“We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know at some moment the black horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors,” he continued. “Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking — what time is it? But none of the clocks have hands." – George Goodman (aka Adam Smith), "The Money Game"
Tesla Motors (TSLA) has played a key role in a technological revolution that has transformed and will continue to transform the auto industry. The company has fostered remarkable innovation in – and consumer acceptance of – electric vehicles as a viable alternative to the ubiquitous internal combustion engine.
From breakthroughs in battery technology to breakthroughs in marketing strategy, Tesla has made a lasting impact on one of the world's largest industries. Tesla makes cool electric cars – and has made electric cars cool.
Unfortunately for the company, all its Trojan work and hard-won acceptance of electric cars belong to everyone. And unfortunately for those investors intent on staying long Tesla, the market will eventually realize the truth. I certainly wouldn't want to be in their position when that happens.
Tesla mania
Tesla’s market capitalization has roared upward along with its share price, surpassing those of many industry leaders. Even after last week’s share price drop of more than 7.5%, the company is still up 71.5% year to date.
In April, Tesla cruised past General Motors (GM) to become America’s most valuable car company. While GM reclaimed the top spot for a while, Tesla again has a higher market capitalization thanks to a summer surge that saw it surpass the valuation of European giant BMW (BAMXF, Financial) in early June. The company now has a staggering valuation of about $60 billion.
The market has clearly marked Tesla for a glorious future. But is that valuation at all justifiable? Any sober analysis will find the answer to that question to be a resounding no. Indeed, following in the grand tradition of Tulipomania and the DotCom bubble, Tesla’s eye-watering valuation looks like a textbook case of irrational exuberance.
A problem of misidentification
The fundamental valuation problem is straightforward: Investors are treating Tesla like a persistently high-growth tech stock with essentially infinite green fields and massive margins.
But that is not what Tesla is.
For all its hype and Silicon Valley flimflam, Tesla is ultimately an automaker and exists in a competitive universe full of players large and small, many of which are now turning their attention aggressively to the electric car market. The fundamental economics of automobile manufacturing, along with the rising competitive surge from incumbent companies, makes a $60 billion price tag deeply suspect.
Comparing Tesla’s valuation to other automakers turns suspicion into utter incredulity. Take BMW, which has a valuation roughly equal to Tesla’s. Yet BMW delivered more than 2.3 million vehicles in 2016, including 62,000 electrified vehicles, with pretax group net profit of nearly $8.3 billion. Compare that to Tesla in 2016: 76,230 electric vehicles delivered and a net loss of $773 million. Clearly, something is not right here.
Tesla would need to maintain a rapid and persistent growth rate to come anywhere close to the delivery numbers of its "peers." Taking Tesla's 2016 annual deliveries as a base, and assuming a generous 70% compound annual growth rate, it would take Tesla more than six years to match BMW's 2016 delivery numbers. Yet somehow the two companies have nearly equal valuations. That fact becomes even more laughable when we consider that BMW aims to deliver 100,000 electrified vehicles in 2017, a 61% increase year on year. Tesla clearly does not have the luxury of cruising past stalled rivals. On the contrary, competitors are ramping up their own offerings to compete with Tesla's.
Investment thesis
What I have written so far may sound like a cut-and-dried thesis for shorting Tesla, but that is not quite the case. Trying to halt a speeding car is as dangerous as trying to catch a falling knife (if not more so). The end of the upward run certainly feels close, but it is perilous to guess when the penny will drop. One can be right but at the wrong time. The virtual certainty that Tesla will ultimately fall hard and fast is not the same as getting the timing right.
But recent events do suggest that Tesla is losing some of its sheen. For a company with a growth story dependent on rapid and sustained sales growth, a mounting inventory buildup, as has been reported recently, is a pretty bad sign. Add to that the eyebrow-raising announcement last week that Tesla’s Model S, its new and much-hyped sedan, would not be entered into the North American Car & Truck of the Year competition. While not attending a competition is hardly reason enough to turn against Tesla, it is a signal that all may not be right under the hood.
Short players might determine that the time is indeed nigh, but I generally prefer long plays when I can get them, especially when dealing with a psychologically perilous market.
Another strategy, when looking at opportunities in this industry so roiled by disruptive forces, is to identify other auto companies playing a leading role in the space, but whose share prices are not inflated by irrational exuberance. GM is a solid candidate for this alternative strategy. The American automaker has paid attention to the shifting market and has directed substantial resources to every aspect of next-generation auto, investing in electric vehicles, self-driving technology and even ride sharing.
With Tesla, the key takeaway for investors is that the company is unlikely to lead the auto industry of the future, let alone dominate it. It is already radically overvalued, even if it manages to post sustained sales growth on an unprecedented scale.
Prudent investors with a conservative streak will simply steer clear of Tesla. More aggressive types might find great rewards shorting or buying put options.
Once the market finally realizes that its market capitalization cannot be justified, Tesla will have to reap the whirlwind of panic-selling. Eventually it will settle into a more reasonable price range, but only after investors accept it for the auto stock that it is.
Disclosure: I/We have no position in any of the stocks mentioned.
