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If you have ever driven a Tesla (TSLA) then you know that it is a wild ride, but nothing compared to the Tesla share price in 2020. From the start of the year to 19th February it was up 219% but gave up those gains when it dropped 61% through 18th March. It then sky-rocketing up 498% through 13th July before dropping back 23%. If you like stocks with high volatility then you could not want for a better stock than Tesla.
In every bar and coffee shop everyone is talking about Tesla and its share price. They ask: “What’s going on?” “Can I afford not to be involved?” Others ask: “With triple-digit returns in a few months, is this a good time to cash out and take profit?” The Tulip Mania of 1636 has become Tesla Mania of 2020. So let’s examine the facts and then you can make an informed decision for yourself.
What do we know about Tesla’s price?
The company has yet to break into the black on an annual basis and so without positive historic profit data it is impossible to use conventional earnings metrics as a measure of value. Tesla pays no dividends and so income yields offer no clue as to valuation either. In such circumstances sales become the best gauge of value.
Sales (USD Mil)
Source: Tesla IR and Morningstar
So let’s consider the price to sales (PS) ratio. Market capitalization at the time of writing is $286 billion (based on a share price of $1,544.65). So using $26 billion for sales we have an eye watering PS of 11. Toyota (TM), as an industry comparison, has a PS of 0.65.
What does this mean? Well consider this. If Tesla could convert all of its revenue into profit then investors would earn a respectable 9.1% earnings yield (the reciprocal of 11), but alas no company converts all of its revenue into profit. And so we are able to conclude that at today’s market price it would be mathematically impossible for an investor to receive more than a 9.1% return – this becomes an absolute (albeit unreachable) ceiling.
In fact, after factoring in the costs of sales, operating costs, financing costs and taxes that 9.1% substantially diluted. If Tesla were able to convert half of its sales into profit then 9.1% would become a 4.6% earnings yield for an investor (not particularly attractive now).
So what percentage of sales does the company convert to profit? Well, to date, on an annualized basis, Tesla has never converted any of its sales to profit. Said differently, they have only ever been loss making and all of the sales revenue, and then some, is consumed by the business. In 2019 Tesla lost $862 million, but that was an improvement on the $1 billion loss the company posted in 2018.
Is Tesla likely to become profitable this year? That is the million dollar question. Tesla made a small profit in the first quarter of 2020 amounting to a mere $16 million. If they make the same level of profit in the remaining three quarters of 2020 then they will have generated a total profit of $64 million for the year. Better than a loss, but a drop in the ocean for a company valued as highly as Tesla. On a market capitalization of $286 billion that $64 million profit amounts to an earnings yield of 0.006% (you would be better advised to put your money in risk-free Treasuries). $64m profit would also imply a forward PE ratio of 4,468.
To put things in perspective the average long term PE of companies in the S&P 500 is 15.8 and excellent money making machines such as Apple (NASDAQ:AAPL) only trade on a PE of 28. So how do you feel about buying Tesla on a PE of over four-thousand?
Let’s give Elon Musk the benefit of the doubt in assuming that the company pulls a rabbit out of the hat and generates $500 million in profits this year. That would put the company on a PE of 572. That still does not look very attractive as an investment prospect.
No company has ever maintained a triple digit PE ratio for very long. If Tesla were able to increase its profit to $7.5bn per year then that would put it on a PE of 38 which is more realistic for a growth company in a cyclical industry. But, assuming that a miracle happens and Tesla generates $500m this year, that still implies growth of 1500%. Said differently, it would need to increase quarterly deliveries from about 90,000 to about 1.3 million vehicles, so how likely is that?
What do we know about Tesla sales?
Auto manufacturing is a capital intensive business with logistical constraints. Whereas Microsoft is able to supply unlimited amounts of software at almost no marginal cost, for a car manufacturer to increase capacity it needs extra factories, robots, human resource, parts, raw materials, storage, transporters, etc. So Tesla would not be able up its supply any-time soon even if it was miraculously hit by an increase of 1500% in demand. This was evidenced when the cheaper Model 3 was launched and the company struggled to match supply with demand causing dissatisfaction among customers who were required to wait far longer than anticipated for delivery.
So we know that increasing supply is likely to be slow even in good economic times. But the global auto industry has been knocked on its back by COVID-19 and has experienced a 39% drop in sales year on year, the biggest fall since records began.
Notwithstanding the pandemic, Tesla delivered approximately 90,650 vehicles in Q2 2020 (it was Tesla that used the word “approximately” when announcing the data so we are unsure of the exact number). There are three points worthy of note here.
First, is that in the same period the company only produced 82,272 vehicles and so delivering more than you are producing implies either a capacity squeeze on the company or else an anticipation of a decline in demand going forward.
Second, is that there seems not to be an expansion in deliveries but a contraction. Q2 2020 may have seen 90,650 vehicles delivered, but that is down on Q2 2019. In fact, both Q1 and Q2 in 2020 saw a lower number of vehicles delivered than in each of the three previous quarters of 2019.
Third, is that deliveries are for cars sold at some earlier date. There is no such thing as immediate delivery on a vehicle which needs to be produced to the specification of the customer and then registered before delivery. And so many of the deliveries in Q2 2020 would have been cars ordered in Q1 prior to the coronavirus outbreak. So it is safe to assume that deliveries in Q3 will be negatively impacted by a fall in Q2 sales while the world was locked down.
What do we know about Tesla’s 2020 prospects?
The market seems to be taking Elon Musk at his word that Tesla will “comfortably exceed” 500,000 units delivered in 2020 (a 36.2% increase over 2019’s level) but based on deliveries in Q1 and Q2 both being well below target, that is looking like a mathematical impossibility. Tesla would need to deliver in excess of 160,000 cars in each of Q3 and Q4 to make that happen. Looking at the chart above and the deteriorating COVID-19 situation, do you think that is likely to happen?
Tesla produced impressive 2019 numbers that appeared, on the face of it, to show strong growth. But was it all smoke and mirrors? Of the $24.6 billion in revenue that Tesla generated in 2019 much of it was buoyed by a fourth quarter number just shy of $7.4 billion which itself was boosted by Tesla bringing forward some of its 2020 sales. While borrowing 2020 sales may be a neat management trick in respect of 2019, it is one that will make it more difficult for the company in 2020. Small wonder that Q1 2020 sales dipped to $5.9 billion.
Not only were sales pulled forward thus negatively impacting 2020 prospects, but Covid19 has caused a shock to both supply and demand in the car market. If that were not bad enough, competition in the electric vehicle (EV) sector is heating up from other well established car manufacturers. None of this bodes well for Tesla in 2020.
What do we know about demand for Tesla cars?
Tesla’s unit sales are in fact plummeting, hence the recent price cuts announced by the company. Lower sales coupled with lower prices is not a good thing for any business.
Looking outside of the United States, in February before the Corona-virus hit, Tesla’s sales fell 68% in the Netherlands and 92% in Norway.
Why are these countries so important? Well Norway, for example, has a huge government subsidy on electric vehicles and approximately 75% of all new cars sold in that country are electric. You would think that makes it a great market for a company such as Tesla. However, in February 2020 Tesla sold a grand total of 83 vehicles in Norway versus 1,016 in February 2019. That’s a huge decline and indicates how strong competition is becoming from other manufacturers.
Below is a list showing EV car sales in Norway for the month of May 2020 and for the first five months of 2020. In the list, the new models are green and the models that were recently rejuvenated with at least a bigger battery pack are yellow.
The table demonstrates an awful lot of competition for Tesla and the impact on its sales is evident for all to see. If this is an indicator of the way the market for EVs is going, Elon Musk will need to scale back his ambitions somewhat.
Norway is the most important EV market outside of China. But in China things are not very much better for Tesla. Auto insurance statistics show that Tesla is well short of the 3,750 vehicle registrations per month that it had forecast.
Even at home in the United States where Tesla once boasted complete domination in the EV sector, other auto manufacturers have invested heavily in R&D and are now providing substantial competition. Ford (F), General Motors (GM) and BMW (OTCPK:BMWYY) for example are eroding the market share of Tesla.
What do we know about the share price of Tesla?
Vehicle deliveries are flat to declining, market share is being lost to competitors and in a cyclical industry such as car manufacturing the industry is in a pandemic induced deep crater.
And how has the market responded? As the chart below shows, the share price is up 800% in the past year. The price of shares seems to have run a long way ahead of the underlying value of the stock.
Tesla is a great innovative company that deserves plaudits for the impact that it has had on the move away from combustion engines towards cleaner electric technology. But, as the great Benjamin Graham said in The Intelligent Investor in 1949, “even a wonderful company at the wrong price makes for an awful investment.”
On May 1, Elon Musk himself tweeted that “Tesla stock price is too high [in my opinion]” and that was when it was trading at a mere $800. Now the share price is close to double that at close to $1,600! If it was overvalued then according to the man who ought to know, what does that say about it now?
The share price of Tesla appears not to be based on the future prospects of the business nor on its recent performance.
Each wave of investors is instead fueling the gains of those that invested before them. And as the price climbs higher so more investors blindly jump in. And the process continues. This is known as the greater fool theory: Notwithstanding the underlying value of a security, provided that there is a greater fool than you willing to pay a higher price than you paid, you’ll make a profit! The problem arises when others stop buying and you were the last to buy as Sir Isaac Newton discovered.
What can we learn from history?
In 1720, Sir Isaac Newton, having lost today’s equivalent of $5m on shares in the South Sea stock, is quoted as having said “I can calculate the motion of heavenly bodies, but not the madness of people.”
Do you see any parallels in the shape of the South Sea share price curve (below) and that of Tesla (above)?
Source: Marc Faber
By way of another more recent example, let’s look at Texas Instruments (TXN). The company was the darling of the stock market in the 1990s. From 1995 to 2000 the company increased its earnings by a factor of ten but over the same period so many investors bought its shares that the share price expanded by 55 times. Needless to say, the price subsequently corrected by 80% as the chart below demonstrates.
Again the shape is the same. Notwithstanding the company being an excellent business, when its shares are overbought then the market price runs too far ahead of intrinsic value and a correction ultimately occurs. The similarity in the sharp overbought spike in price of Texas Instruments with that of Tesla in 2020 is overwhelming.
People seem to be buying Tesla shares not on the basis of a rational long term investment, but rather as some form of lottery ticket hoping for a short term win.
Will Tesla shares go higher in the short term perhaps reaching $2,000? Probably. Will Tesla shares experience a sharp reversal at some point? Without doubt. It cannot possibly produce enough earnings in the near term to justify its market price. Be reminded that Elon Musk said that the share price was too high. As Benjamin Graham said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” Price and value ultimately converge.
The situation therefore becomes one which is not too dissimilar to playing Russian Roulette. If you invest in Tesla at this kind of price level you may walk away smiling, but sooner of later someone will be holding the revolver to their head when the bullet fires. Good luck if that is your idea of fun. It’s not investing. It’s pure speculation and the further the shares climb, the more the odds are stacked against you.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.