Is this worse than 2000? The case of Tesla Motors

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.

Conclusion

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.

 

 

 

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5 comments

  1. Your probably right that the valuation is stretched, but focusing on the business I think the Red Bull analogy isn’t great. The battery is probably a much more important piece of the Tesla story and I wouldn’t be surprised if in a decade they turn out to be an advanced battery manufacturer who happens to sell cars. See here: http://venturebeat.com/2014/08/01/how-teslas-battery-gigafactory-could-change-everything-not-just-electric-cars/

    Battery manufacturing should benefit from scale and IP advantages, but since Tesla has given away their IP maybe that competitive advantage no longer exists. I don’t know enough about the technology to say what the barriers to entry are, but I know batteries have been notoriously difficult to produce and improve over the years.

    I still think you have to be mad to be an owner of the stock given it seems nearly impossible to predict how this all shakes out. That being said I still wish there were more people in the world like Elon Musk.

    1. Mike,
      analogies are never perfect. That’s just how I (a layman) was thinking about the problem. Your point is valid…
      I also do not understand why he gave away the patent, I feel Musk is more focused on “changing the world” than to generate shareholder returns, probably that’s why.
      I am also not so sure that batteries – or electric cars for that matter – can solve the carbon crisis (assuming ther is indeed a carbon crisis). Most people seem to forget that the electricity usually has to comes from conventional sources (coal, atomic…)..How this is supposed to improve carbon emissions is beyond me
      I have just read you link and could not detect anything special about Tesla with respect battery technology. As I understand the guy plans to decrease battery costs by boosting capacity. Fine, this should work. but probably there is a reason why nobody has built such a large factory in the US so far. Could it be that it is uneconomic? The problem with batteries, as I understand, is not that we do not know how to produce them cheaper (Scale), but how to improve their energy input/output ratio….Unfortunately there is nothing about that in the article..
      (I admit, I read it quickly so I might have overlooked something)
      rgds

      1. I did laugh the first time someone pointed out that the slogan for Tesla ought to be “Powered by Coal.”

        As far as improvement on carbon emissions it is more about matching inconsistent supply with inconsistent demand. I.E. storing solar energy that is captured during the daylight hours and using it during the evening when there is peak demand. I have seen estimates on how much energy we are currently wasting due to lack of viable storage options, but I’m having difficulty recalling the source at the moment. The Economist had an issue a few months ago that briefly touched on some of the topics.
        http://www.economist.com/news/technology-quarterly/21635331-matching-output-demand-hard-wind-and-solar-power-answer-store
        http://www.economist.com/news/technology-quarterly/21635332-jb-straubel-charged-more-electrifying-californian-carmaker-he

        On the problem with batteries my understanding is that both your points are correct, but reliability is also a significant issue. Lithium-Ion has historically had problems with overheating which causes fires exhibited in the Boeing 787 roll-out a few years ago.

        That being said we are vastly approaching (perhaps beyond) my knowledge base on this issue and there is a lot of uncertainty which as an investor would prevent me from being interested other than reading about it for general worldly wisdom. Also if your a believer in the capital cycle like I am, with the sheer amount of dollars (and rumors flying that giants Apple and Samsung will soon be joining) being thrown at this problem it seems likely returns will be sub optimal or perhaps negative for a significant amount of time. On Telsa itself the range of outcomes is probably extremely wide and at current prices the market is probably pricing in a high (inappropriately high?) chance of success. But, I think there is a lot of overly simplistic analysis on both the bull and bear sides that does not acknowledge that at this point the range of outcomes probably encompasses both a (much) lower stock price and a higher one which makes it an unattractive long or short in my opinion.

        Also since this is my first time commenting I want to compliment you on the work you’ve done on this blog. Very intellectually stimulating and I hope you continue for the foreseeable future.

        Best,

  2. I have shorted TSLA off and on over the years. It’s been a good reminder to not short things with open-ended upside potential, no matter how ridiculous the fundamental case. My main catalyst was that the lack of logistical/operational infrastructure would start to dog the company as it scales volumes, but no one really seems to care about the mounting operational risks or the manufacturing complexity that will come with moving beyond being a one-model hobby car company into a sustainable platform. This company is on a very long leash with the Street; I’ve never been on a conference call where management pauses the call to come up with an answer to a q and the stock ticks up in after hours…

    That said, I still think the fundamental short case is quite strong and its not the worst thing to have in a long/short book, as I would think that at this point it has to be pretty asymmetric to the downside…

    With batteries (and I’m by no means an no expert here), my understanding was that Tesla has taken conventional technology and pushed it to the max, blocking a bunch of old school batteries together to get something capable of powering a high-performance auto with reasonable range. Achieving the next level of performance will require a quantum leap in materials science and is by no means a new engineering problem, with batteries having advanced fairly immaterially in many many years. While Tesla did run laps around the incumbents in some respects with their dash UI and other neat little ideas, this is a much bigger challenge to solve and its questionable that they have the resources to compete in this against GM/Toyota/VW, all of whom are very interested in all kinds of next-gen technologies.

    That said, maybe they have the talent to do this. They have some very highly regarded engineers; could JB Straubel be the Ferdinand Porsche of the 21st century? I wouldn’t want to bet on them at this price, but the short is by no means riskless in this perspective.

    But you’ve hit on the fundamental issue for this company; everyone in the auto business talks obsessively about scale and there has been the story of the past decade in the auto biz – gain scale, max out platform volumes across engine/drivetrain packages, and leverage R&D across a focused multi-brand portfolio. VW is the extreme of this model.

    Could Tesla do this independently? Probably not. Porsche is a good comp given the ‘concentrated’ line-up, and one can imagine Model S/X/3 volumes as being roughly comparable
    to the 911/Cayenne/Boxster. That said, even with Porsche’s heritage (which counts for a lot in this price range; these are emotional purchases), there were questions about their ability to survive independently, even with their substantial platform sharing deals with VW (which probably owed a lot to the intertwining familial history; its not clear Tesla could sign deals like this with a Toyota or GM). The benefit of having Porsche within VW seems to be pretty clear at this point and if it was questionable that Porsche could survive on its own I have my doubts about Tesla.

    There is definitely M&A value, but definitely not at this valuation and I sincerely doubt Musk would ever sell. On the other hand, Elon Musk was brilliant in catering to conspicuous green consumption, and I think Peter Thiel’s characterization of their strategy in 0 -> 1 is pretty fair. Musk is a compulsive, driven visionary so who knows what he could do. With enough wheeling and dealing he could yet make a horse race of it…

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