to its resale value guarantees
  • Level of tariffs on imported Teslas by foreign countries
  • Availability of raw materials needed to produce batteries at the gigafactory
  • Performance of and potential disagreements with Tesla's partners in operating the gigafactory
  • Persistence of "range anxiety" among potential EV purchasers

Conclusion

The easy money has clearly already been made in Tesla stock. What intelligent investors do in the beginning, foolish investors do in the end. I believe that the current crop of Tesla longs are in the latter category, simply because they seemingly refuse to even consider the fact that the risks vastly outweigh the rewards at Tesla's current market valuation and that, even if the company executes its business plan flawlessly over the next 3-5 years, shareholders can still lose big. I've presented the four reality checks above with the hope that at least a few such investors will have the courage to consider the "other side" of the Tesla story.

Disclosure: The author is short TSLA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.