Elon Musk's Next Move For Tesla

Summary

• Tesla has been dealt a wonderful hand. How will it choose to play it?
• Elon Musk has a fantastic and very unique opportunity right now. I explain what he ought to do now and what could he learn from Henry Singleton and Warren Buffett.
• The Tesla share price has been the topic of much debate in recent weeks. Bulls anticipate $2,000, bears expect $200 by year end. Does price really matter?

INTRODUCTION

The price of Tesla (TSLA) shares has been nothing if not extraordinary in recent months. On 6^th March 2019 it was $178 and on 13^th July 2020 it traded at $1,794. That amounts to a 1,000% price change in the space of 16 months. Plenty of articles have been written on Seeking Alpha, including one by me, discussing whether or not this price is justified. Accordingly, I shall refrain from rehearsing those same arguments here.

Tesla Share Price, Source: Macrotrends

Instead, this article is for both the Tesla bulls and the Tesla bears to enjoy together. It explores the situation in which Elon Musk now finds himself from a unique perspective. As the CEO of a company that has seen its share price jump 1,000% in a year what should he do? I argue that there are the most fantastic opportunities available to him if he wishes to capitalise upon them.

In order to assist in your understanding of what it is that I am advocating, I will first analyse (in general terms) why share price matters. This will then lead on to the opportuntiy for Tesla and Elon Musk.

PRICE MATTERS

With the intention of not wanting to focus on the Tesla share price (which would result in heated debate between bulls and bears) I shall instead use a different company to exemplify the point.

In the year 2000 Microsoft (MSFT) was the darling of the stock market. Its market capitalisation was $620 billion and it accounted for 5.3% of the value of the entire S&P500. Having had its ((IPO)) in 1986 the fourteen years that followed were mind-blowing - annual growth rates were 43% for sales, 51% for earnings and 68% in terms of its market capitalisation.

The problem stemmed not from the business, which would continue growing its top and bottom lines at rates that were well in excess of the economy and of other companies. The problem was the price, which at 31 times sales and 80 times earnings, was way, way ahead of the business. With a ((PS)) ratio of 31, even if Microsoft had been able to convert all of its revenue into profit (which no business ever can), investors would have seen only a 3.2% earnings yield on invested capital. That would fall far short of the hurdle rate for any rational investor. So how much of the revenue did Microsoft convert into profit? The answer is that it had an impressive 39% net margin and so the earnings yield offered to the investor at that time was a paltry 1.25%. This is confirmed by the ((PE)) ratio of 80 as the earnings yield may be calculated as the reciprocal of the ((PE)) ratio: 100 divided by 80 equals 1.25. Who in their right mind invests in an equity offering a 1.25% return when risk-free ten year Treasury was offering 6.03%. As Benjamin Graham said in his 1949 book the Intelligent Investor, “A great company at the wrong price makes for a poor investment”. That was very true in the case of Microsoft in the year 2000.

The primary issue is that when price runs too far ahead of value, as was the case here, there will always be a period of consolidation that follows. Either the price will drop back in line with value, or else price will stagnate for many years until the value catches up with price. It was the latter that happened with Microsoft.

From 2000 until the end of 2019 Microsoft continued to experience outstanding growth. Revenue grew at 9.4% per year increasing from $21.8 billion to $134 billion over the period. Profits grew at 7.9% per year increasing from $8.7 billion to $41.6 billion. And, because the company repurchased a net 26% of its outstanding shares during that period, the earnings per share grew by 9.9% per year. Yet this time the share price massively underperformed the growth in the business because it was working-off its initial enormous overvaluation. So despite sales increasing by six-fold and profits increasing five-fold, the market cap in the same period only doubled which amounts to a ((OTC:CAGR)) of only 3.6% on the price of the company. For the eagle-eyed reader who is wondering how dividends factor in to this story, I can tell you: With the introduction of dividends in 2003, the total return achieved by a person buying Microsoft shares in the year 2000 and holding them through to the end of 2019 was only 5.9% per annum. None of us would be very happy with that!

Microsoft share price versus PE ratio, Source: James Emanuel

Microsoft was a case of the great business at the wrong price. The ((PE)) ratio of 80 in the year 2000 was the clue for the investor. By the end of 2019 the ((PE)) ratio had pulled back to a more reasonable 35, meaning that an investor lost 59.6% to multiple contraction over the period. Said differently, the 9.9% increase in earnings per share over the period was diluted because the multiple of earnings that the market was using to price the shares had fallen 59.6% - and so 59.6% of 9.9% is the 5.9% return achieved by the investor because he overpaid for his shares in the first place! I hope that this example has hammered home that price matters really does matter for any share! (Multiple contractions and corporate valuations are explained in greater detail in my book if any reader is interested in exploring this topic further).

WHAT SHOULD ELON MUSK DO NOW?

Let us not argue about whether or not Tesla shares are fairly priced. Let us simply remind ourselves that when the share price was $800 that Elon Musk tweeted that in his opinion the Tesla share price was too high. So let us assume that Elon Musk still believes it to be too high. What should he do?

Source: CNBC and Twitter

Allow me to answer that question with lessons learned from some of the best capital allocators of all time.

Henry Singleton founded Teledyne (TDY) in 1960. It grew by acquisition into a large highly successful conglomerate and Teledyne’s shares rose substantially as a result However, it was the manner in which Singleton achieved this growth that is pertinent to Tesla.

In 1966, at the stock market peak, Teledyne shares were trading between 50 and 75 times earnings which Singleton knew was way too high. So what did he do?

The most important role for executive management is allocation of capital within the business and this was an area in which Singleton excelled. Teledyne began using its overvalued shares as currency for acquiring over 100 companies. He was therefore exploiting a temporary pricing inefficiency in the market by converting imaginary value into real tangible value for Teledyne. It was a brilliant move.

This was not the only time that Singleton capitalised upon market pricing inefficiency. In the bear market of 1973 to 1974 the entire market collapsed and the Teledyne shares price was pulled down with the rest of the market. The share price fell 75% from its high at the end of the 1960s. At this point Singleton knew that his company was being undervalued and so this time he bought back his own company’s shares at bargain-basement prices. Over the decade that followed Teledyne bought back approximately 90% of its outstanding shares at prices averaging 10 times earnings. The (PE) ratio was thus a useful gauge of value throughout.

The moral of this story is that the best corporate management teams are those that are adept at capital allocation. Singleton was the best. If you have not read Singleton’s biography, “Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It” then you really ought to seek it out. You could not ask for a better book on great corporate management and capital allocation.

Henry Singleton is not alone in the club of shrewd CEOs. Warren Buffett is another awesome capital allocator. It is, in fact, the secret to his decades of success at the helm of Berkshire Hathaway (BRK.A). And so here is a story of what Buffett did when he believed that Berkshire’s shares were overvalued.

In 1998 the entire stock market was overpriced and the ((PB)) multiple of Berkshire was a little above three. Buffett believed that the company and its shares were worth approximately half of the price that the stock market had given it. So what did he do?

Just like Singleton, Buffett used $22 billion worth of his over priced stock as currency to acquire another company (General Re). Genius! Buffett effectively acquired the investment portfolio of General Re, which he valued at $25 billion. The portfolio was 90% fixed income products which allowed Buffett to switch from a heavy concentration of equity investments in a market that was very over-priced, into much better valued bonds. And because he thought his stock was being priced by the market at twice its intrinsic value, he effectively paid the equivalent of $11 billion worth of value for $25 billion of assets! Best of all, because he used Berkshire shares as currency for the deal rather than cash he managed to reduce his portfolio exposure to an over priced equity market by half without paying any capital gains tax, then at 35%. Even more of a genius!

CONCLUSION

Elon Musk could learn a great deal from Henry Singleton and Warren Buffett at this particular time. Tesla shares are currently trading at 11x sales, more than 30x book value and with a forward PE well in excess of 500. The Tesla shares are more inflated now than Teledyne or Berkshire Hathaway has ever been. Why not utilise this window of opportunity in the same way that Singleton and Buffett did. Toyota (TM) has a ((PE)) ratio of only 7.7, a ((PS)) multiple of 0.65 and a ((PB)) multiple of less than one indicating that its market price is less than the value of its net assets. Its market capitalisation is about $175 billion (Tesla is currently valued close to $300 billion). Toyota, sold 10.6 million cars in 2019 generating profits of $7 billion while Tesla sold 0.36 million cars and made a loss of close to $1 billion. Yet the market says that Elon Musk could buy Toyota outright for half of the value of Tesla. The better deal might be to use one quarter of the current value of Tesla to buy half of Toyota in a share swap deal. That would instantly make the new company "Tesla Toyota" the biggest car manufacturer on the planet. It would give Tesla instant production capacity to produce tens of millions of cars (a more than 30x increase on what it has now). It would also give Tesla a much larger and stronger distribution network globally. And the economies of such scale would allow Tesla to produce EVs at a much lower unit cost increasing profitability and more importantly affordability. The latter would assist Tesla in becoming the most competitive EV manufacturer in the world. In short, it would give Tesla the moat that it needs in order to be the company that Elon Musk has ambitions for it to be. I know what I would do if I were Elon Musk! I know what Henry Singleton and Warren Buffett would do.

Elon, it’s over to you buddy!

As an addendum to this piece, consider this: even if Elon Musk chooses not to follow the path of the great capital allocators mentioned in this article, there is nothing to stop you exploiting this opportunity. If you are long Tesla then you are in possession of overvalued currency which you could use to diversify into a better valued company such as Toyota. How good a capital allocator are you? This window of opportunity may not last for very long, so don't waste time thinking about it. As they like to say in the US, "this is a no-brainer!"