The fastest growing car company in world, Tesla Motors (TSLA:xnas), has had a bumpy ride this year. First its shares were down 40% before rallying 85%; Tesla founder and CEO Elon Musk said earlier this year that the company would not have to raise capital and then months later he announced a capital raise to fuel investment in the Gigafactory 1 and lifting its 2018 production goal to 500,000 cars delivered.
Tesla has also been criticised for its all-stock acquisition of SolarCity and is recently being investigated over the fatal car accident with a Tesla car in Autopilot mode. We look at the investment case for Tesla Motors given this string of events...
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Source: Saxo Bank
Autopilot mode accident
Recently, the car industry has had to grasp with its biggest fear over autonomous driving when Tesla announced that a person was killed in car accident while driving in a Tesla car in Autopilot mode on May 7.
Given that Tesla raised $1.4 billion in equity capital on May 18, speculations have surfaced that Tesla withheld the outcome of the accident to not interfere with its capital plans. US regulators are currently investigating whether the car accident can be classified as material and therefore should have been filed with the SEC on the day of the accident.
Judging from the insignificant response in the stock market, Tesla has a very good case of rejecting the notion that this a material event. Also other carmarkers do not announce when their customers die in car accidents.
In any event, the regulatory approval for self-driving cars is not the crucial factor driving Tesla’s valuation or future potential.
The SolarCity acquisition
On June 21, Tesla announced its offer to acquire SolarCity (SCTY:xnas), the largest US residential and industrial solar provider, in an all-stock deal to create the world’s first vertically integrated energy company offering end-to-end clean energy products to customers.
While the deal makes sense from a pure operational and strategic perspective the deal raises the risk profile of Tesla making the stock even more difficult to value because the company will be one-of-a-kind with no direct peers.
The combined company will have a market value of $35.5 billion, generating negative $1.45 billion in cash flow from operations and negative $3.05 billion in free cash flow on an annual basis.
With Tesla’s recent capital raise, the combined cash and short-term investments on the balance sheet will equal $3.48 billion so unless the combined company significantly improves cash flow generation the company will have to raise additional capital within 18 months.
The combined company generates $4.71 billion in revenue the past 12 months, which is expected to increase to $10.9 billion over the next 12 months – still only around 10% of Nissan Motor’s revenue.
SolarCity’s business is also dependent on tax credits being extended until the economics of scale makes solar competitive enough against other energy sources. As a result, Tesla’s overall business is still very sensitive to policy decisions on clean energy. Here the US presidential election later this year could be a massive event risk for Tesla, as the Republican Party is seen as less positive on renewable energy due to the government subsidies required.
Valuation discounting perfect execution
With negative operating income and negative cash flow, investors naturally have to base their valuation on Tesla on far into the future projections for cash flow, operating margin and revenue.
The only meaningful valuation metric at this point in time is the EV/sales ratio in which Tesla has the highest measurable in the global car industry. Based on the average EV/sales ratio among other car companies with operating margins above 10% (a measure which Tesla has announced it will attain in the future), we can compute the expected revenue that the market is discounting.
The market is discounting Tesla to reach $56 billion in revenue which would translate into around 3% market share based on recent revenue figures – the size of Peugeot
Based on the current order book at Tesla, the expected revenue over the next 12 months at $10.2 billion is realistic unless deliveries fail spectacularly against estimates. To get to $56 billion in revenue from that point on over a 10 year period would require an 18.5% annual growth rate which is significantly above the industry average (both current and historically) so it needs to come from sizeable market share gains.
If Tesla’s future consists of other things than cars (think Powerwall, Powerpack, solar panels, etc.) then a higher EV/sales could be justified (lowering the required growth rate to justify the current valuation).
An important point to remember as an investor when investing in growth stocks is the compounding effect. The chart below shows what investors should have paid (fair value) for Microsoft’s shares in June, 1990 based on a cost of equity of 14.5%.
Microsoft’s computed fair value EV/sales ratio was 42 (Facebook’s EV/Sales was 13.2 at the time of its its IPO). With the benefit of hindsight, early investors in Microsoft greatly underestimated the compounding effects and thus those who bought shares in June 1990 saw a 44% annualised return over 12 years.
It might be that in 12 years’ time, Tesla’s shares will appear to have been cheap at an EV/sales ratio of 3.4
The main reason for our current negative view on Tesla shares is the high expected growth rate.
Tesla is not Microsoft. The marginal cost of sales is much higher and the two industries have very different capital requirements. In our view, Tesla will have to tap into capital markets multiple times to fuel its investment needs and to allow the company to keep up with the competition.
Apart from Tesla’s own lofty production target of 500,000 vehicles in 2018 and its historical precedent for missing these targets, the expected increase in competition is by far the biggest threat.
The eight largest carmakers in the world have an average of $158bn in annual revenue and thus incredible financial power. In addition, these carmakers have experience in ramping up production fast – something Tesla is just beginning to learn.
If electrical vehicles are the future (rather than hybrid cars), then other carmakers such as Toyota (7203:xtks) and Volkswagen (VOW3:xetr) will have to invest in large-scale battery production as well. Tesla’s Gigafactory 1 is estimated to cost around $4-5 billion and will take 4-5 years to build.
If other carmakers were handling their own battery production, we would surely have heard about it. So Tesla is two to three years ahead of the competition in this regard, as they would need batteries in order to ramp up their own EV production...
(It might also be that Tesla will provide other carmakers with batteries; Musk has said before that he wants EVs to succeed above anything, which was also the main motivation for giving away Tesla’s patents.)
However, the recent delivery figure for Q2 was a huge disappointment and it increases the likelihood that Tesla will not be able to ramp up production as fast as it might like... or as fast as it has communicated that it will.
Additionally, the current cash flow trajectory makes us negative short-term on the stock and as a result we are selling Tesla shares.
— Edited by Michael McKenna
Non-independent investment research disclaimer applies. Read more For more on equities click here.