July 23, 2020
Tesla reported their Q2 results last night and the market is sounding impressed. Marketwatch has this headline: “Tesla’s blowout earnings prompt bulls and bears to boost price targets“.
The Tesla story has been a long road full of unusual action in markets and the current quarter is no different. The company is overpriced, perhaps by ten times (1000% too expensive) using any reasonable measure, yet the stock’s ascent has been ferocious.
There is plenty to read about the company elsewhere and this post is simply to counter that argument that Tesla had blowout earnings. Their earnings were nothing even close to blowout, in fact the results (linked here) show that Tesla had just a 1% increase in revenue (quarter over quarter) and a 5% drop in revenue (year over year).
Tesla has many fans and there are many ‘explanations’ for the high valuation of the company and they include:
- Tesla is not a car company, rather a technology company and their technology is going to change the way we use cars.
- Tesla’s energy business is going to revolutionize the way we store and manage electricity.
- Tesla cars will provide a service revenue stream when their self-driving technology makes their cars robo-taxis.
- Tesla has the largest BEV market share and so will dominate the market for a long time
- Tesla has a significant lead on battery technology and so will continue to dominate the industry in prices, range and therefore margins.
There are other arguments, but these are probably the largest contributors. There are problems with these arguments, which may be worth reviewing, but the real issue is that the economics of making Tesla cars are not all that appealing.
The reality is that Tesla doesn’t make any money from producing and selling cars. In their most profitable quarter (Q2, 2018), Tesla made $1,456 per car after backing out regulatory credits. They did that without paying for a dealership network and without paying for advertising. Certainly avoiding the overhead of these costs seems pretty cool, but it is unlikely to last.
This number may not be clear to anyone listening to the celebrations amongst company executives, some analysts and fans of the car and technology, because this number excludes Zero Emission Vehicle (ZEV) and other regulatory credits.
Many of the other car makers in the world are penalized for not selling or not selling enough zero or low emission vehicles and to avoid penalty, they purchase credits from Tesla, with an excess of credits. Tesla (wisely) generates significant revenue from that relationship, at least for now.
When this revenue is backed out of their automotive profits, they have never made an annual profit.
Note the three charts below. Tesla cars delivered, Total automotive revenue, and profit per car. In the Profit per Car chart, the orange bars reflect their GAAP profit per car with regulatory credits subtracted.
This distinction is important, although there is a thread of acceptance regarding ‘what does it matter where the profit comes from?’, but when valuing a company, the source of revenue and it’s persistence is very important.
It is reasonable to expect that the use of battery and hybrid vehicles will grow substantially. That has happened, very aggressively, in the 13 years since the introduction of the Toyota Prius, and even Tesla’s growth has been substantial, particularly given the short period of time since the Tesla model 3 was introduced. The growth however appears to be slowing and quite dramatically.
Look again at the cars delivered chart. In the third quarter of 2017, Tesla began producing the Model 3 for the North American market. As they setup their manufacturing facility and ramped up production the company faced many problems and, according to CEO Elon Musk, was days away from bankruptcy in 2018. Ultimately they resolved the production problems and delivered cars to customers. With huge pent up demand, the company succeeded in selling every model 3 they produced in the second and third quarter of 2018.
In 2019, Tesla began to sell their cars aggressively in Europe and being a cool new thing, sales went very well. Tesla was the best selling electric vehicle for a while. Then in the fourth quarter of 2019, Tesla began selling their cars aggressively in China with the opening of the Shanghai plant (allowing them to do so without import duties). These boosts in sales can be clearly seen in the cars delivered and the automotive revenues charts above.
Beyond the initial ramp of sales in the second and third quarter of 2018 (that’s two years ago!), Tesla has not had any significant gains in sales. Their revenue has flat lined and is actually declining. After spending billions to build their plants (and suffering appropriate losses) the company’s profitability is stalled at close to break-even. In fact, if you back out the regulatory credits, they have never made an annual profit.
As the company neared bankruptcy in 2018, many naysayers pronounced that the company was doomed. It is not doomed any longer. There is a fighting chance that Tesla becomes a significant major player in the automotive landscape, however there is no evidence that it will be a significant profit making machine.
For some perspective on that, there are about 60-70 million cars sold in a typical year worldwide. Tesla sells about 400,000 cars a year currently, making it about 0.6% of the worldwide market. According to InsideEVs, 2019 saw the purchase of 2.2 million electric vehicles, and Tesla made up just 18% of those 2.2 million vehicles. In the very niche market of electric vehicles, Tesla appears dominant, but the competition is really just starting.
In 2020, sales data for Europe to date shows that Tesla has remained strong, but their Q1 market share has dropped to just 9% (from 18% last year) while overall EV sales in Europe have climbed 41%. One year does not make a trend, either for the superiority of Tesla, or for the increases in competition taking away their crown. At best it would be wise to assume that the market is growing and competition is robust. Further volatility in market share should be expected.
Of course the same is true in China. The boost in sales in the final quarter of 2019 was directly related to substantial deliveries in China. The same is probably true for the first quarter of 2020, although results begin to get muddled by the COVID-19 pandemic which started around Christmas in China before arriving in North America in February.
What is known is that the company has not experienced explosive growth since the start of mass production of the model 3 in the middle of 2018. Another way to consider this is that their original, North American market is about 350 million people (about 110 million cars). Europe opened the market to another 440 million people (about 200 million cars), and China, over 1.2 billion people (and about 270 million cars). Yet sales have not skyrocketed.
There are a lot of unknowns as to why sales are not ramping up rapidly. The company suggests that it is a production bottleneck and therefore they are growing production in China (Giga Shanghai) and Germany (Gigafactory Berlin) and the recent announcement for the ‘Cybertruck’ near Austin Texas. Other factors may be at play.
The COVID crisis cannot be overlooked in the 2020 results, however the lack of growth in 2019 suggests that there may be other factors at work. The price of the cars may be reducing adoption. Even a modestly equipped model 3 is priced around U$45,000 and is about 25% more expensive than the AVERAGE purchase price for a car in the US (around U$36,000 in 2019*).
There are other problems. Range anxiety, styling, usage/fit for purpose and other issues will always be around. Some problems are company specific. There have been widely reported quality issues, service problems and lack of charging infrastructure. Some of these may be resolved over time, however they will raise costs for Tesla and reduce profitability even further.
The thrust however is that Tesla is too expensive. Because they don’t make money selling cars, they are not showing any growth, they have growing competition and they have a niche product it is hard to see how this valuation is justified. A number of valuation metrics are shown below with a comparison to other car makers and other technology companies.
There are plenty of analysts that are providing mathematical, comparative and emotional justifications for the current valuation, and the hopeful can latch on to these analysis but some macro analysis may be more appropriate.
There is an expectation (IEA, Global EV Outlook) that in 2030, there will be 75 million EVs versus the 4.8 million at the end of 2019. Overall, McKinsey puts Tesla at about 16% market share worldwide**. If they were to rise to 20% market share of 75 million vehicles by 2030, then they would sell 15 million vehicles over the next 10 years. For the sake of simplicity, if we assume they sell two million cars per year at the peak, and were just as profitable in that year as their best quarter yet (third quarter of 2018, they made $1,456 per car after backing out ZEV credits), they would earn $2.9 billion.
If you then use Volkswagen’s price/earnings ratio, you would find that the company might be worth $61 Billion. While the comparison with Apple is raging currently, and their businesses are vastly different, in market dynamics, revenue streams and more, still one can make the comparison. Using the Apple price/earnings ratio, we find that Tesla might be worth $72 Billion in 2030.
It is currently trading at $300 Billion with sales of under 400,000 cars.
Of course it is possible to adjust a lot of things not discussed here. First of all, Tesla has another business, energy generation and storage. This analysis has ignored it because Tesla has failed to make any significant progress in the business, and there is vast competition in this space. An assumption could be made that the company may become more profitable, but this is unlikely as their key components become less expensive (think batteries), competition will reduce pricing to compete and win market share. It is just as likely that they will have to spend more money on advertising, on model refreshes, on service and support and more, as competition increases.
There is speculation that they could generate revenue from ‘self driving taxis’ and this could happen, but it is more likely that Tesla will separate this off into a stand alone company for reasons of liability and valuation.
Another area that is ignored is the technological achievements of Tesla, both proposed and actual. These include self driving cars, where Tesla has been making promises for many years (and it is worth noting that they have been booking revenue for this capability despite the fact that it is not production ready, which is an SEC violation). While Tesla has impressive technology and may even be first to market with this capability, others will surely follow with similar technology so any lead will diminish relatively quickly. A final area is battery technology, where many highlight the ‘lead’ that Tesla has in this area, again, the vast research in this area will make their lead obsolete within a few years as a practical matter.
The excitement over Tesla and the great work they have done and continue to do is normal in a ‘new’ or ‘revolutionary’ market. The classic disruption gets a lot of attention and Tesla is at the centre of many emerging technologies, but as mass adoption occurs, the excitement dies down and economics becomes the driving force.
Purchasing Tesla shares is a gamble on perfect execution. While the company deserves some premium for the many innovations they have developed and will continue to deploy, none of that comes without significant cost, and those costs include failure, they include heavy R&D spending, they include turnover of key personnel and more. If owning shares of Tesla is necessary, be prepared for low and possibly negative returns over the long term.
*Note that the median is likely to be much lower. For example, the top eight best selling cars in America all have top configurations that sell for less than 36,500. If EVERY one of the top eight cars sold in the US in 2019 was the highest price version of each model, the median price of a car would be around $30,645 before taxes. A significant portion of the population still buys less expensive versions!
**Note that Tesla’s market share in the US and Europe is falling, but rising in China. Worldwide, Tesla’s market share has risen in 2019. All of these numbers are in a niche, fast changing market, so drawing conclusions should be considered speculation due to short term nature of the data.