By Ben Strubel of Strubel Investment Management
3/3/2014
Strubel Investment Management’s Dumb Investment of the Week for this week is Tesla Motors Inc (NASDAQ:TSLA) stock. Notice I said stock. I have nothing against Tesla or its vehicles. In fact I would love to purchase a Tesla car (the 400hp Model S Performance please). Also, I think that electric or hybrid cars are the future. They are cheaper to operate and the all electric drivetrains are much simpler than the traditional internal combustion and mechanical transmission combination.
The issue isn’t whether or not Tesla is at the cutting edge of technology (it probably is) or whether or not the Tesla Model S is the future of passenger automobiles (I think it might be). The question is what will the mature Tesla business model look like and is the stock priced attractively today. On those two questions I’m afraid the answer is “mediocre at best” and “no.”
Since its IPO in 2010 Tesla Motors Inc (NASDAQ:TSLA) stock is up an astounding 1198% (as of 2/27/14 market close). The market values a company that sold barely more than 22,000 cars in the past year at $30.55B. That’s close to the value of Nissan Motor Co., Ltd. (ADR) (OTCMKTS:NSANY) (TYO:7201) ($37.45B) and well north of the market value of Fiat S.p.A. (ADR) (OTCMKTS:FIATY) ($12.73B). For comparison purposes Nissan sold 4.8M cars in 2012 and Fiat sold 4.4M. (Note: 2012 is the latest year for which OICA has comprehensive production statistics)
Tesla Motors Inc (NASDAQ:TSLA) has generated no earnings and no free cash flow over its history yet the stock price has risen ever higher based on investors assumption that at some point in the future the company will reach maturity and begin creating value for shareholders. We think that investors’ assumptions about the company’s future are flawed and that Tesla will not be nearly as big or as profitable as its current valuation implies.
Before we talk about Tesla specifically I want to discuss the auto sector as a whole.
The Automotive Market is Brutally Competitive
The automotive market is one of the most competitive in the world with thin profit margins and low returns on capital.
Consumers, in general, have almost no brand loyalty. Yes there are people that will only buy a Ford, swear by German cars, or refuse to buy Japanese but they make up a very small minority of the market. Most consumers buy vehicles based solely on what is the best car they can buy for their money. Manufacturers are forced to not only compete on price and attempt to sell vehicles for the cheapest amount possible but they also need to compete on features as well. That means not only are sales prices low but the cost of goods line item on the financial statements is high as well. Companies need to offer alloy wheels instead of steelies, electric sunshine roofs (one of my favorite Jeremy Clarkson from Top Gear phrases), bigger engines, navigation/infotainment systems, more inexpensive interior fit and finish, and so on. This means profit margins for auto manufacturers are razor thin.
The chart below shows the EBT (Earnings before Taxes) margins for the eight largest auto manufacturers Morningstar has data for.
(Data source: Morningstar.com) We’ve elected to exclude the recapitalized in bankruptcy GM from industry average calculations.
For comparison purposes The Coca-Cola Company (NYSE:KO) and Philip Morris International Inc. (NYSE:PM) have averaged EBT margins of 28% and 16% respectively over the past decade.
The problem for auto manufacturers is this profit must be plowed right back in to the business. The formula for Coke hasn’t changed in decades. Besides building bottling plants and screwing around with ancillary products Coke doesn’t have to invest much capital back in their business. An even more extreme example is Philip Morris International. The tobacco blend for Marlboro cigarettes and the manufacturing process hasn’t seen any great changes, of every dollar Philip Morris generates in profits it only needs to invest $.20 to maintain and grow its business. The remaining $.80 gets returned to shareholders.
Ever since Alfred P. Sloan at General Motors Company (NYSE:GM) introduced the concept of the annual model the automotive industry has been on a cap ex treadmill to hell. Almost every year manufacturers introduce minor changes to all their models. Major platform changes occur every 5 to 10 years on average and every several decades completely new engines need to be designed from the ground up. This means an enormous amount of money is spent on R&D (which depending on the accounting rules may or may not be capitalized) and on building new plant and equipment to manufacture the new model and redesigned components. All of this translates into absolutely abysmal returns on assets. On average the automobile industry can only generate on average over the past decade 2 cents in returns for each dollar of assets.
(Data source: Morningstar.com) We’ve elected to exclude the recapitalized in bankruptcy GM from industry average calculations.
For comparison purposes Coke and Philip Morris International generated 15 and 22 cents on average over the past decade for each dollar of assets.
Implications of Tesla’s Valuation
Investor buying Tesla Motors Inc (NASDAQ:TSLA) stock now are hoping that a company with no earnings and no free cash flow eventually blossoms into a major player in a sector beset by skimpy margins and low returns.
When a company generates no net income or free cash flow and has an unproven business model it’s difficult to make projections in to the future, luckily for us Tesla operates in a mature industry with a well known business model so we can deduce what their eventual business model may look like. All high volume passenger vehicle manufacturers have similar returns on capital and similar profitability levels so we can use the data of existing firms as a proxy for Tesla. Remember that no matter how innovative or flashy sounding Tesla and it’s technology are it is at its core a company whose business is selling passenger automobiles and is thus subject to the same market forces as all other passenger automobile manufacturers.
Right now Tesla Motors Inc (NASDAQ:TSLA) has a market cap $30.55B. According to Value Line over the past 5 years the automotive industry has an average annual P/E of 13.5. Working backwards this means that Tesla would need to generate about $2.26B ($30.55B / 13.5) in after tax net income. We now need to adjust for the tax rate. Tesla has aspirations on becoming a global car company and the average tax rate over the last decade for the top eight global manufacturers we had data for is 32%. Using a 32% tax rate Tesla needs to generate $3.3B in EBT (Earnings Before Tax) ($2.26B / (1 – .32). The next question is how much margin will Tesla earn on each vehicle? Since the automobile sector is rather uniform we used industry average EBT margins of 4.3% which means Tesla needs to generate $77.4B in sales ($3.3B EBT / .043). With Tesla realizing an average selling price of $88,881 for each vehicle sold in 2013 that translates in to about annual run rate of 870,741 cars.
The problem with this model is that we don’t know how long it will take Tesla to reach maturity. To rectify this we will have to make some more assumptions regarding equity risk and how long it will take until Tesla reaches a steady state.
Over the past 5 years Tesla Motors Inc (NASDAQ:TSLA) has grown sales at a compounded rate of 78%. We will give Tesla the benefit of the doubt and make the assumption that this growth rate can continue. At that rate it would take Tesla somewhere around 6 years to break in to the top 10 auto manufacturer which is where the market’s current valuation puts it.
The next question is how risky is this proposition? I’d say it’s very risky! History is littered with failed startups but let’s assume Elon Musk is a genius (actually we probably don’t have to assume that part, he seems like a brilliant guy) and we are taking on very little risk with an investment in Tesla. Over the long term the stock market has averaged returns of a shade under 11% so let’s use 11% as our required return on investment.
Using those assumptions gives us after tax income of $6.3B (11%*$30.55B*(1+11%)^6). Using our same 32% average tax rate and 4.3% average EBT margin we arrive at $9.2B in EBT and sales of $214.9B or 2.4M Tesla Model S cars sold.
Keep in mind this is an estimate made using heroic assumptions. Tesla Motors Inc (NASDAQ:TSLA) reaches maturity and a steady run rate of 2.4M cars sold in only 6 years. The stock is no less risky than the market as a whole. And what about the network of supercharger stations? The model assumes someone else builds and funds those. We also assume Tesla can keep selling cars with an average price of $88,000. Ford Motor Company (NYSE:F) (I used Ford since the data was easiest to access) realized an average selling price of approximately $21,543 on the 6.3M vehicles they sold last year. (The number is actually likely lower as parts sales are included in the top line sales figure).
Summary
While I think Tesla Motors Inc (NASDAQ:TSLA) is a great, innovative company and I wish them and Elon Musk great success I think the stock price has gotten very much ahead of its self and is overvalued. Investors must remember that despite all the flashy new technology Tesla is operating in the same market as every other vehicle manufacturer and is very likely to have a similar business model once it reaches maturity.
If you know of a dumb investment that you think would be a good topic for a future article or have an investment you’d like me to investigate, send me an email at [email protected].
Disclosure: Long PM
Comments are closed.