Tesla (TSLA) A Pricing Game, Not a Value Proposition

My post on Tesla must have touched some nerves because I got more than my usual share of backlash from Tesla bulls. While some of it was just vitriol, many contained interesting counter arguments to mine. I thought it would be useful to play devil’s advocate and present the case for being bullish on Tesla. I have to tell you that I was not able to convince myself but I may convince you.

Before I make the case for Tesla bulls, I would like to be clear on two points. First, I have no economic or emotional stake in the outcome of the valuation. I don’t have a short position on the stock, and don’t plan to, and I have never owned Tesla and don’t regret missing out on the run-up either. Second, notwithstanding the hyperbole that has prefaced some of the press descriptions of my post, I don’t consider myself a valuation guru, expert or prognosticator. If you are bullish on Tesla, I don’t view you as a sucker or a dunce and I can think of at least three justifications for your bullishness.

Tesla has viable paths to higher value: In presenting my estimate of value for Tesla, I thought I was fairly explicit that it was “my” valuation and not “the” valuation of Tesla. One reason I posted my spreadsheet and left it open, for you the change, is because I understand that there are and always will be differences of opinion on the future of a company, especially one as explosive as Tesla. As I see it there are three possible paths to a value higher than the current price.

• The disruptor: It is possible that Tesla is one of those rare companies that disrupts an entire business and changes the definition of what comprises success. Just as Amazon upended the retail business and Apple the smart phone business in the last decade, it is possible that Tesla will create a new paradigm for a successful automobile company: a company that generates Ford-like revenues with Porsche-like margins. (My valuation for Tesla, the disruptor)
• The power train/battery master: I may have misclassified Tesla as an automobile company and that it’s real innovations are in the power train and battery technology that will make electric cars viable. Ted Lim, one of the commenters on my Tesla post brings a great deal more knowledge than I do to this possibility and he points out the potential for Tesla to become the supplier to other automakers making electric cars. The potential market for batteries and other original equipment may be smaller than for cars but the margins may be better. (My valuation for Tesla, the OEM company)
• The “first mover”: If Tesla is more technology than automobile company, there is the possibility that if it can establish itself as the leader in the business, there may be a tipping point, where size feeds itself. In practical terms, you are arguing that if Tesla charging and service stations are more extensive than the competitors, buyers of electric cars will be more likely to buy Teslas, thus making it the “electric car” company. (My valuation for Tesla, the network winner).

While I view these paths as narrow and difficult to sustain, I can see why others have a different point of view. There is one note of caution I would add about profitability. Some of you have pointed out that Tesla already has a 25% profit margin and that my assumption that it will generate a pre-tax margin of 12.5% is therefore way too pessimistic. There are two reasons to not get carried away with the current margin. The first is that margin that Tesla is reporting is a gross profit margin, which is significantly higher than an operating margin or a net margin; there is many a cost between the gross and the net. The second is that having a high gross margin, when you are selling relatively few cars at a high price is easier to do than maintaining that margin as you scale up.

Tesla is a pricing game, not a value proposition: When stocks are up four fold or five fold, as Tesla has over the last year, they attract a different class of investors and what happens to the stock price may be more a reflection of what I call the pricing game, rather than underlying value. In two earlier posts, one after the Facebook IPO and one early this year on Apple, and argued that the pricing game is characterized by two features. The first is the ebb and flow of momentum will cause prices to move with investor mood shifts; remember how quickly the momentum game shifted against Apple in September 2012. The second is the supremacy of “incremental information”, where small pieces of news, that have little effect on long term value, have an outsized effect on price. Thus, the story that Elon Musk (who has been masterful at directing the price game to Tesla’s benefit) will be driving across the country in a Tesla S (to show that the car has the range to do so) will get news coverage and may affect the stock price. While I am a believer in long term investing based on value, I have a great deal of respect for the pricing game and recognize the dangers of getting in the way of momentum, at least in the near term. I also know that there are others who are far better than I at playing this game and don’t begrudge them their profits. Thus, if you have been playing this game with Tesla for the last year, you not only have the profits to show for it but also my respect.

There may be a “strategic” buyer for Tesla: This may be cynical of me, but I think of strategic buyers as buyers who first decide that they absolutely have to buy a company and then come up with a price to make that a reality. Since the decision to buy is made before the price is set, it should come as no surprise that strategic buyers tend to pay too much. In the context of Tesla, it is obvious that every large automobile company wants to be the winner in the “electric car” race and will invest large amounts to succeed. While Toyota, Daimler and Ford may all be trying to do this internally, at the moment, history also tells us that patience is not a strong suit in most corporate boardrooms and that one of these companies will probably feel the urge to move faster and spend more. At a market cap of $20 billion, Tesla may seem to be too large a target but as I noted in a series of posts last year, good sense seems to go out of the window in the acquisition process, and more so with large acquisitions than small ones. If Tesla is acquired, you can rest assured that Mr. Musk will extract a significant premium over the market price, even if that price itself is substantially higher than value, and that the acquiring company (and its bankers) will come up with nice buzzwords (control, synergy) to explain it away.

I hope this post does not come through as defensive. I stand behind my judgment of value for Tesla in the my last post, but all I would take out of that valuation is that I would not buy Tesla at today’s price. Given my fear of getting whipsawed in the momentum game, I would not sell short either. It was not meant to be investment advice. I am a firm believer that investors have to take responsibility for the own choices and I will respect yours. Thus, if you are a long-term investor in Tesla, because you believe that there are viable pathways to a value higher than the price, I understand your motives. If you are a trader who is playing the pricing game with the stock, I can tell you that I wish I could play that game as well as you do, but I stink at it. So, I won’t even try. In closing, though, if you are a Tesla bull and you feel threatened by a blog post from me, I think you may be a lot less secure in your bullishness than you think.

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