Thursday, January 30, 2020

An Ode to Luck: Revisiting my Tesla Valuation

When investing, I am often my own biggest adversary, handicapped by the preconceptions and priors that I bring into analysis and decision making, and no company epitomizes the dangers of bias more than Tesla. It is a company where there is no middle ground, with the optimists believing that there is no limit to its potential and the pessimists convinced that it is a time bomb, destined to implode. I have tried, without much luck, to navigate the middle ground in my valuations of the company and have been found wanting by both sides. For much of Tesla’s life, I have pointed to its promise but argued that it was too richly priced to be a good investment, and during that period, Tesla bulls accused me of working for the short sellers. They did not believe me when I argued that you could like a company for its vision and potential, and not like it as an investment. When I bought Tesla in June 2019, arguing that the price had dropped enough (to $180) to make it a good investment, they became my allies, but that decision led to a backlash from Tesla bears, who labeled me a traitor for abandoning my position, again not accepting my argument that at the right price, I would buy any company. I would love to chalk it to my expert timing, but luck was on my side, the momentum shifted right after I bought, and the stock has not stopped rising since. When Tesla’s earnings reported its earnings yesterday (January 29th), the stock was trading at $581, before jumping to $650 in after-market trading. It is time to revisit my valuation and reassess my holding!

Tesla in June 2019: A Story Stock loses its story!
It was in June 2019 just over seven months ago, when the sky was full of dark clouds for Tesla, as a collection of wounds, some internal and others external had pushed the stock price down more than 40% in a few months, that I took a look at the company and valued it at just over $190 per share:
Download spreadsheet
In arriving at this value, I told a story of a company that would grow to deliver $100 billion in revenues in a decade, while also earning a 10% pre-tax operating margin. One concern that I had at the time was that the debt load for the company, in conjunction with operating losses and a loss of access to new capital, would expose the company to a risk of default; I estimated a 20% probability that Tesla would not survive.  At the time that I wrote the post, I posted a limit order to buy the stock at a $180 stock price, and when it executed a short while later,  some of you pointed out that I was not giving myself much margin of safety. I argued that the distribution of Tesla value outcomes gave me a much larger chance of upside than downside. At the time of the investment, I also described the company as a corporate teenager, with lots of potential but a frustrating practice of risking it all for distractions.

A Story Update, through January 2020
When I bought Tesla, I had no indication that it had hit bottom. In fact, given how strongly momentum and mood had shifted against the stock, I expected to lose money first, before any recovery would kick in, and I certainly did not expect a swift return on my investment. The market, of course, had its own plans for Tesla and the stock’s performance since the time I bought it is in the graph below:

One of my concerns, as an investor, is that I can sometimes mistake dumb luck for skill, but in this case, I  am operating under illusions. The timing on this investment was pure luck, but I am not complaining. What happened to cause the turnaround. There were three factors that fed into the upward spiral in the stock price:
  1. Return to growth: In the middle of 2019, Tesla’s growth seemed to have run out of steam and there were some who believed that its best days were behind it. In the two quarters since, Tesla has shown signs of growth, albeit not at the breakneck pace that you saw it grow, earlier in its life.
  2. Operating improvements: One of Tesla’s weaknesses has been an inability to deliver on time and maintain anything resembling an efficient supply chain. In the second half of 2019, Tesla seemed to be paying attention to its weakest link, focusing on producing and delivering cars, without drama, and even running ahead of schedule on new capacity that it was adding in Shanghai.
  3. Radio Silence: I know that this will sound petty to Musk fans, but Elon Musk has always been a mixed blessing for the company. While his vision has been central to building the company, he has also made it a practice of creating diversions that take people’s attention away from the story line. He has also had a history of pre-empting operating decisions with rash missives (pricing the Tesla 3 at $35,000 and producing 5,000 cars/week) that led to operating and credibility problems for the company. Musk has been quieter and more focused of late, and the last six months have been blessedly free of distractions, allowing investors to focus on the Tesla story.
In earlier posts, I have drawn a distinction between the value of a stock and its price, noting that traders play the pricing game (trying to gauge momentum and shifts) and investors play the value game, where they invest based upon value, hoping for price convergence. While price and value are driven by different factors, in the case of Tesla, there is a feedback effect from price to value because of (a) its high debt obligations and (b) its need for more capital to fund its growth. As stock prices rise, the debt obligation becomes less onerous for two reasons. First, some of it is convertible debt, at high enough stock prices, it gets converted to equity. Second, Tesla’s capacity to raise new equity at high stock prices gives it a fall back that it can use, if it chooses to pay down debt. By the same token, the number of shares that Tesla will need to issue to cover its funding needs, as it grows, will decrease as the stock price rises, reducing their dilution effect on value.

Valuing Tesla in January 2020
There have been three earnings reports from Tesla since my June 2019 report, and the table below shows how the base year numbers have shifted, as a consequence:
Tesla Quarterly Reports & Earnings Call on January 29, 2020
The base revenues have increased by about 9%, and operating margins continued to get less negative (turning positive in the last quarter of the year), as long-promised economies of scale finally manifested themselves. In the table below, I highlight the changes that I have made in key inputs relating to growth, profitability and reinvestment. 
Download spreadsheet
Specifically, here is what I changed:
  • Higher end revenues: My revenue growth rate, while only marginally higher than the growth rate I used in June 2019, delivers revenues of just above $125 billion in 2030, about 25% higher than the end revenues that I forecast a year ago. Since this will require that Tesla sell more than 2 million cars in 2030, I am not making this assumption lightly.
  • Higher margins: My target pre-tax operating margin has also been pushed up from 10% to 12%, reflecting the improvements in margins that the company has already delivered and an expectation that the company will continue to work on a more efficient production model than conventional automakers. 
  • More efficient reinvestment: My reinvestment assumptions for the long term resemble those that I made in June, with every dollar in invested capital delivering $2 in revenues, as the company adds capacity. In the near term, though, I assume less reinvestment, assuming $3 in revenues for every new dollar of capital invested, since Tesla contends in its January 2020 earnings call to have capacity online to produce 640,000 cars, enough to cover growth for the next year or two.
If you are surprised about the lower cost of capital in January 2020, that drop has little to do with Tesla and more to do with changes in the market. First, the US treasury bond rate has dropped to 1.75% from 2.26% in June 2019, creating a lower base for both the costs of equity and debt for the company. Second, while Tesla’s bond rating has not improved dramatically, default spreads on bonds have dropped over the course of the year. Finally, the price feedback effect has silenced talk about imminent default, but I understand that a momentum shift and a lower stock price can rekindle it, and I have halved the probability of default. With this more upbeat story, the value that I get per share for Tesla is $427, and the details are shown below:
Download spreadsheet
If your criticism of this valuation is that I am letting the good times in the stock feed into my intrinsic value estimate, I am guilty as charged, but I have never been able to completely ignore what markets are doing, when doing intrinsic value. To see how each assumption that I have altered feeds into the value, I broke down the value change into constituent pieces.
The biggest increase in value comes from increasing the margin, accounting for a little bit more than half of the value change, followed by higher revenue growth and then by lower costs of capital. Note that the firm’s debt load magnifies the effects of changes in the value of operating assets on equity value, and the options that had dropped in value with the stock price in June 2019, are reasserting their role as a drain on value. If there is a lesson that I would take away from this table, it is that the key debate that we should be having on Tesla is not about whether it can grow. Given the size of the auto market, and the shift towards electric cars, the growth is both possible and plausible. It is about the margins that Tesla can command, once it becomes a mature company, which in turn requires an assessment of what the auto market will look like a decade from now. If you believe that an electric car is an automobile first, and electric next, it will be difficult to reach and sustain double-digit operating margins, if you are not a niche auto company. If, in contrast, your view is that the electric car market will be viewed as an electronic or tech product, you may be able to justify higher margins.

What now?
In the interests of transparency, I should start with a confession. I went into this valuation wanting to hold on to Tesla for a little while longer, partly because it has done so well for me (and it tough to let winners go, when they are still winning) but mostly because at a 7-month holding period, selling it now will expose me to a fairly hefty tax liability; short-term capital gains (less than a one-year holding period) are taxed at my ordinary tax rate and long term capital gains (greater than a year holding period) are taxed at a 20% lower rate. This desire to derive a higher value for Tesla (to justify continuing to hold it) may be driving the optimism in my assumptions in the last section, but even with those optimistic assumptions, my value per share of $427 was well below the closing price of $581 at the end of trading and even further below the $650 that Tesla was trading at after the earnings release. Could tweaking the assumptions give me a value higher than the price? Of course! I could raise my end year revenues to $200 billion ( plausible in a market this size) and give Tesla an 18% operating margin (perhaps by calling it a tech company) and arrive at a value of $ 1,168 per share, but that to me is pushing the limits of possibility, and one reason why I hold back on simple what-if analyses. A Monte Carlo simulation allows for a more complete assessment of uncertainty and in the table below, I vary four key assumptions (revenue growth, target margin, reinvestment efficiency and cost of capital) to arrive at a value distribution for Tesla:
Simulation Results
At the price of $650/share, post-earnings report, Tesla is close to the 90th percentile of my value distribution. While it possible that Tesla could be worth more than $650, it is neither plausible nor probable, at least based on my assumptions.

A Post Script
Holding on to the hope that I could defer my sale of Tesla until June (to qualify for long term capital gains), I looked at buying puts to protect my capital gains, but that pathway is an expensive one at Tesla, given how much volatility is priced into the options. Reluctantly, I  sold my Tesla holdings at $640 this morning, and as with my buy order in June, I don’t expect immediate or even near-term gratification. The momentum is strong, and the mood is delirious, implying that Tesla’s stock price could continue to go up. That said, I am not tempted to stay longer, though, because I came to play the investing game, not the trading game, and gauging momentum is not a skill set that I possess. I will miss the excitement of having Tesla in my portfolio, but I have a feeling that this is more a separation than a permanent parting, and that at the right price, Tesla will return to my portfolio in the future. 

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6 comments:

James said...

I am quite disappointed that you did not use your updated valuation of Tesla as an opportunity to apply the analysis you laid out in "The Big Market Delusion" to the EV market. If ever there were a stock that cried out for a rational assessment of the overall market and the company's likely share of it (as well as the economics attendant to this share), this would be it.

Unknown said...

Your analysis speaks for itself but today's move would have covered a nice chunk of your tax effect. My bet is it touches 1000 before a meaningful pullback.

Edward Brown said...

Prof. D:
Congratulations! Nice result for you and a good teaching example for the rest of us.

I have continued to be consistently wrong on Tesla. I have no position at present but I think the present market cap is nuts.

I was surprised to see you increase the growth percentage on your new estimate. In between your estimates, Tesla barely grew, I think. I believe one quarter they actually shrank YOY.

I don’t expect Tesla to achieve a profit margin materially different than that of GM or Ford either. But as mentioned, I have been consistently wrong!

Again, congratulations and thank you for posting. Respectfully, -Ed Brown

Anonymous said...

Great post. However, I can't help but wonder if the terminal value is overly conservative (2 million cars/$100b revenue in a decade, growing at just 1.75% thereafter).

The global automotive industry produced 95 million vehicles in 2018. If, as many expect, EVs gradually take market share from ICE vehicles, why would we expect the leading EV manufacturer's growth to slow to a crawl after 10 years/2 million vehicles?

Eva S said...

You missed another 50%.

beniamiin said...

Thanks for sharing and thanks again for an interesting read.

I know we should not get caught up in the cost of capital but why is it that it moves toward the median and the cost of capital increases? I would expect the company to be safer if the story you lay out in your valuation comes true. Is it based on rates reverting to the mean (based on the very low rates today, that also caused the low cost of capital of 7.0% currently)

best,
Ben