FSD potential keeps Tesla our largest investment

Introduction

At ELM Responsible Investments, we try to identify companies that are not only driving positive change for the environment and society but also investing in innovation and adding to their intangible asset base. 

With all the data and information available today, investing based on easily observable data such as Price / Earnings ratio is no longer enough. We think insights and analysis of intangible assets, such as a company’s R&D capability, culture, future products etc., are much more critical for long-term investors.

The valuation of Tesla is a heavily debated topic lately, not least because of the emotions – positive and negative - stirred up by their controversial CEO, Elon Musk. Despite the controversy, Tesla is the most significant position in our Global Fund.

Why is Tesla the largest position?

For Tesla, we have identified 10 Key Value Drivers, which are the most critical variables for the company's long-term valuation. We form a view of these variables and input them into our proprietary valuation calculator (available for free on our website). When we do this, we see that the future returns are very compelling.

What are the 10 Key Value Drivers?

The most critical variables for Tesla’s valuation are the following:

1. Full Self Driving (FSD) Penetration Rate
2. FSD Price
3. FSD Profit Margins
4. Average Selling Price of a Vehicle
5. Vehicle Deliveries
6. Vehicle Profit Margins
7. Capital Expenditure
8. Operating Expense
9. Cost of Capital
10. Terminal Growth Rate

What is the MOST exciting variable?

We can run valuation sensitivities on each variable using our proprietary valuation calculator. When we do this, we learn that while future vehicle delivery, profitability and investment rates are all critical, the most exciting variables are those associated with Tesla’s FSD features.

What is FSD?

FSD is Tesla’s autonomous vehicle offering, considered one of the most difficult Artificial Intelligence (AI) challenges we face. Alphabet-backed Waymo and others are also working on autonomous vehicles, but Tesla is way ahead of the pack given the vast amount of data they possess.

Tesla owners can subscribe to the FSD feature for US$15,000 annually in selected regions. With FSD, the car will drive itself and act like your driverless Uber service.

We all know that the utilisation rate of cars is low – most cars only get used for a few hours a day. With FSD, the vehicle's utility will increase significantly as different household members can utilise one vehicle.

For example, in my family, if we had FSD, the Tesla could take my wife to work, come back home, drop off the kids to school, fit in a grocery shop, pick up the kids from school, and then pick up my wife from work. Without FSD, we would either need two cars, rely on public transport or a car share service. 

When considering these alternatives, the value of FSD to our household is much greater than the cost of US$15,000 annually. Unfortunately, this feature is not available in Australia yet, but as the technology continues to improve, we expect more regions to approve this technology.

How vital is FSD to the valuation of Tesla?

We think the current market capitalisation of Tesla does not include the upside from FSD. Over 4 million Teslas have been sold in the past 5 years, and we think another just under 1 million vehicles will be sold in the second half of 2023. We need to ask ourselves three questions regarding FSD and its impact on Tesla’s valuation:

1. What percentage of the total Tesla fleet will take up FSD in the future?
2. What will FSD cost in the future?
3. What will the incremental profit margin of FSD be in the future?

The most straightforward question to answer is the third… FSD will be a software update, which we think will attract software-type gross profit margins closer to 80%-90%.

The second easiest question to answer is the second… we need to think about the value to the consumer, and then determine the price. As I mentioned, the alternative to FSD is buying a second car, relying on a car share service or public transport. The annual cost of buying a second car (including the purchase price, annual insurance and registration costs etc.) will be the upper bound of the price of FSD, and the cost of public transport and a car share service will be the lower bound. The current price of FSD is US$15,000 annually and we assume it will eventually cost US$20,000 per annum as the technology improves.

Next, we need to consider the percentage of the total Tesla fleet that will take up FSD as an option in the future. Approximately 7% of the Tesla fleet has subscribed to this feature today, paying the annual subscription fee. We assume 20% in the future as the technology improves and more jurisdictions approve the feature.

Using our valuation calculator, you can input your assumptions and see how they impact the company's long-term valuation.

What do the bears say?

I often hear from Bears: 

“Tesla is expensive because more competition is coming, and their growth will slow.”

CEO Elon Musk is targeting 20 million vehicles per annum in the future, but with increased competition, the bears consider this target aspirational. 

I think however, they have a good chance of getting close to that goal given Tesla’s competitive advantages. They are only one of two profitable electric vehicle manufacturers today, and profitability allows them to cut prices and take market share (I will discuss why this is so important in a future article). 

But even if they do fall short of Musk’s long-term vehicle delivery goal, the opportunity from autonomous vehicles is significant enough for us to remain invested.

Conclusion

Homing in on the Key Value Drivers and using our valuation calculator allows us to focus on what matter to long-term valuation. We see the opportunities in long-term vehicle deliveries and the value potential through FSD for Tesla. 

Furthermore, the valuation we have discussed in this post is only for the Tesla Motors segment. The company has additional opportunities in energy storage, supercomputing, and robotics which we don’t think is fully appreciated by the market.