Tesla Is A Religious Sect

Summary

• An increase in demand for EVs carries with it the consequences of an increase in methane emissions into the atmosphere, which is ~35 times stronger than carbon dioxide.
• As the market is saturated with new vehicles that surpass Tesla by the key indicators, consumers are likely to gradually move away from Tesla.
• Tesla is currently valued as approximately the entire EV market in 2027, having a P/E of >280, a P/CF of 185.75, and a P/S of 30.44.
• To justify its current valuation Tesla's revenue should grow with its 8-year CAGR of >40% and investor's required return should be <6.5%, which is hard to imagine at the moment.
• I recommend getting rid of Tesla's stock and forget about it.

Why this article is called like that

A few weeks ago I was listening to the 183rd episode of Animal Spirits, a podcast about finance and investing, hosted by Michael Batnick and Ben Carlson. That particular episode is called 'Never stop buying lottery tickets'. Michael and Ben touched on the subject of enormous Tesla (TSLA) stock's growth and then Michael said:

If it (Tesla) does 15% or 20% (annual growth of the business) it can still fall massively short of expectations. And that's the thing. People don't think it's a car company. It's a religion.

Michael Batnick at 10:45 of the 183rd episode of Animal Spirits

The last phrase has really caught my attention due to its brevity of what's going on around this concrete company. Let's compare the definition of 'religion' and that euphoria with Tesla. Here's what Wikipedia is saying:

A religion is a set of beliefs that is passionately held by a group of people that is reflected in a world view and in expected beliefs and actions (which are often ritualized).

The investors who buy Tesla today certainly... :

1. passionately believe that this company is the one that will change today's gasoline cars into an eco-friendly analog of electric cars that do not spoil the environment;
2. are convinced that Tesla is the best automobile company in the world in terms of creating electric cars, therefore, despite a rational approach to valuation of its stock, they are ready to overpay by a lot;
3. expect that due to the increased demand in the market and the awareness of all mankind of the benefits of electric cars, the company will grow at a phenomenal pace.

Author's note: I may have missed something from describing this group of people, but in general, these points describe them broadly. 

Everything really converges: there is a certain group of investors who, despite the extreme overvaluation of the company (Forward P/E > 280), continues to buy its shares, and also experience hopes that someday this investment will meet their expectations.

Let's dive deeper into the 3 specific statements and try to understand how realistic they are.

#1 - Electric cars that do not spoil the environment

More than one-quarter (28%) of Americans believe that driving an EV will not help the environment at all (14%) or that it will help the environment “a little” (14%). These individuals may be less motivated to consider buying an all-electric car than the one-quarter of Americans (25%) who believe that driving an all-electric car will help the environment “a moderate amount,” the 17% who believe that it will help the environment “a lot,” and the 29% who believe that it will help the environment “a great deal."

Source: Resources for the future, Climate Insights 2020: Electric Vehicles

The most important advantage of Tesla's cars (and their counterparts) is that they use electricity instead of gasoline. So the carbon dioxide emissions occur only when the owner of the electric car lowers the front window to order coffee at Starbucks.

But why don't these people think that the electricity production for EVs in itself is mostly due to the combustion of coal or natural gas?

Source: U.S. Energy Information Administration, Electricity in the United States

Of course, the use of solar panels and windmills is increasing (in relation to total electricity production), but the use of natural gas is also growing steadily:

Source: Author's calculations based on Electric Power Monthly by EIA

From 2018 to 2020, the production of electricity from coal combustion decreased by 18.35 pt. That's the most harmful source of energy generation, which accounts for 80% of power plant carbon emissions.

The 3-year CAGR of solar energy production for the analyzed period is ~11.81%, which indicates the biggest growth in the sample; the other renewables (excluding solar and hydroelectric) grew at 5.21% CAGR. The energy generated by natural gas is growing at a 3-year CAGR of 3.1%, which is a lot, too. The increased demand for electricity will lead to the continuation of the current trend when the emission of methane into the atmosphere due to the use of natural gas will warm up our planet at an accelerated pace:

Like coal, natural gas is a fossil fuel that contributes to air pollution and has environmental and health risks. <...>  Drilling and extracting natural gas and transporting it in pipelines results in the leakage of methane, the main component of natural gas that’s 35 times stronger than carbon dioxide at trapping heat.

Source: Enova Energy Group, Which Types of Energy Source Produces the Most Pollution?

Proponents of electric cars can counter that most cars are charged with solar energy. But the problem with this source of electricity production is that it is available in certain geographical areas, which limits the addressable market.

I understand that using EVs, in the long run, is much safer for the environment than using gasoline engines. However, the followers of the EV sect are mistaken that their cars are completely safe for the environment. To be completely safe, you need to charge them with energy generated by solar panels or another renewable source. This introduces additional costs that can exceed the cost of the car itself.

#2 - Tesla is the best automobile company in the world in terms of creating EVs

In the article written by ALT Perspective (Is NIO A Tesla-Killer?) why NIO Limited (NIO) produces EVs, which might be superior to Tesla's one in terms of price, acceleration speed, the powerfulness of engines, etc.

Author's note: The article I'm referring to was written in 2017, so something might be outdated.

Here's another example of how Tesla's EVs might be losing when compared to their peers. In this case, Kristen Lee, a senior automotive reporter at Insider, wrote that she would rather pick Volvo's Polestar than Tesla's Model 3:

<...> It's futuristic and screen-heavy, sure, but it's also still a car's interior. I don't need to learn new multi-tasking skills just to use it. And having Android automotive as the native operating system is nice.

Source: businessinsider.com

I understand that such a conclusion is just a matter of opinion, but the followers of the sect of St. Tesla should also understand that the company's cars are now far from the only ones on the market.

I also don't understand why Tesla is behaving like a startup, being essentially the largest company in a historically "value" market. Philippe Chain, Tesla’s former VP of Quality, gave some interesting insight into testing processes at Tesla's factories.

The executive [Philippe Chain] said that Musk didn’t care about shipping cars with inconsistent panel gaps that could be fixed later because he believes that consumers will be willing to overlook the quality issue in order to drive the car.

Source: electrec.co

This attitude leads to a deterioration in the quality of the cars supplied to customers.

Source: electrec.co

Striving to serve the customer as quickly as possible, when the quality of the cars is relegated to second place, inevitably leads to dissatisfaction and the return of goods.

Tesla is trying with all its might to "disperse" its sales no matter what it costs, thereby taking on a huge operational risk. As the market is saturated with new vehicles that surpass Tesla by the key indicators, consumers are likely to gradually move away from Tesla, and no amount of Elon Mask's charisma might help here.

#3 -  Increased demand in the market

Here I must pay tribute to the expectations of the adepts. Tesla is the undisputed leader in the EV market today:

Source: McKinsey Electric Vehicle Index: Europe cushions a global plunge in EV sales

But in 2019 the global EV market was valued at $162.34 billion and forecasted to grow at a CAGR of 22.6%, reaching $802.81 billion by 2027. Sounds insane, until you recall the current Tesla's market capitalization of ~ $807 billion. That is, if we take the average expectation of CAGR for the total EV's addressable market (TAM), Tesla is currently valued as approximately the entire EV market in 6 years.

No Tesla's assets (including $1.5 billion of bitcoins and brand value) can justify the bubble that we are seeing right now. It doesn't matter how much the market grows in the future, it's already priced in with a huge premium. Such a high valuation can only be explained on the condition that the company becomes a monopoly in the market, which I highly doubt.

How fast should the company grow to justify its current valuation?

To be fair, the company's revenue has really grown at a phenomenal pace in the past few years:

Source: Author's calculations

But if you look at the year-on-year revenue growth, you can see a downtrend, which indicates a growth slowdown in general:

Source: Author's calculations

I think it is obvious to all readers of this article that the company simply cannot physically grow anymore with an 8-year CAGR of 41.04% in the future. But for test purposes, let's just pretend that it's possible. Then Tesla's revenue in 2021-25 is going to look as follows:

Source: Author's calculations 

In the last 2 years, the FCFF / Revenue ratio has entered the positive zone, showing an increase of 4.6 pt.:

Source: Author's calculations

Let's assume this ratio grows by 1.5 percentage points annually:

Source: Author's calculations

Given these input assumptions, Tesla will have stunning free cash flows over the next 5 years:

Source: Author's calculations

Despite the stock's beta of 2.06, let's assume that the company's risk to the market is no different from the industry average. So I assume a required rate of return of 7% (WACC). The growth of the company in perpetuity ("Gordon's g") will be equal to 3% so that the terminal value of the company does not account for more than 95% of the entire enterprise value.

The amount of cash on the company's balance sheet is ~$7.6 billion more than the amount of total debt. Minority Interest is $850 million. Thus, the equity value is ~$689.2 billion, which is +23.71% more than the current market capitalization.

So even with such bold assumptions that I took to build the model, the stock still turned out to be overvalued. However, the downside potential is quite sensitive to the required rate of return and the growth of FCFFs in perpetuity:

Source: Author's calculations

With such high expectations and assumptions, the company can be undervalued only if the required rate of return (WACC) is below 6.5% and the FCFF growth in perpetuity is >= 3%.

Thus, being realistic, we cannot say that the current price of Tesla's stock is fair, or even close to being called like that.

Comparables valuation

I have already mentioned the high P/E of the company, so now I would like to draw your attention to other equally important market multiples that do not require accounting profitability to remain representative.

Source: Author's calculations

Tesla's Price/Sales ((ТТМ)) is almost 4 times (~394.49%) higher than the average multiple of the selected sample (I included the company's main competitors in terms of EV production). This could be justified by the phenomenal growth in revenue (as, for example, in NIO's case), but Tesla's revenue growth (FWD) is only +83.24% higher than the average (which is impressive in itself, but to justify the market multiple, the excess should be approximately proportionate). 

The same holds when we look at the EV/Sales multiples:

Source: Author's calculations

Tesla looks especially overvalued in terms of Price/Cash Flow matched with Levered Free Cash Flow Margin:

Source: Author's calculations

Tesla's P/CF is ~185.75, whereas the peer group's average is 21.96, including TSLA itself (i.e. 745.75% more). Levered FCF Margin of the company is only +75.25% higher than the average, not being the biggest one in the sample (Ford Motor Company (F) holds the biggest FCF margin of 17.72%).

Thus, based on the comparables valuation conducted, I conclude that the growth of Tesla's main financial indicators cannot justify such high market multiples. Therefore, the company can be safely called overvalued against the background of other market players.

Conclusion and where I can be wrong

I know the title of this article sounds provocative, but it only succinctly describes how many rational investors think about the phenomenal growth of TSLA, which has gotten off the ground a long time ago.

I just checked whether it makes sense to compare Tesla with a religious sect, delving into the definition of the latter concept. So I came to the following conclusions:

1. The belief of people who buy electric cars that this significantly reduces emissions into the atmosphere is wrong. Not significantly. I also cited facts that an increase in demand for EVs carries with it the consequences of an increase in methane emissions into the atmosphere, which is 35 times stronger than carbon dioxide at trapping heat. In this conclusion, I might be wrong, because the production of electricity using renewable sources is growing many times more than any other harmful source. But until renewable energy sources are among the three most widely used, this problem of electric cars remains unsolved.
2. Tesla's cars are far from the best electric vehicles in many respects (speed, engine power, battery life, etc.), and it's still behaving like a startup to boost sales, disrupting the required testing process. As the market is saturated with new vehicles that surpass Tesla by the key indicators, consumers are likely to gradually move away from Tesla.
3. If we take the average CAGR for the total EV's addressable market (TAM), Tesla is currently valued as approximately the entire EV market in 6 years: its Price/Sales ((ТТМ)) is almost 4 times higher than the average industry multiple; P/CF is ~ 185.75, whereas the peer group's average is 21.96, including TSLA itself. While the company behaves like a startup, it doesn't grow like a startup to justify its current valuation. However, here I must admit that I'm taking the risk of comparing apples to oranges because the company is not like the sample I use for comparables valuation. On the other hand, even when compared to NIO or BYD Company Limited (OTCPK:BYDDF), Tesla's "close friends", the company does not look impressive.

But the biggest risk is that nobody knows when this sect is destined to fall apart...

Thanks for reading to the end! 

I am very interested in what you think about TSLA. Do not hesitate to share your opinion/suggestion/question in the comment section below. I'd be happy if you like this article and follow me. Thank you!