Hey Folks,
In this first edition, I’ve analyzed Tesla. It’s one of the most interesting and talked-about companies in the world. As I started researching the company, I discovered many surprising things I didn’t know. I distill these findings here. I hope you like it.
Please send me your comments, especially if you think I’m wrong (or committed some mortal mistake). I’m open to changing my opinion!
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I’ll see you at the next one!
Fred.
Tesla (TSLA)
5-bullet Summary:
The change from ICEs to EVs is underway, and Tesla is the leader in EVs.
After 2018, Tesla learned how to manufacture cars at scale and has reached escape velocity. With a number of models to be released, Tesla is ready to grow profitably (and fast).
Tesla is years ahead of competitors in battery technology, software development, and electronics.
Traditional manufacturers will have to change their business models to compete with Tesla. Change is hard and costly. Some manufacturers will not survive.
I think ten years from now Tesla will be producing at least ten million vehicles per year. I value Tesla at $950/share (vs. $725/share currently).
At this point, Tesla doesn’t meet my investment criteria because the implied three-year annual return is <25%. I’m waiting for a larger correction; if that happens, I plan to buy some of it for my personal portfolio.
You can read my full write-up below.
Thoughts on Tesla
People often mix analyzing a company as a business or as an investment. A company can be a good business but a bad investment, or the opposite. What we ultimately want is a great business that’s also a great investment.
Tesla illustrates this misconception. Some love the company and think it’s a good investment because they love the company; some hate it as an investment and think it’s a terrible company because they hate it as an investment.
Let’s make that difference clear and start with the following: the car manufacturing industry kind of sucks. The industry is cyclical, capital-intensive, and highly competitive. ROI is low. Still, it’s an attractive market worth $2.5 trillion a year. Despite the unattractive features of the industry, some companies may thrive in this large market if they have an edge over competitors.
As an investment, Tesla has done quite well. It’s now the second-largest auto manufacturer in the world with a $160bn enterprise value. Tesla is only behind Toyota, which has an enterprise value of $375bn. Tesla produced 370k vehicles in 2019. Toyota produces 10 million cars a year. To justify this massive difference in numbers, Tesla must have a much different growth profile, a much different business (for example, with higher operating margins), or both.
Tesla’s Business Model Is Different
The auto industry kind of sucks, but the business is no mystery. Traditional OEMs build their franchises around efficiently manufacturing internal combustion engine (ICE) vehicles at scale, launching new models with upgrades every year, and distributing and servicing their cars through a third-party dealership network. OEMs compete on price, product and service quality, and brands. They depend on manufacturing efficiency and scale because they rely on operating leverage. There is a learning curve, and traditional OEMs understand manufacturing. They also understand engines and vehicle design.
OEMs depend on scale gains and manufacturing efficiency to keep margins. Tesla is no different. The company battled through the early production of Model 3 in 2018. Ultimately, Tesla succeeded, but it was a close call (let’s call that Tesla’s tipping point).
However, Tesla’s business model is different from traditional OEMs in important ways. The main component of an EV is the battery. Tesla understands batteries, electronics, and software. Traditional OEMs have never focused on battery technology, and your car (if it’s not a Tesla) is like an old blackberry, whereas Tesla is like an iPhone. Tesla has no dealership network, its workers aren’t unionized, and it doesn’t pay dividends (it can reinvest all of its cash flows back into the business).
Of Facts And Opinions – Tesla’s Competitive Advantages
Here are some facts:
1. Electric Vehicles (EVs) are superior to ICEs and will replace ICEs.
EVs are simpler, have fewer parts, make less noise, are more efficient, and have lower maintenance costs. It’s a gradual process, but EVs replacing ICEs is a matter of “when” not “if.” Given emission regulations in Europe, the “when” is less than ten years. This process is well underway. OEMs have already announced the launch of several new EV models in a couple of years. The move to electrification is pervasive across the industry.
2. Tesla’s cars are better than most cars (not only EVs).
If you don’t believe me and you can’t buy a Tesla, watch some videos (for example this, this, and this). Tesla-owners say Model 3 (or Model S, or Model X) is the best car they have ever had. Aside from the regular advantages of an EV, Tesla’s cars are better because they have advantages in performance, range, and technological features.
I think Tesla has competitive advantages relative to traditional OEMs:
First-mover advantage: Tesla is the leader in EVs and has developed unique battery technology, car design, and software over several years. Traditional OEMs are behind and will have to incur losses in their EV development pathway. For example, Tesla Model 3 has a full self-driving computer that has innovative hardware (chips) incorporated with Tesla’s software – all designed by Tesla. Traditional OEMs don’t have those capabilities, and even with massive investments, they may take years to catch up with the technology. This first-mover advantage may also impact Tesla’s ability to be the first to create full self-driving technology. That’s because Tesla is collecting tons of data from its thousands of vehicles driving on the streets – something no other OEM has.
First-principles advantage: Because Tesla has no baggage developing ICEs, the company reasons from first principles for designing and developing vehicles. Traditional OEMs have difficulty doing that. For example, when creating EVs, they often adapt old designs from ICE cars, which puts them behind in terms of performance and costs.
Core competency advantage: Tesla’s core competencies are battery technology and software development. Traditional OEMs’ core competency is engine development and mass production of vehicles. The shift to EVs doesn’t imply minor upgrades or changes to an existing model; it’s a different paradigm. Further, Tesla has a different business model, which takes the competitive battle to a different playing field.
No-legacy advantage: Traditional OEMs have a legacy that prevents change. They must keep selling ICE cars over the next years while developing EVs. They must also deal with the adaptation of current factories, changes to their supply chain, and other disruptions. For example, traditional OEMs may have to cut dividends to reinvest in the business, putting extra pressure on management.
Many factors position Tesla ahead of the competition. Ultimately, how successful Tesla will be depends on traditional OEMs. To compete with Tesla, traditional OEMs must change.
No one knows how that will play out, but we know one thing: changes are hard. In the history of business, we can think of many examples of that (1, 2, 3, 4). Spoiler alert: incumbents often fail. The closest comparison we may draw is with Apple and Nokia. In Q2 of 2010, Apple sold 8 million smartphones while Nokia sold 24 million. One year later, Apple sold 20 million, and Nokia sold 17 million. In 2007, Nokia was worth $150bn. In 2013 it sold its smartphone business to Microsoft for $7.6bn.
This comparison is revealing because Nokia was the undisputed leader in the business of manufacturing phones. It happens that Apple launched a product that was more than a phone. Therefore, it changed the competitive playing field so much that, in the beginning, Apple had no competitors. Tesla’s cars are like regular ICE cars, just like the iPhone was like Nokia’s phones.
Auto manufacturing is an industry with high barriers to entry. Industries with high barriers to entry are prone to resist innovation because innovation usually comes from new entrants. Consider that the auto industry is competitive, not innovative. Tesla managed to jump over the barrier (remember the tipping point), and traditional OEMs are now forced to innovate to survive.
We can hint at the resistance to change from the current actions of traditional OEMs. I think this question from Morgan Stanley’s analyst on Fiat’s last earnings call illustrates this point:
Mike and Richard, a couple of questions. First, on hybrids – how to say – hybrids suck, right? I mean, come on, guys, they’re complicated, consumers don’t seem to want them. Toyota can barely give their patents away. Governments like the UK are starting to exclude them from credits. I think the UK is outlawing them by 2035; other cities are likely to follow. They don’t make money.
Mike, FCA is, in my opinion, one of the keenest, if not the keenest, most experienced management teams in the industry. Explain to me why are you throwing hard-earned money after these powertrains that really have no future. I understand the short-term logic, but I just – it’s got to be only a couple years like getting away from that, right? It seems like a big waste.
Valuation
Unit Growth
The size of the global auto market is about $2.5 trillion. Tesla makes $25bn in revenues. It has 1% of the worldwide market. That means Tesla can keep growing revenues for a very long time, at a very high rate. EVs, including hybrids, have now ~12% share of the global market (in units, not revenue). Tesla has a market share of ~13% of global EV sales. There are no market size constraints at this point. That’s good news for Tesla.
Tesla targets production growth of more than 50% per year. That’s a high number, but not crazy. Toyota makes 10 million cars a year. To reach Toyota’s production, Tesla needs a 40% CAGR over ten years. I think that’s reasonable.
Tesla has a good pipeline of products coming into the market over the coming years. Model Y, Cybertruck, Roadster 2, Tesla Semi. New models expand Tesla’s addressable market and support growing demand for their cars. As such, I don’t think Tesla will face a demand problem in the coming years. Ford sells 900k F-series trucks, FCA sells more than 500k Dodge Ram trucks and GM sells 800k GMC and Chevy trucks, all of that per year. You can see how Tesla could sell 1 million Cybertrucks per year in the US.
In a nutshell: as long as Tesla releases new models in different categories with the same or higher quality as Model 3 at reasonable prices, Tesla will grow. Consider that much of this growth comes from greenfield expansion – meaning it comes from expansion into model categories, geographies, and from the expected expansion in EV adoption. This kind of growth is easier to materialize. For example, Tesla dominates 60% of the EV market in the US. If the EV market expands, on an absolute basis, Tesla is likely to benefit even if competition increases, and it loses some market share. So, Tesla reaching the production capacity of Toyota or GM ten years from now is not a stretch.
Revenue Growth
Let’s pause and think about reasonable prices. The average selling price (ASP) of a car in the US is $40k. Tesla’s ASP is close to 55k. Tesla’s master plan is to mass-produce EVs and accelerate the adoption of EVs worldwide. The company has consistently brought down production costs, and consequently prices, due to improvements in battery technology, design, and manufacturing.
That should continue. Tesla can charge lower prices in the future, supporting demand growth. But because Tesla has a superior product, on average, Tesla prices will not be as low as the competition. Let’s assume a 10% premium to the market average.
We also have to factor price inflation. The ASP in the US is $40k today, but ten years ago, that number was closer to $30k - a 3% CAGR. Let’s assume a 2% annual inflation to Tesla’s ASP over the next ten years.
Margins
Now, to margins. A good EBITDA margin for automotive revenue is 10-11%. Some OEMs achieve margins of up to 15%, depending on the year. Tesla’s margin profile could be even higher because Tesla commands higher prices, doesn’t spend on advertising, and doesn’t sell through dealerships. Let’s assume dealerships have a gross margin of 5% on new vehicle sales. That means that Tesla D2C model could expand its EBITDA margin to +15%. GM spends roughly $4bn per year on advertising and promotion. That’s 300 basis points on $130bn of automotive sales, and a path for +18% EBITDA margin for Tesla - if you’re optimistic.
Tesla also gets some extra points for its software updates, which can generate high-margin income (it’s already selling an FSD option for $7k), and its other business lines like selling insurance for Tesla cars, selling solar roofs and power walls, not to mention the possible launch of a ride-hailing service (yes, like Uber and Lyft) ahead of robotaxis. We don’t know how that may play out in the future, and let’s not pretend we do. Still, it adds optionality.
All considered an EBITDA margin of 11% seems reasonable.
Dilution
In 2019, Tesla generated roughly $1bn in free cash flow. Tesla spent ~$1.6bn to build its China factory, which has a capacity of 150k vehicles a year. Using the same ratio of investment/capacity, Tesla would need to invest $100bn over the next ten years to reach a production capacity of 10 million cars. Let’s consider that Tesla can improve its capital efficiency (say, by 20%) and generate positive free cash flow (say, an average of $3bn per year) during the next ten years. It would still need to raise $40-50bn for growth CapEx. Also, Elon Musk has a generous compensation package. We account for dilution of roughly 70 million shares in our valuation (~40% dilution).
Multiple
The average EV/EBITDA multiple in the auto industry has been ~7.5x over the last ten years or so. Tesla’s multiple is higher and should continue to be higher. Fundamentally, that’s because it has a more vigorous growth profile. The hype around the stock also helps. As long as it can keep a positive outlook from expected growth, that multiple will be higher than those of traditional OEMs. Let’s use 10x EV/EBITDA ten years from now (2030), which considering a 10% discount rate and 50-70% cash flow conversion from EBITDA, implies a terminal growth of 3-5% - not out of the ordinary.
Our valuation spits a price of $950/share. This number is simply based on a 10x EV/EBITDA multiple, considering EBITDA of ~$60bn in 2030, using a discount rate of 10%, and ~230mm shares outstanding. Note that I don’t incorporate the value of Tesla’s energy business or other service lines, simply because it’s too speculative to estimate their value at this point. It’s all upside.
It’s a back of the envelope valuation (or rather a one-page valuation). In the long-term, I think directionality trumps accuracy. That means that the business analysis has more weight than getting decimal points right, and I don’t want to invest in anything too complicated. And, to that point, that’s why I try to use conservative assumptions and leave a large margin of safety as part of my investment criteria.
Changing some of the assumptions will yield different results. For example, if I assume an EV/EBITDA multiple of 9x (not 10x) and an EBITDA margin of 9% (not 11%), the value is close to $700/share. You can see why a margin of safety is essential.
Risks
An investment in Tesla inevitably brings risks, but my view is that they are lower than many other investors think. Like I said, after the 2018 “manufacturing hell,” Tesla reached a tipping point (meaning they learned how to build cars at scale profitably). Even if sales growth doesn’t materialize as I expect, the company still has cars considered the best in the industry, technology that is years ahead of competitors, and a brand that is incredibly valuable with thousands of loyal clients. The balance sheet is not a fortress, but it is healthy. Tesla has $8bn in cash (sufficient to fund the next two years, at minimum) and debt of $15bn. For comparison, Toyota has cash of $ 55bn and debt of $192bn. In my valuation, I already consider significant equity dilution.
All of this leads me to think the risk of permanent loss of capital is low. It’s a qualitative analysis more than quantitative, but I think the possibility of Tesla going bankrupt over an investment horizon of two to three years is far-fetched.
Conclusion
At this point, Tesla doesn’t meet my investment criteria because the implied three-year annual return is <25% (again, margin of safety). I’m waiting for a more significant correction; if that happens, I plan to buy some of it for my portfolio.
Going forward, I want to keep an eye on Tesla’s progress and check if there are holes in my investment thesis. More specifically, I’ll look for the following:
Tesla’s growth in units produced: This year, I expect them to produce more than 500k units. Between 2021 or 2022, Tesla should be marching to more than 1 million cars/year.
Opening of new factories: Tesla has already initiated diligence to construct a new factory in Germany. Let’s see how that goes. Tesla also may build another factory in the US, expand its factory in China, and even expand to Brazil.
New models release: Tesla has many products in the pipeline. The Model Y should start sales this year, and new releases should come up in 2021.
Other developments: from insurance, solar roofs, ride-hailing, software updates, self-driving technology, etc.
Thanks for reading,
Fred