July 27 2020 - Tesla And Irrational Exuberance
Changes in the valuation of the company are way harder to justify from changes in fundamentals than the actual valuation.
Tesla is currently valued at 10 times the value of comparable peers.
Time to proudly leave the party!
I have to admit it. I am not neutral with Tesla (TSLA). I doubt anybody is, but the truth is that I have been wrong for a long time. I was short well ahead of the infamous "funded" tweet and just then I decided it was enough. Luckily for me I realized I was paying too much intra-day attention to Tesla and I did quit.
I say luckily because after a brief fall to 8 by May-19, that implied an enterprise value (EV) of B, once after the tweet lie became clear, Tesla sky-rocketed up to 7 in Feb-20 (EV of 5B). Then it fell to 1 by March (EV of B) to recover new fresh heights by the 22nd of July of ,592 or an implied EV of 0B, when I started to write this article.
To put it mildly, it is practically impossible to convince any minimally rational mind that the business of any company can change its fundamentals so quickly from one quarter to another as to justify changes in value of a fraction of those magnitudes from one quarter to another.
I have not discussed yet if Tesla is expensive or not, I'm just saying that the changes in price of the company shares cannot be based on any type of fundamental factor linked to the business, because simply enough, fundamentals cannot change so rapidly and so aggressively in such a short time.
What can change so much in a year or in a quarter?
You can argue that the future of EVs is brilliant, but it is infinitely more difficult to argue that it is 7 times brighter now than one year ago. The market in all its efficiency, considered that what was worth B in May-19 is now worth 0B, after slightly more than a year.
Considering that the company still makes cars and that it has not significantly changed its product mix in that period, the only reason for this astronomical change in value is a combination of any of the following:
- The EV market pie has got bigger, way bigger than what the market was discounting one year ago, and that Tesla will be able to at least keep its share in the pie.
- Tesla will be able to eat a whole lot more pie than before. Back in 2019-Q1 the global EVs share of Tesla was estimated at 16% by McKinsey and some articles estimate it is 19% by the end of Q1-2020. It is an increase, yes, but shy of going from 16% to 116% which is the proportional increase that could be implied by the share price. Obviously a 116% market share is impossible (even for Tesla) so this increase in value implies that even assuming that Tesla can sell all EVs bought in the world, the EVs market has increased its potential size by 16% in the last year.
In both cases, or in any combination of those possible explanations, the market is additionally assuming that Tesla will be able to produce and sell now 7x more cars than it was expecting one year ago.
Again, I am not saying that the sales of Tesla have to increase by 7x to justify this change in value, it is even more than that. It implies that the market has assumed that current future sales of Tesla are now 7x bigger than it was assuming one year ago.
To put this change of value in perspective, it would require an additional production (to the one that the market was already expecting one year ago) of 2 million additional cars p.a. at an ASP of .000 with a 20% EBITDA margin, a 15% tax rate and a 8% discount rate, for the coming 25 years, and this is not even deducting any capital expenditure that would be required to produce those cars.
The other alternative is that the market is wrong, that it was wrong one year ago, or is wrong now or, again, a combination of both. As we cannot be sure if B was a proper valuation or 0B is a better one, we can be sure there is nothing in the business of the company that justifies this difference in valuation. Let's look at current valuation to try to get some clues.
Current valuation of Tesla
Tesla declared in Q2-20 that its production capacity was 640K cars p.a. and expanding up to 790K by year end. Let us take that future capacity as if was the current capacity, and as if all the capex for that level of production had already been deployed and paid. Just to be sure I cannot be accused of being too conservative in my assumptions.
With the same inputs as before (20% EBITDA margin, 15% tax rate, and 8% discount rate) the PV of that production volume for the next 25 years would be B, assuming no maintenance capex (again just to be safe I am not conservative). This is not even paying taxes and that current 20% margin, boosted by subsidies, remains untouched.
After adjusting for cash and debt, the B is equivalent to B of equity value (0 per share). That valuation implies a 19x multiple on annualized 2Q-20 EBITDA.
At that multiple, only Ferrari (NYSE:RACE) would be more expensive than Tesla. But Ferrari is ahead of Tesla in terms of margin per vehicle and pricing power. They simply play in different leagues. BMW (OTCPK:BMWYY) or Audi (OTCPK:AUDVF), the companies that might better compare with Tesla, are trading at 6 to 10x EBITDA.
Let's say that the maximum rational multiple for Tesla is double the one of BMW or Audi. Then the value would reach B of enterprise value and B of equity value (0 per share).
So even assuming for overly close to irrational optimistic DCFs and double-than-peer-multiples, the limit of possible valuation for Tesla, in my opinion of course, would be in the -90 billion range or 0 to 500 per share.
Currently, Tesla is trading at slightly more than 3 times the upper limit of that range.
Another proof of exuberance
When we try to value things according to some reality check, a company's value should be backed by its capacity to provide enough free cash flow for its shareholders as to provide sufficient risk adjusted return on their investment.
When that reference is forgotten, awkward effects begin to take place.
In the case of Tesla, since the distortion is so huge, it happens that Tesla could buy 100% of Volkswagen (OTCPK:VLKAF), with its own shares or issuing shares and paying in cash, pay a 50% premium over the market price of VW, and still it would be able to boost its EBITDA post-merger by almost ten times. If it paid no premium, it would boost its post-merger EBITDA per share by almost 11 times, as you can see on the table below:
Yes, Tesla, the best auto industry in the world could buy its rival issuing 78 million shares (42% of its current capital), pay a 50% premium, and still be able to increase its post-merger EBITDA per share by almost 10 times.
Why the need to make cars. The best business of Tesla that they could think of right now is to buy external EBITDA with its extremely overvalued shares.
No matter what they buy, it would always increase its EBITDA as it has to issue so few shares for companies that make much more EBITDA than they do.
Yes, by irrational as it may seem, there are investors who prefer to buy a ,590 share of Tesla that in the last twelve months has produced a total of of EBITDA per share, compared to investing that same amount of money in 9.6 shares of VW that would have produced a total of 0 of EBITDA in the same period (€83.5 p.s. x 1.15 fx.rate x 9.6 shares of VW). Please compare those two figures again. It is an impressive difference.
In a hypothetical merger of Tesla and VW, 93% of the post-merger EBITDA would belong to VW and only 7% to Tesla.
In the table below, I show the valuation multiples of relevant peers:
In terms of EV to EBITDA, Tesla is 10 times more expensive than Toyota (NYSE:TM), 8 times more than BMW or 3 times more than Ferrari. Porsche, probably the company that most resembles Tesla by ASP and margin, is not a listed company so I cannot compare a market value for it. As you probably know it is also owned by VW.
Let us take an 8x EV/EBITDA as a representative average of BMW and Audi. You have to take that multiple and double it, then double it again, then double it again, and then increase it by 25% to get to the 80x of Tesla.
You take Ferrari, a company that makes an EBITDA per car that is more than double the ASP of Tesla and that produces cars that instead of losing value as they age, they do the opposite. Well, investors in Tesla assume that they can pay 55 more years of EBITDA than they need to pay for Ferrari.
As I have disclosed in the table, I have used 2019 figures for all the companies and LTM for Tesla just to favor the numbers for TESLA as it is growing more than the rest from production ramp-up.
To be more optimistic I will assume that the company has already reached its 790,000 cars capacity, not adjusting for any remaining capex, and assuming that ASP and margin remain the same as in LTM. I include in the last column as Tesla nears 790k.
The resulting valuation multiples for Tesla in that hypothetical case would be a 40x EV/EBITDA multiple, still 15 years more than Ferrari and 5 times more than the average of BMW and Audi.
Back in the days, I mean two years ago, people discussed debt issues related to Tesla. Now debt is only 2% of EV as market capitalization has dwarfed debt.
It is not that debt is small, it is B, or B net of cash, equivalent to 4.3x-2x, but as the market value of equity has risen so dramatically, debt has become irrelevant.
By the 22nd of July 2020, the Company would have to issue only 10 million shares (5.4% of the capital) to pay back 100% of its gross financial debt.
If I were Tesla, I would nevertheless hedge the risk of a market turnaround and issue a few shares to pay back for all the financial debt and be ready for additional expansions when required. The market hype with the company is so high that probably it would be understood as positive and not as important signalling of overvaluation.
I shorted Tesla when it was at 0. I did not lose money, but I lost money that I had previously made by shorting the stock so I cannot be fully objective no matter how hard I try.
I would never short the stock again, and probably any stock, because no matter how overvalued I understand it is, it can still double and make me lose money and patience. I would never buy Tesla at this price or anything above 10x EBITDA which in the best of cases (assuming 790K cars of production capacity) would yield a maximum of B - 4 per share (.6B of EBITDA x 10 - .4B of NFD).
As the market is valuing the company at c. 0B I have to convey that there is an overvaluation equivalent to 0B, which is equivalent to the market cap of Toyota and Ferrari, or equivalent to the market cap of VW, Daimler-Mercedes, BMW, General Motors, and 50% of Ferrari altogether.
There are other signs of bubble valuation. When a company loses or gains in a month a value that is equivalent to companies that produce more than ten times the number of cars that Tesla produces, there must be something strange going on.
For those that have enjoyed the ride, well done. You have been wise or lucky, who cares, but take your money and leave the party. You will be able to tell the story for a few decades. I would do it if I had made it.
For those that, like me, only watched on the sidelines, it is a pity we did not join the ride, but please DO NOT DO IT NOW.
Yes, it can go to the moon, but you must be aware that fundamentals are like gravity and they exert their attraction even from long distances and they do it constantly.
For those that went short I guess it has been another lesson of the famous quote about the market staying wrong more time than you can stay solvent. Whoever that has been in the market knows that. Here lies another lesson, but if your pocket is deep enough don't leave now either!
It would make sense to go short now? Yes, a lot, but I won't go short for the same reasons I stopped doing it 00 ago and to be honest, because I do not have the guts.