Stocks

Tesla Stock Could easily drop more than 50% If Model 3 Cannabalizes S And X

Editor’s note – below  are three recent posts by Dr. Brad Cronell on Tesla Stock and Model 3 combined into one.

When most people are asked what a technology company is, they think of computers, software or bioscience – companies with a lot of PhDs doing complicated things. But that definition applies to companies not that are not commonly thought of as “technology” like those involved in oil fracking. From an investment standpoint, I argue that a technology company is defined by two characteristics: miniscule marginal costs and network effects. Facebook is a perfect example in both respects. With regard to marignal costs, what does it cost them to add one member or one advertiser? With regard to network effects, people want to be on Facebook because other people they know are there. These two characteristics are so important from an investment standpoint because they allow for rapid and massive scaling at remarkably little costs. Hence, the massive market capitalization of successful technology companies.

Notice by this definition, Tesla is not a technology company. That is primary reason why I have such a hard time explaining its valuation.

Tesla Fire Elon Musk Engineer Tesla Stock Tesla Model 3

One thing I have not discussed regarding Tesla is risk.  In my view, the risk for anyone buying the stock north of $350 is extraordinary.  What will happen, for instance, if the Model 3 turns out to be a modest success with very small profit margins?  Put simply, the company’s cash flow situation will become critical, particularly if the Model 3 cannabalizes the more expensive and more profitable Models S and X.  Under such circumstances, the stock price could easily drop more than 50%, supported at that level by a potential buy out.  My point is that this possibility is not a “lightning strikes” consideration.  Given the demand for electric cars and the move away from sedans, I see it as a real possibility.  So the downside risk at current stock price levels is extraordinary.  And I do not see any upside potential.  But I have been wrong about the upside before.

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With Tesla hitting new highs over $350, it seems only fair to admit that I was wrong when I thought it was overvalued at $300.  But was I wrong?  The truth is I don’t know.  TWhile the stock has run-up further, it has done so without the release of any fundamental information that would alter my valuation.  The Model 3 is still an unreleased four door electric sedan.  The battery and solar panel business are still highly competitive and not very profitable.  The logistical problems of manufacturing and servicing the new Model 3s remains.  So before I finally fall on my sword on this one, I need some actual information.  Hopefully, that will be forthcoming in the next couple of months, but who knows.  It is possible that the hype will continue to year end even if the Model 3 appears in only modest numbers.