Tesla: Great cars, ordinary investment

The hype over Tesla’s (NASDAQ:TSLA) new Model 3 is exceeded only by the hype in the company's share price

After unveiling its Model 3 recently, the excitement over Tesla (NASDAQ:TSLA) and its founder Elon Musk has only increased. Who can’t but admire Musk as he leads the transition from the internal combustion engine to electric powered vehicles?

Yet in my view the hype over the Model 3 is exceeded only by the hype in Tesla’s share price. At US$257, Tesla has a market capitalisation of around US$34bn compared to US$46bn and US$50bn for General Motors (NYSE:GM) and Ford (NYSE:F), respectively.

To put these figures in perspective, Tesla sold 51,000 cars in 2015 whereas GM and Ford sold 3.6 million and 3 million respectively in North America alone (and millions more around the world). Unsurprisingly, whilst its two US-based rivals made billions in operating profit, Tesla recorded an operating loss of US$720m.

Despite this, Tesla sells for an enterprise value to sales multiple of 9 compared to 0.6 for General Motors and 1.1 for Ford, although its gross margin at least is double that of its rivals.

Ordinary financials

Of course, Tesla is still a young, fast growing company and, along with its expansion into the mass market segment of the car industry with the Model 3, also has a nascent energy storage business.

Nevertheless, whilst investors may ignore fundamentals in the short term, over longer periods earnings, cash flow and balance sheets matter.

Here, things are more sobering. Tesla’s US$720m operating loss obviously doesn’t cover interest on its US$3bn in convertible debt. Moreover, it still has more than US$1bn to spend completing its Gigafactory in Reno, Nevada – and this is assuming Tesla only pays US$2bn of the total estimated cost of US$4-5bn – as well as expanding its sales, servicing and charging networks and getting its Model 3 into production. With deliveries of the Model 3 beginning in late calendar 2017 at the earliest, it won’t generate any income for Tesla for at least eighteen months.  

Scale matters

The company initially focussed on the premium end of the electric vehicle market (eg the Model S) to develop its brand, technology, development and production expertise before mounting an assault on the mass market segment.

In terms of its brand at least, Tesla has certainly been successful: 325,000 people have already submitted a US$1,000 refundable deposit to reserve their Model 3.

Unless you’re Ferrari (NYSE:RACE), however, the car industry is one in which scale matters. It costs hundreds of millions, if not billions, of dollars to develop a new model, satisfy the myriad of safety and environmental regulations, and ultimately get it manufactured and out on the road.  

Tesla believes that further economies of scale along with reductions in the cost of batteries will enable it to sell the Model 3 profitably at its intended starting price of US$35,000 (before relevant US Federal and State tax credits).

Perhaps it will be successful but competition is likely to be much more fierce compared to that faced by its earlier, premium vehicles. Whilst there are significant barriers to entry to the car industry – including capital, economies of scale in research and design, manufacturing and advertising, a distribution network, and so on – existing car manufacturers have much lower barriers to entry (or ‘mobility barriers’ to use Michael Porter’s terminology) to the electric vehicle segment.

Moreover, their financial resources and existing research and design teams, production and distribution networks mean they will be formidable competitors in this area. For example, General Motors has just announced its Chevy Bolt electric vehicle will be available later in calendar year 2016 for US$37,500 before tax credits and will have a range of 200 miles, slightly less than the Model 3. 

Moreover, the ‘traditional’ car manufacturers’ financial resources mean the electric charging networks necessary to support their electric vehicle fleets will be built, either separately or as part of a consortium. Their financial strength and other businesses also give them the option to price their electric vehicles below cost if they so choose.

Tesla has previously relied on word of mouth and media coverage to advertise and as the reaction to the Model 3 launch showed, this is still a powerful marketing mechanism. Yet even Apple (NASDAQ:AAPL) – whose users are equally as loyal as Tesla car owners – constantly advertises to keep its products in the public consciousness and battle ferocious competitors. 

With competition ramping up, Tesla will likely have to resort to advertising to differentiate its products from the competition. Whilst it sold far more vehicles, General Motors spent more than US3bn on advertising last year.

Capital raise?

Even if Tesla’s Model 3 is a raging success and its energy storage business highly profitable in the longer term, increasing operating losses, rising debt (although the US$330m in Model 3 deposits will help, at least temporarily) and significant capital expenditure requirements mean further capital raisings are likely on the cards.  

Moreover, there’s no guarantee that Tesla will meet its Model 3 production deadline and in fact earn significant profits in coming years yet shareholders are assuming this is almost certain at current prices. 

I hope Tesla and Musk succeed but I'll be watching from the sidelines.

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