From agnostic sceptic to true believer. That’s how veteran CNBC commentator and equity investor, Jim Cramer, summed up his philosophical shift on Tesla (US:TSLA) last December. He’s not alone. The shares have skyrocketed – and been on quite a volatile ride in the process – as investors have tripped over themselves to get a piece of the action.
Tesla itself said 2019 was the turning point for the business. Many, though far from all, doubtful Wall Street analysts have been brought around too.
Love it or hate it, Tesla has always been a Marmite company. There has been good reason for such a dichotomy – the car maker has been on the edge for a while and it has been forced to tap debt markets time and again. The view has been that it will either go to the moon or go bust trying.
Elon Musk, the mercurial chief executive and founder, is a divisive character with as many detractors as champions. His run-ins with the regulators left many questioning the corporate governance at the company and whether investors would continue to stump up the necessary funds to keep the show on the road. Indeed, a lot of the bear case rested on the idea that he is a charlatan; that the numbers are all made up.
But a sharp turnaround in the company’s fortunes and a rejig at the top – although Mr Musk remains the man in the hot seat – has spurred an aggressive rally in the stock. This has taken place not against a great surge in earnings or profits (although two straight quarters of profits has been important); but instead a seismic rerating based on expected sustainable future cash flow. Hitherto non-believers are now worshipping at the altar of Tesla and their messiah, Elon Musk.
Elon Musk: a puzzling leader
Genius or charlatan? One of the most divisive elements of the Tesla thesis is Mr Musk. The chief executive is not everyone’s cup of tea and is far from being a Wall Street favourite. On an earnings call in 2018 he used the words “boring” and “bonehead” to describe analysts’ questions. Last month he said retail investors have better insight than institutions. Analysts’ predilection for hard data and facts have come up against the more esoteric Mr Musk.
His (in)famous ‘funding secured’ tweet, when he told investors that he would take the company private at $420 a share, earned him rebuke by the US Securities and Exchange Commission. Mr Musk subsequently had to agree to allow company lawyers to vet sensitive tweets. He also was forced to resign as chairman. At the same time there has been a clear-out of the board.
While highlighting some past misdemeanours and a tendency to do things on the fly, the point here is to say that things have changed for the better over the past two years. One thing is for sure: investors are increasingly believing in Mr Musk’s genius.
The turnaround for Tesla has been as rapid as it’s been surprising. The company is now worth more than any other carmaker except for Japan’s Toyota, as the market capitalisation has risen to exceed the likes of Ford, GM and now even Volkswagen. Of course, their vast debt piles give them an enterprise value (EV) that is still greater than that of Tesla – $267bn (£205bn) in the case of VW – but nonetheless it highlights a marked shift in the sector. Investors are prioritising growth over incumbency, or value. Tesla trades at a sales-to-EV ratio about 10 times higher than peers. Revenue growth of more than 30 per cent will vastly outstrip traditional carmakers in 2020.
Short sellers who persistently targeted Tesla have lost their shirts as the stock rallied from a 52-week low at $176 to a high at $968, before quickly dropping $200. Short sellers lost $5.8bn in January alone, according to data provider S3 Partners.
By the start of February, the buying reached fever pitch as the shares shot higher by 20 per cent in a single day, which was followed by a 14 per cent jump. Shorts chalked up mark-to-market losses of $3.1bn on Monday, 3 February and $2.58bn the following day. At the time of writing, the shares were worth about $800 each.
Short interest in the stock – which had been as much as 40 per cent of the free float – has collapsed as bears sweated and threw in the towel. Much of the rally following the third quarter earnings release can be attributed to simple short covering. Even Steve Eisman, the investor who bet against the US housing market before the great financial crisis and won, is among those to feel the pain. Mr Eisman, the protagonist in Michael Lewis’s book, The Big Short, was forced to cover his short and admit that sometimes you just have to walk away.
But what first started as a massive short squeeze morphed into a bout of manic speculation as investors worried about missing out. The short squeeze swiftly turned into a 'fear of missing out' (FOMO) rally. In a single day some 12,000 accounts on Robin Hood, an investment platform favoured by US millennials, bought the stock for the first time.
Tesla saw record daily trading volumes of 47m shares, 60m shares and 48m shares on 3, 4 and 5 February, respectively.
“In our experience, we’ve never seen a stock rise that much that fast with such little regard to past fundamentals or track record,” Needham analyst Rajvindra Gill said in a note to clients. Mr Eisman says the stock has become “unmoored from valuation because it has certain dynamic growth [and] cult-like aspects to it”.
This was classic irrational exuberance, a complete decoupling of the price action from fundamentals. But just because a stock goes parabolic and becomes grossly overvalued based on traditional metrics such as trailing or even forward price/earnings (PE) multiples, it doesn't mean that there is not a bullish case in the longer term.
There is much more to this than short-covering and manic speculation would suggest; the bull case is now stronger than ever.
Two related questions need answering: why the sudden lust for the stock, and was it warranted? As recently as July we were still casting doubt on the viability of the business after a pretty shoddy first quarter of 2019, which capped a pretty poor run of results. At the time in a note to clients, I dubbed this a "car crash" and I was not alone. Since launching its mass-market Model 3 in 2017, Tesla had consistently underwhelmed and burned through a worrying amount of cash to get the car out of the door.
The company reported a net loss of $702m in the first quarter of 2019, equivalent to -$2.90 a share – much worse than the -$0.69 consensus expected. Revenues were also a miss – coming in at $4.54bn against the $5.2bn expected. Net cash fell to $2.2bn, down $1.5bn from the end of 2018, largely down to the repayment of a $920m convertible bond. The effect of the cut to US federal tax credits on 1 January 2019 had a clear impact. Sales revenues were down 41 per cent from the fourth quarter, when purchasers rushed to get in to take advantage of the tax credits. Returning to profitability in the third quarter of the year looked like a big stretch.
Dan Ives, the influential Wedbush analyst, notes: “The table has turned quickly for Musk as a few quarters ago the company was facing red ink, demand issues were lingering in the US, and the management turnover was seeing a major perceived talent drain."
But by the third quarter, Tesla had achieved a profit as promised, but it was to the surprise of many watchers of the stock. In the third quarter Tesla made $143m against a loss of $1.1bn in the first half. It wasn’t all rosy, though. Revenues came in at $6.3bn, down from $6.8bn a year ago, and short of the $6.5bn expected. Deliveries had reached a record in the quarter, but fell short of expectations.
By the fourth quarter, the progress hinted at in the third quarter was secured, with forecast-beating earnings and revenues. Excitement about China was building at the same time as cars began rolling off the production line in Shanghai. Despite ramping for weeks, the shares leapt another 14 per cent on the announcement. Steeper gains in early February followed.
Critically, Mr Musk now expects Tesla to enjoy ongoing free cash flow and net income. Even more importantly, the market believes him. The company also said deliveries this year will easily exceed 500,000, a lofty 35 per cent increase from last year. Tesla has made claims many times in the past that it would deliver 500,000 vehicles in the coming year, but this time it looks achievable. A new gigafactory in China is already ramping output and production from another in Germany is coming. The Fremont, California, factory alone will be able to manufacture 500,000 units annually.
I suggested last October, when the third-quarter numbers were released, that it could be the turning point for this battered stock. After spending big to get the Model 3 out of the door, it had managed to cut costs by 16 per cent and looked to have the cash on hand – $5.3bn – to invest in getting the Model Y to market. The company expects the higher-margin Model Y to vastly outsell all other models ‘combined’.
There are several factors behind the turnaround beyond a couple of decent quarters of growth, not least the stronger-than-expected demand for Tesla vehicles, which analysts at Morgan Stanley believe has created “more optimism around the long-term margin profile of the business”.
Progress in China – the world’s fastest-growing electric vehicle (EV) market – is also very promising, both from a demand and margin perspective. There have also been supportive developments on subsidies and investors are excited about product expansion. According to Morgan Stanley, these factors, and certain market and technical factors, have led to “a significant reduction in the market's implied risk premium for this asset”.
China: more to come but priced in?
There are a lot of reasons to be encouraged about the market opportunity for Tesla in China, in particular. For starters, Tesla has ramped up production there faster than most expected, by as much as six months. The impact of the coronavirus outbreak – which forced Tesla to delay deliveries from its new Shanghai plant – still needs to be appreciated fully, but ought to be only a temporary blip. Two, there are signs of increased government support for Tesla in China, as shown by its access to cheap capital from the government. Three, the coming year looks to offer a more supportive environment for the EV market in China.
Morgan Stanley analysts say: “The world’s largest EV market is still largely untapped and our team believes the company offers the most desirable product to consumers in a crowded field. The ability to build and start rather impressive levels of production at a plant in under 11 months is testament to the company’s desire to tap into the market and perhaps the Chinese government’s desire to attract the company’s technology and knowhow to help transform its own domestic industry.”
Wedbush’s Mr Ives agrees that China holds the key. In a research note in January, he wrote: “The new long-term bull case scenario on the stock is $900 with Tesla's ability to ramp production and demand in the key China region during the course of 2020-21 a major swing factor on the stock.”
However, the stock’s rally may have already priced in the potential demand in China, which even the most bullish think is worth about 1m units a year. Morgan Stanley even questions whether any foreign automaker will be a long-term winner in the Chinese market. To illustrate its concerns about the country, it values Ford China at zero and has lately reduced the value of GM China to a mid-single-digit PE. “We continue to have concerns on the long-term viability of a US player in the Chinese EV market. Moreover, we believe investors must consider global trade and geopolitical risks as Tesla’s exposure to China increases,” it says.
Globally, of course, the EV market is the only show in town. This makes Tesla, structurally, perfectly poised to capitalise on a vast new market. Rather than going into detail on the expected future growth of the EV market, we can simply point to the British government’s decision to ban all petrol and diesel – including hybrid – new car sales by 2035 to illustrate the way the wind is blowing.
What about the competition?
One of the most common things you will note about coverage around Tesla’s market capitalisation is the discrepancy in sales volumes between it and peers. VW sold nearly 11m vehicles in 2019 compared with Tesla’s 367,500. No contest, and yet Tesla is worth $135bn in market capitalisation to VW’s $84bn. The reason is because of the structural shift in the auto industry that Tesla is spearheading.
Tesla has the head start in the EV market, but the traditional automakers are hot on its heels.
Mr Ives says: “In our opinion, the company has the most impressive product roadmap out of any technology/auto vendor around – which the market cap reflects versus its traditional auto competitors – and will be a ‘game changing’ driving force for the EV transformation over the next decade with Model 3 front and centre.”
The team at Morgan Stanley agrees, saying it is encouraged by Tesla's execution and believes it ought to be among the world’s most valuable auto companies. They add that Tesla is “perhaps the most important auto company in the world given its EV leadership”.
Technology leadership is central to the Tesla investment thesis. There is no competitor that can match Tesla in terms of performance, efficiency, range and self-driving capabilities at comparable cost. A recent teardown of the technology of the Tesla 6 suggested its progress is six years ahead of rivals’ and led a Japanese engineer to declare “we cannot do it”.
On the premium side, there is the Porsche Taycan, which offers a similar performance but at a much higher price point and with a lower range. VW is the only rival that is seen reaching a similar level of scale and cost – it plans to launch 70 different EV vehicles by 2028. On self-driving, most peers – often known as OEMs (original equipment manufacturers) – are years behind. In terms of the battery, UBS suggests Tesla has a roughly 20 per cent outperformance over peers.
There is an argument that the likes of the Taycan, Mercedes-Benz EQC, Audi E-tron and others will reduce demand for Tesla vehicles, forcing it in turn to cut prices. And while Tesla has a competitive edge at present on the battery front, the OEMs will catch up. Clearly Tesla won’t have the market to itself, but it doesn’t need to in order to have a market cap equivalent to peers.
The autonomous vehicle (AV) side is also probably under-appreciated. Taking the human element out of the driving is an even bigger shift than going to full electric. All of Tesla's vehicles are connected, constantly training and improving the ‘self-driving neural net’. This is a definite edge over the competition and again most agree Tesla is some years ahead. The managers of Scottish Mortgage Investment Trust (SMT), which has invested nearly 6 per cent of the fund in Tesla’s shares, see the company’s software advantage as central to their continued bullish support.
Profits are coming
As a result of these factors and more, UBS reckons Tesla will become the most profitable OEM. It’s expected to exceed 10 per cent operating margin – currently around 5 per cent – from 2022 and generate $3bn-$5bn in free cash flow each year. “Volumes are likely to double to 0.8m units by 2022 on known products and capacities, and double-digit growth can continue thereafter,” it says. But, at the current share price, such a bullish scenario is taken for granted.
Debt is also becoming less of a concern. Steady free-cash-flow generation will greatly reduce Tesla’s requirement to tap debt markets for capital expenditure (capex). Net debt to Ebitda (earnings before interest, tax, depreciation and amortisation) is down from 17 times to three times in a year. The immediate concerns about the balance sheet have gone.
Added to this, about $4bn in convertible bonds are due to mature in the next four years and these should – at current equity prices – convert into stock, effectively wiping out the equivalent level of debt. The balance sheet looks stronger than it has for a long while.
Bears hope fade
Short interest in the stock has fallen drastically, but there are still plenty of investors out there who are clinging on grimly. Indeed, there was some incremental increase in short positioning seen at the start of the year prior to the delivery number coming out. So where do they see the likely downside?
Morgan Stanley analysts note that near-term momentum and sentiment around the stock is very strong, but question the sustainability of the momentum. This rather states the obvious. I don’t think anyone would disagree that while there is a newfound confidence about Tesla’s prospects, the stock price is not necessarily all that reflective of the fundamentals or the risks.
The production and delivery schedule presents a degree of near-term risk. Tesla said it delivered 367,500 vehicles last year – double that recorded in 2018. It was above the forecast of at least 360,000 offered in October, but still at the low end of the expectations for 360,000-400,000 forecast at the start of the year. Investors seem to be shrugging off the fact that growth in 2019 was below the run rate seen in the second half of 2018 as the company ramped production to beat a cut-off for US tax credits. The question is whether Tesla can at least quadruple production in the next few years. One thing that cannot be denied is that Tesla has a history of missing its delivery targets. Slowing US growth should probably be more of a concern than it is. Tesla also faces more, not less, competition going forward despite its current technology advantages.
On this basis, therefore, does the valuation look stretched? According to analysts at UBS, it does. In January, with the stock trading near $600, they noted that Tesla's shares now discount 1.6m vehicles sold in 2025, compared with 367.5,000 in 2019. “Risks in execution and US demand following the phase-out of EV tax credits seem to get ignored. We think the shares are over-shooting right now,” they said, reiterating a ‘sell’ rating, but at the same time raising their price target.
Capex has been a bit lighter than expected, so there are doubts whether the company’s recent free cash boon is sustainable. Investment should be accelerating – bears think Mr Musk is robbing Peter to pay Paul.
There is also the potential for trouble in Germany. Elon Musk is no fan of unions, but Germany’s industrial workforce is heavily unionised. German labour is also expensive. Equally, though, you could easily argue that Germany is a very good location for Tesla’s next gigafactory as it will be able to tap into a highly skilled industrial labourforce and be at the heart of the European automotive sector.
In terms of the Model Y crossover, there are risks of cannibalisation of Model 3 demand. Many investors question whether the Y is sufficiently different from the 3, and analysts have expressed concern that the third row is not large enough to comfortably seat passengers.
On autonomous driving, no one who seriously analyses the stock really believes Tesla is there yet. There have been some well-documented crashes and Tesla could face greater regulation. As Morgan Stanley notes, AV at scale is going to happen in 2030, not 2020.
“We should also look at the possibility of Tesla tapping investors for cash again...” this was what I had written in this very article – that was before the company announced a $2bn cash call, on Thursday 13 February.
Mr Musk said previously he wouldn’t need to, but many of us were unconvinced by this claim. With the stock trading at $800, up fourfold in a year, there is clearly a strong case to be made for raising fresh equity with this kind of valuation. Shares skidded a bit lower on the dilution, but ultimately bolstering the balance sheet at this point is the right strategy. Investors may be tapped again before Tesla turns free cash flow positive in a sustainable way.
Are they any good?
Finally, the big question we have is whether the cars are any good. This can be overlooked by investors who look at balance sheets and expected sales. Here, too, the picture is favourable for Tesla. Yours truly has not had the good fortune to try one, but the data supports the bull case again.
Despite some quality issues and dissatisfaction with aftersales service, customer satisfaction is high. According to UBS surveys of Tesla owners, 85 per cent would recommend the brand to a friend and 88 per cent would buy a Tesla again. Some 98 per cent like the overall driving experience in a Tesla.
Morgan Stanley says the Tesla is thought to be the highest-quality electric vehicle on the road in China “by a wide margin”. Instead the question, as with everything else about Tesla, is: what’s already priced in? Right now, the answer is ‘a lot’ – but history has shown that betting against it has proved a car crash.
How Tesla compares with other carmakers
|Market capitalisation ($)||Enterprise value ($m)||Revenue ($m)||Vehicles sold||Net income($m)||EV/Sales (x)||PE (x)|
Tesla key financial forecasts
|Net Income ($m)||-1004.7||-629.6||1467.3||2681.7||4.0|
Source: Bloomberg. *No data available.