What a great company
Let me start off by saying that I praise the Tesla (NASDAQ:TSLA) business model from a purely qualitative standpoint. The company reinvented car sales by implementing recurring revenue streams after the initial purchase. After the customer buys the car, the company earns additional revenue from superchargers, for example. But Tesla also sells wall connectors and car accessories. The customer has the ability to unlock software upgrades for his car without purchasing any hardware. Currently there is the possibility of purchasing two different upgrades for autonomous driving. In the future, there could be room for more software upgrades, which is why perma bulls of the stock deem Tesla to be a technology company, not a car manufacturer.
I believe there is at least some truth to that assessment. The business model of the company reminds me of Apple’s (AAPL) business model during its earlier stages: Elegant, streamlined, and unique luxury hardware with purposely limited accessibility to some software functions, which creates an opportunity to sell the initially locked use cases of the software a second time later on. Obviously, Tesla is still heavily dependent on initial hardware sales, more so than Apple. And for now, there is nothing similar to an app store. But one can easily imagine features like that in the future.
Tesla has incredible marketing. There’s Elon Musk’s famous and polarizing megalomaniac space absolutism which spurs hype for all of his companies. Customers feel like they are purchasing a product from a company/person able to change the world. That’s a powerful qualitative argument for the company. Customers think they are doing something good for the environment while enjoying luxurious lifestyle benefits from a company with high-quality standards. I believe this is the primary reason why Apple’s business model has been so successful. Tesla is doing things differently than other car manufacturers: For example, calling their cars S, 3, X, Y. From a purely qualitative standpoint, the company is a clear buy. (If that sounded like sarcasm, it really isn’t).
Tesla outperformed massively in the past
In recent years, Tesla managed to outperform their peers massively. The financial statements show characteristics of a rising star technology company: The average revenue growth of the company was ~ 53 % per annum in the last five years. During the same time, the gross margin rose from ~19-20 % to ~ 25-27 %. Tesla became profitable for the first time in late 2019 and was profitable ever since. A comparison to traditional car manufacturers just doesn’t seem right, given their competitors’ small revenue growth and already matured business model.
In Q3/2022, Tesla had Year-over-year revenue growth of 59%. The company almost doubled its operating income and net income year-over-year. However, the spread between total production and total deliveries of cars widened. I believe this is indicative of macroeconomic headwinds, which will affect the company in the coming quarters. More on that later.
All the positives mentioned, qualitatively and quantitatively, don’t get me to buy shares of a company. Operating and financial performance rather serves as the benchmark to beat in the future. Past performance cannot be extrapolated into the future endlessly. But most of the time it’s the best guess market participants have. If expectations of future growth/profitability rise, then the markets discount higher cash flows of the future in the present, and the share price rises in order to display this valuation premium. That’s what happened in recent years with Tesla. The company massively outperformed, and shareholders profited as they should have.
However, rapid moves to the downside always occur when the previously risen expectations of market participants are not met – i.e. the market gets surprised by worse data. I believe the likelihood that negative surprises will happen for Tesla during the next 12 months is very high. My reasoning mainly stems from macroeconomic headwinds and further monetary tightening of the Federal Reserve.
1. Tesla is intertwined with the global economy – and the global economy is likely to decelerate materially.
With all the qualitative and quantitative arguments in mind, Tesla still generates the vast majority of its revenue from the traditional automotive sector. In Q3/2022 the company had 87 % of its revenue originating from sales, regulatory credits, and leasing. A mere $ 2,762 B originated from alternative revenue streams, such as Energy generation, energy storage, and other services. Some of the additional software upgrades for the Tesla models are included in the automotive sales, but they make up only a minor portion of the revenues.
While the revenue growth and the trajectory of the profitability cannot be compared to traditional car manufacturers, the dependency on demand for luxury cars remains the same. The automobile industry depends heavily on the balance sheet of the average customer. Generally, consumers will always spend first on consumer staples. If the average balance sheet of consumers is healthy enough, they will start spending on consumer discretionaries. Usually, the balance sheet is healthy if assets appreciate and the cost of credit lessens, i.e., yields decrease. And here’s the problem:
2. The balance sheet of the average potential customer of Tesla got materially worse.
Let’s start with America, where most Tesla cars get sold: During 2022, the 60/40 portfolio got hit hard because the inverse correlation of bonds and stocks started to reverse because of inflation. The housing market hasn’t sold off at similar levels in 2022. But as long as mortgage rates stay this elevated, the optimistic case for 2023 is an illiquid market with sideways price action because the average homeowner is reluctant to sell at a lower price, and buyers can’t afford today’s rates coupled with yesterday’s prices. Either rates or prices have to go down (assuming a liquid market). Additionally, there’s less money left after buying all the consumer staples needed in everyday life because of high consumer price inflation. However, the rising US Dollar cushions the financial impact on American consumers partially.
The luxury car demand in Europe is likely to get eroded. Europeans face not only the same (or worse) pain in terms of asset prices. But also much worse consumer price inflation due to the Energy and Food situation. The decline of the Euro in recent months adds additional fuel to the fire. Europeans don’t enjoy the privilege of earning their wages in the global reserve currency.
Lastly, there’s Chinese demand, which accounts for the second most car sales of Tesla during recent quarters. And this is a tricky one: On the one hand, the potential abandonment of zero-COVID policies could spur demand for Tesla cars. On the other hand, Chinese demand is loaded with geopolitical risk. China could raise tariffs on American cars or prohibit the sales completely in response to the export bans on chips, for example. There are also many specified EV companies in China that represent avid competitors (e.g. NIO (NIO), BYD (OTCPK:BYDDY), XPeng (XPEV), and Li Auto (LI))
I think it’s almost guaranteed that the revenue of Tesla cannot grow at the previous pace. I believe the market is still way too optimistic about the future, given the rich valuation multiples of Tesla.
In my opinion, the revenues will not only exit the previous trendline, but the expenses of Tesla may rise materially too. Rising energy prices should burden the margins of Tesla while preventing potential customers from buying their luxury product. If consumer price inflation stays sticky, wage increases may burden Tesla too, in 2023. However, with the current macroeconomic headwinds, I can imagine sharp disinflation during H1/2023. To my belief, that disinflation will not be constructive for asset prices because the reason for inflation receding will most likely be demand destruction.
3. Tesla is as overvalued as it was a year ago.
Almost every stock is a buy at some price, and Tesla’s stock price fell from $400 to $230. But I think the stock is nowhere near a buy. Investors have to ask themselves what they are getting when buying shares of a company. Either it’s cash flow in the form of dividends, or its cash flow that is being reinvested in the company in order to grow revenues and raise the profitability of the future. Clearly, with Tesla investors don’t get any dividends, so they are betting on future cashflows.
The cash flows of the future are discounted by the risk-free rate plus a risk premium. The risk premium rose as the economy is expected to slow down in the future, and investors are getting increasingly risk intolerant. The risk-free rate has increased already since the Federal Reserve hiked rates rather fast. I believe most of the sharp decline of Tesla’s share price originates from the elevated discount rates. So this is all baked in.
What I believe to not be priced in by the markets yet, are the expectations of lower future cashflows due to a slower-growing revenue trend and rising expenses, therefore decreasing future margins. With a 50+ PE/FWD ratio and PS/FWD of 8.5 the shares of Tesla are priced for perfection (FWDs are already at lofty levels). This leaves little upside to Tesla’s share price originating from operating performance. However, if the expectations of future cashflows worsen, the stock price of Tesla should deteriorate further. I believe that the 45% drawdown was almost exclusively because of the change in the underlying discount rate and not because of changes in future cash flow expectations.
4. The upside for Tesla is a Federal Reserve pivot
Given that the valuation of Tesla is still at a ridiculously high level, my belief is that the upside for Tesla shares is that financial conditions ease, yields come down from their historic rise in 2022, and the Federal Reserve stops the monetary tightening. Elon Musk and Cathie Wood (ARKK) know this, which is why they are calling out the Federal Reserve for not easing financial conditions. Both of them are only talking their book when they explain how technology is going to make things exponentially cheaper and deflationary, and therefore the Federal Reserve should never hike ever again.
I think that the reality is different. In a deglobalizing economy with wars and polarizing world views which originate from a slowly receding single global superpower, inflation is very likely to be higher for a prolonged period of time.
Almost certainly, the Federal Reserve will pivot at some point in the future. I think there’s no question about it. But the prerequisites for a pivot are either that inflation comes down materially or that something breaks. I think the most likely scenario is that both happens: Inflation decreases because of the demand destruction caused by a global recession. The problem for Tesla is that this scenario would likely be negative for the share price at first. If the global economy enters a recession in 2023, then the demand for luxury cars is likely going to dwindle, expectations of future cash flows should decrease materially, and the share price of Tesla could significantly fall because of it. To my belief, it is only after the monetary easing that the share price of Tesla can recover. Likely from a permanently lower base.
The risk of shorting Tesla from here is that the soft landing scenario proposed by the Federal Reserve happens. In such a scenario, the economy would be able to withstand much higher rates for longer than most market participants currently expect. Slight demand destruction would remove the tightness in the labor market so prices could stabilize at a lower inflation rate, but the economy wouldn’t face a harsh recession. If a soft landing materializes, the Federal Reserve could stimulate earlier via monetary easing, and the share price of Tesla could appreciate further. Although I believe the chances of a soft landing scenario get smaller day by day, it’s still a possible outcome.
From a company development perspective, the risk remains that Tesla could outperform even the current lofty expectations. For example, government subsidies for ecological car purchases could spur demand for Tesla cars and drive the stock price higher. The risk of shorting any stock remains that the mathematical upside is limited, but the potential downside is unlimited. During a bear market, in particular, violent bear market rallies (e.g. June 2022) can cause huge losses in a short period of time even though the general direction remains downwards. Therefore I am warning investors of sizing their positions and try to time entry and exit points accordingly.
All in all, Tesla reminds me of Intel (INTC) during the 2000 dot-com bubble. Back then, Intel was a great company with good products. The problem was that the stock was incredibly overvalued. After the bubble popped, Intel continued its business with success but the stock price never reached the previous high.
Why Tesla Bulls shouldn’t be excited by this Bear market rally
At the start of writing this article (Oct. 20), many indicators pointed towards a local bottom. Since then, the S&P500 (SPX) rose ~ 5-6%. In case of a dovish surprise from the Federal Reserve today, the market could rally violently, and Tesla shares would profit massively. However, Tesla bulls should be careful as I do not believe that the (continuing?) rally will prove to be a permanent bottom, but rather a local one. I think that only if the economy enters a recession, the expectations of Tesla’s future cashflows get adjusted, the share price corrects to a reasonable valuation, and the Federal Reserve pivots, it’s time to buy the dip. That time could still be several years ahead.