Ludicrous Mode

Tesla is a hot company; the stock is even hotter. Charged up by sexy products and an eccentric CEO, the company and its stock attract a diverse range of passionate aficionados – from trader-bros in their parents’ basements to hedge fund moguls in glitzy skyscrapers; and, may we add, a few rational investors who happen to be Buylyst subscribers – we’re doing this analysis for them. Trader-bros and hedge fund moguls are welcome too.

We’ve never invested in Tesla. We’ve always wanted to, but every time we dug in, TSLA seemed too expensive for us. In other words, the stock price at each stage required us to be a little too optimistic about the company’s prospects. Needless to say, the market constantly disagreed with us. There were 2 occasions when we could have bought TSLA, but we didn’t (in hindsight, regrettably): 1) in the summer of 2019 and 2) in April 2020, right after the Covid-19 market crash. But regret is never useful.

We’ve comforted ourselves with a Buffettism: we’d rather commit mistakes of omission than commission. So far, the only real downside of omitting TSLA has been a nagging indigestion caused by perennial FOMO. We had made peace with all that until Tesla decided to do a 3-to-1 stock split a few days ago. Some of our subscribers had a sudden FOMO attack. We caught some by email osmosis.

We know that the stock split does nothing to increase or decrease Tesla’s intrinsic value. It does, however, make the stock accessible to smaller investors with a more manageable ticket size. Imagine an investor that has $10,000 in “play money” and believes in a reasonable amount of diversification; with TSLA now closer to $250 per share after the split, this investor can allocate about 2.5% of her portfolio with one share. Before the split, one share of TSLA would make up a minimum of 7.5% of the portfolio – not exactly sleep-well-at-night investing.

For the past week, we’ve been experiencing some of that FOMO indigestion again. But we never let FOMO drive our decisions. TSLA doesn’t get a free pass. More importantly, we don’t want our subscribers to go in blind. While this analysis is not meant to preach what our subscribers should or shouldn’t do with their money, it is about delineating “what they need to believe” to buy into the Tesla story.

The Tesla story is well known, and we won’t pretend to have any inside knowledge; nor are we Elon worshippers. So, we’ll keep this analysis succinct and mostly numerical. We thought about the type of Tesla analysis we’d like to see, and we couldn’t find anything on the internet that was definitive enough…actionable enough. Most of them waxed eloquent about how Tesla is really a tech company, and how its amazing self-driving software will conquer the world. These articles were all fun to read and even informative, but the numbers attached to those stories seemed fuzzy and arbitrary. In the case of one famous investor (who shall not be named), the projections were flat out comical.

Well, we could be wrong again. But we’d rather miss out IF those comical projections do come to pass. We never want to willingly participate in manic euphoria that doesn’t manifest into reality. The latter is inexcusable in our books. But maybe, we thought, investing in Tesla today doesn’t require manic speculation. In this analysis, we’ll put some definitive markers down on what we need to believe about Tesla to consider buying its stock. Here’s a good starting point:

Would you believe that Tesla can generate 40% annual revenue growth over the next 5 years? We’ll spend the rest of the analysis unpacking this Buycast – not a forecast,…a Buycast. More on that later.

Here’s what’s coming up:

1. The TSLA Buycast
2. Sanity Check: Revenue Growth Buycast
3. Sanity Check: Cost Assumptions
4. Short Story: Positives & Negatives
5. Appendix 1: Cash Flow and Buycast Details
6. Appendix 2: Global Passenger Car Sales

Ludicrous Buycast?

We’d like to think that we invented the term Buycast; probably not, but we’re going to keep using it anyway. You saw the Buycast in the previous section. So, let’s start unpacking that. Here’s where the Buycast of 40% “annualized revenue growth we need to believe” comes from:

If you’re confused, don’t worry. We’ll keep unpacking this. The point of the Buycast is to paint a picture of the company in the future that justifies, in our opinion, its current stock price. We need to make a few assumptions to do that. This is not a science, so we won’t pretend to have figured out the secret to investing. This is about making reasonable assumptions, devoid of euphoria or despair.

We’re going to delineate our process first, and then unpack its most salient parts in the following sections. If you’re not a nerd like us, congratulations! Please feel free to skip to the next section. Remember, we’re just trying to estimate “what we need to believe about Tesla to consider buying the stock today…”

What needs to happen:

1. Return Requirement: 50% in less than 5 years.
2. Desired Stock Price: Add 50% to current stock price and we get around $415/share.
3. Desired Free Cash Flow:
   1. We assume that Tesla will maintain its current share count – they certainly don’t look like they need to rely on external financing to fund growth.
   2. If the share count stays the same (it could decrease as well), then it’s an easy conversion to the “required market capitalization” by multiplying “required price” by the share count.
   3. Then we divide the “required market capitalization” by 20 to get our “required free cash flow”. More on this in our last Buy Scan.
4. Now it’s time to “move up” the cash flow waterfall to back solve into “revenue growth we need to believe…”. That involves making some cost assumptions.

Cost Assumptions:

1. Future Cost Structure:
   1. Depends on Gross Margin and Fixed Cost assumptions
2. Future Gross Margin:
   1. Same as last 12 months ending 6/30/2022, which is about 27%. Auto companies tend to have low gross margins. Tesla has, by far, the highest gross margins in the business.
3. Fixed Costs:
   1. R&D Expense increases at a rate of 10% per year for 5 years – we expect more investments in software and fast-charging technology.
   2. Selling, General & Administrative Costs increase at 5% per year for 5 years.
4. Capital Costs and Taxes:
   1. Increases in Working Capital neutralize to $0 on average over a 5-year period.
   2. The long-term debt load and, therefore, cash interest costs remain roughly the same as 2021 – which is around $266 million per year.
   3. Cash Tax Rate is 21%.

When we combine “what needs to happen” with the Cost Assumptions listed above, we arrive at our Buycast:

1. Revenue Buycast: $361,235 million…that’s $361 billion. And therefore…
2. Revenue Growth Buycast: 40% annualized over the next 5 years

Let’s unpack these numbers some more.

Sanity Check: Revenue Growth Buycast

Here’s the chart you saw before:

Is this believable? It’s a little hard to say when we see it on the chart above because Tesla doesn’t have a long history as a mature company.  So, we asked ourselves, “how many cars does Tesla need to sell in our Buycast scenario?”

To come up with a reasonable answer we had to make some reasonable assumptions. Before we list them out, it’s useful to paint a picture of what Tesla’s business looks like:

OK. Now we can list our reasonable assumptions:

1. Tesla’s revenue growth will be fueled mostly by Model 3/Y sales. That’s certainly been the case over the last couple of years. We expect this trend to continue.
2. The bulk of the revenue growth will, therefore, come from the Autos segment. But let’s assume that the Energy & Other segment won’t be a slouch either. Let’s assume that its revenue will double in 5 years. That’s approximately a 15% annualized revenue growth rate.
3. Within the Autos segment, let’s say that Model S/X sales will also double in 5 years – also a 15% annual growth rate.
4. Pricing Assumption – we assume that prices will decrease by 5-7% with increased competition. Here’s what we assumed:
   1. Model S/X Average Price: $80,000
   2. Model 3/Y Average Price: $50,000

The north star in all these assumptions is our Revenue Buycast of $361 billion. That’s the given objective. The assumptions above – about Model S/X sales & Energy revenue growth are the constraints in this equation. The OUTPUT is “Model 3/Y sales in 5 years. You saw the progression of revenue segments and Auto Deliveries earlier. Here are the charts again, now updated with our Buycast:

Do you find this believable? Again, it’s hard to compare this to history because Tesla is not a mature company. But there are 2 other ways to answer that question - subjectively:

1. What market share of global passenger vehicle sales would the Model 3/Y line represent in the Buycast scenario?
2. Where in the totem pole of the best-selling passenger vehicles would this Model 3/Y Buycast be placed?

To answer the Market Share question, we need to put down some markers:

1. Let’s assume that the total number of passenger cars sold in the world 5 years from now will be around 65 million annually (see Appendix 2 for details).
2. We won’t count any future releases like the Cybertruck or their big Semi Truck.
3. We’ll add up the Buycast or both Model S/X cars and Model 3/Y. That adds up to about 6.9 million cars.

6.9mn cars out of 65 million is approximately 11%. 

To consider buying TSLA today, we’d need to believe that Tesla’s market share would be about 11% in 5 years. Believable? Well, here’s the best data we found for the current market share totem pole:

Basically, we need to believe that Tesla will be right up there with Toyota and Volkswagen, assuming those two giants get their act together on EVs. Based on Tesla’s current demand, we can safely say it’s possible that it will be one of the top automobile companies in the world in 5 years. But is it probable? That leads us to our second question:

If the 3/Y line of cars makes up most of Tesla’s sales, where do they stack against the current toppers?

To answer that question, we need to make another adjustment: Let’s split the Model 3/Y Buycast in half – so, each model, 3 or Y, will account for half of the Buycast. So, to consider buying TSLA, we’ll need to believe that Model 3 and Y sales will be roughly 3.4 million units (annually) each. Where does this number stack up?

Do you find this easily believable? You could, if you believe two other sets of events:

1. Tesla successfully introduces more lineups – like the Cybertruck or a Model Z (?) – that will also sell like hot cakes a la Model 3.
2. The other Auto companies will still be fumbling with the EV rollouts for the next 5 years.

Both these scenarios can happen. We believe that it is possible that Tesla will be the top Auto company in the world. We just can’t get around to believing that its probable. At best, we can give it a 50% chance. That won’t justify the current stock price. This is a purely subjective call based on our numbers.

Speakin’ of subjectivity…

Short Story: Positives & Negatives

The Tesla story is well known, so we won’t dwell on it. Right off the bat, we’ll list the most salient positives and negatives, in our opinion:

Positives: 

1. Macro/Policy Tailwind: 
   1. There’s a seemingly unstoppable momentum in EVs. Tesla kick-started it, and it’s bound to be one of the leading participants of it. Most developed countries are committed to the EV revolution. Even if they achieve half of these objectives, It looks like serious acceleration over the next 8-10 years.
2. Products: 
   1. Tesla’s products evoke emotion, mostly positive ones. Reviews are good, and most owners love their purchase. Feel free to google Tesla reviews.
3. Software: 
   1. Many analysts claim that Tesla’s software for running an EV geartrain and for Autonomous Driving is far ahead of competition. This may be true. Software may be Tesla’s insurmountable Moat. But we have no way of confirming or quantifying it.
4. Founder/CEO: 
   1. Tesla has a visionary founder CEO. Founders who make good CEOs are rare. Based on products and numbers alone, Elon Musk happens to be one of them. But also see Negatives…

Negatives:

1. Competition: 
   • It’s clear that Tesla has sub-par competition currently. Combustion engine behemoths like Volkswagen and Toyota are scrambling to execute a smooth transition to EVs. The substantial cash flow from the combustion cars are too good to pass up, which creates some (apparent) ambivalence in making the commitment to become bona fide EV companies. We’ve been saying that the German trio of Daimler, BMW, and VW will make a big plunge and use their production efficiencies to slow down the Tesla juggernaut. We’ve been wrong so far…but not completely…see below.
2. Elon: 
   • Well, he’s an enigma. While we’re always optimistic about founder-CEOs, Elon is as unpredictable as they come. His regular bouts and rants about political issues (which we believe was behind the otherwise inexplicable Twitter drama) are unnecessary distractions. His other interests, we fear, could lead Tesla astray. But we can’t attach a probability to this eccentricity harming Tesla’s numbers. Maybe he really is a real-life Tony Stark. But we can’t dismiss the possibility of a reputational blowback on Tesla sales, especially once VW, Toyota and Daimler offer compelling EVs. Obviously, we can’t quantify this blowback.

About Ze Germans: It’s not that the Germans aren’t serious about EVs, but they haven’t dominated the way we thought they would. Maybe the pandemic slowed things down. Maybe it’s the fact that range anxiety is still widespread, which keeps their combustion/hybrid cash cows alive. But despite still being predominantly combustion car companies, Volkswagen and Renault seem to have made some inroads into Tesla’s domain, at least in Europe.

Sanity Check: Costs & Margins

Since our Buycast – of revenue growth and, hence, Model 3/Y sales growth – relies heavily on our operating cost assumptions, it’s only fair we show you why we think our assumptions are reasonable.

The first 2 charts show you how, in our opinion, we’ve been fair in our assumptions. The last chart is an output of the first 2 AND our revenue Buycast. We always like to do a sanity check by comparing the output – EBITDA and Free Cash Flow margins, in this case – to past data. Overall, we’re satisfied with our assumptions – they’re not ludicrous.

So, what should we do?

We are not going to buy TSLA at this point. We’re just not going to be able to sleep well at night hoping that Tesla can consistently generate 40% revenue growth annually for 5 years. It can happen, but the subjective probability we attach to it is lower than 50%.

An interesting question is, “at what price would we buy TSLA?” For us, it comes down to “revenue growth we CAN believe”. This is subjective, but maybe with a Buycast (revenue growth we’d need to believe for a 50% upside in the stock) of about 30%, we’d be on the fence. We can see ourselves being rationally exuberant about a 30% annualized revenue growth rate over the next 5 years. Coincidentally, that’s what the market has priced in, based on our estimates. So, if Tesla’s revenues were to grow at an annual clip of 30%, the stock doesn’t have much upside.

We’ve made a chart that shows what we believe is a reasonably fair price for TSLA at each revenue growth assumption. So, now we’re not back solving anymore – we’re going the traditional route of plugging in a growth input for Revenue and getting a Free Cash Flow estimate based on some cost assumptions. The output in our analysis so far – revenue growth – becomes an input in this case. We’re just doing this to give you a better sense of what you need to believe.

We believe TSLA is at least fairly priced, which means there isn’t any (rational) upside or any margin of safety (for things to go wrong), however you want to look at it.

Appendix 1: Cash Flow & Buycast Details

Appendix 2: Global Passenger Car Sales

Source: International Organization of Motor Vehicle Manufacturers