Saturday, February 4, 2023

Control, Complexity and Politics: Deconstructing the Adani Affair!

The India Rising story hit some turbulence last week, as one of its biggest corporate success stories, the Adani Group, was hit with a report from Hindenburg Research, an investing group that specializes in targeting and shorting companies that it believes have dubious accounting and business practices. In response, people have fallen into two groups, with the Adani family and its supporters arguing that the short selling report is a hit job by a "foreign" entity to bring down not just the company, but also the country, and others noting that the report just reinforces what has troubled them about the company's meteoric rise in the last decade. I will confess that I know very little about the Adani Group, and I have nothing invested financially or emotionally in the company's fortunes. If you are looking for advice on whether you should buy or sell Adani shares, based upon my analysis, you will be disappointed. Instead, I will argue that the ingredients that led to the Adani stock price meltdown last week, which include an ambitious family group obsessed with control, a financial market where trading momentum trumps financial fundamentals and a capital market (debt and equity) where governments and regulators put their thumbs on the scale, are embedded in many Indian companies, and represent the weakest links in the India story.

The Lead In

    As noted in the introductory paragraph, I start from a position of ignorance about the Adani Group, and it thus made sense to fill in that gap. In doing so, I will undoubtedly bore those of you who have followed the company closely, and know far more than I do, and I apologize. 

The History

    The Adani Group, founded by Gautam Adani, started life as a commodity trading partnership business in Gujarat, and listed on stock markets in 1994, as Adani Exports, with a large chunk of its revenues coming from its operation of a local port in Mundra, with a subsequent entry into the edible oil business. The group's investments were regionally concentrated, but over time, they have expanded into other businesses and across India, and while I seldom draw on corporate presentations, I will make an exception and use a slide from Adani's January 2023 pitch to describe their business mix:

Link to Adani Corporate Presentation

With the exception of Adani Wilmar, a food processing business that has recently been bolstered by acquisition of leading brands, the rest of the Adani businesses share some common characteristics. First, they are infrastructure businesses, requiring large up-front investments and having long gestation periods, with regulatory and government oversight. Second, an increasing proportion of the company's investments are related to energy, in green energy and gas transmission/distribution, but the company's most significant investments are in logistics, especially in airports and ports . While each of these businesses is operated by a stand-alone Adani company, the businesses flow through a holding company, Adani Enterprises. The percentages of each company that is held by the Adani family is shown in brackets in the picture, and we will return to examine the implications later in this section.

The Rise to Market Prominence

    The Indian economy, in general, and Indian public markets, in specific, have always been dominated by family group companies, with many of the family groups tracing their history back a century or more. Given the historical roots of the biggest Indian family groups, the Adani Group has been a recent entrant, not making the top ten list (in terms of either operating metrics like revenues or market-based numbers like market capitalization or enterprise value) as recently as ten years ago, and barely making the top ten list five or six years ago. That has clearly changed, and at the start of 2023, four Adani companies were in the top twenty Indian companies, in terms of market capitalization, and the collective value of the seven publicly traded Adani companies was $220 billion (17,600 billion), greater than the market capitalization of Reliance, the Ambani family flagship, and India's largest company. In fact, for a brief period  at the start of 2023, Gautam Adani was the second richest man in the world, based upon his holdings in his group's companies:


The surge in market capitalization at the any company, by itself, is not surprising, especially after a decade where companies (like Tesla and Facebook) have added (and lost) hundreds of billions in market capitalization in individual years. The surprise, though, is that this dramatic boost in market capitalization happened at a family group built around infrastructure businesses, where investors have to wait for decades for payoffs, and often not driven to sudden changes in value assessment.

Adani's Operating History

    In an attempt to understand Adani's rise to market prominence, I started by looking at revenues and operating income at Adani Enterprises, the flagship company for the group:

Download data

I broke the 20-year history into three sub-periods, the 2002-2015 time period, where the company grew its revenues steadily and reported solid, albeit low, profitability, the 2016-2021 time period after a major restructuring in 2015 that spun off Adani Ports Adani Power and Adani Transmission, as separate companies, and the most recent year and a half (from March 2021 to September 2022), where the company reported a quantum leap in revenues. During that most recent period, the Adanis acquired a stake in the cement business, another capital-intensive and low profitability business, when they bought Hochim's stake in ACC and Ambuja Cements.
    While the revenue part of the story is one of almost unstoppable growth, it is worth noting that through its entire operating history, the Adani Group has had low operating margins, with the trend lines in the wrong direction. While some of the decline can be attributed to the revving up of reinvestment in new businesses, it is also worth emphasizing that even when these investments start paying off, they will remain low-margin businesses.

Adani's Investment Push

    It is rare to see infrastructure companies grow as quickly as Adani has, and the reason is that growth in this business requires large investments in capacity. Looking at the capital invested at Adani Enterprises provides us with a sense of how much capital this company has employed over the last twenty years to get to its current standing. 

Download data

Again,  the steep drop off in invested capital that you see in 2015 is just a reflection of the restructuring of the company that year, as the invested capital in Adani Ports and Power was removed from the mix. 
    Bringing in the operating income from the previous section, and adjusting for taxes, I scale those after-tax operating earnings to invested capital to estimate a return on invested capital at Adani Enterprises, and as you can see the Adani success story hits a roadblock. The company's return on invested capital has steadily declined, even as it has scaled up, hovering just over 3% in 2021-2022. Again, it is true that in infrastructure businesses, returns on capital improve as assets age, partly driven by higher operating income and partly by declining invested capital, but as with margins, the reality check is that these businesses will struggle to earn their costs of capital. 

Adani's Debt Load

    The investment side of the Adani story is not complete without bringing in the financing part, since the money for these investments has to come from somewhere, either internally, residual cash flows from existing operations, or externally, from new debt or equity. Using the statement of cashflows from Adani Enterprises, I present a picture of how the company funded its investments:

Download data

As you can see from the percentages of financing that Adani Enterprises raised from debt and equity, it is incontestable that the company funded almost all of its growth with debt through this period. In fact, the company continued to pay a dividend to shareholders, even as it raised fresh debt to keep growing, in effect using debt to pay dividends during the 2016-2021 time period,. In the most recent period (2021-22), there does seem to be a push to raise fresh equity, and that may or may not be in response to pressures from investors and lenders to reduce the debt burden.
    The cumulated effects of adding to debt each year, as Adani Enterprises has grown, can be seen in three debt metrics that I report for the company in the graph below: debt as a percent of book capital (debt plus book equity), debt as a percent of market capital (debt plus market capitalization) and an interest coverage ratio, estimated by dividing operating income by the interest expenses:
Download data

The debt to book capital ratio has stayed high through the period, but the rise in market capitalization in 2021 and 2022  lowered the debt to market capital ratio. The interest coverage ratio better captures the limited buffer that the company has on its debt load, since the operating income is barely higher than interest expenses.
    In defense of the Adanis, it is not uncommon for infrastructure companies to borrow money and carry heavy debt loads, especially as they make new investments, on the expectation that as their projects mature, this debt will be repaid as well. What sets Adani apart thought is it scale, since a failure on its part to make debt payments will create ripple effects that are vastly greater than a much smaller infrastructure company.

Adani's Ownership Structure

    It is no secret that family group companies are controlled by the families that run them, but the degree of ownership that the Adanis have in their companies is high, even by Indian family group companies. In fact, the slide that I drew from the company's own slide deck is open about the family's percentage ownership of each of the Adani companies. Consolidating across the Adani companies, it looks like the family owns about 73% of the outstanding equity in these companies:

(Afro Asia, Universal Trade, Worldwide Emerging and Flourishing Trade are counted as part of Adani holdings)

This not a secret and these details are available from an Adani SEBI filing, where the family also includes the holdings of four corporate bodies that they control, as extensions of their holdings. While a family controlling a significant portion of the equity in a family group may not surprise you, the fact that this ownership stake has hardly budged over a decade where the company has increased in scale more than ten-fold, with dependence on external capital for that growth, is striking. The reason, of course, lies in the earlier graph, where we looked at how dependent the Adani companies have been on debt for their funding, rather than equity. There is a control story here that needs to be told, and we will come back to it.

    Of the 27.5% that is not held by the family, a significant percentage is held by foreign institutional investors, with Vanguard and Blackrock making the list, largely through their index funds holdings. Among Indian institutions, LIC is the largest holder with just over 4% of the shares, but the retail investor presence in this company is small, largely because of the low float, though the surge in the company's price in the last two years has drawn some traders to it.

Adani's Market Capitalization

    In our final assessment, I look at how the market have priced Adani Enterprises over time, looking at the multiples that investors have been willing to pay for its operating numbers from earnings to revenues to EBITDA, as well as relative to its accounting value (book value):

Download data

With every pricing metric, the surge in the last two years is striking. The PE ratio for the stock has gone from a modest 15 times earnings in the 2016-21 time period to 214 times earnings in the most recent two years, and the enterprise value has jumped from about 12 times EBITDA during 2016-21 to 53 times EBITDA in the most recent two years. You see similar movements in the price to book, where the stock has gone from trading under book value to 6.7 times book value, and the enterprise value, which was less than revenue in 2016-21 to 2.71 times revenues in the most recent two years.

    By itself, the surge in pricing multiples is a feature of volatile markets, and it is a phenomenon that we saw with technology companies in the last decade. What makes it surprising at Adani is the fact that this is an infrastructure company, and the irrational exuberance that animates pricing in tech or software usually has little play in this sector. In addition, the question of which group of investors is leading the push to higher prices is a puzzle, since, unlike an Agatha Christie mystery, the list of suspects (see ownership structure) is short. One benign explanation is that foreign institutional investors  are using Adani listed shares to make a joint bet on Indian growth, infrastructure investment and Indian politics, and that the pricing is being pushed up because of the limited float, but as we will see when we get to the short sellers' thesis, there are more malignant explanations, as well.

The Shorts Speak up

    All of the information that I used in the last section came from publicly disclosed documents, and there are no secrets. In fact, it is common knowledge that the Adani Group has grown, with a disproportionate dependence on debt, and that the rise in stock prices in the last two years has worked to the family's advantage, as it considers selling some of its ownership stake to raise fresh capital. It is also widely known that one of the competitive advantages of the group is its closeness to political power, and arguing that the company is benefiting from its political connections is neither novel nor uncommon in Indian business setting.

    When the Hindenburg Research report targeting the Adani Group came out a couple of weeks ago, I was surprised for a simple reason. I have seen this group target companies before, using the game plan that they are using with Adani, but their typical target firms are usually much smaller, under-the-radar firms, where public market investors may have missed troubling aspects of operations. The Adani Group is a huge target, by the standards of any market, and it is one of most widely talked-about Indian firms. I must confess that I find the Hindenburg shock-and-awe approach of throwing up dozens, perhaps hundreds of accusations of wrong doings at a firm, hoping that something sticks,  off putting, since even if I am in agreement, I find myself spending time trying to separate the wheat from the chaff, the big wrongdoings from the minor distractions. I may be doing a disservice to Hindenburg and other Adani naysayers, but it seems to me that what they  call the "biggest con" in history has three legs to it, and everything in the report feeds into one of the legs:

Almost every contention in the Hindenburg report can be traced to one of these three groupings, and I will try to regroup them on that basis. 

  • Use of Shell companies: The most damaging of the Hindenburg contentions is that Vinod Adani, Gautam Adani's oldest brother has created a large number (38, by Hindenburg's count) of shell companies, based in Mauritius, and used them specifically for  "(1) stock parking / stock manipulation (2) and laundering money through Adani’s private companies onto the listed companies’ balance sheets in order to maintain the appearance of financial health",
  • Dubious intra-party transactions: Hindenburg contends that the Adani Group has used its shell companies, in conjunction with transactions among its holding companies, some of which are privately owned by the family, to "inflate revenues" and for "manipulate earnings" at their listed companies.
  • Inexperienced (or worse) auditors: Hindenburg notes that the accounts at Adani Enterprises and Adani Total Gas are audited by a tiny and largely unknown auditing firm, Shah Dhandaria, with four partners and eleven employees, some young and inexperienced. Implicit in this statement is the contention that this auditing firm is either incapable of or unwilling to highlight the accounting irregularities at the Adani companies.
  • Listing rules: Publicly traded companies are required to have at 25% of their shares be held by non-promoters to stay listed on exchanges. Hindenburg contends that there are some of the foreign funds that the Adani Group lists as non-promoter holding to pass the listing threshold are almost entirely invested in Adani companies, and controlled by the Adani family. In short, Adani is being accused of violating listing rules, and covering it up.
  • Stock as collateral for debt: The motive for the stock price manipulation, at least according to Hindenburg, is that some of the debt in the Adani companies has been backed up or secured by shares in the company, with a higher market capitalization then allowing these companies to borrow more than they should.
  • Guilt by association: Along the way, Hindenburg notes connections that the Adani Group has to a host of individuals, some within the family (Samir Vora, Vinod Adani and Rajesh Adani) and many outside, who have been accused of fraud and manipulation, or in some cases, been found found guilty and barred from trading.
Hindenburg should be complimented for their legwork, but their critique of the Adani Group rests on a mix of serious contentions, circumstantial evidence and questionable claims. On the first, I would include the Mauritius-based shell entities, with no real operating purpose, and their links to the Adani Group companies. In the second, I would list many of the stock price manipulation charges, since the primary evidence offered is that the Mauritius shell companies hold material stakes in the company, with secondary evidence on delivery volume. To be able to manipulate and move the market capitalization of a company by a hundred billion, roughly the increase in value in 2022, you would expect to see huge numbers of shares being traded by these entities, and I don't see that. On the questionable claims are the ones to do with earnings manipulation, since if Adani is manipulating earnings, it is not doing a very good job, reporting low margins and return.
    I am puzzled that Hindenburg's short thesis spends as much time as it does trying to convince us that the company is over levered. Even if you believe Hindenburg's contention that a low current ratio equates to higher default risk, being over levered is not a con game, but a risk, perhaps a poorly thought through one, but one that equity investors in many investments take to increase their returns. In fact, the infrastructure business is full of companies that borrow heavily, with little or no earnings buffer, and I am not sure that many of them will withstand the Hindenburg test for over leverage. 

My Adani Assessment
   In sum, I am willing to believe that the Adani Group has played fast and loose with exchange listing rules, that it has used intra-party transactions to make itself look more credit-worthy than it truly is and that even if it has not manipulated its stock price directly, it has used the surge in its market capitalization to its advantage, especially when raising fresh capital. As for the institutions involved, which include banks, regulatory authorities and LIC, I have learned not to attribute to venality or corruption that which can be attributed to inertia and indifference. 
  It is possible that Hindenburg was indulging in hyperbole when it described Adani to be  "the biggest con" in history. A con game to me has no substance at its core, and its only objective is to fool other people, and part them from their money. Adani, notwithstanding all of its flaws, is a competent player in a business (infrastructure), which, especially in India, is filled with frauds and incompetents,. A more nuanced version of the Adani story is that the family group has exploited the seams and weakest links in the India story, to its advantage, and that there are lessons  for the nation as a whole, as it looks towards what it hopes will be its decade of growth. 
  • First, in spite of the broadening of India's economy, it remains dependent on family group businesses, some public and many private, for its sustenance and growth. While there is much that is good in family businesses, the desire for control, sometimes at all cost, can damage not just these businesses but operate as a drag on the economy. Family businesses, especially those that are growth-focused, need to be more willing to look outside the family for good management and executive talent.
  • Second, Indian stock markets are still dominated by momentum traders, and while that is not unusual, there is a bias towards bullish momentum over its bearish counterpart. In short, when traders, with no good fundamental rationale, push up stock prices, they are lauded as heroes and winners, but when they, even with good reason, sell stocks, they are considered pariahs. The restrictions on naked short selling, contained in this SEBI addendum, capture that perspective, and it does mean that when companies or traders prop up stock prices, for good or bad reasons, the pushback is inadequate.
  • Third, I believe that stock market regulators in India are driven by the best of intentions, but so much of what they do seems to be focused on protecting retail investors from their own mistakes. While I understand the urge, it is worth remembering that the retail investors in India who are most likely to be caught up in trading scams and squeezes are the ones who seek them out in the first place, and that the best lessons about risk are learnt by letting them lose their money, for over reaching.
  • Fourth, Indian banks have always felt more comfortable lending to family businesses than stand alone enterprises for two reasons. The first is that the bankers and family group members often are members of the social networks, making it difficult for the former to be objective lenders. The second is the perception, perhaps misplaced, that a family's worries about reputation and societal standing will lead them to step in and pay of the loans of a family group business, even if that business is unable to. It is easy to inveigh against the crony relationships between banks and their borrowers, but it will take far more than a Central Banking edict or harshly worded journalistic pieces to change decades of learned behavior.
I know that there are some of you who may view me as unpatriotic for pointing to these flaws, but I think that for the India story to unfold, it has to deal with these weaknesses. The short thesis against Adani can start that process, and I hope that the foreigner card does not get played on Hindenburg, dismissing its claims. There are plenty of Indians (analysts, investors, fund managers) who have been saying and thinking what is made explicit in the Hindenburg report, and the question that we should be asking is why they have not been given bigger platforms to air out their views.
    There is another seam or weakness in the global economic setting that Adani Enterprises exploited, and that is ESG, an acronym far more deserving of the "biggest con" label than Adani, since it is threatening to lay waster to trillions of dollars, not billions. If you review the Adani website and sales pitch, it is quite clear that the company learned to play the ESG game well, creating an entire ESG universe to underpin its companies, and exploiting the green bond market, presumably for its green energy business. The notion that a family group that build ports, airports and gas transmission lines qualifies for green bond issuance, tells you less about the group making the issuance, and more about the emptiness of the green bond promise. In fact, if Adani happens to default on its debt, I hope that it starts with the green bond holders, since I cannot think of a group that deserves default more.

Valuation and Investment Judgment
    I know that your intent in reading this thesis might be a more pragmatic one, where you wonder whether the Adani companies were over valued at the start of this year, when they hit their all time high, and whether they are a bargain, at half that price today. 
  • On the first question, I don't think that there is much doubt that the market was over stretched when it valued the Adani companies collectively at $220 billion (₹ 17,600 billion) and Adani Enterprises at $53 billion (₹ 4,243 billion). In fact, a valuation of Adani Enterprises with upbeat assumptions on revenue growth and operating margins, and without factoring any of the Hindenburg accusations of fraud and malfeasance, yields a value of just about ₹ 945 per share, well below the stock price of ₹ 3,858 per share. 
    Download spreadsheet with valuation
  • On the second question, even with the share price at 1,531 per share, I still think the company is priced too high, given its fundamentals (cash flows, growth and risk) and before factoring the damage that might have done to the company's reputation and long term value, by this short selling episode. 
Even with a further share drop, I am not tempted to buy shares in Adani companies, and it has little to do with the Hindenburg report. I have likened buying shares in a family group company to getting married, and then having all of your in-laws move into the bedroom with you. Investors in family group companies, no matter how honorable the family, are buying into cross holdings, opacity and the possibility of wealth transfers across family group companies. Those risks increase, if the family group companies are built around political connections, where you are one political election loss away your biggest competitive advantage. It is true that at the right price, I would be willing to expose myself to those risks, but it would require a significant discount on intrinsic value, and we are not even to close to that point yet. In short, I will watch this tussle between the Adani Group and Hindenburg from the sidelines, with less interest in the firm and more in what changes it may (or may not) bring to business, investing and regulatory practices in India.

YouTube Video

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Thursday, February 2, 2023

Disagreements and First Principles: The Pushback on my Tesla Valuation

I wrote about my most recent valuation of Tesla just over a week ago, and as has always been the case when I value this company, I have heard from both sides of the Tesla divide. Some of you believe that I am being far too generous in my forecasts of revenues and profitability for a company that is facing significant competition, as it pursues growth, especially with questions about who's in charge of the company. Others, just as passionately, have argued that I am under estimating the company's capacity to grow, enter new businesses and generate additional profits, and have pointed to my history of undershooting with the company. I am not defensive about my valuations, and am completely unfazed by the pushback, but I do think that since some of the pushback revolves around first principles of intrinsic value, rather than specifics about the company, there is value in discussing the issues raised.

My Tesla Valuation: Filling in the Missing Pieces

    When I posted my Tesla valuation, I hoped, perhaps naively, that it would be self-standing, with the combination of the valuation picture and the spreadsheet filling in the details. Based at least on the reactions, I have realized that some may be misreading my story and valuation, ore reacting just to a picture in a tweet. To fill in the missing pieces, I redid the valuation picture, adding the revenue growth rate, by year:

Download spreadsheet
As you look at the sheet, it is worth emphasizing a few estimation details that you may have missed in my original post:
  • First, the revenue growth rate, at least for me, is a means to an end, not an end in itself. A few of you did take issue with the fact that the growth rate that I used for the first five years dropped from 35%, in my November 2021 valuation, to 24%, in my most recent one. That may seem like a negative reassessment of the company, but growth rates can deceptive as companies get larger, and my revenues in 2032 in both valuations converge on almost exactly the same number ($420 billion in November 2021 valuation and $412 billion in this one). Just to provide perspective, using a 35% growth rate now would inflate revenues to $600 billion in 2032 or higher, requiring a very different narrative for the company.
  • Second, as you get past year 5, the revenue growth rate does not drop precipitously to 3.47% in year 6 (more on that in the next bullet), and instead declines, in linear terms, between years 6 and 10 to approach 3.47% in 2032. In short, the company has ten years of growth, not five, but growth rates have to get smaller as revenues gets bigger.
  • Third, if it is what happens after year 10 that puzzles you, it has less to do with Tesla the company and more to do with answers to two questions. The first of the is as companies scale up, there will be a point where they will hit a growth wall, and their growth will converge on the growth rate for the economy. The second is the question of what the nominal growth in the global economy, in US dollar terms, will be, and my best answer to that question is the nominal risk free rate, which was 3.47% at the time of this valuation. I am assuming that Tesla will hit its growth wall at about $400 billion in annual revenues, but as I will note in the next section, that can be debated, but the growth rate forever is bound by mathematical constraints to override.
  • Fourth, on my operating margin assumptions, it does look like I am downbeat about the near future, since my operating margin is dropping from 17.93% to 16% over the next five years, but that is because the former is the operating margin during 2022, and the number careened wildly during the course of the year from more than 19% in the first quarter of the year, to just about 16% in the last quarter. In short, I am assuming that the price cuts and cost pressures of the fourth quarter are more representative of what Tesla will face in the future, as competition steps up.
  • Finally, my starting cost of capital of 10.15% reflects the reality that the riskfree rate and equity risk premiums have risen over 2022, and my ending number of 9% is an indication that I expect Tesla to become less risky over time. There is not much room to maneuver on either number, since half of all US companies have costs of capital between 7.3% and 10.9%.

In short, my value of $130/share reflects the confluence of these assumptions, and as I conceded, I can and will be wrong on each of them.

The Pushback

    I must confess that I have not read every single comment and critique of my valuation, since they are dispersed over multiple platforms, but I do know that the pushback has come from both sides. There are Tesla bulls who are convinced that I am understating its value, and Tesla bears, who are just as convinced that I am overstating its value. Some of the reasons provided are substantive, and merit serious debate, others reflect a serious misreading of intrinsic valuation and a few are just assertions, with nothing to debate.

From Tesla Bulls

    Given that I found Tesla to be overvalued, albeit only mildly, about three quarters of the disagreements posted online to the valuation came from Tesla bulls, some of whom have disagreed with me for a decade, and have, for the most part, been on the right side of the Tesla trade and made a lot of money on the stock. In the section below, I will summarize some of the key arguments, with my responses.

  1. Revenues of "only $400 billion": The most common critique seems to be that I am giving Tesla "only $400 billon in revenues" in 2032, and that this "much too conservative", given its multiple business lines and immense potential. My response to that is that it is only because of Tesla's multiple business lines and immense potential that I am estimating revenues of $400 billion for Tesla, and that number is hard to reach. In fact, in January 2023, there were only five companies in the world that reported annual revenues exceeding $400 billion and they are listed below: 

    Since the $400 billion is in 2032 dollars, I have also reported companies with revenues that exceed $300 billion in 2023 on the table and the list expands, but only to ten firms. There are three lessons that I draw from this table. The first is that while $400 billion in revenues is clearly plausible, it is a difficult target for a firm to hit, and while you can use a higher growth rate than I use, and arrive at end revenues of a $1 trillion or more, you are estimating revenues that no company in history has ever generated. The second is that barring the oil companies, whose revenues and margins ebb and flow with oil prices, the only firm on this list that generates double digit margins is Apple, which has been rewarded with the largest market capitalization of any company in the world. Put simply, there are very, very few companies that generate big revenues and earn high margins at the same time. Third, there are only two companies on this list that have had double digit revenue growth rates in the last decade, Amazon and United Health, and the former generates operating margins in the low single digits. Firms with large revenues find it difficult to maintain high growth, as they scale up.
  2. Operating margins of only 16%: The second critique of my valuation is that I am using an operating margin of "only 16%", backed by two arguments. The first is that Tesla has a superior product to sell and that its customers are loyal, giving it pricing power, and that should lead to higher margins. The second, and more compelling one, is that Tesla has actually been able to deliver margins that exceed 16%, and that as it scales up, economies of scale will lead to increasing margins. On both fronts, I am more cautious. The operating margins that you can deliver as a company depend  on product quality and pricing power, but they are also underpinned by unit economics. The companies that deliver the highest margins incur very low costs in producing the next units that they sell, and that is why software companies, tobacco companies and Aramco have sky-high margins. The bulk of Tesla's revenues, in my view, will come from its auto business (cars, trucks, automated cars...) and the costs of manufacturing an automobile, no matter how efficient you are at operations, are substantial. With legacy auto companies, the median operating margin is about 5-6%, with very few (perhaps a few luxury or niche auto companies) with double-digit margins. It is true that Tesla has businesses, perhaps in energy and software, where it can generate operating margins that are higher, but these businesses, by their very nature, are more likely to deliver billions of dollars in revenues, rather than hundred of billions. On the second point, the notion that economies of scale continue to show up no matter how large a company is a myth; economies of scale are greatest as companies go from small to large, but they level off once you scale up. I believe that Tesla has already harvested the bulk of its economies of scale benefits, and will face a tougher grind going forward , and time will tell whether I am wrong on this front.
  3. Multiple Businesses: One of the most common critiques from Tesla bulls is that my valuation fails to incorporate all of the businesses that Tesla operates in, and that I was valuing it as an auto company. That is not true! In fact, it is precisely because Tesla has other businesses (software, energy, batteries) that it can use to augment its core auto revenues that I assume that revenues can get to $400 billion, making it larger than any other auto company in the world by a third and that operating margins will stay at 16%, which no auto company can sustain. It is true that I don't break revenues down, by business, but that reflects my view that breaking things into detail, without any real basis for forecasting detailed line items creates the illusion of precision, while actually making your valuation less so. The only business, which if it comes to fruition, that could materially affect the revenues is autonomous driving, and I have to confess that I find that there is more loose talk than analysis on that front. In fact, if the reason that you are buying Tesla is because you believe that they have the lead in this space, you may want to pause and ask what part of autonomous driving will be occupied by the company. The revenue/margin/reinvestment assumptions that you will make will be very different if Tesla just manufactures and sell cars with autonomous driving capacity to others (private car owners, ride sharing companies) in the space than if Tesla owned the cars and operates the autonomous business itself. Having watched ridesharing companies like Uber, Lyft and Didi struggle to make money in that business, I remain skeptical about this space being a gold mine for Tesla.
  4. Angst about terminal value: As I noted in the last section, the questions around the growth rate I assume in year 10, and the 3.47% growth rate forever have less to do with Tesla and more to do with the economy. Every company, as it scales up, will hit a wall, where it has become so large that it can grow, at best, at the rate that the economy (domestic or global) that the company operates in. For some companies, that wall comes with larger revenues than others, and the very best companies are able to delay hitting the wall for longer. I have assumed that Tesla reaches this status, when it has revenues of $400 billion, and around year 10. You may decide that this is too pessimistic, but if you do so, the response is not to increase the growth rate from 3.47% to a  higher value after year 10, but to either use higher growth in the next ten years to reach revenues of $500 or $600 billion in year 10, or lengthen the growth period to 15 or 20 years. If you do the latter, remember that growth dissipates between 4-6 years for most growth companies, ten years is already at the 90th percentile of growth periods for the companies and using 20-25 years of growth risks making your company a unicorn.
  5. Exceptional company: I know that none of what I have said so far will be convincing for some of you, who believe that Tesla is not just the next great company, but a one-of-a-kind company, and I accept that. If you believe that, you may very well be okay with letting Tesla's annual revenues hit a trillion and pushing operating margins to 20%. However, exceptional companies may or may not be exceptional or even good investments, if the market prices in their payoff, just as abysmal companies may not bad investments, if the market prices that in. The picture below simplifies the choice:

    In short, making the argument that Tesla is a very good, great or even exceptional company is only half the investment game, with assessing what the market is pricing in being the other half. It was the reason that I argued at a $1.2 trillion dollar market capitalization, in November 2021, even Tesla exceptionalists should reconsider investing in the company, since paying an upfront price for a company to be exceptional leaves you no upside. At best, the company will deliver on its exceptionalism, and you will make a fair return (essentially equivalent to what you would earn on an index fund), and at worst, the company may turn out to be only great or very good, both of which are now negative surprises. I am valuing Tesla to be an immensely successful company, and at the right price ($12 in 2019, $97 in December 2022), I believe that it is a good, perhaps even a great, investment. 
  6. Premiums for Vision: There is a final critique that I find almost incomprehensible, where Tesla is posited to be so special a company and Musk such an out-of-the-box visionary that you cannot capture its value in earnings and cash flows. That is sophistry, at best, since when you pay a price for Tesla's shares, you are putting a value to these ephemeral qualities, with the only difference being that you implicitly assume that these qualities will justify the price that you are paying and in an intrinsic valuation, you have to explicitly work out how these qualities translate into earnings, growth and risk characteristics. 

From Tesla Bears

    For the moment, Tesla bears seem to be happier with me than Tesla bulls, though that may change on my next valuation. Their arguments, though, are that I am over estimating value, and their critiques can be summarized below.

  1. Recession and price cuts: Coming in 2023, Tesla has been cutting the prices of its products, and with economists predicting a recession, my assumptions of 24% growth in revenues and 17.99% margins have been described as "whistling past the grave yard". That is true, but a recession-induced lower revenues growth/margins in the near term will have little or no effect on the valuation, since you will recover on both counts as the economy bounces back. Lowering revenue growth to 15% in 2023 and raising it to 33% in 2024 will deliver almost the same value for the company, as what I get with my smoothed-out values. If you are a long term investor, you are buying a company across economic cycles, not just through the next one, and expectations of a recession may, at best, affect your investment timing more than it does investment value.
  2. Just a car company: Taking the other side of the Tesla bull argument, Tesla bears view the higher revenues and margins that I am forecasting as coming from Tesla's other businesses as a pipe dream. In their view, Tesla software will be bundled with the automobiles and be incapable of delivering additional revenues or profits on its own and autonomous driving is a space that will take a lot longer to actualize, with Tesla facing competition from Google and other tech giants, not other states quo auto companies. I am truly in the middle on this one, splitting the difference between the hundreds of billions that Tesla bulls see as coming from other businesses and the zeros that the Tesla bears attribute to other businesses.
  3. Cost of capital: To the argument that 10.15% is too low a cost of capital to use on a company like Tesla, in a cyclical business and with a unpredictable CEO at its helm, my response is the same it was to the Tesla bulls (who wanted me to use a much lower cost of capital). It is that there is not much room for disagreement on this measure, and much as analysts may want to let their senses drive them, and in the current market environment, costs of capital of 15% or 6% are just off the table.

Conclusion

    I know that you may not believe me on this claim, but I am in neither the Tesla bull nor the Tesla bear camp. It is true that in my valuations of the company, I have found it to be overvalued more frequently than I have have found it to be under valued. That said, I did buy Tesla in 2019, and while I held the stock for only seven months, before I sold it, I am clearly not in the "I will never buy Tesla" camp. If your counter is that I would have been far richer, if I had just bought Tesla and held, that is true, but I would have to abandon an investment philosophy that has not only worked for me, but also allows me to pass the sleep test. 

    Finally, while the dissent and disagreement was mostly polite (and I thank you for that!),  I am puzzled by some of the vitriol on the part of those who disagree with my Tesla story and valuation. I am not in the business of dishing out investment advice, and the only person that my valuation was meant for, was me, and I aim to act on it. I am not trying to convince you, if you are a Tesla bull, that you are wrong and should sell your stock, or if you are a Tesla bear, that you should buy the stock, if it drops below $130. The very fact that you are letting my valuation, which reflects my view and value, shake your conviction should tell you more about your conviction (or perhaps the lack of it) than about my valuation. So buy Tesla, sell Tesla or sit on the sidelines, but no matter what you do, God speed, and good luck!

YouTube Video

Monday, January 30, 2023

Data Update 3 for 2023: Inflation and Interest Rates

If 2022 was an unsettling year for equities, as I noted in my second data post, it was an even more tumultuous year for the bond market. The US treasury market, considered by some still as a safe haven, was anything but safe or a haven, especially at the long maturities, as long term rates soared, with inflation (not the Fed) being the key driver. As a result, treasury bond investors faced one of their worst years in history, losing close to a fifth of their principal, as bonds were repriced. The rise in rates transmitted to corporate bond market rates, with a concurrent rise in default spreads exacerbating the damage to investors. Just as rising equity risk premiums push up the cost of equity, rising default spreads push up the cost of debt of companies, with the added complication of higher default risk for those companies that had pushed to the limits of their borrowing capacity in a low interest-rate environment.  

US Treasuries: Risk and Time Horizon

In classrooms and in wealth managers’ offices, it has been standard practice to push US treasuries and highly rated corporate bonds as safe, and even with price changes factored in, as a portfolio stabilizer, with a mix of stocks and bonds forming a “balanced” portfolio. That is good advice in most years, but 2022 was not one of those years.

US Treasury Rates and Returns in 2022

   To say that 2022 was an eventful year for US treasuries is an understatement, as treasury rates, which started the year close to historic lows, soared during the course of the year. 

Download data
US Treasury rates rose across all maturities, but more so at the short end of the term structure (3 months, 1 year and 2 year) than at the long end (10 year or 30 year). The magnitude of the rises were also of historic proportions, with long term rates more than doubling, and short term rates climbing above the 4% mark. As a result of these rate changes, the term structure which started the year as upward sloping, ended the year downward sloping, giving rise to the usual talk of an imminent recession. As I have argued in prior posts, I believe too much is made of this indicator, but that is a subject for a different time.

Returns in 2022

    In my first classes in finance, as a student, I was taught that the US treasury rate was a risk free rate, with the logic being that since the US treasury could always print money, it would not default. Whether that is true is a debate with having, but even if you believe that there is no default risk in a US treasury, there is price risk, insofar as the price of a bond can and will move as interest changes change. In normal years, those price changes are small, and the return on a T.Bond, with coupons counted in will tend to be positive, but in years when rates move a lot, the price change effect can be considerable, with prices dropping (rising) as rates increase (decrease). Note also that the percentage price change for a given change in interest rates will be greater, for lower starting rates; an increase in the T.Bond rate from 2% to 3% will create a  more negative percentage price change than an increase the T.Bond rate from 5% to 6%. 

    With this context, it is easy to see why US treasury bonds were hit by the perfect storm in 2022, starting the year at a historically low level (1.51%) and going up by a historically high amount (up from 1.51% to 3.88%, an increase of 2.37%). The resulting price change and total return are shown below:

For simplicity, I have assumed annual rather than semi-annual coupons and for consistency, I have kept the maturity of the bond constant at ten years rather than drop it to nine years, after a year.

The total return on a ten-year T.Bond in 2022 was -17.83%, putting it almost on par with the negative returns on stocks in 2022 (-18.01%). Since inflation was 6.42% in 2022, the real return on a US 10-year treasury bond was -22.79%.

Historical Context

    In my earlier post, I noted that US equity market performance in 2022 made it the seventh worst year in stock market history, if you go back to 1928. The T.bond market performance put equities to shame, as it delivered the worst annual returns, in both nominal and real terms, in the 1928-2022 time period:


There were other measures on which the market set historical records, especially if you consider the co-performance of equity and bond markets. By themselves, stocks have had 26 negative return years in the last 95 years and, by themselves, bonds have had 19 negative returns over that period. That said, it is seldom that they have both delivered negative returns in the same year, as can be seen in the table below:

Over the 95-year period, there have been only five years where stocks and bonds have delivered negative returns in the same year, and of those five years, there has bee only one year where there were negative returns exceeding -10% in both markets, and that was 2022
    Investing is full of rules of thumb, and one of those rules that wealth managers have faithfully transmitted to their clients is the notion of a 60:40 mix in asset allocation, with 60% in stocks and 40% in bonds, backed up by the logic that this mix would deliver a more stable measure of returns over time. I will not take issue with that advice, though I find it far too rigid to work for all investor groupings, but in 2022, a 60:40 portfolio would have done little to insulate investors against risk, since stocks and bonds both delivered roughly the same returns (about -18%). 

The Drivers of Interest Rates

    It the question is why interest rates rose a lot in 2022, and if your answer to that question is the Fed, you have, in my view, lost the script. I know that in the last decade, it has become fashionable to attribute powers to the Fed that it does not have and view it as the ultimate arbiter of rates. That view has never made sense, because central banking power over rates is at the margin, and the key fundamental drivers of rates are expected inflation and real growth. 

    To immunize yourself against the Fed story, start with his graph, where I look at T.Bond rates over time, and compare them to what I term an intrinsic risk free rate, a simplistic measure obtained by adding the actual inflation rate each year to real GDP growth that year, in the US:

Download data
The mythology that it was that the Fed that kept rates low in the last decade (2011-2020) with quantitative easing and other rate gymnastics is quickly dispelled by this graph. It was the combination of low inflation and anemic growth that was at the heart of low rates, though the Fed did influence rates at the margin, perhaps pushing them down below their intrinsic levels with its machinations. As inflation has surged in the last two years, treasury bond rates have climbed, albeit at a much slower pace than inflation. That can be explained by the simple truth that it is expected inflation that is incorporated into interest rates, not actual inflation, and that expected inflation has been slow to change in the face of the inflation surprises of the last two years. In the graph below, I present one measure of expected inflation, obtained by taking the difference between the ten-year T.Bond rate and ten-year TIPs (inflation-protected treasury rate):

Download data

This "market-imputed" inflation rate has leveled out between 2-2.5% in 2022, higher than the 1- 1.5% imputed inflation of the prior decade. 

If you still insist claiming that the Fed sets interest rates, it is time to face up to reality. There is no "interest rate room" in the Fed, where the Fed chair or FOMC committee, move the levers to set treasury or mortgage rates. The only rate that the Fed does set is the Fed Funds rate, and it is true that you have seen that rate jump from close to zero to just above 4% in 2022. Before you feel the urge to say "I told you so", take a look at US treasury rates (3-month and 10-year) on this graph, in relation to the Fed Funds rate, and make your own judgment on whether the rates climb after the Fed hikes the Fed Funds rate (which would you be your working hypothesis if the Fed sets rates) or if the Fed hikes rates in response to market rates going up:

Download data

You may come to a different conclusion that I do, but to me, it seems clear that the Fed (and other central banks) are following the market, not leading it, and that inflation is driving both. Just as a thought experiment, consider a world where there was no central bank or Fed, and ask yourself what would have happened to treasury bond rates in 2022, with the inflation news that was hitting markets. I will wager that you would have seen rates go up, with or without the Fed.
    I do think that the Fed and other Central Banks, in the aftermath of the 2008 crisis, overcorrected and misread their mission as keeping economies afloat and financial markets booming, and in the process, they gave risk capital a false sense that it could take huge risks, without demanding sufficient premiums, and come in for soft landings. Much as we bemoan our portfolio performance during 2022, the market developments of the year are, on balance, healthy insofar as they bring risk capital back to earth. That said, I think that the fixation with the Fed is both unhealthy and counter productive. It has not only made investors passive bystanders in the great interest rate resetting, but has also given poorly performing active investors, individual and institutional, an easy excuse for their underperformance.

Corporate Bonds: Risk Plus!

As treasury bonds went on their roller coaster ride in 2022, corporate bonds could not escape the excitement, first because the rising rates on treasuries transmitted into rising corporate bond rates, and second, because default spreads, i.e., the added premium added to treasury rates when lending to riskier entities also exploded during the year.

Default Risk and Spreads

    There is default risk, when companies borrow either from banks or by issuing bonds, and lenders try, sometimes well and sometimes badly, to incorporate that default risk when setting interest rates on bonds. Thus, at least in the corporate bond market, the default spread(s) become the market price of risk or risk premium for debt markets. To set the stage for what 2022 delivered in this market, it is worth noting that default spreads have been low for much of the last decade, and after a brief bout of fear in the first half of 2020, when COVID hit, approached historical lows in 2021. In short, lenders (banks and bond investors) seemed to have decided that the risk of corporate defaults had dropped and priced bonds accordingly. In 2022, that perception changed and corporate default spreads moved up during of the year:

Download data

Note again that the increase in spreads diverged across the ratings classes, in 2022, nudging up only a little across the highest ratings classes (AAA, AA), but jumping dramatically in the lower ratings (BB and below). While we have seen other years, such as 2008, where default spreads have spiked, the effect on corporate bond rates in 2022 was exaggerated  by the increase in treasury rates that we pointed to in the last section. Thus, a company with an investment-grade rating (say BBB), that issued ten-year bonds would have seen the interest rate on these bonds spike from 2.71% at the start of 2022 to 5.60% at the start of 2023.


    As with treasury rates, the best way to see how increasing rates affect investors is to estimate the return that investors in corporate bonds would have made, as corporate bonds rates doubled or more, during the year:

For simplicity, I have assumed annual rather than semi-annual coupons and for consistency, I have kept the maturity of the bond constant at ten years rather than drop it to nine years, after a year.

The return on a ten-year, Baa corporate bond in 2022, with the price change included would have been -23.99% in nominal terms and -31.12% in real terms, making it the worst year in at least my version of recorded history (1928- 2022) for the corporate bond market. The carnage clearly gets worse as you move to high yield bonds, where rising rates pushed down the prices of some of these bonds by 50% or more. Note that all of these calculations keep the bond rating for the company intact, as you move through 2022, but higher inflation and concerns about the economy caused some companies to be downgraded, exacerbating the damage.

Consequences for Companies

In my second post, from a little more a week ago, on my data updates for 2023, I noted that rising riskfree rates and equity risk premiums have pushed up the costs of equity for companies significantly in 2022. As the discussion in the last section should make clear, those rising rates were not restricted to equity, but also to debt, as companies ended 2023 with significantly higher costs of debt than at the start of the year. Bringing in the changes in both components, debt and equity, into the assessment, we computed the costs of capital for US and global companies in US dollar terms, in the graph below:


Just as a comparison, take a look at the equivalent table from the start of 2022:


The cost of capital for a median US (global) company rose from 5.77% (6.33%) at the start of 2022 to 9.63% (10.60%) at the start of 2023. To understand the implications of a rising cost of capital, it is worth remembering that the cost of capital is the Swiss Army knife of corporate finance, affecting almost every decision within a business, and in the graph below, I look at the implications:

Higher costs of capital, in addition to making it more difficult for companies to find new investments (projects, acquisitions), also have unpredictable effects on the mix of debt and equity used in funding (with the effect depending on whether the equity risk premiums rise more or less than default spreads) and increase the propensity of companies to return cash.

Interest Rates in 2023: Playing Prognosticator

    Now that 2022 is behind us, the question that you undoubtedly have is where rates are going in 2023, and as with equity returns, I will argue that it rests almost entirely on how inflation evolves over the course of the year. If inflation stays stubbornly high, rates will stay high as well, and inflation drops precipitously, expect rates to follow them down. On the corporate bond front, the real economy will come into play. If the economy weakens, and that weakness plays out as lower earnings, there will be defaults, as companies that borrowed to the hilt, when rates were low, will now find themselves facing higher interest payments on that debt, that they may not be able to make. That will keep default spreads high, and keep corporate bond rates at their elevated levels. If the economy manages to dodge a recession, there is a strong chance that default spreads will start to drift down, especially in the low-inflation scenario,

    Borrowing on the inflation/economy matrix that I used in my post on equities, here is how I see the combination of inflation and the real economy playing out in interest rates. 
The Fed will spend the entire year chasing market interest rates, and market experts will spend their time watching the Federal Open Market Committee, and telling the rest of us that it is the Fed that is in charge of where rates go next. As in my assessment of equities, I believe that the Fed will add more smoke than fire to this mix, and my advice to you would be to sleep through every FOMC meeting this year and focus instead on the numbers on inflation and the real economy. 

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Datasets

Thursday, January 26, 2023

Tesla in 2023: A Return to Reality, The Start of the End or Time to Buy?

I am not much of a car person and view cars primarily as a mode of transportation. I drive a 2010 Honda Civic, a perfectly serviceable vehicle that is never going to get oohs and ahas from onlookers, but I feel no urge to value Honda. I don't own a Tesla, and have only driven someone else's Tesla, but as readers of this blog know, I valued Tesla for the first time in 2014, and I keep returning to the scene of the crime.  One reason is that no matter what you think of Elon Musk and Tesla, they are never boring,  and interesting companies are much more fun to value than boring ones. Another is that when valuing companies, I am, in addition to valuing a company to see if it is fairly priced,  interested into the broader insights about business and valuation that emerge from the company. Thus, almost everything I know and practice, when valuing young and start-up companies, I learned in the process of valuing Amazon in the 1990s. In the same vein, I have learned a great about the power of disruption and the capacity of a young company (and its founder) to change the way a large, inertia-bound business is run, in the process of valuing Tesla. As I will note in more detail in the post, I have been wrong, and sometimes hopelessly so, in some of my earlier valuations of Tesla, but that does not stop me from trying anew. It is also true that Tesla is a company that attracts strong and very divergent views, and consequently, I get more pushback on my valuations of Tesla than on any other company, but as in last few attempts with this company, I have structured my valuation to allow you to incorporate your disagreement. My last valuation of Tesla was in November 2021, towards its market peak, and given its steep fall from grace, in conjunction with Elon Musk's Twitter experiment, it is time for a revisit.

Tesla: A Revolution Unfolds

    In evaluating Tesla's climb to domination, at least in market value terms, of the automobile business, it is worth remembering how impervious this business was to disruption in the decades leading up to Tesla's arrival. In the United States and Europe, domestic competitors to the established players did not get far, largely brought down by requirements of large capital investments and a distribution system built to favor established players. When Tesla was founded in 2006, with a stated intent of building electric cars, the traditional auto companies were quick to dismiss it as a potential competitor. Tesla's rise is summarized in the graph below, where we look at the company's revenues and earnings over time, with earnings measured in gross and operating terms, and EBITDA capturing operating cash flows:

2022 numbers updated to reflect 4th quarter earnings call on 1/25/23

Between 2010 and 2020, Tesla grew revenues from $117 million to $31.5 billion, a remarkable achievement by itself, but COVID gave the company a boost, as revenue have increased about 250% in the 2020-22 time-period. Just as impressively, the company finally started delivering on its promise of  profitability, going from barely making money in 2019 to an operating margin of 16.57% in 2022. While the company still has skeptics, it is no longer a niche player in a big market, and has moved the sector closer to its vision than the other way around.

    In its early years, Tesla was dependent on equity issuances for funding growth investments, and its liberal use of options to reward management (and especially Elon Musk) opened it up to criticism. Since both  affect share count, I look at the company's net income and earnings per share over its public life:

2022 numbers updated to reflect 4th quarter earnings call on 1/25/23

It is true that the number of shares outstanding has quadrupled over the company's lifetime, but the good news is that the net income increases in recent years have outstripped the share count increase, with earnings per share increasing from 25 cents per share in 2020 to $3.74 per share in 2022.

My Tesla History

    I have valued Tesla multiple times over the last decade, and while I have been wrong at each turn, I have tried to learn from my mistakes. In this section, I will begin by looking at the evolution of my Tesla value from 2013 to 2021, and then present my updated valuation of the company.

My Tesla Valuations over Time

    My first valuation of Tesla was in 2013, and I found the company significantly overvalued then, and in hindsight, there were three errors that I made in that valuation that I systematically found myself repeating in my early valuations. 

  • Growth potential: I underestimated the company's capacity to grow, by limiting its product reach. In my 2013 valuation, I estimated the potential revenues by assuming that Tesla was more luxury than mass-market automobile, giving it revenues of $64 billion in steady state. (It is worth noting that year 10 in that valuation would be 2023, and Tesla's revenues in 2022 were not that far off at $73 billion, albeit with more potential for growth.) Since that valuation, it is clear that the company's products reach a much broader market than I originally anticipated, and my estimates of Tesla's revenues in steady state have increased over time. In fact, in my most recent valuations, I have assumed that Tesla will not only become a mass-market automobile company over time, but that it will have a dominant market share of the electric car portion of that business.
  • Product characteristics: In my early valuations, I viewed Tesla cars as automobiles first and foremost, leading me towards operating margins more suited for a manufacturing company, i.e., single digit values or, at best, just barely double digits. While the experiment is ongoing, it is clear to me that an electric car is both an automobile and an electronic product, with software forming an integral part of a Tesla automobile. That recognition has led me to push margins higher, and that push has been vindicated, at least partly, by the margins the company has been able to deliver in 2021 and 2022.
  • Reinvestment needs: The automobile business has always been capital intensive, with companies needing to invest large amounts in new factories to be able to deliver on growth. In my early valuations of Tesla, I assumed that Tesla would have to follow the same path, and that reinvestment translated into large negative cashflows, with a concurrent need to raise new capital, in the growth years. Having watched Tesla reinvest and grow over the last few years, it is clear to me that the company's been able to generate its growth with far less money invested in plant and more in technology and R&D than a typical auto company. That recognition has led me to reduce my estimates of reinvestment at the company, using a higher sales to capital ratio as my vehicle to reflect that reduced investment need. 
It was this combination of changes that led me to find Tesla to be under valued in June 2019, in the aftermath of Musk's "funding secured" fiasco and stories of cars being built in tents since the company ran out of capacity in its plants. I did buy the stock at the time of that post, and luck was my ally since I caught it at its bottom ($180 per share in 2019 or $12 per share in today terms), though I did sell the shares in January 2020, after the price quadrupled. 
   With the benefit of hindsight, I clearly timed my sale wrong, because right after my sale, COVID hit and the company used its adaptability to take advantage of tumultuous times. The company's stock price soared (reaching $1200/share  in November 2021 ($410 in today's terms), and when its market cap breached a trillion, I revisited my Tesla valuation then, using a do-it-yourself (DIY) structure to allow readers to disagree. Pushing every one of my assumptions to its limits, the best I could do was arrive at a value ($571) roughly half of what it was trading at then ($1200+), about $190/share in current share units. My November 2021 best-case valuation is shown below:
Download spreadsheet
I argued that I could see almost no plausible pathway to get to Tesla's market cap then and that I believed that the company was over valued.

A Valuation Update

       It is a year and two months since my last valuation of Tesla, and it has been an eventful period for the company, Elon Musk, its founder/CEO and the overall market:

  1. The Company: At the company level, even as earnings reports delivered progress towards scaling up and becoming more profitable, there have been questions about whether the pathway is becoming more rocky. In its report on the first quarter of 2022, Tesla beat analyst estimates for both revenue growth and profit margins, but acknowledged COVID-related production problems in its Shanghai plant. In its earnings report from the second quarter of 2022, Tesla reported a slowing of revenue growth to 25% (from the heated pace of 2021) and a decline in margins that it attributed to inflation and competition for EV components. The 2022 third quarter report included news that revenues would come in below analyst estimates, both in dollar value and number of cares. The fourth quarter earnings report, delivered yesterday (January 25) confirmed earlier reports of slowing growth and a decrease in profitability (gross and operating), due to supply chain problems, with the company providing guidance that its pricing cuts will put pressure on future margins.
  2. The Founder Effect: In all of my valuations of Tesla, I have emphasized that it is a personality-driven company, with Elon Musk representing the company's vision and driving or perceived to be driving its decisions. In fact, in my November 2021 post on Tesla, I explicitly noted that it is almost impossible to value Tesla without bringing in your view of Musk into the valuation:
    Until recently, even Tesla critics would have conceded that Musk, in spite of his numerous faults, was a net positive to the company. In the last year, even Tesla advocates have starting questioning that belief, partly because Musk's Twitter adventures seem to be taking up much of his time, leaving a perceived vacuum at the helm of the company. That may be an overreaction, and I am not quite ready to come to the conclusion that he is net negative for the company, but it is undeniable that the net Musk effect being negative is not being dismissed. There is also the question of whether Musk will come under pressure to sell Tesla shares to meet demands from Twitter lenders, and how that will play out in markets.
  3. The Market: The US equity market in January 2023 looks very different from the market at the start of 2022. As I noted in my last post, rising risk free rates and equity risk premiums have pushed up the costs of equity for all companies, and Tesla is not only no exception but is perhaps even more exposed as an above-average risk company. In short, the cost of capital of 6% that I used in November 2021, higher than the median cost of capital of 5.6% for US companies then, no longer is defensible, as the median cost of capital has climbed toward 9.6%.
With these changes in mind, I revisited my valuation of Tesla from November 2021 and made the following changes: 
  • First, I left my end revenues for Tesla back to $400 billion, still a reflection of my view that electric cars will become the dominant part of the auto market, and that Tesla still has not only a lead in that market, but will have a significant market share. In fact, Tesla's revenues of $81 billion in 2022 makes this assumption more plausible, not less so Note that this will still give Tesla more revenues than the largest automobile companies in the world, and will require that they make a transition, at least on core models, to a mass market product (with prices to match). I know that Tesla does and can sell more than just cars (energy solutions and software), but these are businesses that, at best, can add tens of billions of dollars to the mix, not hundreds.
  • In my November 2021 valuation, I had chosen a target operating margin of 16%, higher than the then-prevailing margin of 12.06%. In 2022, Tesla delivered an operating margin of 16.76% before correcting for R&D, and 18.41% after the correction, though its performance varied widely across the four quarters:

    While Tesla's profitability in 2022 has been a pleasant surprise, I have left the target margin at 16% because the forces that pushed the operating margin back down to 16% in the last quarter of 2022, which include price cuts and increasing production costs at their plants, will only intensify as Tesla seeks out market share. There is a niche market story that can be used to justify higher operating margins at Tesla, but that story would be incompatible with it having revenues of $400 billion.
  • Third, my cost of capital for Tesla has jumped to 10.15%, reflecting a world of higher interest rates and risk premiums:

Download spreadsheet

This is still an upbeat story, but the value per share that I get with these updated inputs is about $130, a mark down from my November 2021 valuation, and about 10% below the stock price ($143 on January 25, 2023)

As with my previous valuations of Tesla, I am open about the fact that my Tesla story and inputs come with uncertainties, significant and potentially value-changing. Rather than wring my hands about these mistakes or be defensive about them, I chose to run a simulation, replacing my point estimates for revenue growth, operating margins and cost of capital, with distributions to arrive at the following value distribution

Note that my median value is slightly lower than my base case value, mostly because there are more potential upside values than downside value. The bottom line, though, is that the median value, at $120, confirms that the stock is overvalued, at least based on my estimates, at least at its stock price of  $143. However, unlike November 2021 or at other points in Tesla's life, the stock is very much in play, and anyone who bought the stock on 12/27/22, when the price hit $109, would have got a reasonable bargain. I am writing this post, in the aftermath of Tesla's earnings report, and the stock is up in the after market, perhaps in reaction to the fact that the company beat its earnings per share forecast, the least meaningful part of any earnings report. To be honest, there is nothing that I see in that report, which is still barebones, that would lead to fundamentally reassess Tesla's value, but clearly the earnings per share beat and the "news is not as bad as it could have been" effect is clearly playing out in Tesla's pricing.

Lessons for Investing

    When valuing companies, it is important that you focus on the task at hand, which is to value a company and make an investment judgment on whether you should buy or sell the company, but it is also productive to look for general lessons that you can use in valuing other companies in the future. The Tesla valuation offers me a chance to examine bigger questions including how much a personality (Musk in the case of Tesla) can affect value, when the laws of business catch up with even the most successful disruptors and finally, and most depressingly, how politics has entered investing and business decisions in ways that we will come to regret.

1. Personality-driven Companies

In entertainment, sports, politics and business, we live in a personality-driven world, where individuals are given more attention than institutions. This is not a new phenomenon, but social media has furthered this trend, by giving influential people platforms and megaphones to reach tens of millions of followers. Some of the highest profile corporations in the last decade have tied their business stories to their founders, making it difficult to separate one from the other. In many cases, this has helped, not hurt, these companies, as Jack Ma drew investors and customers to Alibaba with his enthusiasm and energy, and no one sold Tesla to customers and investors better than Elon Musk. In both cases, though, we are discovering that there is a downside to personality-driven companies, since as human beings, these personalities come with good and bad qualities. There is no doubt in my mind that Elon Musk has enough vision to power a dozen companies, but he is also easily distracted and sometimes eccentric, but that is the package that drew people to the company a dozen years ago, when the company was started, that engineered its ascent to trillion-dollar market cap status, just a couple of years ago, and is now, at least in the eyes of some, weighing down the company. 

Good founders find ways to build businesses that outlast them, as Bill Gates did at Microsoft and Jeff Bezos at Amazon, but that required them to set aside egos and to overcome their desire for control. With Tesla, I still believe that Musk's vision is critical,  but it is essential for Tesla's long term success that he takes two actions. The first is to stop being the spokesperson for the company on all things small and large, and allow others in the company to find their voices. The second is to either build a management team that can run the company without him, if that team does not exist, or if it does, to give more visibility and front-stage status to the members of that team. I will wager that many investors in Tesla would be hard pressed to name its CFO or others in its top ranks, and that is an indication of how completely Musk has dominated the Tesla conversation.

2. The Universal Laws of Business and Economics

    When looking at businesses, it is worth remembering the business rules that have always governed success and failure, and recognize that while there are some companies that can deviate from these rules for a period of time, they eventually find themselves subject to them. I capture these business rules in what I call my valuation triangle, shown below:

Put simply, most businesses that want to grow faster have to accept that this higher growth will come with more risk (because it will require entering riskier geographies or marks segments), will need more investment in capacity (to be able to deliver on that growth) and often require accepting lower operating margins (because you may have to cut prices to sell more). For most of the last decade, Tesla has seemed to be impervious to these rules, showing a capacity to deliver revenue growth with rapidly rising margins in a competitive electric car business, and doing so with far less reinvestment than other automobile companies. 

That said, though, there are indications that the company, while still delivered wondrous results, is finding itself coming back to earth. The recent report that the company plans to cut prices for its cars in the United States may be a transitory change in policy, but it is more likely a reflection of the reality that customers, for whatever reasons, are now willing to at least look at other carmaker's offerings, if the price is right. In the same vein, the challenges that Tesla is facing in its manufacturing plants and with supply chains are familiar problems that all manufacturing companies face, and reflect the fact that it it Tesla no longer a niche company with absolute pricing power, selling to a fanatically loyal customer base. My guess is that the stories, while more negative than positive, will even out over time, and that Tesla will be able to stay ahead of its competitors, but for those investors and analysts who are used to Tesla posting super normal performance, it may take time to stop treating  normal performance as a negative surprise. 

3. Everything is political

In a world where where you shop, to where you eat and even which sports teams you cheer on depend on which side of the political divide you fall on, is it any surprise that politics is now affecting business and investing choices as well? It is one reason why I have argued against bringing ESG into companies and investing, because there is almost no social issue that an ESG-measuring service can defensibly bring into a score, without a backlash.  In the case of Tesla, the politics of the moment are undeniably an issue, and I would argue that where your political views will have more of an effect on whether you think Tesla is under or over valued than any of its operating numbers.  It is amusing to see Tesla advocates become adversaries overnight, mostly because their politics have diverged from Musk's, and Tesla opponents become its defenders, because they are in political agreement with Musk. As should be clear from my many posts on Tesla, I fall in the muddled middle when it comes to Musk. I believe that he is a visionary, not so much because Tesla is at the cutting edge of technology, but because he has changed the automobile business and our driving choices fundamentally. There are qualities that I admire in him, and qualities that I do not, but I think that as a society, we are better off with him than without him. That said, I would like to think that my decisions on whether to buy or sell Tesla will be unaffected by my personal views on Musk, but that may be just my delusion speaking. 

YouTube Video

Spreadsheet links

  1. Valuation (DIY) of Tesla in November 2021
  2. Valuation (DIY) of Tesla in January 2023