“Wow, Elon Musk!”
That was the cathartic cheer and cry of relief in millions of American homes on May 30, after two months of forced confinement, when the SpaceX Falcon 9 rocket and Dragon Capsule lifted off from Cape Canaveral carrying two American astronauts bound for the International Space Station. It was the first ever manned SpaceX mission and the first time since 2011 that an American-made rocket had taken Americans into space. SpaceX is of course one of Elon Musk’s companies.
As if on cue on the very next day, Musk’s other monster rocket, Tesla stock, blasted off again and shot out of its range, adding nearly 8 percent to reach $898.10, a level that was more than double its March low of $361.20. Days later, the boosters fired again and lifted the stock above $1,000 and then once more, after a two-week pause, to $1,500, where it is now taking a brief respite in the orbit of companies valued at $300 billion.
There in the stratosphere, the stillness of space envelops the investor as it does the astronaut. Escape velocity has been achieved for shareholders, some with many, many millions in profits, leaving the earthbound shorts (people who bet against the stock) but a small and distant memory to be mockingly blotted out of view.
These shorts, hopelessly weighed down by what’s left of traditional investment discipline, have (so far) lost a cumulative $18 billion in vain expectation that the Tesla rocket would reverse, crash, and burn. All they can do now is stare at their screens and argue to whomever will still listen that this stock rocket will eventually come back to Earth.
Not necessarily. Consider Amazon, Apple, Microsoft, launched long ago and now heading deeper and deeper into the trillion dollar galaxy.
The question then is whether Tesla, though much smaller today, can one day join the outer reaches traveled by these companies, or whether it will crash as so many hot stocks have in the past. Tesla bulls are confident that it can maintain its current trajectory, a belief that is owed in no small part to the faith that they have in Elon Musk.
It’s A Car Company
In its surge on July 13, Tesla stock climbed 15 percent in the morning, adding about $40 billion to its market value. But later in the day, stock indices retreated and Tesla ended the day in the red, giving back the morning’s $40 billion gain and then some. Each one of these $40 billion moves, up and then down, corresponded to the entire market value of BMW or of Daimler (owner of the Mercedes brand). So Tesla added one full BMW and gave back one Daimler within the same day.
As of July 15, Tesla’s market value stood at $287 billion — $120 billion more than the entire German auto sector comprising BMW, Daimler, VW and their various brands (VW owns not only Volkswagen but also Audi, Porsche and other nameplates). These German automakers sold a combined 16 million cars last year, generating an industry net profit of nearly $24 billion, while Tesla sold 367,500 cars at a net loss of $862 million.
Tesla cannot be valued on its earnings, which are nonexistent or too low. On a price-to-revenues measure, it is trading at 11.7x 2019 revenues. If you allow a 30 percent revenue increase in 2020 (unlikely, but let’s be generous), it is now trading at 9x 2020 revenues. By comparison, BMW’s stock is trading at 0.37x 2019 revenues and Daimler at 0.23x.
The bulls, unfazed by these extreme disparities, make the following argument.
It’s Not A Car Company
Their main belief is that Tesla is not a car company but a technology company. As such, they argue that it should trade at multiples usually associated with tech companies rather than with the auto sector. The price-to-revenues ratios of all auto makers are below 1x or even below 0.5x, well below the ratios of the tech giants, which exceed 5x. Apple, Amazon, and Google all trade near 6x their 2019 revenues. Microsoft is near 12x and Facebook near 10x, close to Tesla’s current 11.7x.
So what exactly is that proprietary Tesla technology? It is in the batteries, the software and any resultant changes to other components.
In batteries, Tesla has a significant advantage in range (the number of miles an electric vehicle can travel on one charge) over other electric vehicle (EV) manufacturers. The average range for other EVs in the US (excluding Tesla) is 170 miles, but it is 300 miles for Tesla cars. According to Gene Munster, a widely followed analyst at Loup Ventures, the optimal range is 400 miles, a level already reached by the Tesla S Long Range.
The ultimate challenge for EV makers, however, is to deliver the highest possible range at the lowest energy input and battery weight. Analyst Matt Joyce developed a core efficiency rating to measure each vehicle: Tesla is clearly ahead as shown in the table on this page. Munster predicts that Tesla will gradually bring battery production in-house, a move that will allow it to cement its lead over other companies:
The disadvantage of vertical integration [in-house production of batteries] is billions of dollars in capital expenditures related to factories and production equipment, along with the high cost of recruiting and maintaining in-house technical design and testing talent. The most significant advantage is that product design cycle times decrease, which quickens the pace of innovation, which is Tesla’s central competitive moat.
The other important Tesla technology is software for myriad applications but eventually culminating in the Holy Grail of fully-automated driving. Musk said this month that he expected Level 5 autonomy (fully-autonomous driving under all conditions) to be available before the end of 2020.
From a financial standpoint, the issue of whether Tesla is a car company or a tech company comes down to the question of its gross margin. Auto manufacturers have much lower gross margins, usually in the 10 to 20 percent range, than technology companies. The German automakers have gross margins of 20 percent or a little lower while the American tech giants all have gross margins near 40 percent or higher. Facebook has the highest, with 82 percent. Apple delivered 38 percent in 2019 and Microsoft achieved 66 percent.
What accounts for this difference in gross margins between the automakers and the tech companies? To make it simple, it is the marginal cost of production, the cost of producing one more unit. When Ford gets an order from a dealer to make a new car, it has to procure all the materials to make that car: the aluminum, the steel, the plastic, the copper wiring and so on. And that’s before all the finished or semi-finished components made by its suppliers, the wheels, the tires, the door locks, the electronics, the small motors that power the windows, the wipers, the list is almost endless. For an auto company, therefore, the marginal cost of production is heavily weighed down by the cost of raw materials and of components sourced from other companies.
Now contrast, say, Microsoft. When it receives an order for its online Office Suite of applications, the cost of this one incremental “unit” is negligible, as the software is downloaded directly online by the buyer. All that Microsoft has to do on its end is ensure that it has a sufficient number of servers and enough capacity to service this new buyer.
So going back to Tesla, we have to recognize first that it may not be only a car company but it is also a car company. It does produce cars after all and it has to source the materials and components to assemble cars just as Ford does.
Here, the bulls argue two things. One, that Tesla has far fewer parts because it does not have a traditional engine and that therefore it will eventually sharply reduce its cost of production (and improve its gross margin) as its volumes rise. Two, that Tesla’s proprietary technology is so great that its gross margin will eventually rise to 30 percent or higher, within striking distance of Apple’s gross margin. This will occur if Tesla’s battery advantage is sustainable and can command high pricing, and if its mobility software develops quickly enough to become the industry leader. Indeed, even today before Level 5 autonomy, Tesla has been selling its software at $7,000 a piece at a margin of 90 percent, according to Munster.
Whether in batteries or in software, Tesla could then claim a leadership position in products that have low or very low marginal costs of production.
Blue skies and cautionary tales
If we consider Apple as a reachable margin benchmark, we could speculate that Tesla would deserve a price to sales of 5x some future year’s revenues if it managed to reach a 35 percent gross margin.
In order to justify the current market value of $287 billion, Tesla would then need revenues of approximately $57 billion (287 divided by 5) and a gross margin of 35 percent. How likely is that in the next two or three years? These revenues do seem achievable by 2023 given the annual growth that the company is seeing. As to the margin, it will all depend on how soon Musk delivers on Level 5 autonomy, and on the pricing and margin of that product. It is certainly conceivable that Tesla will be selling a large quantity of self-driving software by 2022 or 2023.
That is one of the bets made by the biggest bull on the stock, a fund manager named Cathie Wood at Ark Invest, who has set a “base case” price target of $7,000, which would give Tesla in a few years a market value of $1.3 trillion, placing it alongside today’s Apple, Microsoft, Amazon and Alphabet/Google in the small club of trillion dollar companies.
Ark’s analysis is available online and it rests on two assumptions. One is that Tesla will be able to cut its production costs and raise its gross margin in line with Wright’s Law. Developed by engineer Theodore Wright (1895-1970), this law holds that the cost of production declines as volumes grow due to economies of scale and experience-curve effects. The other assumption embedded in Ark’s base case is that Tesla robo-taxis (driverless taxis), autopiloted by Tesla software, will be a big thing within the next three or four years. Tesla would then compete with — or, better yet, replace — Uber and Lyft at a fraction of their costs.
Perhaps. Perhaps this will all come to pass. The history of investing shows that we ignore visionaries at our own peril. But it also shows that we should trust them at our peril too. More to the point, market moods change even when facts don’t. The stock market, we all know, can be volatile and even those investors who believe in a long- (or even medium-) term view would be wise to keep an eye on the near-term. Buy and hold is a sound approach to investing mainly if one buys intelligently.
If for example you had bought Amazon stock at the peak of the 1999-2000 bubble, you would have by now made your money 30 times over ($10,000 invested then would be $300,000 today), but only if you had had the nerve and the financial resources to stay with it every day since then. On the way to riches, you would have first lost 94 percent of your investment in the 2000-01 bear market. If you had held on despite your $10,000 being reduced to a meager $600, you would have recovered nearly all your losses slowly by 2008, only to then lose 65 percent again in the 2008-09 financial meltdown. Your commitment to keep your then $3,300 invested would have paid off nicely in the great bull ride of 2009-2020.
On the other hand, if you had placed $10,000 in Amazon stock at its 2001 bottom, you would have today $5 million in capital gains, but here again, only if you had had the stomach to hold on through thick and thin.
The cautionary tale writes itself. A company’s future value does not necessarily determine its stock price in the near term. Whether one takes a position in Tesla today or waits for a possible pullback is for every investor to decide based on their own appetite for risk. That is what makes a market.
And yes, it is also possible that the bulls are wrong and that competition will keep margins well below 35 percent. Or that Musk is exaggerating Tesla’s potential. The founder of Muddy Waters, a research house that has been negative on the stock in the past, is unsparing in his criticism of what many regard as Musk’s undisciplined communication style.
Spirit of the times
No stock trades in a vacuum. There are outside factors that appear to have contributed to Tesla’s rise. With “socially responsible” investing (SRI) on a seemingly inexorable rise, foundations, endowments, and funds that vowed to dump their fossil-fuel holdings and to green their portfolios have fewer investable options than they might like. Their new guidelines make it much more likely that they will buy and hold Tesla stock.
It is not hard to see the company’s attraction to investors wanting to be seen to be doing the right thing. Other, more pragmatic, investors may have no interest in SRI, but may like the idea of speculating on the demand for stocks that will benefit from SRI’s rise.
The latter is an example of a phenomenon, brilliantly described by John Maynard Keynes, who realized that an important aspect of money management amounts to anticipating how other investors would behave. He compared it to a game:
in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces that he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. . . We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.
And of course, in considering the rise of the Tesla stock, we cannot ignore the enormous stimulus pumped into the market by the Federal Reserve and by Congress, which have created a melt-up in brave-new-world growth names of which Tesla is one of the most prominent examples.
The Falcon 9 rocket is designed for reuse. At the end of each mission, it effects a smooth landing back on earth. Musk’s challenge is to soft-land Tesla’s valuation by delivering strong results for many years. Whether he can do just that and then relaunch it periodically towards outer space is for every investor to decide. Whatever happens, this voyage will be one for the history books.
Please note that Mr. Karam may at times have a position, whether long or short, in any of the stocks mentioned herein. This article should not be treated as investment advice.