Rob Hansen ( Vontobel AM) | Tesla was one of the highest-flying stocks in 2020. While optimism about the future of electric vehicles (EVs) is understandable, Tesla’s current valuation reflects aggressive assumptions about its dominance of the electric vehicle market and its array of ancillary businesses.
On its surface, Tesla is a structural grower in EVs with potential network effects, significant first-mover advantages and seemingly limitless possibilities in adjacent businesses. These factors have propelled Tesla’s valuation to astounding levels of $700 billion. Aside from selling EVs, Tesla’s other service-oriented and ancillary businesses appear to offer immense potential. For businesses with these types of nascent ancillary or service-oriented offerings, investors typically pay a small premium for a low probability of big potential in the future. However, Tesla’s current valuation reflects a high probability that its EV business will remain dominant and still unproven businesses will succeed.
The role of government policy across the globe is important to the EV growth story. Governments have begun to tackle global warming by establishing policies to support zero emission vehicles, such as EVs. The world’s largest automobile markets (China, the US and Europe) have utilized a combination of subsidies and regulation to help cultivate the EV industry. This has driven volume growth expectations to elevated levels for Tesla.
One does not have to be an EV bear to have concerns about Tesla’s current valuation. Assuming a 22% compound annual growth rate in EV sales volumes over the next 10 years implies that Tesla is trading at over 60x 2030 EPS! Even for the most bullish investors, this is too high a price for just an automobile business. Therefore, we estimate that just under half of Tesla’s market value is derived from selling EVs and the rest is from ancillary businesses. While Tesla’s shares tend to run ahead of fundamentals, current levels imply that it will dominate EV sales and many of its adjacent businesses are a sure bet. In short, a lot must go right for Tesla’s valuation to be justified.
The foundation of the Tesla thesis largely rests on its first-mover advantage with battery technology and supply chain mastery. Tesla’s first-mover status has theoretically bred an insurmountable lead in battery IP and supply chain, which should lead to lowest-cost production. Once lowest-cost production is established, Tesla will then reduce consumer prices and undercut rivals right as the S-curve of EV adoption kicks in. Tesla is expected to increase its sales from 500,000 cars per year today to close to 4 million cars by 2030, generating automobile gross margins that are 1% to 4% higher than its peers. For reference, GM sold an average of 4 million cars worldwide over the last three years with gross margins of 19%.
There are many uncomfortable assumptions about competition embedded in Tesla’s bull thesis, but given Tesla’s market cap, we think the Tesla story is more complex than just selling EVs like any other original equipment manufacturer (OEM). Otherwise, Tesla would not be trading at such a high valuation.
More than an automaker?
The foundation of Tesla’s business model is based on the number of EVs Tesla puts on the road. The company’s first mover advantage builds a driver base, which industry analysts believe will morph into subscribers that can be monetized every month, as Tesla’s subscribers are expected to pay a monthly fee for various additional services. Eventually this will churn out predictable profits with software-like margins that are decided by the number of monthly active users (MAU) multiplied by average price per unit (ARPU).
What services can Tesla provide? This is where industry analysts’ imaginations have taken hold. Many envision a menu of potential monthly surcharge services that subscribers can choose from to add to their vehicle. Potential services include: an autonomous vehicle package (currently an upfront cost), regular performance upgrades, monthly supercharging fees, monthly maintenance packages and even Tesla Infotainment complete with live streaming and/or Tesla Arcade.
Tesla also has ancillary businesses that could be monetized and packaged with its vehicles too; there is Tesla Energy, Tesla Insurance and Tesla Mobility. Suddenly Tesla is not just an OEM, but also an OEM plus a Software as a Service (SaaS) business. But wait, the story doesn’t end there! Tesla recently announced significant updates to its battery technology as well as ramping up its own battery manufacturing capacity. The company could become a battery supplier to other OEMs too.
Salivating yet? The share price is telling us the cake has been baked and we can all eat it too. While parts of this exciting story may play out over the next five to 15 years, progress is unlikely to be linear as the market suggests. In fact, we think there are several key risks that the market may be overlooking.
Rising battery competition
There are three key ingredients necessary for a first-mover advantage to be sustainable:
- time to build a wealth of technical expertise;
- accumulation of potential scarce resources such as key suppliers, talented employees, etc.; and
- a consumer base that faces high switching costs.
Unfortunately, we think Tesla only has the first ingredient and that its first-mover advantage may erode.
While Tesla currently has superior battery technology, competition is coming and fast. According to Wolfe Research, new EV entrants have raised $36 billion over the last two years. At the same time, old guard automobile OEMs have spent $50 billion on research & development and capital expenditures for EV technology. Many governments worldwide have heavily incentivized EV production. With investors and manufacturers clamoring for this growth, Tesla’s first-mover advantage is likely to be transient.
Battery technology is rapidly evolving and Tesla’s dominant position is not guaranteed. Currently, Tesla has a significant lead in battery technology with plans for cobalt free batteries (cobalt is expensive and difficult to procure). However, most experts believe that solid state batteries are the holy grail for EVs as they go further (800km/500miles), charge faster and last longer. While solid state batteries have been difficult to develop thus far, rivals including Toyota, QuantumScape and Samsung SDI believe they can achieve commercial production in the next ten years.
High hopes for services
Even if Tesla reaches expected volume targets because of faster-than-expected EV adoption, Tesla’s stock still incorporates too much value for the potential of its other businesses. Simply put, embedded option value in Tesla’s other businesses factor in a near certain probability of success, despite risks that may crimp profitability.
Most importantly, competitors could begin to provide some of Tesla’s service-oriented offerings for free. Old guard automobile OEMs are not known for being rational, especially during cyclically weak periods. At the same time, numerous EV startups are eyeing Tesla’s cake too. Performance upgrades, supercharging fees, and maintenance packages are fee streams that are easy to disrupt as OEMs begin to deliver connected EVs with similar features.
Tesla Insurance is under threat too. Rival GM has its own insurance offering in the works, which is likely to be based on driver habits using data collected from the automobile. Once other OEMs have developed EVs, data collection will ramp up quickly and insurance offerings may follow.
There are also safety risks in Tesla’s potential autonomous driving and mobility packages. Tesla is the lone creator of autonomous vehicle technology that eschews an important vision system called Lidar (Light Detection & Ranging). This system allows a vehicle’s computer to create a 3D representation of the environment around a vehicle and provide a higher level of safety. The vast majority of experts agree that neglecting this technology in favor of cheaper radar and camera-based options poses safety risks longer term.
There is no denying that Tesla has disrupted the automobile industry and likely for the better. It has compelled the entire world to move forward from a 150-year old internal combustion engine technology and forced competitors to redesign vehicle architecture from the ground up. Tesla has developed impressive manufacturing capabilities and taken the lead in battery design and intellectual property. Tesla also has potential in its services and ancillary businesses too.
While there is a lot to like in the Tesla story, at this juncture there are too many risks in the Tesla thesis and a valuation that leaves little to no margin of safety, which a long-term investor should see as paramount to success.