Tesla: High Ground Versus Low Ground

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About: Tesla, Inc. (TSLA)
by: Kwan-Chen Ma
Summary

After a disappointing Q1, Tesla investors will continue to focus on both demand and margin tradeoff.

Tesla’s high ground case assumes that Model 3 will ramp up to support the original full-year 400,000 unit delivery guidance and Model 3’s 3.5% gross margin target is still intact.

This high ground case will take Tesla's stock price to $400 by the end of 2021.

The low ground case assumes that, with the expected ramp of Model 3 and an announced focus on autonomy, the R&D and SG&A expenses cannot be muted as in Q3 and Q4. It will take some time for EPS and free cash flow to increase.

The low ground case computes that the stock price will fluctuate, at best, between $300 and $350 in the next two years.

Tesla’s (TSLA) car demand remains the key issue. Q3 and Q4 deliveries have been “pulled-forward” to anticipate a halved tax credit of $3,750 on Jan. 1. Subsequently, Q1’s Model S and Model X deliveries fell to 12,000 units, down 45% from Q1 '18. Q1 Automobile revenue declined by 42% sequentially and gross margin dropped by 20% from Q1 '18. After paying back the bond, cash burn reached $900 million, exceeding consensus estimate of $464 million. On March 8, Tesla closed a $2.7 billion equity raise. While Tesla’s short-term picture may look grim, the impact from both the fading tax credit and bond payment has been long expected. In addition, it appears that CEO Elon Musk’s saga with the SEC has become so predictable that it may be already priced in. Therefore, in this post, in a forward-looking setting, I used Tesla’s current positive and negative financial outlook to estimate the corresponding future stock prices, assuming the consensus forecasts materialize.

Tesla’s High Ground Forecast Financials

Even with weaker than expected Q1 results, it is encouraging that the management still sticks to the previous full-year 360,000-400,000 unit delivery guidance. The Street estimate appears to indicate that the revenue will improve sequentially as Model 3 deliveries ramp up when the standard range shipping and leasing options become available (Table 1A). Management also reiterated its Model 3 gross margin target of 25% and also a similar GM prediction for Model S and Model X by the end of year (Figure 1C).

During the recent autonomy investor day, Tesla tried to refocus investor attention on the company’s potential technological ability in autonomous driving and new mobility. The company also realizes that swapping capex with free cash flow is not sustainable, nor consistent with the long-term technology goal. The capital expenditure is expected to return to the normal level in the next few quarters (Figure 1E).

From Forward Financials to Forward Stock Prices

At this point, I explain how to convert forecast financials to future stock prices: If a stock is priced based on its forecast financials at the time, I should first find those financial metrics which have traditionally affected the stock prices. Once a historical relationship between the historical stock prices and these financial metrics is identified, the current estimates of these financial metrics at different future times can be fed into the model to generate the future stock price targets. Eventually, stock prices are affected by management's guidance and analysts' estimates of future financials. Analysts' estimates are closely tracking management's guidance, if available, as it contains the most forward-looking information.

As a result, Tesla's stock prices are known to react to analysts' forecasts of future revenue, EPS, gross margin, capital expenditure, free cash flow, and the company's unique metric like car delivery. Keep in mind that although I used historical data to estimate a historical relationship, it is still a forward-looking process. This is because, at any point of time in history, Tesla's price is estimated by the forward estimates of the five financial metrics at that time. The only assumption I made is that investors used the same (forward-looking) valuation structure to price stocks consistently. Using the relationship and the analysts' next 10-quarter estimates of the five metrics, I was able to compute the future stock prices corresponding to those forward financials.

Tesla High Ground Price Targets

In Figure 3A, I showed how analysts' high ground forecast of stock prices should have looked (in green), compared with the actual Tesla's stock prices (in black), where dotted green lines indicate the forecasted stock price if the same historical pricing model is extended to the future points. Since June 2013, Tesla's actual stock price has moved very closely with the fundamental forecast price most of the time. This would give me some comfort about the validity of the assumption that investors looked at forward fundamental metrics in pricing Tesla's shares. For the future period Q2 2019-Q4 2021, I showed the quarterly predicted stock prices based on analyst current forecast of the forward financials corresponding to those time points. The predicted Tesla stock price moves from $271, $356, $420, to $433 by the end of 2021. Given the high ground scenario, Tesla's stock will rise from $300 and go over $400 by 2021 (Figure 3A and Table 2).

Tesla’s Low Ground

Tesla’s Q3 shift in production to low-priced Model 3 variants in order to increase its addressable market resulted in a modest increase in Model 3’s weekly production to 4,700 vehicles but with a stiff price of a lower Q4 24.7% gross margin, suggesting that $35,000 Model 3 still didn’t make money. The low price Model 3 is expected to ramp up in Europe in 2019, which explains the slower recovery in EPS until 2H 2019 (Figure 1B). At least in the near future until March 1 convertible debt matures, Tesla still plays catch 22 by switching free cash flow with capex. Free cash flow is not expected to have a meaningful increase until 2020 when operating cash flow picks up (Figure 1D).

By including less than encouraging future EPS and free cash flow outlook in the calculation, I was able to estimate the low ground stock prices for the next two years (Figure 3B and Table 2). Under the forecast scenario, Tesla's stock will fluctuate between $310 and $344, assuming that all the scheduled forward financials materialize. Note that even with some negative outlook, Tesla's price will still rise markedly above the current low $200 level.

Takeaways

At this point, Tesla investors will continue to focus on both demand and margin tradeoff. Tesla’s Q3/Q4 decision to accelerate lowered price variants of Model 3 ahead of the halved tax incentive led to Q1's misses on revenue and EPS. Currently, the Street holds the view that the Model 3 will ramp up to support the original full-year 400,000 unit delivery guidance for the remainder of 2019. Model 3’s gross margin target of 3.5% is still intact. The practice of switching between CAPEX and free cash flow will stop. This high ground case will push Tesla's stock price to $400 by the end of 2021.

On the other hand, with the expected ramp of Model 3 and an announced focus on autonomy, the R&D and SG&A expenses cannot be muted as in Q3 and Q4. It will take some time for EPS and free cash flow to return to the previous normal level. This low ground case suggests that the stock price will fluctuate, at best, between $300 and $350 in next two years.

Between the two likely scenarios, Tesla’s Q2 earnings are likely to create more questions than answers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.