Tesla - Is Share Price Really 3 Times Enterprise Value?

Aug. 8.14 | About: Tesla Motors (TSLA)

Summary

The growth assumptions embedded in the current share price are aggressive.

The enterprise value is far lower than the market capitalization, even under rosy assumptions.

Risk-reward would suggest the momentum won't carry the day.

I'm always hesitant to venture an article on such an emotionally-charged stock like Tesla (NASDAQ:TSLA), but I'm considering entering into a short position, and wanted to share my opinion. This article is not intended to be a recommendation for you to short the stock. You should only buy or sell any stock after researching the company and after ensuring that the trade fits in with your asset allocation, your risk tolerance and your time horizon for investing.

The Company and Analysts

I will not waste words on the impressiveness of the company or its management team. Suffice to say that the product is innovative, it is desirable, and it has demonstrated appeal for the upper end of the consumer market. I sort of think of Tesla as a capital intensive operation that trades like a dot-com. Tesla is a fine company, yet I have estimated that the enterprise value is less than the market capitalization - even under aggressive growth scenarios. There's no shortage of published opinions around this stock - another thing that makes me hesitant to publish. I read that a Morgan Stanley analyst proclaimed the company the most important in the world, and I read another analyst who proclaimed that shorting the stock was like standing in front of an oncoming train…fair enough. The bull case seems to be rooted in strong growth of product sales, the fascination with the Gigafactory (and all the side businesses that it could spawn), and the disruptive nature of the company. The bear case is normally fundamentally-driven, with a few skeptics proclaiming that there is a lot of smoke and mirrors in the forecasts. Fundamental shops tend to be opposed to the stock on valuation grounds (Schwab, Ned Davis, S&P), while momentum shops tend to love the stock.

Financial Metrics and Ratios

The argument that Tesla lacks a fundamental valuation consistent with its share price seems to be a common critique. Implied in share price ratios (as seen below) is a growth assumption which one must evaluate critically. If the actual growth falls short of the forecast, then the share price will quickly decline. And in my opinion, inflated expectations is the crux of the bear case for the stock.

  • P/E is enormous - Tesla is still loss-making (although operating profit just turned positive), and there are aggressive forecasts - the PE service that I use shows a forecast PE of 213, compared to 16 for the S&P
  • Other ratios are equally high - price/tangible book of 29, price/sales of 12, price/cash flow of 923

For a high-growth/early-stage company, these ratios will always be inflated, so we must look deeper.

Enterprise Value - "Cocktail Napkin"

I prefer to utilize simple analytics to help get a feel for the "big picture" case, because it is easy to craft a detailed valuation model and then get lost in the detailed assumptions (Or worse, start believing them). So, let's take a simple metric to estimate the enterprise value as 8 times earnings. But, let's not use today's earnings. Rather, let's look into the regulatory filings at the incentive compensation plans, and let's index off of that.

According to the filings, the following are executive goals:

  • Completion of the first Model X Production Vehicle
  • Aggregate vehicle production of 100,000 vehicles in a trailing 12-month period
  • Completion of the first Gen III Production Vehicle
  • Achievement of annualized gross margin of greater than 30.0%

These factors seem well-defined, and in sync with the company's success. In fact, corporate governance analysts might applaud the ease with which one can quantify meeting these management goals. And while one could argue that sales should be more important than production, let's not be "nit-picky". Let's assume that if they can make the 100,000 vehicles, then they can also sell them. Let's also assume that the average selling price is $75,000. One final assumption, the SGA% - let's assume that operational scale really helps and that the SGA expense ratio falls from the current level of 30% all the way to 15% of sales. The result is as follows:

So, in a nutshell, there is a 300% premium still on the enterprise value even if we hit the lofty goals which are shown in the executive compensation plan. We could relax the assumptions even more - for example, we could assume $100K average sales price and 10X EBITDA, bit we're still falling far short of the current market capitalization (about $31 billion).

Other Liabilities

I'm originally an accountant by profession, so I tend to view financial statements with an auditor's skepticism, and usually think about things like "what are the statements not showing?" I'll save that kind of stuff for a different article, but would like to raise awareness to a few areas where liabilities could be greater than forecast, and hence, the margins lower.

Warranty Reserve - I read an article where there is talk of bubbling warranty problems, and anyone who follows the financial press will recall the hype around the battery issues. I'm not suggesting that the warranty reserve is good or bad, just wanted to point out that the current reserve was $72 million on March 31, 2014. Should the above-mentioned sales targets be reached, one would reasonably expect the warranty reserve to climb along with sales. The actual expenses for warranty repairs will be a function of the performance of the vehicles over time. The reserve could turn out to be too big or small - it's a risk to keep an eye on.

Lease Guaranteed Value - Imagine if you could use your iPod for 3 years, and then sell it back to Apple (NASDAQ:AAPL). Better yet, imagine if Apple guaranteed your buy-back price. Since I have read more than one report comparing this company to Apple, I figured it would make an interesting analogy. But, seriously, a Tesla Model S could be considered a fashion statement for a wealthy driver. No-one buys it to save money on gas! So, if we consider the iPhone and the Model S to both be luxury accoutrement for rich people, then one should consider that Tesla guarantees:

50% of the original base purchase price of the 60 kWh Model S plus 43% of the original purchase price for all of the options, including the upgrade to the 85 kWh battery pack (exclusive of taxes, fees, and accessories).

Of course, there are stipulations on the guarantee, but, still, this means Tesla will be eating a lot of 3 year-old cars that aren't as sexy or rare as they were a year ago. To me, it sounds like a potential mess, and makes one wonder how accurate the average selling price of $75,000 is in my above model.

Currently, Tesla is on the hook for about $300 million of lease guarantees. You can do the math if you believe that this phenomenon is linear to the sales forecast I used for enterprise value.

Ok, the GigaFactory

I love the name, really. It excites the imagination, and still hasn't even been built. The definition and selling of this battery plant is an example of the salesmanship of the CEO, and just one more reason why folks tend to compare him with Steve Jobs. To be sure, Musk is a visionary, and he is an excellent marketer.

About that battery plant, though. I think it is sufficient to say that the creation and management of a battery plant represents vertical integration for Tesla. They were previously a car company who had a hard time filling their supply chain with enough batteries, so why not open your own factory? And better yet, convince your primary supplier to help kick-in some investment along the way. Net result, Panasonic agreed to contribute $200 million towards the joint venture. Well, is it really a joint venture? I'm not sure. Here is the precise wording from the press release:

Earlier today, Panasonic and Tesla entered into a formal agreement to partner on the Gigafactory. Panasonic will invest in production equipment that it will use to manufacture and supply Tesla with battery cells. Tesla will prepare and provide the land, buildings and utilities for the Gigafactory, invest in production equipment for battery module and pack production, and be responsible for the overall management of the Gigafactory.

Not to get too picky, but it seems like Panasonic is still owning the equipment to make the battery cells, and they are selling these battery cells to Tesla. Tesla is packaging them into modules and packs. Now, that "sale" is taking place inside the Gigafactory which is owned and operated by Tesla. I've got to mull over that one a bit more - seems like a losing strategy at first pass. Quality issues with the batteries will impact Tesla's reputation, and will create struggles between Panasonic and Tesla, who will be very joined at the hip.

The Stated Risk Factors

These always show up in the fine print, but I find it useful to think about them for a while.

Certain statements in this shareholder letter… are subject to risks and uncertainties:

  • Statements regarding gross margin expansion and profitability;
  • Statements relating to the progress with respect to product development, including Model X development and launch plans;
  • Timing and pace of production and delivery expansion for Model S, including the production volume, rate, and ramp expectation of our new production lines;
  • Growth and demand, in particular in China;
  • Right hand drive market launch expectations;
  • Ability to achieve vehicle demand, volume, production, revenue, leasing, gross margin, spending, and profitability targets;
  • Future store, service center and Tesla Supercharger openings and expansion plans;
  • Tesla Gigafactory timing, site location, partnerships, plans and output expectations, including those related to Model 3; and
  • The ability for us to conclude future agreements with Gigafactory partners, including Panasonic.

These forward-looking statements …may differ materially from those projected. The following important factors...could cause actual results to differ materially:

  • Ability to design and achieve market acceptance of Model S and other new vehicle models, specifically Model X and Model 3;
  • Risk of delays in the manufacture, production and delivery of Model S vehicles or the development, production and delivery of Model X vehicles;
  • Ability of suppliers to meet quality and part delivery expectations at increasing volumes;
  • Tesla's ability to continue to reduce or control manufacturing and other costs;
  • Consumers' willingness to adopt electric vehicles;
  • Competition in the automotive market generally and the alternative fuel vehicle market in particular;
  • Tesla's ability to establish, maintain and strengthen the Tesla brand;
  • Tesla's ability to manage future growth effectively as we rapidly grow, especially internationally;
  • The unavailability, reduction or elimination of government and economic incentives for electric vehicles;
  • Tesla's ability to establish, maintain and strengthen its relationships with strategic partners such as Daimler, Toyota and Panasonic;
  • Potential difficulties in finding and finalizing details for the first Tesla Gigafactory site, obtaining permits and incentives, negotiating terms with technology, materials and other partners for Gigafactory, and maintaining Gigafactory implementation schedules, output and costs estimates; and
  • Tesla's ability to execute on its retail strategy, new stores, service center and Tesla Supercharger openings.

(note - I abbreviated some of the above - the citation is here)

Some people claim that these are all legal language which the lawyers force to be included. But, students of markets know that this disclosure stems from the Securities and Exchange Act. These are useful, they are important, and they can help a prospective investor gauge the potential for blips in the forecasts.

Price Performance

Following is the 12-month chart - it is impressive!

Source: Nasdaq

The "crayon line" is mine, I use it as a rough guide to see how far a stock is moving towards a parabolic increase. In general, as the price rises above the linear trend, one can think of the price performance as possibly "getting ahead of itself". In other words, there could be an attractive short term down-side move which falls inside the context of a larger bullish appreciation - solely due to the variance from the trend-line. As always, remember that technicals are used as one aspect of a holistic investment decision. But from the above chart, one can easily see how frustrating a short position on Tesla might prove to be.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a short position in TSLA over the next 72 hours. 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.