Tesla: A Valuation Framework

| About: Tesla Motors (TSLA)

Summary

Recent SA articles focused on Tesla have been mostly qualitative, creating a less-than-academic backyard brawl between longs and shorts, believers and non-believers.

Rather than add any fuel to the fire, this article outlines my own financial model in an attempt to provide a valuation framework to spark quantitative discussion.

Based on my financial analysis, TSLA as a stock may have room to run and current trading levels are not necessarily pricing in future revenue streams.

However, Tesla faces significant execution and financial risks and my projections show that the company will not be cash flow positive until FY 2020E.

Introduction

Telsa (NASDAQ:TSLA) is a growth stock in a capital intensive industry developing a category-defining product. For these reasons, most contributors on SA avoid writing about the company's fundamentals in favor of qualitative discussions. The bullish Tesla articles I have seen focus on feelings or the "Musk Factor" or the quality of the product or "Musk's Vision." The bearish articles discuss the risks involved with Musk's fly-by-the-seat-of-his-pants operating style or the gigafactory (or lack thereof) or shady disclosure practices or perceived poor historical financial performance. While these qualitative discussions are very important and may ultimately explain the success or failure of Tesla, not many are grounded in fundamentals. This article is my attempt to discuss Tesla's fundamentals by providing a relatively easy to understand valuation framework.

The back and forth on SA sparked my interest in establishing a position in the stock. Could Tesla's future financial performance possibly justify the current valuation and what exactly would that look like? Are the assumptions underlying the valuation realistic? Could Tesla overcome the "cash burn" of recent quarters to emerge as a leading car manufacturer? I spent a lot of time creating the financial model I'm about to disclose and discuss to answer these questions and more.

After completing my analysis, I do not believe Tesla is significantly underpriced or mispriced. As many contributors have pointed out, the company faces substantial financial and execution risks in bringing the Model 3 to market profitably, or at all. In fact, I'm both long TSLA shares and long May 20 $230 put options (just enough to hedge my long position for the quarter - I'll explain more at the end after we have some context). However, I do believe there could be substantial value in other product lines that are not currently reflected in my model.

If you disagree with any section of this article, you'll likely end up disagreeing with the conclusion. Rather than closing up shop and calling me names, please try to finish the article and let's have a discussion. I'm open to feedback on these assumptions which can always be adjusted. I will continue to adjust my model as additional information becomes available.

Surgeon General's Warning: Reading the following analysis may cause considerable dryness, fatigue or outrage and may leave you feeling unfulfilled, especially if you hate numbers or are extremely bearish or bullish (although I did try to use as many charts as possible).

Qualifiers (Or Why This Might Suck)

  • The below model focuses on Tesla's automotive business and all results are non-GAAP unless otherwise noted (no deferral of lease gross profit). The model assumes tracking performance for the non-automotive segment.
  • The below model is not granular down to the level of battery cost reductions, supercharger economics, etc. My assumptions are generally based on guidance, the company's historical performance, and, in the outer years, profiles of mature auto manufacturers.
  • The below model assumes that the Model 3 and its derivatives are the company's only new products through FY 2023E.
  • The below model and related assumptions are, in general, near or below street-consensus. I will highlight key differences toward the end of the article.

Unit Sales and ASP - Meat, Meet Potatoes

The meat and potatoes of any financial model are the operating assumptions. As you can see below, I have assumed sales of Model S and Model X begin to trail off in FY 2018E as Tesla starts to ramp Model 3 production. Musk tends to gratuitously thank Model S and Model X owners for their funding of the Model 3, leading me to believe that he doesn't really care about those models. Musk realizes that the future of EVs (at least for Tesla) is the Model 3 and beyond. Either way, it is clear that the Model 3 drives Tesla's valuation (pun intended). For reference, Tesla is forecasting 500k units sold in FY 2020E. I believe a 500k unit run-rate would require additional manufacturing facilities and is an aggressive goal. Therefore, I have assumed ~66% of that goal, or 336k units delivered in FY 2020E.

A few key takeaways:

  • My assumption for Model 3 FY 2018E production of 92k units might turn out to be a bit aggressive. However, recent comments by Musk lead me to believe he will put everything into getting the Model 3 out on time and in force. I would expect the bulk to occur in the back half of the year.
  • I have forecasted gradual ASP declines for all models, with Model 3 flat-lining around $42.5k (you would expect further price compression as battery costs decline, but technological advances and new features will likely offset cost improvements and keep prices elevated for some time).

Non-GAAP Automotive Sales - A Long Name for Revenue

The chart below simply shows the sales outcome that results from my operating assumptions (volume x ASP) plus sales from the non-automotive segment. Not much to note here except the funky shaped growth line (shape not unexpected given the ramp in Model X and Model 3 deliveries). Based on today's stock price, TSLA is trading at ~2x my expectation for FY 2018E sales (a bit on the high-end based on that one metric).

Gross Profit - Don't Shoot the Messenger

Sales less COGS - pretty simple. TSLA has disclosed non-GAAP gross margin of ~25% for the Model X and is approaching 30% on the Model S. I have assumed that scaled production of the Model 3 will result in non-GAAP gross margins in the 22% area. I believe this will be the most contentious section of the article. My gross margin assumptions are somewhere between the bears (who believe Tesla loses money on each car sold - which is absolutely untrue. Each incremental car sold certainly provides a positive contribution margin) and the bulls (who are expecting Apple (NASDAQ:AAPL)-like gross margins). The fact is that Telsa is a growing car manufacturer and appears to be valued as such, at least for the moment. To be clear, I'm referring to non-GAAP gross margins, which pull forward gross profit amounts deferred under GAAP due to lease accounting.

R&D Expenses - Musk's Favorite Expense

Relatively speaking, Tesla spends an extraordinary amount on R&D. Ford (NYSE:F), BMW (BAMXY) and Toyota (NYSE:TM) spent $6.7B, $5.6B, and $8.8B in FY 2015, respectively. However, they also sold 130x, 38x and 200x more vehicles than Tesla in FY 2015, respectively. On average, R&D spend for these competitors was ~4.7% of sales in FY 2015. I don't mind Tesla's outsized R&D spend right now. That spend, combined with Musk's uncanny talent for getting more done with less, is what might set Tesla apart from the pack. It would be interesting to see what the company's competitors plan to spend on EV/autonomous R&D in FY 2016E and beyond.

SG&A Expenses - You Have to Spend Money to Make Money (Or to Lose More)

If you visit SA often, you might hear that Tesla does not advertise its products. While that is not entirely true (they hosted a pretty crazy Model 3 launch event - with giveaways!), it is pretty clear that traditional advertising would not provide any value to the company right now. If you are super rich or super fond of debt and looking to buy a luxury EV, there is probably a decent chance you have heard of Tesla because there also is probably a decent chance that you live in California. You could argue that there will come a time when education of the customer will be necessary (I'm not 100% sold on this point). For reference, Ford, BMW, and Toyota spent, on average, approximately ~4.1% of their sales on SG&A in FY 2015.

For reference, Tesla has guided to a combined 20% increase in operating expenses (R&D + SG&A) for FY 2016E. I am slightly higher than that at an approximately 25% increase.

Adjusted EBITDA (Or the Holy Grail of Valuation for Dummies)

Just another result chart (gross profit less R&D and SG&A plus D&A). However, this one is a little more important. Bankers like to use adjusted EBITDA to value companies.

Valuation... TLDR Section

There are a few key points for discussion below:

  • Capital expenditures: Tesla is guiding for $1.6B in capital expenditures for FY 2016E. I have modeled a modest ramp as the company continues to build out manufacturing capacity, the gigafactory (or not?) and the supercharger network.
  • Change in working capital: I'm including deposits received from Model 3 reservations for change in working capital (as they would be under GAAP). The only benefit to the auto manufacturing model is that it requires relatively low working capital if you exclude finished goods (here's to you Toyota). Accounts payable can greatly exceed accounts receivable (more favorable supplier payment terms vs. customer terms) and a bulk of inventory is in the form of finished goods, which can be financed with ABL borrowings.
  • WACC: I used 12% for this valuation which, in my opinion, is about right for Tesla's risk profile. As I mentioned in the opener, the company faces substantial financial and execution risk in bringing the Model 3 and its derivatives to market. The company's cost of debt is low as almost all borrowings are fully collateralized.
  • Terminal EBITDA multiple: I used 10.0x for this valuation which, again, in my opinion, is about right for a growing car manufacturer. Given the bulk of TSLA's value is represented by the terminal value, I wanted to remain somewhat conservative here. This could be considered low for a business that is expected to continue growing at a rapid rate (20%+).
  • Net debt and share count: I have assumed that the existing convertible notes are converted, increasing shares outstanding and leaving Tesla with a $1.1B net cash position. I also have assumed that a modest number of shares are issued for stock-based compensation (~22MM shares over seven years).

That's right, you read this entire article for a $240 price target (with a few caveats - read on).

Street Consensus vs. My Expectations for Q1 and Beyond

The street, in general, is fairly bullish on Tesla, especially in the outer years. This could simply be a function of the delay in updating estimates. The chart below compares key metrics from my model to the street.

The chart above helps explain why I'm long May 20 $230 put options (when I bought the puts, consensus Q1 non-GAAP EPS was for a loss of $0.50). The street is overly aggressive and has been for some time. However, that hasn't seemed to matter yet. After Q1 results on May 4th, I expect downward revisions for Q2. After Q2 results, I expect downward revisions for Q3 and so on and so forth until the sell-side analysts learn their lesson (fat chance). I actually had to update the above chart while I was writing this article as estimates were revised down. I'm hoping for an equity issuance after earnings to knock the stock down to the $200 area so that I can close out my puts and buy a few more shares (I know, wishful thinking, right?).

Beyond the next few quarters, I believe there are a few catalysts that could have a material impact on TSLA's share price, only one of which I view as very likely:

  1. (+) The company is able to fund capital expenditures via cash from operations earlier than expected. I view this as highly unlikely until FY 2020E, at which point I expect Tesla to be free cash flow positive.
  2. (-) The "Tesla Aura" begins to fade, causing resale values to decline. This is possible but only if the Model 3 fails badly - people love a good craze.
  3. (+ or -) A technological breakthrough in autonomous driving or battery technology. As an uninformed non-scientist, I view the latter as much more likely than the former.
  4. (+) Announcement of a ride-sharing service via the Summon app, which is my highly likely catalyst. A partnership with Uber (Private:UBER) also is possible but very unlikely given Uber will want wide appeal.
  5. (+ or -) Significant investment in remote-charging or battery swap technology by a well-funded competitor in the U.S. market (Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Apple). I view this as unlikely in the short term as software will be their main focus - each will want to ensure their ecosystem is used in as many autonomous vehicles as possible.

Conclusion

Telsa is a fun stock to value. As a growth stock in a capital intensive industry, over 90% of the company's valuation is in its terminal value. My belief is that TSLA will continue to trade on delivery figures and cash burn metrics until 2017 when Musk again captivates the industry with Part II of the Model 3 reveal. For that reason, covered calls using Jan 17 contracts could be an option for nervous longs.

For purposes of this analysis and in an attempt to avoid an all-out civil war, I have valued Tesla as if it was just an auto manufacturer. I'm not knowledgeable enough to ascribe any outperformance to the energy business. If this article is well received and there is enough demand, I will look to post a similar article on Tesla's opportunity in the shared-autonomy space, which I believe could represent close to 30% of Tesla's sales and operating profit by FY 2023E and is not included in this model.

Please feel free to reach out with any questions or PM me if you want to know how a change in any of my assumptions would impact today's price target.

Cash is King (Bonus Section)

As promised, I have prepared an analysis showing the company's projected cash position through FY 2018E. My projections show the company achieving positive free cash flow on a GAAP basis by FY 2020E. I believe that the interim funding gap is small enough to be filled by the ABL facility and that an equity issuance is not absolutely necessary. However, I also think that given the extraordinary initial demand for the Model 3, the market would not view a $2B equity issuance negatively.

In the quarter ending December 31, 2015, operating cash flow was essentially breakeven on a GAAP basis (a use of $30MM). Tesla was able to borrow ~$200MM against new leases to pay for half of its ~$400MM capital expenditures (effectively switching from GAAP to non-GAAP). I expect Q1 2016E GAAP operating cash flow to be approximately the same despite fewer deliveries, ongoing struggles with Model X production, and modestly higher capital expenditures. ~125k Model 3 pre-orders in Q1 2016E (Or is it refundable reservations? What is the politically correct term?) will help offset incremental quarterly cash burn. I have assumed 300k Model 3 preorders in Q2 2016E will help boost GAAP operating cash flow.

Despite what you might believe, the below analysis assumes realistic numbers for the ABL draw. As inventory increases in preparation for greater deliveries, especially leading up to the Model 3 launch, Tesla will be able to draw at least 66% of the increase under the existing borrowing base, which can be amended as needed.

Disclosure: I am/we are long TSLA, TSLA MAY PUT OPTIONS.

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.