The Clock Is Ticking for Tesla Motors

A couple of widely used phrases in Investing 101 are never bet against the market and do not think you are smarter than the market. I tend to agree with the first one only. You can be smarter than the market because markets can be unintelligent at times, creating mispriced opportunities. But betting against the market can be risky as you never know how long the market's unintelligence will persist. One such example of market persistence is Tesla Motors (TSLA, Financial). Earnings have been in the red since forever, yet the stock has almost doubled year to date. The primary rationalization is Tesla is a growth stock. Growth is good, but it can only be used to justify a stock’s price by incorporating it into the valuation. Just because a company is on a growth path does not mean it should be valued arbitrarily.

Let’s cut to the chase, Tesla Motors is overvalued even based on high growth assumptions. The company is expensive compared to Amazon (AMZN, Financial) and Netflix (NFLX, Financial), which also have lofty valuations. The company faces stiff competition from giant auto manufactures and is certainly not the dominating player in the industry.

Industry insights

Electric vehicle stock targets, based on country commitments, indicate a compound annual growth rate of 67% during 2015 to 2020. According to the International Energy Agency, EV stock will increase from 0.8 million in 2015 to an astonishing 12.9 million in 2020. Research from Bloomberg Energy Finance predicts a 35% share for electric vehicles in new car sales by 2040. They note that decreasing battery prices will bring EVs’ total cost of ownership below internal combustion engine, or ICE, cars by 2025.

TechNavio forecasts the electric vehicle market will grow at a CAGR of 42% during 2016 to 2020. The firm cites sharp reduction in lithium-ion battery prices to be the key factor for this rosy growth forecast. A dated report from Transparency Market Research, however, forecasted a CAGR of 19.2% during 2013 to 2019.

Overall, high double-digit growth is expected in the EV market going forward, but forecasts range from a CAGR of 20% to a CAGR around 70% over the next five years. Uncertainty in these forecasts makes EV investments like Tesla a high-risk bet. Growth forecasts are not the only problem for Tesla, however.

Tesla has a fundamental valuation problem

The company is trading at a skyrocketing valuation, which can hardly be justified through any metric. Earnings are still in the red and the company faces stiff competition from auto giants going forward.

Jeffrey Gundlach, who oversees over $105 billion in assets at Los Angeles-based DoubleLine Capital, told Reuters,

"As a car company alone, Tesla is crazy high valuation. As a battery company - one that expands and innovates substantially - maybe the valuation can work."

The company recently surpassed General Motors (GM, Financial) in terms of market cap, which is outrageous given the fact General Motors sold 256,000 vehicles during March, while Tesla managed to sell only 76,000 units during the entirety of 2016. Moreover, Tesla’s market cap per car stands at around 100,000 while it is only 5,000 for General Motors. That is based on Tesla’s 2018 unit sales target. Even Tesla’s 1 million deliveries per year target by 2020 cannot justify this outrageous valuation as it reduces the market cap per car to around 50,000.

Focus Equity Estimates

To get a clear picture, analyze Tesla’s pricing structure. Tesla’s car prices range from $68,000 to $138,000, resulting in a mid-point price of more than $100,000. Add the $35,000 Model 3 to the mix, this average price will come down drastically. Now, the market is paying more per car as compared to Tesla being able to charge for it. The company is effectively demanding more money per car from investors than it can make from selling that car.

Look at the company from an earnings perspective. Analysts are modeling for a loss during 2017 followed by EPS of $1.84 during 2018. Earnings growth of 35% p.a. is expected over the next five years. With the assumption of 35% earnings growth over the next five years, ignoring the loss of 2017 and an extreme assumption of 5% perpetual growth, a value of $178 per share can be derived. Note that cost of capital is completely ignored for the purpose of valuation.

Focus Equity Estimates

Note this valuation is based on assumptions I believe Tesla will not be able to meet. Still, the price target falls short of the current value the market has put on the stock.

Let’s do an EVA valuation by taking the growth figures of the industry. Incorporating TechNavio’s 42% CAGR forecast into the valuation also shows overvaluation.

Focus Equity Estimates

Tesla is overvalued by more than 100% based on the rosy EV market forecasts. Additionally, it is not certain Tesla’s earnings can grow at the rate of market growth projections.

Dominating EV market or a delusion?Â

Tesla delivered around 76,000 cars in 2016 while total battery-powered electric sales were more than 739,000 units during 2015, exposing the illusion that Tesla is the dominating player in the market. Tesla managed to cater around 15% of the market, indicating its domination of the EV market is overhyped. What is more interesting is the best-selling battery electric car over the last six years is not Tesla; it is the Nissan Leaf.

Source: IEA (pdf) and Tesla’s SEC filings

Skipping the beta production testing can be problematic

Tesla is ordering the final equipment for production while skipping the industry standard of ordering cheap tools first. The company’s financial woes or timeline pressure can be among the reasons for skipping soft tooling. This could mean more problems with model 3 and an increased susceptibility to increased recalls or warranty repairs. Elon Musk is following a high-risk strategy in order to meet the Model 3 deadline. This can only end well if the company delivers on time, which can be achieved through skipping soft tooling. Timely deliveries, however, might go in the background if the quality is compromised. The point is Tesla can deliver on its 500,000 units promise by increasing the operational risk, but the valuation still cannot be justified by keeping this promise.

Tesla does not compare well to other growth companies

Yahoo Finance and Focus Equity Estimates

Growth companies like Amazon and Netflix do not have PEG ratios as high as Tesla Motors. Earnings are expected to grow at 28% p.a. and 59% p.a., respectively, for Amazon and Netflix, yet they have a lower PEG ratio than Tesla. This indicates the growth argument from bulls is a moot point. Growth can only be justified as long as it can be backed by future earnings. Valuations based on these growth forecasts do not support Tesla’s current price. Nevertheless, Tesla is a very expensive stock even by growth stock standards, as the table above clearly depicts.

Final thoughts

The EV industry will witness explosive growth in the years to come. But it does not give Tesla a pass to trade at a valuation that cannot be justified through incorporating growth. A stock price should be backed by some thesis; growth is the widely cited reason for Tesla. However, there are broad differences in forecasts and there is no visibility for Tesla’s market domination going forward. Moreover, as mentioned above, this growth is incorporated to calculate the company’s value. Even the most optimistic growth projection will not reveal any upside whatsoever. Overall, Tesla is a classic example of how markets can be inefficient. Investors should stay away from Tesla as the stock is up for a major correction going forward.

Disclosure: I have no position in any stocks mentioned and no plans to initiate any positions in the next 72 hours.

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