Stop Comparing Tesla To Legacy Automakers - Tesla Is Far More Attractive

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Includes: F, GM, TSLA
by: Scott Morton

Summary

Tesla is an entirely unique business in almost every aspect, and we should stop comparing it to legacy automakers.

The legacy of Tesla's competition is an opportunity for Tesla to succeed.

There are multiple growth opportunities available for Tesla.

At the end I provide some food for thought for Tesla shorts.

"Tesla (TSLA) has a greater valuation than both Ford (F) and General Motors (GM), but only makes a tiny fraction of the cars. Even if Tesla was successful the valuation just does not make sense!"

This is one of the most common themes voiced within the investment community, but it's fundamentally flawed. Trying to determine a fair valuation for Tesla by comparing it to legacy auto manufacturers is inappropriate and I will attempt to explain why throughout this article. Multiple factors including Tesla's unique business model, the competitive environment, and future growth opportunities will illustrate why Tesla should not be compared to legacy auto manufacturers and why at a valuation of $50bn Tesla may in fact offer a very attractive investment opportunity.

It's first of all inappropriate to compare Tesla with legacy automakers because the two businesses are at completely different stages in their life cycle. Tesla has only been around for 15 years which is nothing relative to the 100-and-something year old legacy automakers. This is highlighted by the fact that legacy automakers must undertake R&D simply to maintain current revenue streams. Between 2013 and 2017 GM spent a combined $36bn in R&D yet revenue declined from $155bn to $145bn. Over the same period Tesla spent a combined $3.7bn in R&D, but revenues grew from $2bn to $11.7bn.

TSLAvGM_LifeCycle

There are pros and cons for both companies here, but I believe the advantage lies with Tesla.

GM currently operates at a scale of vehicle production that Tesla can only envy. With that scale comes plenty of capital and talent which can be deployed to fend off competition. EV competition in particular however presents GM with a huge dilemma and as such the company is reluctant to put its resources to use. In order to compete with Tesla, GM must expend additional capital in order to transition from manufacturing ICE-vehicles to manufacturing electric vehicles. Porsche's head of production, Albrect Reimold, has spoken publicly about the financial costs, time constraints, logistics and mobility issues involved with such a transition. The problem for GM is that, by nature of being a mature player in a mature market, they have experienced all of the significant growth that they are ever going to. Overall market demand for vehicles will not grow simply because the vehicles are now electric as opposed to fossil fueled - EV sales will simply cannibalize and replace ICE vehicle sales. GM must therefore undertake all of these additional challenges and expenditures knowing full well that revenues will not grow by any significant amount. The only conclusion that GM can draw is that a transition to EV manufacturing will only hurt their bottom line.

Not only that, but by shifting the focus to EVs, GM will render their current factories, production lines, patents, designs - anything that specifically relates to ICE products and production - either partly or fully redundant. GM's 2017 financial statements record a combined $79bn worth of property, plant and equipment on the balance sheet. These entries are recorded on the assets side of the balance sheet, but make no mistake they are liabilities. This is the equivalent of owning a printing press in the advent of the Internet or a Blockbuster franchise during the birth of Netflix. With shareholder equity recorded at just $36bn it's easy to see how writing off even a small percentage of these "assets" could materially and adversely impact GM and its shareholders.

The point here is that GM has little incentive to rapidly transition to EV manufacturing and would rather stave it off as long as possible regardless of it being widely accepted as the socially responsible thing to do. You may label me as a conspiracy theorist for suggesting this, but the unfortunate reality is that for businesses profits often trump ethics. Tesla has no such internal conflicts with its balance sheet or revenue streams and is therefore free to pursue a future which represents nothing but growth for the company. The combination of a lack of internal conflict for Tesla and the extreme baggage that is the legacy for established auto manufacturers may very well lead to Tesla significantly outpacing the competition.

We also should stop comparing Tesla to legacy automakers because they operate under different business models. Tesla, unlike legacy automakers, does not operate using a dealership network. Jim Chanos and Bob Lutz both argue that this is a disadvantage for the business, but I completely disagree. While a dealership network may add value to the business model of GM by taking on the primary responsibility of servicing customer cars, a dealership network has very little value to offer Tesla. Tesla vehicles by nature of being electric have far less mechanical parts that are likely to fault and therefore require less servicing in comparison to ICE vehicles. The servicing requirements of an ICE vehicle not required for a Tesla include, but are not limited to, oil changes, transmission fluid, spark plugs, timing belts and clutches. The lack of such servicing requirements reduces the overall cost of ownership for an electric vehicle in comparison to a comparable ICE vehicle and increases the value proposition for consumers. Just in case you have concerns about the potential cost of having to replace a Tesla car battery (after all that is a significant and expensive component of the car) then I will point you to toward the Finnish taxi driver who estimates that his Tesla could last 620,000 miles (1 million kilometers). An additional benefit of running a direct-to-consumer business model is that Tesla has full visibility and control of the customer experience. With all this in mind it becomes clear that dealerships for Tesla would be nothing more than profit taking middle-men and the company is better off without them.

Tesla's business model also is differentiated from legacy automakers because it contains a software component. Tesla vehicles with their console-only minimalist design (which is said to lend the Model 3 to potential gross margins of over 30%) combined with over-the-air software updates allow the company to up-sell high margin revenue products such as Autopilot and Full Self Driving at any point during the lifetime of the car. Currently Tesla's two available software programs are priced in a range of $3-6k each and are available for purchase to a fleet of at least 200,000 vehicles and growing. It also has been speculated that Tesla could launch an in-car app store which would allow the company to generate Apple-like revenues by charging a fee to all app developers who publish on said store. Legacy auto makers could replicate this functionality and I fully expect that they will. Although this would take away a currently unique aspect of Tesla's business model it would not make the business model itself inherently less valuable or economically attractive. The number of firms operating a particular business model does not diminish the value of that business model. That's why sectors as a whole are assigned different valuation multiples as a general rule of thumb. If the earnings of a traditional automaker (which typically trade below an earnings multiple of 10x) are valued less than that of a software company (which can trade at a multiple of anywhere between 20x and above) then it seems only logical to conclude that earnings which stem from a combination of those two businesses, while not as valuable as those of a software company in isolation, must be at least some degree more valuable than those of a traditional automaker as we currently know them. For this reason I argue that if/when traditional automakers decide to follow Tesla's lead and develop high-margin software products we should not necessarily revise and downgrade Tesla's valuation, but should instead revise and upgrade the valuations applied to the rest of the automotive sector.

The final aspect of Tesla's business model that makes it different from legacy automakers is Tesla's energy division. Tesla in its current state is not by any significant margin more than just a car company. For Q2 of 2018 Tesla's revenue totaled $4bn and less than $400m of that was from the energy division. This however does not mean that Tesla will always be just a car company. The opportunity for Tesla in this segment is huge. The energy storage market is expected to be worth $296bn by 2024 and Tesla is currently a leader in energy storage solutions with respect to battery capacity, cost per kWh, and power output capacity. Additionally Tesla's solar energy products allow the company to tap into a market expected to be worth $422bn by 2022. These are huge markets that are only expected to grow year-on-year. If we assume a conservative 5% growth rate for each of these markets then by 2030 they could be worth a combined $1,000bn annually. Mark Spiegel, in a podcast with QTR, is quick to point out that Tesla is currently cutting back its solar division, and a quick Google search would seem to confirm his statement. It's true that the energy division of Tesla's business has stagnated in recent quarters, but it is still significantly larger than it once was.

It does beg the question though, if the opportunity in these markets is so great, then why isn't Tesla pushing more aggressively into them? The answer to that question is a combination of corporate strategy and human behavior. First of all we need to understand that society as a whole requires time to adopt new technology as illustrated in the diagram below:

Technology Adoption

Secondly we need to understand a fundamental principle of economics. In life resources are finite and therefore choices and trade offs are necessary. With these two factors in mind put yourself in the position of Tesla. You have two product portfolios which you can bring to market and limited resources to do so. In one product portfolio you have the Model S, Model X and Model 3:

Tesla Vehicle Line-up These are somewhat new innovations in the respect that they are electric, but on the whole they are still familiar and widely recognizable as vehicles. Show the above photo to the general public and 99% of them would be able to name these products as "vehicles" or "cars" simply by looking at them. A significant portion may not be familiar with the brand, but regardless they already hold an understanding of the functionality and purpose of the product they are being shown. On the other hand, you have a product portfolio which contains this:

PowerWall Show this product to the general public and 99% won't have a clue what they are looking at. That's not their fault. A car has very defining and unique characteristics: Four wheels, two wing mirrors, a windshield, some doors, and more importantly it's literally a hundred years old. The Tesla Powerwall on the other hand is just a featureless box. The lithium-ion battery itself has been around for about 50 years, but applying that technology to large-scale energy storage for both domestic and commercial use is a very new concept. In order for this particular product to be adopted in the mass market there's a learning process that consumers are required to undertake. Consumers must learn about a product - how it operates, its functionality and practical applications - before they even begin to consider purchasing it. The process of educating consumers would take time and money from Tesla and those are two things that the company just doesn't have to spare at the moment. It would be foolish of Tesla to gamble on the mass adoption of a new technology when they have a far more familiar and attractive product range that's significantly easier to generate revenue with.

Regardless of balance sheet concerns, focusing on the sale of EVs before solar and energy products is the right strategy to pursue. By focusing on electric vehicles Tesla is able to establish a customer base which as suggested by their choice to purchase a Tesla are 1) environmentally conscious and 2) early adopters of new technology. These are two very important characteristics that make them an ideal first-phase target market for adoption of Tesla's energy and solar products. This is exactly why Tesla advertises its energy products to existing Tesla vehicle owners through their app. It's my belief that by first establishing brand awareness and presence of mind with consumers through the automotive industry that Tesla will ultimately end up dominating the renewable energy and energy storage markets previously mentioned.

I'm not saying that legacy automakers are destined for bankruptcy, but there's no doubt that they have challenges to deal with that Tesla does not. Likewise I'm not saying that Tesla by any means has an easy road ahead. The company has a mountain of debt to deal with, an excruciating amount of public scrutiny to endure, and a CEO who as the days go on appears to care less and less about whether he remains in that position. What I'm saying is that we should stop comparing the two. Tesla and legacy automakers although they both produce cars operate with entirely different motives, different business models and different prospects for growth. I hope that if you have made it this far then you and I are in agreement on that. I also want you to consider that while Tesla is not comparable to legacy automakers as we know them, Tesla may not be comparable to any other business at all. I challenge anyone reading this to point me in the direction of another vertically-integrated electric only vehicle manufacturer with investments and prospects in both the solar energy and energy storage businesses. In the highly unlikely event that you can do that show me one operating at a scale and with brand loyalty even remotely comparable to that of Tesla. My original investment thesis for Tesla was simple - this is a great brand, with great products going after huge markets. That still remains true today and in my opinion an investment in Tesla at the current valuation of $50bn presents far more potential reward than risk.

I often wonder why Tesla is such a heavily debated and controversial company. I have only been on this planet for 20 years, but during that time I have witnessed more industry disruption and innovation than I can recall. The champions of this innovation - Bill Gates, Jeff Bezos, and Steve Jobs - along with their respective companies have always been so highly revered in society. Yet when Elon Musk comes along an angry mob forms to kick sand in his face and drag him through the mud. While I appreciate that it's the right of market participants to short a stock, the fact that some of those short sellers go as far as to insinuate or even outright call Musk a fraud to me is both abhorrent, and frankly, depressing. The argument that Musk is a fraud is illogical. There are far easier ways to defraud markets than to take on the mammoth tasks that Elon and Tesla have set out to tackle. This year we have seen Elizabeth Holmes charged with fraud for misleading investors on the potential capabilities of the company's future products, but what was once just a potential future for Tesla is quickly becoming a reality. We see the growth of Tesla every single day. We see it on social media, in the news, and in the streets. This is a real company with real products, real customers, and very real prospects. The fact that Tesla has survived such intense public scrutiny for so long, not to mention government agency investigations, only speaks to the resilience of the company. If Tesla truly was a fraud we would surely know it by now.

Elon Musk, as a South African immigrant who came to America with dreams of a better future, is the epitome of the American dream. I would even say Musk is one step beyond the American dream, because he hopes of not only a better future for himself, but for everyone on Earth - including the shorts. Label me a Tesla or Elon Musk fanboy if you wish, but the objective truth is that a future where the world is fully powered by renewable energy and not reliant on fossil fuels is a better one. It may be easy to look at a financial statement, see that the current picture isn't fantastic, and take a short position, but just because you can do something doesn't mean you should. In my opinion, anyone who labels Elon Musk as a fraud, or hopes for him to fail - especially in the pursuit of personal profit - should be ashamed of themselves, and it's easy to understand why he acts out at those individuals. I think anyone in his position, who is trying to do good for the world only to be criticized and labelled a fraud, would struggle not to.

I have used GM as a point of discussion multiple times in this article, but GM is just a placeholder for any and all legacy automakers.

Disclosure: I am/we are long 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.