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Tesla Motors: The Car is Electric, The Stock is Not, Part II

By Elliott H. Gue, on Mar. 24, 2014

Editor’s Note: This is second of my two-part series on how Tesla has captured the imagination of tech-driven investors, but in reality there are much better tech investments in the automobile sector. We’ve already added several of these names to our Wealth Builders Portfolio.

Let’s backwards engineer Tesla’s current share price of nearly $235.

Tesla may be considered “cool” but that doesn’t change the fact that it’s basically a manufacturing firm selling a product to consumers. Industrial companies and manufacturers are cyclical companies exposed to broader economic conditions in their target markets. Industrials are often valued using enterprise value to earnings before interest, taxation, depreciation and amortization (EV/EBITDA) multiples.

Tesla currently trades at over 660 times trailing 12 month EBITDA and 70 times estimated 2014 EBITDA. In contrast, Cummins (NYSE: CMI), a high quality manufacturer of diesel engines with an operating margin similar to what Tesla will ultimately be able to achieve trades at 12 times trailing EBITDA and about 9.3 times 2014 estimates. BMW, a luxury automaker just like Tesla, trades at 9.3 times estimated 2014 EBITDA.

Neither is a completely fair comparison. After all, Tesla will only produce the Model S in 2014 and has viable plans to introduce a Model X SUV in 2015 and the Gen III in 2017, so EBITDA is likely to grow far faster than for established industrial concerns like BMW and Cummins.

To capture a full year of Gen III sales, let’s use 2017 EBITDA estimates to value Tesla.

Currently only three analysts publish estimates for 2017 EBITDA for Tesla. The highest estimate is about $1.423 billion and the low estimate is about $1.110 billion. Let’s take the Street high EBITDA estimate for 2017 EBITDA at Tesla – on that basis, the company still trades at about 20 times 2017 EBITDA.

Forget industrials as valuation peers – even most technology companies don’t trade at 20 times 2017 EBITDA. Social networking giant Facebook (NSDQ: FB), for example, trades at a multiple of about 11 times on an EV to 2017 EBITDA basis today.

And Facebook’s business is less capital intensive than Tesla’s and offers more recurring revenues: advertisers pay Facebook to advertise on their site month after month while Tesla has to sell new cars to new consumers to earn significant revenues. Facebook’s operating margin is close to 50 percent, about 5 times that of most luxury carmakers.

So how could we arrive at a valuation over the current $250 per share?

Sales Figures Are Wishful Thinking

Let’s start by taking a stab at some projections to generate sales estimates for Tesla over the next few years.

We know that the Gigafactory will have the capacity to produce batteries for around 500,000 cars by 2020 and Tesla has indicated that the factory it purchased from GM and Toyota in California was once able to churn out 500,000 cars per year – it seems logical that in a best-case scenario Tesla could churn out half a million cars per year by the end of this decade if there’s enough demand to support that output.

My sales estimates for the Model S and Model X are based on the idea that these two models sell about equal amounts once both production lines are ramped to full capacity. Since the two models have a similar price, it doesn’t really matter much from a revenue perspective which model sells better.

My sales estimates also assume that the average selling price (ASP) for both the Model S and Model X holds steady around $105,000. This implies most consumers opt for the larger 85 kWh battery pack and add on a large number of optional features. It also assumes that the US government continues to offer a federal tax credit of about $7,500 per vehicle to lower the effective cost of the car and stimulate demand.

In my view, these estimates for Model S and Model X demand are more than optimistic.

This year, Tesla expects to sell about twice as many Model S cars outside North America as they do in North America. If that ratio holds through 2020, it would mean that by the end of this decade Tesla is selling about 17,000 Model S and 17,000 Model X cars per year in North America alone.

That means there are over 30,000 people willing to buy a $100,000 car every year in the US and Canada. This implies both models outsell any other luxury car on the market, including many much cheaper gasoline-powered models like the Audi A6 and the Lexus LS.

These estimates also assume that Tesla doesn’t see much of an impact from competing electric vehicles introduced over the next few years.

BMW, for example, plans to introduce the i3the i3 City Car and i8 Sports Car this year and VW plans to start selling an all-electric version of its Golf.

While competing manufacturers seem to face higher battery costs than Tesla today, it’s not a huge jump of logic to think that the major automakers could bridge at least some of that cost gap over the coming 5 years.

The estimates above also assume that Tesla’s average selling prices (ASPs) remain $105,000. Already, Tesla is seeing a bit of erosion in ASPs. Early buyers were primarily wealthy individuals who wished to own a fully loaded version of the car but, as the market saturates, more marginal buyers looking for a base model Tesla will probably represent a growing portion of the customer base.

My estimates for Gen III sales are even more optimistic in my view. Selling mass-market cars is a very different market than selling luxury automobiles and many luxury manufacturers have been burned trying to bridge the gap.

First and foremost, the value proposition of a $40,000 to $50,000 electric car for the mass market is unclear when there are many comparable gasoline-powered models out there offered at a cheaper price with longer range. Even factoring in an 80 percent fuel cost savings, it would take years to offset the added cost of a Tesla Gen III.

And, sales of mass market cars are highly cyclical. In recessions, car sales tend to slump and manufacturers are often forced to offer incentives to tempt buyers. Odds are there will be a recession at some point between 2014 and 2020 and I doubt Tesla will be immune to its effects.

In the US, the average age of cars is now at a record high, implying that consumers are driving their existing cars longer rather than buying a new ride. Is there really an appetite to sell a car as expensive as the Gen III?

And I make the optimistic assumption that most Gen III buyers worldwide are willing to add a lot of options to the base model, keeping the average selling price at $50,000 through 2020.

Of course, there are other, bigger risks. The Tesla battery fire incidents that hit the company in 2013 appear to have been overblown by the media and the statistics suggest the Tesla Model S is every bit as safe as a gasoline-powered car.

Nonetheless, the Model S was introduced in June 2012. It’s unclear yet what sort of maintenance and performance issues might arise over the next few years. For example, the battery pack on Tesla’s Roadster model (now discontinued) was only able to hold about 70 percent of its original charge after about 100,000 miles of driving.

Tesla thinks the Model S battery may perform better but there are no guarantees. If these battery packs deteriorate over time, consumers may not appreciate the significant reduction in the range of the car that results.

To offset this risk, Tesla has offered guaranteed resale values for Model S buyers who wish to sell their cars back to the company 36 to 39 months after delivery. So far, management has said that it believes the fair market resale value will exceed the guaranteed resale minimum Tesla offers. If that holds, this isn’t a major liability for Tesla but we won’t know what the fair market resale value of a model S looks like 3 years after purchase until the second half of 2015. If it’s less than expected, Tesla could be forced to make good on its minimum resale value guarantee at a significant cost.

The Gigafactory Is Giga-hyped

Finally, there’s the gigafactory. This is a huge project and Tesla has made the vague prediction that it will be complete in about three years. That timetable could slip significantly — $5 billion construction projects are major undertakings prone to delays. In fact, assuming that this factory will be completely on time and in the assumed budget is a little irresponsible. If there is a timetable push-back, it would delay sales of the Gen III model as well since Tesla is relying on cost savings from large-scale battery pack production to manufacture the lower cost model.

And, Tesla may also not achieve the expected battery cost savings, cutting its margins on the Gen III or, in a worst case scenario, rendering the car economically unfeasible at the expected sub $50,000 price point.

Bottom line: the sales and revenue estimates in the table above assume that everything goes right for Tesla and there are no hiccups in production or hiccups in the global economy over the next 6 years. If you aren’t laughing at those assumptions, you should be.

Just to be generous, I also assume the firm manages 12 percent operating margins, well above the 10 percent or so common in the luxury auto market. I make this assumption even though Tesla plans to sell lower-margin Gen III mass market cars in greater quantities by the end of the decade.

And, I toss aside the fact that Tesla is a manufacturer and assume the company can trade at a technology-like 15 times EBITDA in 2020 and 3.5 times sales. Using a 12.5 percent annual discount rate on top of these rosy assumptions, this model projects a current valuation for the stock of between $225 and $390 per share at the end of 2014.

Tesla currently trades near the low end of that range but that’s not the issue. My point is that in order to get to the current price, we have to assume a perfect world and a high valuation. We don’t live in a perfect world and stocks priced for perfection have an established track record of disappointing investors.

With sales of over 763,000 units in 2013, Ford Motor’s F-150 pickup truck is by far the most popular model of passenger vehicle sold in the US. The competition isn’t even close – in 2013 the second and third best-selling vehicles in the US were the Chevrolet Silverado and Toyota Camry with sales of about 480,000 and 408,000 units respectively.

And the F150’s dominance is nothing new as 2013 marked the 32nd year with the truck topping the league tables and its 37th year as the nation’s top-selling pickup.

Ford’s popular truck has retained its market-leading position due, in no small part to a history of innovations and improvements.

In January at the Detroit auto show, Ford unveiled its most significant redesign of the best-selling F-150 in decades, a revolutionary shift that’s been rumored for years and is already creating shockwaves through the auto industry.

The company is serious about this change. The company began developing the new technology a decade ago at Jaguar, a luxury carmaker owned by Ford between 1990 and 2007.

But this technology is now ready for the mass market. And Ford is already spending billions to retool its factories to handle the new production techniques and meet the anticipated surge in demand for an F-150 pickup offering close to 30 miles per gallon, making it the most efficient standard-sized pickup on the market.

And Ford is so confident that it’s already working on plans to roll out this new technology across its entire product line-up.

GM is following suit, announcing in February its plans to introduce a vehicle with a similar technology in the 2018 model year.

We’ve identified a small-cap company trading under $13 per share that’s a prime beneficiary of Ford’s new model line-up. Unlike Tesla, this stock is under the radar screen and is currently in an out-of-favor industry group. It’s trading at less than 1 times sales and could see upside of 40 to 70 percent over the next 9 to 12 months.

In fact, our latest portfolio addition is already on the move. Price premiums for its core product are soaring to near record highs; yet, it’s taking advantage of low US natural gas prices and plummeting electricity costs to dramatically reduce its cost structure and boost profitability.

To find out more, we’re offering a risk-free trial to Capitalist Times PremiumSign up at our special introductory rate of $79 per year and download our report on the US auto industry and our latest recommendation. If you decide the publication isn’t right for you, cancel at any time in the first 30 days of your subscription for a full refund, no questions asked.

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