Tesla - Here's why we don't own it

In a wire we posted last year we discussed the primary elements that lead to the burst of the tech bubble and why FAANGS + M felt like a new euphoria that reached valuations we were no longer happy to pay. A new, and arguably far more extreme poster child for extreme valuations now is, Tesla.

Over the past 12 months, Tesla’s market capitalisation has risen 8-fold (from $100bn to $800bn), making it the 5^th largest company in the US. During that period consensus earnings forecasts rose by 50-100%, meaning over three-quarters of the price increase was driven by factors other than earnings. We think that the most important factor is the interest rate environment, which encourages risk-taking and increases the discounted value of future cash flows. In other words, it plays right into the hands of high-growth companies such as Tesla.

Normally we would provide insights on why we do own a particular stock. This time we provide some reasons why we don’t own Tesla.

When we analyse what has driven such a staggering (and rapid) rise in Tesla’s share price, the thing that’s immediately apparent is that only a fraction of the increase has been driven by changes in the company’s underlying fundamentals.

During the 12 months in question, analyst revenue forecasts for the company have risen by around 25% and analyst earnings forecasts by more like 50-100%. Those sorts of upgrades are impressive (and would, on their own, have justified a very nice increase in the share price). However, this still leaves well over three-quarters of the actual increase in the share price to be explained by other factors.

We are effectively talking about $500bn (half a trillion dollars!) of new market capitalisation being created by factors other than higher earnings expectations. To put this $500bn figure into perspective: it’s greater than the total market value of companies such as J&J, JP Morgan, and Walmart.

Several factors have combined to drive a large part of Tesla’s amazing rally, including:

• The rise in prominence of “thematic” investing (and the surge in popularity of thematic ETFs). Tesla falls into two of the hottest thematic buckets: (1) ESG Champions and (2) Disrupters. Investor money flooding into those thematic funds resulted in consistent demand for Tesla stock. Within one of the greatest momentum-based bull markets that we’ve ever seen, this process has become self-fuelling. It works like this: strong inflows into a collection of thematic funds generates price appreciation in all of the stocks held by those funds (each fund is forced to buy more of those same stocks with the new money, at literally any price); this drives positive performance and generates additional momentum-based demand for the funds themselves (as well as for the individual stocks that the funds are purchasing); which results in further inflows, additional buying and additional performance; and on it goes (until, at some undefined point in the future, the thematic/momentum music finally stops).
• The even more spectacular rise in prominence of the so-called “Robinhood” crowd. Essentially newer/younger participants in the market who have been using their post-COVID spare time and disposable income to buy shares in those companies whose products they most support and admire. It’s easy to see why Tesla would be a strong favourite amongst this crowd.
• The dramatic shift in the interest rate environment. Not only the sudden return to a zero cash rate, but also the belief that rates will remain low for a long time, which has increased risk tolerance and dampened the focus on “the time value of money”. This has played into the hands of high-growth companies (whose cash-flows are skewed further out into the future); companies whose profitability is negative/negligible today, but whose “some-time-down-the-track” profitability is expected to be substantial; and companies with longer-dated speculative (“what if one day...?”) appeal. Tesla falls into all three of these categories.

The above factors do not mean that Tesla’s resultant market capitalisation, as enormous as it may be, is “impossible to rationalise”. The issue with Tesla is simply that its current valuation is predicated on several positive outcomes all eventuating, with little allowance for: (1) the inherent conflict between (and double-counting of) some of the assumptions made within that bull-case scenario; (2) the various risks to those positive outcomes; and (3) the true time value of money.

To illustrate this, let’s look at the high-level thesis that is commonly used to support the stock’s valuation:

• Assume that, in 2030, electric vehicles (EVs) will make up 25% of all auto sales and that Tesla will have a 30% market share of those EV sales. This would equate to around 8.3m sales of Tesla vehicles in 2030 (vs. the 0.5m sales made in 2020 and the company’s total production capacity entering 2021 of around 0.8m).
• Assume that the average sale price of those Tesla vehicles will be around $40,000 (vs. closer to $60,000 in 2020).
• Assume that Tesla will be able to maintain its current margin structure (which is far superior to the incumbent auto-makers).
• All of which would give a profit-per-vehicle-sold of around $6,400, which would, in turn, equate to around $53bn of total profit in 2030 (on the 8.3m vehicles assumed to be sold).
• Continue to apply a high-growth multiple (say 25-30x) to this notional 2030 profit figure, even though mature auto-makers tend to trade on very modest multiples.
• Rationalise the continued application of a high-growth valuation multiple by arguing that: EVs will still be growing faster than the overall auto-market; Tesla’s other business opportunities (such as batteries, software subscriptions, robo-taxis, and insurance) should add to the overall value of the group; and there is potential for value-adding acquisitions.

None of these assumptions are irrational. As outlined above, the problem really arises from:

1. Inherent conflict between some of the individual assumptions. For example, it seems feasible that, by adding a cheaper “mass-market” vehicle to its product range, Tesla should be able to reach >8m sales in less than a decade’s time (compared with the 0.5m of premium-only sales made during 2020). However, if we’re assuming that the company’s shift into the mass-market will be that successful, shouldn’t its margin structure begin to shift towards that of a mass-market car manufacturer (lower margin business) and away from that of a premium car manufacturer? Another example is the often-cited opportunity in robo-taxis, which could well be a massive market (in which Tesla would be a major player). However, we can’t value that new market in isolation and simply add a chunk of it to Tesla’s valuation, because we need to consider the negative impact that the proliferation of robo-taxis would have on sales to consumers.

2. Insufficient allowance for the aggregate risks to the bull-case outcome. While each individual assumption used in the Tesla investment case might not be irrational, each of them carries a level of risk and the investment case falls away if some or all of them don’t come to fruition. By way of example, there is clearly risk associated with the expectation of Tesla expanding production and sales roughly 10x over the next ten years. Scaling up glitches, increasing competition, trade wars, regulation and new technology are just some of the challenges that Tesla could face. There is also a clear risk that Tesla won't be able to maintain its market-leading margin profile and, finally, there is a risk that the stock won't continue to trade on a premium multiple. For purely illustrative purposes, if we assume that there is an 80% chance of each of these three risks being successfully navigated by Tesla, the implied probability of all three being navigated is just 51% (80% x 80% x 80%). Using a more sanguine probability of success for each of, say, 60% (still effectively giving Tesla the benefit of the doubt), results in a just 20% probability of all three coming to fruition. Given the very high probability of across-the-board success that is currently built into the share price, we don’t like those odds.

3. Insufficient allowance for the time value of money. Based on the optimistic assumptions outlined above, we arrived at a notional profit in 2030 of $53bn. If we then apply a relatively high multiple to that profit figure (say 25x), we can arrive at a 2030 valuation of $1.3trn. At face value, this makes today’s market capitalisation of “only” $800bn look skinny. However, when we translate that number into a compound annual investment return over the next 10 years, the answer is under-whelming: not much more than 5% per annum (assuming everything goes to plan). Noting that, even if we stretch the 2030 multiple even further (to say 30x), this annualised return will only increase to 7%.

In summary:

• Tesla has built a superb franchise and the original sceptics have clearly been proven wrong.
• However, at today’s valuation of $800bn, the company is really going to need to live up to all the hype (and then some).
• We estimate it offers a 5-7% annual return if everything goes to plan. However, for the reasons outlined above, there is still a significant chance of a less-than-ideal outcome, meaning the probability-weighted return is even lower than this.
• Based on the above we can confirm that Tesla is truly a leader in EVs (Extravagant Valuations).

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