Tesla (TSLA) again, with fewer numbers plucked out of the air

I got a comment from Russ about my recent TSLA post, in which I concluded that a ton of future growth is already priced into the stock. The gist of his comment is that earnings could be a lot higher than I’ve been assuming. What powers a conventional car is an internal combustion engine–an expensive machine spewed out of large-scale factories that need to operate at close to capacity just to break even. The technology is also mature. In contrast, TSLA uses gigantic batteries, a technology in its infancy, i.e., one where costs are falling.

So I decided to abandon my back-of-the-envelope approach and take a look at TSLA’s 2019 financials. Call this my front-of-the-envelope analysis.

2019 sales and direct expenses

TSLA sold 367,500 cars in 2019, at an average price of $54,341 each. It made a gross profit from auto sales (I’ve ignored leases) of $4.0 billion, or $10,900 per car. Gross profit means after all direct cost of manufacture, including materials, labor and the cost of running the plant (including depreciation).

general expenses

The company spent about $4 billion on R&D + sales, general and administrative expenses (SG&A). This offset basically all the manufacturing profit. TSLA had interest expense + taxes, so it made a loss for the year.

where the operating leverage is

The essential point, which somehow eluded me last week, is that the general expenses laid out in the preceding paragraph have been steady for the past several years. Typically, an analyst would have them accelerate at some (low) trend rate of increase. Still, any increase in this expense number will be dwarfed in short order by the rise in gross income if TSLA continues to grow at the current high rate.

If we thought that TSLA could expand sales at 30%/year for the next half-decade, while retaining the same gross profit, then it would have gross profit in 2025 of about $15 billion. If general expenses increase at 5% yearly, they would be around $5 billion then. Net income would likely be about $7.5 billion, or close to $40/share.

new battery?

What about the battery? Let’s assume–I’m just making numbers up here–that the cost of parts is a third of total gross costs (three kinds of costs: materials, labor, factory) and that the battery is half of the cost of all parts. That would make the cost of today’s battery about $7000 per car. Say new technology cuts that figure in half. That would add $3500 to the gross profit per car for TSLA, assuming (unlikely, I think) it could retain the whole amount. TSLA’s unit sales in 2025 would be about 1.4 million at a 30% cagr, meaning $14/ share more in eps, if so.

As I’m writing this, the TSLA price is about $1700, implying a pe of just over 40x, assuming no changes in unit profits and 30+, on the same assumptions, if all the profits of new battery technology accrue to TSLA.

dealing with Tesla (TSLA)

If the question came up about whether to buy TSLA at $1400 (I have no intention to do so), how would I decide?

If I were making a recommendation to someone else I’d do a detailed spreadsheet in which I’d try to project the level of future earnings, the rate of their growth and how long I thought the superior growth would continue.

Today, I’m going to do a quick, back of the envelope, calculation. My aim is to get an idea of what level of future earnings is already reflected in the price of TSLA.

valuation

Let’s say the current price is $1400 a share. The market cap is $260 billion, implying that about 185 million shares are outstanding. Let’s say that I would be willing to pay 30x future earnings for TSLA, once it starts to earn on a regular basis. That implies earnings at some point of $45 a share, or earnings of about $8.5 billion a year, to justify today’s price.

Let’s assume this all comes from selling electric cars. Let’s put the average selling price at $40,000 and the net profit to TSLA from each at $4,000. If so, how many cars does TSLA need to sell to make $8.5 billion? The answer is 2.2 million units. That’s as many as Mercedes or Kia or BMW do and would put TSLA at the low end of the top ten global auto brands.

If I’ll only pay 20x earnings for an auto company, TSLA has to sell 50% more vehicles, or 3.3 million, to get the $1400 share valuation. That would put the company in the lower middle of the top ten, somewhere around Chevrolet, Hyundai or Nissan.

Is that doable? Well, the American car companies, operating in a heavily protected market, have been by and large pretty sorry companies for most of my lifetime. The Europeans are currently embroiled in a scandal that’s resulted from widespread falsification of emissions testing results for the diesel cars they sell in their home markets. The chaebol and zaibatsu conglomerate structures in Korea and Japan mean profits and innovation are at best secondary considerations. In other words, the competition isn’t particularly stiff.

The world market is about 70 million units annually, so 3.3 million would be around a 5% market share. Again, not impossible–although at the high end of what traditional auto companies have been able to achieve recently.

time

How long will it take for TSLA to be able to manufacture 2 million+ cars a year? The company was making them at a 400,000 unit annual rate at the end of 2019. At a 30% growth rate, it would take close to ten years. At a 50% growth rate it would take four or five.

In other words, today’s stock price is discounting very large growth for TSLA and paying today for earnings that are easily a half-decade in the future. What I think is significant about this is that in my experience the US stock market rarely discounts earnings more than two years ahead. How so? Pre-financial crisis studies (when there were lots more experienced analysts) show that securities analysts aren’t able to make accurate earnings forecasts more than a year ahead. Also, how far in the future the market is willing to discount is also a measure of market bullishness. I’ve rarely seen markets where investors are willing to pay today for estimated earnings three years in the future. Eighteen months is more usual. In bear markets, no one pays for any future earnings! In this case, though, the market is willing to pay for profits much farther ahead than in typical bull markets.

my take

I can imagine a world where TSLA is the leading maker of electric vehicles, with a global market share of, say, 10% and where electric vehicles are the dominant form of ground transportation. That outcome is not in the current TSLA price, in my view. But my guess is that if this happens, it’s also at least another half-decade in the future. Unless/until enough time passes that the market wants to pay for this, my guess is that TSLA will be at best a market performer.

I think the market’s willingness to discount far into the future is primarily a function of super-low interest rates. There’s also the sense that substantial structural changes to global economic life are in the offing and that it’s important to have a portfolio oriented toward companies of the future rather than those of the past. But if fixed income investments were to become more attractive–that is, if interest rates were higher–portfolios would shift toward bonds. At the same time, I think, the discounting mechanism in the stock market would become more conservative/less willing to look five-ten years ahead. That would spell trouble for TSLA …and many other tech-ish names.

oil below $20 a barrel

The Energy sector of the S&P 500 makes up 2.8% of the index, according to the S&P website.  This is another way of saying that none of us as investors need to have an opinion about oil and gas production, which makes up the lion’s share of the sector.

Last weekend Saudi Arabia and Russia, with a fig leaf provided by the US for Mexico’s non-participation, led an oil producers’ agreement to cut production by around 10 million barrels daily.

Prior to the meeting, crude had rallied from just over $20 to around $23.  Right after, however, the Saudis announced price discounts reported to be around $4 barrel for buyers in Asia.  Prices were reduced by a smaller amount in Europe but went up for US customers–apparently at the Trump administration’s request.  That sent crude prices into the high teens.

Why is this the best strategy for Saudi Arabia?

The commonsense answer is that Riyadh thinks it’s more important to secure sales volumes than it is to be picky on price.  This is at least partly because the world output cuts reduce, but by no means eliminate, the oversupply.  So there are still going to be plenty of barrels looking for a buyer.  Another reason is that since demand has dried up the Russian ruble has dropped by 20%.  That’s like a 25% local currency price increase for Russian crude, meaning lots of room for Moscow to undercut rivals.

investment implications

The most leveraged play to changes in oil prices is oilfield services.  Companies that specialize in exploration–seismic services, drilling rig firms–are the highest beta, firms that service existing wells less so.  During the oil price crash of the early 1980s, however,  drilling rigs were stacked for a decade or so.  On the other hand, oilfield services firms are the ultimate stock market call on rising oil prices.

Given that US hydrocarbon output and usage are roughly equal, the country as a whole should be indifferent to price changes (yes, it’s more complicated, but at this point we want only the general lay of the land) rather than the net winner it was 15 years ago.  However, within the country oil consumers normally come out ahead, while oil producers are losers.

Typically, the resulting low gasoline prices would be a boon to truckers and to commuting drivers.  The first is probably still the case, the second not so much.

The bigger issue, I think, is the fate of the Big Three Detroit auto producers, who are being kept afloat by federal government policies that encourage oil consumption and protect high-profit US-made light trucks from foreign competition.  While nothing can explain the wild gyrations of Tesla (TSLA) shares, one reasonable interpretation of the stock’s resilience is the idea that the current downturn will weaken makers of combustion engines and accelerate the turn toward electric vehicles.

Personally, I’m in no rush to buy TSLA shares–which I do own indirectly through an ARK ETF.  But it’s possible both that Americans won’t buy new cars for a while (if gasoline prices stay low, greater fuel economy won’t be a big motivator).  And the rest of the world is going electric, reducing the attractiveness of Detroit cars abroad, and probably making foreign-made electrics superior products.

If there’s any practical investment question in this, it’s:  if the driving culture in the US remains but the internal combustion engine disappears, who are the winners and losers?

 

 

 

 

 

 

 

 

Tesla (TSLA): dreaming and reverse engineering

As I’m writing this, TSLA’s market cap is around $160 billion, with the stock up 50%+ over the past week and having more than doubled in a flat market over the past month.

I have no real idea what’s behind the move  …desperate short covering?  …glitchy trading AI feeding on positive price momentum?  It looks crazy, though.

My thoughts:

–conceptually at least, we’re now living in a post-fossil fuel world.  This is much more evident in, say, Europe than in the US.  (The current administration here is clueless.  It actually favors the most heavily polluting fuels and is fighting industry efforts to keep US-made auto relevant in world markets through increasing fuel efficiency.  If this were a century ago, we’d be backing firewood.)

–the trickiest part of a car to make and maintain is the internal combustion engine.  Substitute big batteries and suddenly building is easier, manufacturing costs go down and you don’t need an extensive dealer network for sales and service.

Tesla is the leading brand name in electric cars.  There’s also some evidence that the manufacturing problems that plagued TSLA are now behind the company.

–we’re still in the “dream” or “concept” stage of TSLA’s development, so it’s very hard to gauge what the company is worth.  On the other hand, we can ask ourselves what the current share price implies must be already factored in, as follows:

—-let’s say that the market for automobiles is 100 million units/year, with 25% of those in China and 20% in the US.  Suppose TSLA can capture a 1% market share over the next few years.  That would mean manufacturing 1 million cars.  Let’s pluck numbers out of the air and say that they’ll sell for $40,000 each and have an after-tax margin of 20% (using margins is bad–never do it–but we’re just dreaming here).  That’s $8000 each, or $8 billion in total.

—-the point of this reverse-engineering is to see that the stock is now trading at 20x that annual earnings figure (market cap =$160 billion).  To buy/hold the stock at this point one would have to believe that the future for TSLA is better than I’ve just described.

—-how could that happen?:  the margin number I’m using is very high in conventional auto company history; there’s the issue of creating a network of charging stations to serve the cars; there’s also a (less important, I think) question of usability of electric cars in colder climates.  The biggest unknown, in my opinion, is how large a lead TSLA has on other would-be electric car makers.

Primary competition will likely come from Europe, where whose diesel emission cheating scandal has wrecked the market for conventional cars, thereby accelerating the move toward electric.   Their biggest impediment–ironically, a major point in favor of TSLA, is the backward-oriented posture of the administration in Washington.

On the other hand, given that TSLA has manufacturing operations in the two largest markets, maybe a 1% market share is too low.  Again, I have no idea.  But I think that’s the bet buyers today will be making, whether they realize it or not.

my $260 price target for Tesla (TSLA)

A regular reader recently asked how I arrived at $260 as a price target for selling TSLA, which many of you will know I have been trading alongside my younger son for a while.

 

To some degree, I’ve regarded TSLA in the way I would look at any growth stock.  That is to say, I look for signs that the company can grow faster than the market expects and/or would sustain an above-average expansion pace for longer than the market believes.

I then try to use the company’s financial information, plus government, trade association and individual competitors’ data to project an income statement and flow of funds statement for several years into the future.

In TSLA’s case, reliable data are scanty.  In addition, the company’s own projections of its production capacity and sales have not been anything to hang your hat on.

 

Typically, and for a stock I would consider as a core part of my portfolio, I would try to make a projection that I believe to be reasonable, or perhaps mildly aggressive, and would reassess as/when the stock reaches the future target price that projection would lead me to.

In the case of TSLA, however, I did something different.  I decided to make an extremely optimistic projection, one I thought would leave the shares at least temporarily overvalued–and which would serve as a sell signal.

 

This is what I did:

–I decided to make my projection based on 2018 earnings, since I don’t think anyone has the faintest idea of what earnings for years farther in the future will be

–I took the TSLA production forecast, which has proved consistently too optimistic, of 500,000 cars during 2018 as a given

–I decided that most of these cars would be Model 3s, where the average selling price indicated in preorders is about $42,000, as another given.  To account for a small portion of more expensive models, I rounded the average selling price up to $50,000

–I examined other publicly traded auto companies worldwide.  The highest pre-tax margin I found (yes, although this is a dangerous shortcut, I did use margins) was Porsche, at 15%.  I assumed that TSLA would achieve that margin in 2018, even though I think the figure is substantially too high

–I assigned a financial reporting tax rate of 25%, which is probably too low.  That gave me net financial reporting profits of $2.8 billion, and earnings per share of $17.10

–I decided to apply a price earnings multiple of 15x to the earnings number, even though auto companies typically trade at single digit valuations.  I don’t think TSLA should trade at the 20x+ multiple that an IT stock would merit, so 15x seemed about right.  That gave me a valuation, based on 2018 earnings of $257–which I rounded up to $260.

 

As we can clearly see from a TSLA chart, the stock blew through my $260 target in March-April as if it weren’t there.  It peaked, for now, at least, at $386–leaving an embarrassingly large gap between me and it.

 

Where did I go wrong?

The obvious place is in the PE multiple.  The prevailing market view would seem to be that 2019 earnings will be, say, $25/share, and that it’s safe to be factoring anticipated earnings for two years from now into today’s stock price.  Another way of saying the same thing, one which I think must be TSLA bulls’ belief, is that TSLA is this decade’s Amazon (AMZN)

That may well be correct.  Personally, I’m uncomfortable making the bet, though.  One thing experience does tell me, however, is that, barring a total corporate collapse, the stock is highly unlikely to get back to the $180 – $200 range that has marked the lows over the past couple of years.