On the morning of Sept. 22, just as investors were getting ready to reconcile the chatter leading up to Tesla's (TSLA -4.45%) Battery Day against what the company would announce that afternoon, one investor sounded a cautionary note regarding the electric car manufacturer's valuation, tweeting:
For reference, EBIT are earnings before interest and taxes, and "RegCredit" refers to regulatory credits, which are Tesla's major profit engine.
The author subsequently deleted the tweet -- he scrubs his account regularly -- but he's been insistent with this warning: This was at least the third version of a tweet that first appeared on Aug. 31, the day Tesla's split its stock 5-for-1.
Meet Michael Burry: Doctor, hedge fund manager, contrarian
The tweet was from Michael Burry, a doctor turned hedge fund manager played by Christian Bale in the The Big Short, the film adaptation of Michael Lewis' eponymous account of the housing bubble and the investors who scored enormous returns by betting against it.
Just as Burry spotted the bubble in the housing market early on, he might be onto something with his suggestion that Tesla shares are in a bubble of their own. There are three hypotheses that would allow us to square the numbers in his stark comparison:
- The market expects Tesla to dominate the global auto industry, capturing over a third of its aggregate value.
- The market expects Tesla to mutate into something different than a pure-play auto manufacturer, such that the comparison between its valuation and that of the auto industry is meaningless.
- The market is beyond caring about Tesla's long-term fundamental prospects. Tesla's current market capitalization is the product of a speculative mania and bears no relation to any reasonable assessment of the company's future prospects.
Even giant redwoods don't grow to the sky. Tesla's valuation looks stretched. Image source: Getty Images.
There's no "winner-take-all" in the auto industry
With regard to the first hypothesis, let me first state that the competitive dynamics of the auto industry don't allow for "winner-take-all" outcomes. Note, for example, that Toyota (TM 1.93%) -- the world's second-largest auto manufacturer and a model of manufacturing efficiency -- captured "just" 23% of the $100 billion in global auto industry profits that Michael Burry referred to in his tweet. That statistic provides some context for the notion that Tesla will capture 35% of the value in the industry.
To quote a widely respected authority on corporate finance and valuation (more from this figure below), "[auto manufacturing] is a sector, where earning excess returns has proved to be difficult even for the best of firms." Earning excess returns is an absolute prerequisite for any firm that aspires to capture a third of an industry's total value.
Electric vehicles are no Holy Grail for value creation
Furthermore, the transition to electric vehicles or autonomous vehicles will do nothing to increase Tesla's chances of grabbing that better-than-one-third slice of the value pie because Tesla has no advantage in autonomy and no enduring advantage in batteries (the far-fetched plan to mine Tesla's own Nevada lithium claim that Mr. Musk announced on Battery Day notwithstanding).
The second factor is critical because electric battery cost is the largest component in the difference in the cost of manufacturing an electric car versus a car with an internal combustion engine (currently, every car manufacturer, including Tesla, loses money on the electric cars it builds).
First, Tesla has no relevant proprietary battery technology; in fact, it doesn't even manufacture the lithium-ion batteries that power its vehicles -- Panasonic does.
Furthermore, within the next five years, Tesla will have lost any scale/cost advantage it may have had with regard to batteries. Indeed, the world's largest auto manufacturer, Volkswagen, expects to produce up to 330,000 electric vehicles next year, with a target production of 1.5 million in 2025 and is currently building a battery cell factory with an annual capacity of 16 gigawatt-hours in a joint-venture with Swedish battery manufacturer Northvolt. Tesla will struggle mightily to achieve its guidance for 2020 of delivering 500,000 vehicles (it produced 184,944 units in the first half of the year).
Tesla's dwindling brand advantage
Credit where it's due, Tesla does have a competitive advantage in its brand, but this "moat" can only help protect its existing franchise as a niche luxury car manufacturer (and even that will be challenging).
The brand currently enjoys an intangible appeal and cult status with a small population of affluent first adopters. But the mass market is where the rubber meets the road, so to speak, and it simply won't tolerate Tesla's abysmal manufacturing quality and service (Tesla was ranked dead last in JD Powers' 2020 Initial Quality Survey, with 50% more problems per vehicle than the industry average).
Moreover, flourishing brands enable companies to raise their prices without suffering customer defections; they don't lead them to institute price cuts, as Tesla has now done repeatedly.
Add to that an onslaught of competing electric vehicle models (which has already seen Tesla's market share plummet in Europe this year), and we can reasonably exclude the idea that Tesla will ultimately capture 35% of the value of the global auto industry as wildly remote.
Four stories for Tesla
The second hypothesis, that Tesla's valuation simply reflects the market's expectation that it will mutate into something other than a pure-play auto manufacturer, is more open-ended and trickier to tackle, but I found an excellent resource: a meaty blog post by Aswath Damodaran. Professor Damodaran of New York University's Stern School of Business is arguably the leading authority on corporate valuation and has been following Tesla for years.
In his Feb. 6 post, Damodaran lays out four different "stories" for Tesla's future and values the company accordingly. The first three, "The Big Auto Story," the "The Techy Auto Company Story," and "The FAANGy Auto Company" relate to our first hypothesis and don't come anywhere near justifying the current stock price. ("FAANG" refers to five popular high-growth tech companies.) The optimistic "FAANGy Auto Company" scenario tops out at an intrinsic value estimate of $241 per share (split-adjusted). This result bolsters our decision to reject the first hypothesis as fanciful.
As its name suggests, story four, "The Make-your-best Company," allows for a more ambitious vision of Tesla's future and is better suited to examining our second hypothesis. Selecting only the very most favorable assumptions, it gets us to a fulsome valuation estimate of $2,106 per share pre-split: about $421 split-adjusted.
Tesla's stock closed at $442.30 on Monday.
Why "Make-your-best Company" is risky
The risk here is that the $421 valuation is built on a set of disparate assumptions about Tesla's future that are nothing short of miraculous and assume such a miracle is a certainty. Or as Damodaran warned, back when the stock price was just below $150 (split-adjusted): "With the [Make-your-best Company] story, you are approaching the most dangerous place in valuation, where you pick and choose each assumption, without considering the ones you have already made. Put simply, is it even possible to build a company that generates revenues like Toyota, earns margins like Microsoft and invests more efficiently than any manufacturing company in history has ever done, while still preserving the low cost of capital of an auto company?"
In other words, if Damodaran is right, buying (or owning) Tesla's stock at that price represents an "all-in" bet on a vision of the company that's scarcely conceivable.
A subset of Tesla investors are making this very bet; they believe in an extraordinary future for the company and that this future is so likely as to be nearly certain.
Consensus view or crowd momentum?
It's hard to believe that this is the consensus view, i.e. that this view of Tesla's fundamental prospects has now prevailed and is setting the current stock price.
This brings us to our third hypothesis, that Tesla's stock price is the product of a speculative mania. This article examined the first two hypotheses and found them lacking. As a result, the "bubble hypothesis" remains as the most likely explanation for the recent price action in Tesla's stock. And clues that momentum has overwhelmed all fundamental considerations are in plain sight.
Consider Aug. 31, the day Tesla completed its 5-for-1 stock split: Investors bid the price up 13% on the day, raising the company's market value by the same percentage. The last time you cut a pizza into slices, by how much were you expecting the size of the pie to increase?
