Tesla: Great Business, Speculative Stock

Summary:

• Tesla, Inc. is a rapidly expanding business with a great brand and multiple avenues for future growth.
• The last 3 years have demonstrated immense growth in production capacity, sales, and profits sparking investor enthusiasm, though it is uncertain if this performance can continue into the future.
• Our models indicate Tesla would have to increase free cash flow by 40%/year for the next 5 years to justify current market prices.

Overview and Thesis

Tesla, Inc. (NASDAQ:TSLA) is succeeding in ways most people thought were impossible. If it can be considered a car company, it is on a different playing field than the others, with massive sales growth, minimal capitalization with long-term debt and near 30% gross margins on its vehicles. The company is capitalizing on the shift to electric vehicles (“EVs”) and is expanding into related fields such as energy storage products and solar energy offerings. In addition to its already available electric sedans and SUVs, it promises new future offerings such as the Cybertruck and electric semis. It is also a pioneer in the field of autonomous driving and intends on creating a fully autonomous ride hailing service.

Qualitatively, this company is an investor’s dream, and it is reflected in the share price. Chances are you, or somebody you know enthusiastically owns Tesla shares because it’s pioneering the future. I have no reason to argue with this claim, but when such great enthusiasm is involved, danger signals should begin flashing for any intelligent investor. In order to justify a $600 billion market cap, our models suggest Tesla would need 40% free cash flow (“FCF”) growth per year for the next 5 years, with little room for error. If the company instead is only able to grow by 30% a year in this time frame, our model indicates current market quotations have approximately 30% downside. Therefore, investors should use caution, as buying Tesla shares at current prices is inherently speculative.

The Growth Factor

To say the least, the last three years have been immense for Tesla. When looking at a rapidly expanding tech company, I like to subtract out stock-based compensation (“SBC”) as well as add back estimated growth capex to get a better understanding of free cash flow attributable to shareholders. I used the difference between depreciation and amortization and capex to estimate the latter. For many popular companies, this calculation makes free cash flow look much worse. This is not the case for Tesla, and can be seen in my calculations below:

Adjusted FCF more than tripled from 2020 to 2021 and increased by nearly 50% from 2021 to 2022. Production and sales of their cars have increased almost identically, indicating any production increases are being absorbed by eager buyers. The company may be able to increase sales by almost 40% this year, as they recently reported deliveries of over 420 thousand vehicles, with 1.3 million sold in 2022 for reference. This happened in a time frame where consumer sentiment, though recovering, was close to record lows. This indicates the luxury branding provides some recessionary resiliency. As Tesla has less than 4% market share in the U.S. and around 2% in Europe and China, there is still likely plenty of room for growth as manufacturing capacity increases.

Valuation

I took an optimistic approach to my valuation, as the company appears on track to increase sales by nearly 40% this year and is continuing to aggressively expand production capacity. With scale, there will likely be some fixed cost savings making the marginal car cheaper, which could potentially offset any margin pressure by competitors. Margins are also protected by the company’s strong brand value, which demands a premium from luxury consumers. Optimistically, I assumed the company can increase adjusted free cash flow by 40% per year for the next 5 years, and then grow 4% into perpetuity for terminal value. These calculations can be demonstrated as follows, with an estimated value of approximately $620 billion for the company:

It is worth noting, that this calculation provides little room for error on the part of Tesla. If there are any unexpected hiccups, total returns would be muted. If for example we assumed instead that Tesla was only able to grow free cash flow for 30% for the next 5 years, a much more conservative assumption, our estimated value for the company would only be $435 billion. This would indicate 28% downside from current market quotations. Investors should take note of how much growth is being implied by current market prices and think about if they are willing to take that kind of risk.

Risks

Competition and Reliability

Although at times it seems like it does, Tesla doesn’t operate in a vacuum. Other car companies will continue to improve their electric vehicle offerings and possibly steal market share from Tesla. Additionally, though Tesla is rated above average for electric vehicles by Consumer Reports in terms of reliability (40/100), this rating is abysmal compared to hybrid vehicles of their competitors which scored 78 on average.

Ride Hailing Service Competition

If you have recently roamed the streets of San Francisco, you may have been surprised to see driverless cars zipping around the city. Waymo seems to have a first mover advantage on the driverless ride hailing market, offering services in the city to those brave enough to try it.

Huge Growth is Priced In

As noted in our valuation models, for the current market price to make sense, the company would have to continue to grow free cash flow by 40% for the next 5 years. Profits tracks car production and sales closely, so this would indicate a nearly 40% increase in production and sales per year. By 2027, this would mean the company would need to produce 7 million vehicles per year from 1.3 million in 2022. I am skeptical Tesla can do this without any margin pressure from competitors, though the company increased production by nearly 50% from 2021 to 2022.

Luxury Nature of the Vehicle

Tesla has a great brand, with a reputation for being sleek and top of the line technologically. This can be a boon for many consumer monopoly type businesses, though cars have a much higher price point. There may be a cap on how many cars can be sold, simply because there are less consumers interested in a luxury vehicle.

Reliance on Stock-Based Compensation

For a long time, Tesla has been blessed by a relatively high market capitalization in relation to competitors, allowing the company to minimally dilute shareholders with stock-based compensation. This gives the company a clear competitive advantage, though any reduction in market price could be detrimental to the business model and limit shareholder value realization due to dilution.

Conclusion

Qualitatively, this may be one of the best investment stories out there with multiple avenues for rapid growth. An excellent business must demonstrate its ability to grow in its existing markets and expand into related markets, and Tesla has been doing a fantastic job with this over the last few years with electric cars, trucks, battery packs and solar power systems.

Nonetheless, an intelligent investment must be justified on both qualitative and quantitative grounds, and our models suggest Tesla’s fair value is around $620 billion if we use extremely optimistic metrics for production and sales growth. If instead we assume that Tesla can only grow free cash flow by 30% a year for the next 5 years, estimates for company valuation are reduced to $430 billion. Investors should take note of how much growth is being implied in the current Tesla, Inc. market price, and if that suits their risk tolerance. I personally would not consider a position at current market quotations.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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