A few months back, this post by soberlook.com made me sceptical about Tesla (Nasdaq: TSLA) and alternative fuel vehicles in general. Since fuel efficiency is constantly improving, the argument goes, the marginal benefit of switching to a fuel-efficient car decreases exponentially. Put differently, as traditional cars are getting more efficient by the day, it pays less and less to incur the switching costs (higher price, inconvenience…) of alternative fuel vehicles.
From this I deduced that Tesla might never become as mass market as implied by its valuation (USD 35 billion at its peak). Lower oil prices in the meantime are another headwind.
Tesla and Tobin’s Q
And Tesla’s valuation is indeed demanding, as was laid out nicely last week in article on FT-Alphaville. The author uses Tesla’s historic R&D and capex in order to estimate its “replacement” value, i.e. what it would cost somebody to replicate what Elon Musk has done so far. The answer: USD 3.1 billion! Honestly, I was surprised by the low number. For comparison: that’s 50 percent of Apple’s annual R&D. Dividing the current business value (approx. USD 27bn) by the replacement value gives you a Tobin’s Q of 9!
In other words: the market is valuing Tesla at nine times of what it cost to build! This valuation makes only sense if the company enjoys a “moat” resulting in outsized returns down the road – so far Tesla has been loss making.
But, does Tesla’s have a moat?
Let me confess that I am no auto industry expert, but here are my thoughts for what they are worth.
First, Tesla is still unprofitable despite charging Porsche-like prices which leads me to conclude that good, old “economies of scale” is still the name of the game for manufacturing businesses – you need a critical mass of units to cover the fixed costs. Tesla is no exception.
I also hear that Tesla is an amazing vehicle, quite cutting-edge technologically. A lot of bulls make this argument and I suppose they equate superior technology with “moat” in their head.
In order to assess whether Tesla’s technology indeed constitutes a “moat” we have to answer the question of how easy it is to build a top-notch car, i.e. we have to judge the results so far. For comparison, just look at the story of Austrian Formula-1 team Red Bull Racing:
Red bull, an energy drink producer (!), decided a few years back to enter Formula one for marketing reasons. It hired the right people, has spent a meaningful amount of money and competes successfully with the likes of Ferrari and Mercedes ever since. No question, Red Bull’s execution was excellent, and good execution is rare. But, I reason that if Red Bull can dominate the most competitive racing series, building a single good car is doable. Certainly for the likes of Toyota, Mercedes and, maybe, Coca Cola 🙂
To sum up: it seems to me that building a cool and fast car can be done in short time – at least, if you are willing to throw some money at the problem. So, the fact that Tesla can build expensive, technologically advanced cars does not necessarily mean there are barriers to entry – no indication of a “moat” to see here, if you ask me.
Wait a minute! Does this mean car manufacturing is easy?
Of course it is not. After all, we know that there is huge dispersion in profitability between the Toyota’s, the Volkswagens, Porsches on the one hand and the GMs, the Peugeots and the Fiats on the other. And the profitability patterns have been persistent for quite some time suggesting that there indeed is some kind of “moat”. What is it?
It appears, while it is possible to build an excellent car in limited numbers, the challenge is to deliver high quality in mass production AND be profitable at the same time. This is difficult as success depends on a host of factors, such as production processes, reliable supplier networks, logistics and a large and skilled workforce. These are not easy to replicate, take time to perfect (60+ years in the case of Toyota) and therefore constitute a legitimate “moat”.
On the other hand, most tech companies’ “moats” come in the form of network effects. Microsoft Office, Google or Facebook are all about the network and high switching costs. Indeed one could say, efficient production processes and economies of scale are to the car industry what the network is to Silicon Valley. While Elon Musk, Tesla’s founder, no doubt is a marketing genius and a skilled lobbyist and networker, he still has to prove it can deliver on that one. Count me sceptical.
I have long asked myself why established car brands do not already compete with Tesla since they already have electric, or hybrid car series. Especially, because Tesla partially relies on technology from established manufacturers (just as Red Bull does for its Formula-1 car). Now, I have got the feeling they are using Tesla as a canary in the coal mine. Think about it: it is like free market research for them. Should electric cars really take off, they are in a much better position to quickly seize the opportunity capture market share with their capacities already in place. In the opposite, they do not loose any money.
I am reluctant to short Tesla as it is a fashion stock. Given easy money and the ongoing M&A wave, it is indeed possible that Tesla will be taken over at an absurd valuation. The same goes for many other start-ups. I do think, however, that the optimistic valuations we are witnessing in the start-up sphere are reminiscent of the dotcom bubble and are accompanied with a general overvaluation of the market (the only difference between now and then, is that back in 2000 stocks outside tech were at least fairly priced). I usually do not buy index puts and prefer to hold cash instead, but at these market levels they could even have a positive expected value. I am really thinking about setting myself an index target of, say 2250 in the S&P, where I commit myself to buy an out of the money put.
Let’s wait and see.