When interest rates are at zero (or less), the future is cheap and thus Tesla is trading on rosy expectations. Therein lies the problem for Tesla’s investors, because the market eventually will want to see those expectations become reality.
Apple’s iPhone and Tesla’s Model S both were “game changers” in their respective industries when they were introduced. The iPhone was an enormous gamble. It pushed the limits of available technology — microprocessor, screen, battery and wireless capability — beyond what seemed possible in 2007. Undoubtedly, if Apple had not created the iPhone, someone else would have, but when? No one knows, but the iPhone accelerated the arrival of the future.
It was the most important product invented in the first decade of the new century. Its success gave birth to a half-trillion-dollar smartphone industry. Hundreds of billions of dollars were poured into R&D, accelerating development of technologies and applications unimaginable just a decade earlier.
This brings us to Tesla, the most important company born in the US since Apple. Before Tesla, we equated electric cars to golf carts. Tesla has shown the electric car can be equal and, in many ways, superior (high performance, lower energy consumption, quiet ride) to the ubiquitous internal combustion engine (ICE) car.
Tesla’s Model S will transform the auto industry dramatically. Consumers and car companies alike are starting to look at ICE vehicles as relics, even though they still constitute 95 per cent of cars sold globally. It is clear electric (and maybe fuel-cell) vehicles are the future and that may be only a few years away. However, it would be much further off without Tesla’s Model S, which was a paradigm-changer in an industry that had not seen revolutionary changes since Ford’s Model T.
Unlike Apple, though, Tesla may or may not be around in five years. Mass-producing a car is an incredibly difficult, capital-intensive undertaking. Tesla has shown it can make a phenomenal but expensive ($100,000) luxury electric car, which addresses a limited market. But on its own, the Model S cannot justify Tesla’s current valuation. For that, Tesla needs to profitably mass produce hundreds of thousands of cheaper Model 3’s, a $35,000-$40,000 electric car.
At today’s valuation of about $50bn, Tesla’s shareholders are paying for future earnings, not the $650m in losses the company had in 2016. In 10 to 15 years, Tesla needs to make at least $4bn-$5bn in profits to justify today’s price.
Tesla’s car may be superior to ICE and other electric vehicles in the market but a car’s main function is getting you safely (and in relative comfort) from point A to point B. Thus, the economics of Tesla’s Model 3 are grounded by current ICE cars. Tesla cannot charge a significant premium above the competition.
The iPhone did not have real competition when it was introduced, just $150 Nokia “dumb phones” and $250 only slightly smarter BlackBerrys. Apple was able to charge $700 for the iPhone because the cost was subsidised by wireless carriers and the product was exponentially better, so the higher cost did not make it unattractive to most consumers.
It is much harder for Tesla to do the same. Tesla’s cars are competing with their ICE brethren as well as with electric cars introduced by established automakers. Even when car factories are operating, they are losing a lot money due to fixed costs. Profitability requires producing a large enough number of units to cover those fixed costs.
Tesla’s success will depend on its ability to achieve scale to produce hundreds of thousands of cars a year. But to get to that number it will need financing.
Bond investors, even in this environment, will look at Tesla’s losses and either refuse to lend to the company or demand an interest rate that will make the carmaker look like a junk bond borrower — which, looking at its profitability profile today, it is.
The only other way to finance losses is by issuing stock. The more expensive the stock, the cheaper the financing. Thus, we arrive at the paradox of Tesla stock: Tesla’s success as a business and its value are completely dependent on the price of its stock. If the stock price stays high, then the company can issue shares to finance its growth and cover its losses until it gets to scale. If the stock price declines — and they do decline at times — let’s say to $100, Tesla’s market capitalisation will be about $15bn. To raise $1.5bn then, Tesla’s shareholders will be diluted by about 10 per cent (at today’s price, this dilution is only 3 per cent).
As a Tesla investor, one must be both good at predicting the company’s success as a business — its ability to produce good, profitable cars — and its stock price level before it turns a profit. Even if you get the first one right but the stock price declines before the company becomes profitable, your interest in the stock may be severely diluted.
Vitaliy Katsenelson is chief executive at IMA and author of ‘Little Book of Sideways Markets’
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