On Thursday, Tesla (NASDAQ:TSLA) released the Model 3, and we feel it is worth commenting given the car's integral role in transforming Tesla from a luxury car manufacturer to a company that can compete with BMW (BAMXY) and Mercedes and other global automakers.
We love the car: it looks great; apparently it drives wonderfully as well. This comes as no surprise to us as Tesla has a long track record of making beautiful cars.
What we continue to not love is Tesla's valuation and the assumptions implicit in that valuation. So let's run through some back of the envelope calculations to see what the Model 3 is worth, exactly.
What If Tesla Becomes BMW/Mercedes?
BMW and Mercedes each had an ASP of around $45k for their cars (based on segment revenues divided by car sales found in each company's 2015 Annual Reports) in 2015 (BMW's came in higher at $48k, but this is largely due to Rolls Royce being included in their automotive segment), and each company earned EBIT per car of slightly above $4,200 in 2015. We regard this as the upper limit for automotive manufacturing currently: BMW and Mercedes have scale, technological advantages and sell luxury, high-margin products.
We expect that when fully optioned out, the ASP's for the Model 3 will end up between $38-$45k (for example, just enabling the autopilot costs $3,500, bringing the car to $38,500 without any other options), and therefore using BMW and Mercedes as comparables isn't likely to result in a figure too far off the mark in this scenario.
For simplicity's sake, let us assume Tesla starts production of the Model 3 right off the bat as a "mature producer." We assume capex equal to deprecation in our very simple model, and changes in net working capital as a mere 2% of sales.
We start sales in 2018 (the first full year of production) at 500,000 units, which is the current capacity of its Fremont plant. We grow sales at a CAGR of 25.8% until 2026, with end sales coming in at 3.3 million units. This sales growth figure represents more than double the growth rate for Mercedes and BMW's automotive sales, and fits the assumption that Tesla steals market share from their larger competitors. We don't see the introduction of EV's as expanding the market size largely due to price (i.e., Tesla isn't offering a $2,500 product that makes cars suddenly accessible to everyone), so all Tesla can do is steal market share.
Now we add Model S and Model X production to that. We assume 115,000 units of production for the two units in 2018, growing at 15% a year (slower than the Model 3 due to market saturation). These add the same assumed $4,200 per car in EBIT as that was a blended number from Mercedes and BMW. Blended ASP for Tesla assuming a $38,000 ASP for the Model 3 and $100,000 ASP for the Model S/X is $49,000 in 2018, and drops to $45,000 by the end of the model due to the growth in the lower priced Model 3 relative to the Model S/X.
Total unit sales in our simple model end at 3.3 million, which is the same as our unit sales assumptions for Mercedes in 2026, assuming a CAGR for Mercedes of 5%. BMW unit sales we assume to be similar. Note that the 5% growth assumption is very aggressive for a few reasons: global GDP growth is significantly less than 5%, and we assume TSLA steals market share from BMW and Mercedes, meaning the automotive market has to expand significantly for the luxury automotive companies to expand at a 5% clip, WHILE Tesla steals share.
These assumptions bring Tesla's EV to $32.6 billion. Note that this valuation doesn't include the battery segment.
So, assuming Tesla needs no capex, and can earn margins equal to Mercedes and BMW, start production at 615,00 units (500,000 Model 3, and 115,000 Model S/X) in 2018 and grow that to 3.3 million units in 2026, Tesla's automotive division is worth $32.6 billion, roughly in line with the company's market cap today.
The problem is, these assumptions aren't realistic. At all.
Using $4,200 per car as an EBIT margin right off the bat is unrealistic. As we outlined above, Mercedes and BMW both have scale advantages over Tesla that enhance their EBIT margins. The information Tesla has given us about gross margin targets for the Model S and X leads us to believe gross margins will not be materially different for Tesla from the rest of the industry (both BMW and Mercedes have GM's for their automotive offerings of around 20%). Tesla's target of 30% margins for the S and 25% for the X fit with the industry: luxury offerings are higher margin. So on the income statement side of things, we think $4,200 EBIT margins (~9-10%) are attainable for Tesla's automotive offerings at scale.
Getting To Scale
The key issue for Tesla is how cheaply it gets to scale. The company estimates $1.5 billion in capex in 2016, and probably the same in 2017. Fundamentally, building out production capacity for 3.3 million cars takes a ton of money, and Tesla adds to that bill by building out their supercharger network (which may turn out to be prohibitively expensive).
If we retool our capex assumptions in our simple model from being 3% of sales to 4% of sales (or about $1.2 billion in 2018), it drops Tesla's EV from $32.6 billion to $25.3 billion. At 5% of sales EV drops to $22.5 billion.
You can play with the assumptions all you want, but the point is made: cars are a capital intensive, generally low-margin business, and to get to scale Tesla still has to invest billions of dollars in production capacity and subsequent maintenance of that capacity. It's not a matter of how Tesla can finance it: they can probably do it from internal operations if they're careful; it's simply that any capex weighs on free cash flow.
It is also worth noting that the timing of cash flows matter: We assume Tesla's capex is spread out evenly over time. If, as is the likely eventuality, Tesla's capex is all up front, then that takes an even bigger chunk out of our assumed value.
On that note, we assume the company can earn EBIT margins of $4,200 per car in 2018. If we relax that assumption and start Tesla out at $2,500 per car increasing steadily to $4,200 per car in 2026, EV drops to $18.7 billion.
People like to talk about EV competition all the time, but our view is that it is unlikely to eat all of Tesla's lunch. The Bolt (NYSE:GM) is hideous, the Leaf (OTCPK:NSANY) is dopey. Tesla's Model 3 is a very attractive car, and is a few years ahead of the game.
The risk is that the competitors start to figure things out. BMW is on the cusp of making its entire lineup electric. Mercedes is set to launch four EV's by 2018. People need to remind themselves that the Model 3 they saw this week was the Model 3 of late 2017, early 2018. Comparing it to the current offerings from competitors gives you a false sense of security: yes you can place a (refundable) deposit on it now, but by the time you actually get the car, Tesla's competitors will have something just as good on the market.
Because of this, we question how much market share Tesla will really grab. Not only does Tesla face capital constraints in expanding its production, but it's doing so at a time when competitors with significantly more distribution and production capacity are trying to expand into the same market. Ultimately a car is a car, and while EV's may take all of the combustion market away, the car market isn't growing at a pace fast enough to have another competitor the size of Mercedes or BMW in it.
We have no doubt Tesla can deliver 500,000 cars a year, but 3.3 million? We just have a tough time envisioning how that happens in the face of the extreme competition that will emerge. People love to point at the Model 3 and compare it to how the Model S fared against the S-class and 7 series, but we see some differences between the Model S and the Model 3 in this regard.
When the Model S came out it WAS a game changer: it was the first beautiful electric car that had a long enough range to really make the concept work. The world had never seen something like it before. In that sense, the Model S was like the first iPhone.
The problem is that in the intervening years, competitors have caught up to Tesla: battery technology has improved remarkably, and automakers now see (perhaps in large part due to the success of the Model 3) that there is a demand for EV's, if they are well-made and effective. Tesla has no advantage in autonomous driving (for example, Mercedes has more sensors in their E-Class than Tesla has in their offerings). Telsa has no advantage in electronic drivetrains. Telsa, except flashy marketing, has no sustainable competitive advantage that will allow them to earn excess returns to the automotive industry over time.
So with this competitive environment in mind, we should ratchet down our growth assumptions for Tesla. If we reduce our 2026 estimates for total unit sales (keeping everything else constant) from 3.3 million to 2.5 million, then Tesla's EV drops to $13.1 billion. At two million units in 2026, that number drops to $10.7 billion (a small change from 2.5 million as we assume most of the decline in growth comes later in the Model 3's lifecycle).
So, adjusting our original assumptions for the required growth capex, and then for the likelihood of competition, Tesla's automotive EV ranges comes in optimistically at $13.1 billion. It's important to note: with two million unit sales in 2026 (the same as Mercedes today), we have Tesla earning roughly $8.5 billion in EBIT, on $86 billion of sales, which would make the company more profitable than Mercedes today, although not by much.
But What About Batteries?
Thus far, our analysis has excluded Tesla's battery division. We are of the view that Elon Musk's promises regarding this opportunity aren't going to pan out. Tesla doesn't have proprietary technology in this area. Its suppliers are entering competition with Tesla in the space, and there are a growing number of competitors in the area with better financial resources than Tesla. All Tesla has, when you really look at it, is marketing.
We question the economics of Tesla's battery offerings as well: the payback period for a Powerwall is roughly 38 years at peak pricing (which is rare). Obviously people will want to buy the product for other reasons than economics, but if Tesla's products most relevant market is "in the wild" of Hawaii and Australia as Tesla says, that's not a multi-billion dollar opportunity.
Now, obviously much of Tesla's effort in improving battery technology relates to Tesla's automotive offerings: if the largest cost portion of EV's can be reduced, margins go up, and Tesla looks good. The problem is that Tesla's battery technology isn't particularly superior to that used in the Bolt, for instance.
So, the question investors have to ask themselves is whether a division with no sustainable competitive advantages and massive resource disadvantages to the competition is worth the difference between the $10.7 billion EV of Tesla's automotive segment and the current EV of $33.1 billion? No, is the answer. A battery division is NOT worth $22.4 billion.
So What Is Tesla Worth?
We are not of the view that Tesla is a failure of a company, indeed, we are very impressed by how well Tesla has done. But the value of the company is mathematically proven to be the present value of the free cash flows that company generates. Using even the most generous assumptions that overlook most of reality, Tesla's automotive segment is worth $32.6 billion. If the battery segment adds another $3 billion to that (valuation discussed below), gives you $35.6 billion, or about $256 per share. A very very small upside. Of course, we assign a 0% chance of this valuation actually being fair for reasons listed above.
So, at this point, we don't have to even say what Tesla is worth: it's not worth what it's trading at. This is the core of our thesis on Tesla: the current stock price bakes in sky high expectations, and there's nothing to give you upside. If everything goes perfectly, the stock isn't worth what it trades at, and if there are problems (and guess what, there have been and will be problems), that value goes down.
But just for fun, let's add it up. We value Tesla's automotive segment at an EV of around $10-12 billion, assuming EBIT per car growing from $2,500 in 2018 to $4,200 in 2026, and 2.5 million deliveries in 2026.
Let's just take Elon's word for it and say the battery division does $2 billion in sales (he's said "a few billion dollars in sales in 2017), and because it's a low margin business with effectively no sustainable competitive advantages except marketing and glitz and glamour, that it's worth 1.5x 2017E revenue, or $3 billion.
So we put that together and get an EV estimate for Tesla of $15 billion, take of the $1.72 billion of net debt and you get to $11.28 billion in market cap, or about $100/share.
You can justify adding all sorts of premiums to that valuation if you wish for all the intangible assets Tesla has (Elon Musk, a sense of doing "right" by the world; whatever), but you have to do a lot of contortions to plug the ~$20 billion fair value gap between what the cash flows justify and what the company is trading at.
When you look under the hood at Tesla, you see a lot of glitz and glam and marketing, but a real lack of sustainable competitive advantages. They're trying to build an "ecosystem" like Apple (NASDAQ:AAPL) with their supercharger network and service network, but it's not something that competition like Mercedes or BMW (or the two in conjunction) couldn't easily replicate. The company's battery technology isn't overly special, and fundamentally, Tesla can't escape the economics of the main business it's in. Cars aren't a great business like iPhones are.
The Model S was a true innovation, but as is always the case, innovation gets copied, and eventually competitors come up with products that are nearly as good, take market share and drive down returns. It's happened time and time again, and we can already see that dynamic playing out with Tesla: relative to competitors, the company has lost ground since the Model S was released (in large part because competitors saw how successful the Model S was).
We don't think Tesla is worthless, and we don't think they go bankrupt. We think the Model S is probably the most beautiful sedan ever built, and the Model 3 is a great car. Our problem is simply that Tesla is not worth what it's trading at if the company does succeed. It's a matter of math: you can slice and dice the free cash flow drivers and numbers all you want, the valuation doesn't make sense.
Disclosure: I am/we are short TSLA.
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.
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