A common argument raised by Tesla (NASDAQ:TSLA) bulls is that Tesla has immense brand value and that should add billions of dollars to the stock price. But should it?
In a previous article I outlined what I thought Tesla was worth based on the present value of its cash flows. There were a number of comments saying that I had neglected to include the value of Tesla's brand in my valuation. So I thought I'd take a stab at it.
How to Value a Brand
Valuation of a brand is actually relatively simple. A brand's value is the incremental free cash flow it allows a company to generate due to a combination of sales volume due to customer loyalty and increased margins due to higher prices.
Professor Aswath Damodaran provides a nice summary in this presentation, where he compares Coke to a generic cola company and the difference in value between the two is the value of Coke's brand.
Brand Value Drivers
First, let's compare some other well known car brands. We source the brand values from Statistica. While these aren't perfect, they'll do for a quick and dirty analysis.
The first thing to note is that luxury automakers post ~100bps higher operating margins than their economy counterparts. This is to be expected as higher ASPs lead to higher margins. To this end, as many have noted, the Model 3 should be a significantly lower margin car for Tesla than the S or X.
I ran some simple correlations on this data to try and find any relationships between operating margins and brand value and sales and brand value. However, the relationships were weak (~.2-.5). So what I did instead was break up the groups into luxury and mass market.
These results, though not particularly statistically significant, are interesting. They suggest that at the mass market end of the spectrum, brand value is more closely tied to incremental margins earned than sales power. I think this is a simplistic view of things as factors like reliability (for which Toyota (NYSE:TM) and Honda (NYSE:HMC) are famous for) factor heavily into consumer's purchasing power.
At the upper end of the market, the situation is reversed: brand value is more closely correlated to higher sales, which suggests that brand loyalty and prestige is the primary driver of brand value, and that brands don't confer any excess margins. This seems plausible to me.
What this tells us about Tesla is that the company's brand value will be tied to excess sales, not excess margins. So excess sales is the variable that Tesla brand watchers must be concerned with going forward.
How to Value Tesla's Brand
We could simply take a per-car value from the luxury comparables and apply it to Tesla. The median valuation for Tesla's competitors brands on a per car basis is $11,600. Applied to Tesla's forecast 90,000 deliveries in 2016 gets you to $1 billion in brand value, or a whole lot less than the market cap.
Applied to the 325k model S orders, that gets you to $3.8 billion, still significantly short of where Tesla trades.
The point here is that the most valuable car brand currently is Toyota, which has been the number one car company for decades, has better reliability than Tesla, has significantly more resources, and yet only has a brand value of $28 billion, which is significantly less (to the tune of $5 billion) than where Tesla trades. Therefore you can't justify Tesla's valuation based on the intangible value of the brand.
Other Influences on Brand Value
If brands in the luxury segment of the market are tied to sales, then what factors influence that brand value? Reliability, prestige and some measure of cool factor seem to me the most plausible factors.
Tesla is undeniably cool, but cool only goes so far. Cool gets you 325k orders in a week, but eventually the people who need the next new thing are tapped out. I'm of the view that we are getting close to that point for the Model 3 - if you look at the second derivative of the orders, you see that the market is likely rapidly becoming saturated.
To place a value on this factor, 325k orders at a $40k ASP gets you to $13 billion of sales, which should have a maximum of a 10% EBIT margin on them, or $1.3 billion. Taking off taxes, working capital and capex needs to bring those cars to production, you likely have $1 billion of free cash flow. Tesla could produce these in a single year, but that year isn't 2016, it's 2018, so that $1 billion needs to be taken as a present value. At 13%, that $1 billion is only worth $783 million or about $6/share of "cool factor" in the Model 3. Note that I'm assuming the entirety of the 325k orders are excess, implying that no other car manufacturer could reproduce those sorts of sales.
The remaining brand value for the Model 3 will depend on the yearly excess sales that Tesla will generate becuase of its brand. I frankly have no idea what that number will be, but if they sell 325k per year more than their competitors each year, that's worth about $7 billion in perpetuity, assuming $1 billion of free cash flow per year from the 325k excess Model 3 sales.
It's hard to pin down what the cool factor for the rest of Tesla is, but given the lackluster sales of the Model X (which with those doors is arguably cooler than the Model 3), and the fact the Model S has already been in production a long time and is now a saturated market, I suspect the cool value doesn't add much to Tesla's valuation.
If you look at Model S sales vs. other large luxury cars, such as the S-Class and 7-Series, Tesla outsells them all. In 2015, the Model S sold 4632 units more than the S-Class. Running the same calculus as the Model 3, at a 10% EBIT margin, less capex etc. you get to about $3000 of FCF per car (which is unlikely to be realized, in my opinion), which is worth about $106 million as a perpetuity at a 13% discount rate.
The Model X, given its horrendous sales, would add even less to Tesla's brand value.
What about prestige? Hard to put a value on exactly, but I think we can argue owning a Tesla is prestigious. The Model S is gorgeous (although I hate how the doors sound and I'm not really impressed with the interior. Go sit inside an S-Class and see what real luxury is folks) and I know I still find myself looking at them driving around (although that's because I follow the company, not because I'm enamored with the car). I think that the prestige of owning a Tesla is roughly the same as owning a BMW or Mercedes, although slightly different as those who own a Tesla can pat themselves on the back for saving the environment.
Finally what about reliability? Oh, did we mention the Model S lost out to Lexus and Toyota already? How about those Model Xs, renowned for their quality? I think we can safely say that Tesla has a long way to go before reliability is proven.
Here's the problem though: Brand value is highly susceptible to reliability and mechanical issues. Take Toyota for example, which was considered the paragon of reliability until a little accelerator problem forced a multi-million car recall. The end result was billions of dollars in foregone sales for Toyota, and also a decline in the resale value of the cars. The company has moved beyond those times since, but it shows the impact of reliability on sales.
Volkswagen's recent emissions scandal, though not a reliability issue, has had the same effect on the brand, and is the primary reason that VW and Audi's brand per car figure is so much lower in the figures presented earlier in this article.
I'm not saying that Tesla will have a production crisis; but if Toyota or VW can have such massive problems when they're operating at scale, what are the chances that Tesla will go from producing 90,000 cars which have exhibit mechanical problems, explosions and doors that don't work to the 3.3 million cars it needs to sell to justify its valuation?
Further, what are the financial impacts of those problems. I believe they are two-fold. First a decline in sales which reduces the value of the brand. Second, a decline in resale value of Teslas, which hits the company directly because of the residual value guarantee that Musk has provided.
That program directly exposes Tesla to a growing inventory of used cars and buyback guarantees at precisely the time when it is growing production and therefore increasing the chances for something to go wrong, affecting the resale value of the cars.
Because of this, I believe that Tesla's reliability adds negligible value to the company's brand.
So What is Tesla's Car Brand Worth?
Given what I've gone over, I feel that Tesla's brand is currently worth about $8 billion. This breaks down into about $7 billion for the Model 3, another $120 million for the Model S, and another call it $880 million for the prestige factor.
The value of this brand will of course increase the more that Tesla can sell, but seeing as how we don't know how many cars Tesla can sell, what its brand value will be in 20 years, we don't know. The main point is that $8 billion doesn't come close to making up the difference in value between a sensible DCF valuation and the current share price if you incorrectly add it on after running the DCF.
But Here's Why It Doesn't Matter
Brand value isn't something you add on to a discounted cash flow valuation precisely because a brand's value is implicit within that valuation. It shows up in the sales and margin assumptions of that DCF.
The only way Tesla could sell 3 million cars or earn $4,200 EBIT margins is because it has strong brand value.
This should be disconcerting for Tesla bulls: you can't simply say that a cash flow based valuation doesn't account for the intangible goodness that is Tesla's brand. A cash flow valuation DOES account for it, because a brand is only as good as the cash flow it generates.
Because a brand is only as good as the cash it generates, the question for Tesla investors (both long and short) needs to return to sales, cash flow, and actual financials instead of hinging on valuing intangibles.
The core question I have remains: how is Tesla going to compete in the mass market when their mass market offering when fully optioned will cost $55k, or the cost of a BMW 5-series? When did a 5-series become mass market?
Because of this simple pricing fact, the relevant companies to look at for what scale Tesla could achieve is not GM (NYSE:GM) or Ford (NYSE:F) or Toyota. Instead, it's BMW, Mercedes and their competitors, all of whom offer cars priced lower than $35,000 (the CLA's base price is $32k, a 3-series base is $33). These manufacturers all sell under 2 million units, and that is inclusive of sedans, coupes, crossovers, small, mid and full size SUV's, roadsters, and limousines.
So even if Tesla introduces a crossover, that doesn't mean it can go from producing 2 million cars a year to 3 million. It doesn't matter how many products you shove down a market's throat - the market for cars $35,000 and up is only so large, and it already has many players in it.
And that is the ultimate problem for Tesla: it has to steal market share from competitors with more resources, better logistics, better distribution, and better patent protection. Tesla has to steal market share from companies that can see what Tesla is doing, and now that everyone has seen the Model 3 (which isn't released until 2018), they all have two years to respond.
Because of these challenges, I firmly do not believe that Tesla is worth the sky high valuation it trades at, and as outlined earlier, you can't simply say that the brand plugs the $160-plus hole between a DCF valuation based on reasonable assumptions and the share price.
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.