Tesla is a company that I have valued at least once a year for many years, and I have navigate a middle ground between those who love the company and those who hate. For most of Tesla's corporate life, I found Tesla to have potential but to be over priced, but in June 2019, I bought Tesla for the first time at $180. As luck would have it (and it was pure luck), the stock turned around and has not looked back since. Yesterday (January 29, 2020), the stock surged to hit $650 in the after-market after its most recent earnings call. I revisit and revalue the company in this session, and much as I want to continue to hold the company, I cannot justify continuing to hold it. I explain my reasoning, and you are welcome to disagree with it.
(00:00) Welcome back.
In this session I'd like to take a break from the data updates I've been doing
and talk a little bit about Tesla.
Now when I invest and do valuation, I know who my biggest enemy is,
who's gonna get me into trouble, and it's me,
and it's with the priors and preconceptions that I bring into investing and decision-making.
(00:20) And for me no company captures that problem greater than Tesla,
because Tesla in a sense is a company where there's no middle ground.
On the one side you have optimists who believe that this company is gonna conquer the world,
and the other side you have the pessimists who are convinced that this company is a scam game, worth absolutely nothing.
I've tried to have a middle ground and often failed
because I've got abused from both sides of the spectrum.
(00:47) And for the first few years that I valued Tesla,
and in fact, for much of its lifetime,
when I valued Tesla I took the point of view that
it's a company with a lot of potential but I felt it was priced too high.
And when I did this, of course I was accused by people or optimists of
being in the pay of short sellers and being too bearish on Tesla.
(01:07) Well in June of 2019 I surprised myself
and perhaps surprised many of those people by buying Tesla.
I did it on the basis of valuation,
and I did it at a time when the price for Tesla dropped to a point
where I felt it was a good investment.
Now the abuse came from the other side,
people who were pessimists on Tesla felt I bought into the high.
I don't think either side is quite correct, but I can understand where they're coming from.
(01:34) So that investment that I made in $180 is the one that I don't want to revisit in this session
because much has happened between June of 2019 which was seven months ago,
and January 29th, which was yesterday, at the time of the earnings report.
In fact, I wrote this post and did this session
right after Tesla put out its earnings report.
(01:56) So let's take a look at Tesla at June of 2019
which is when I did my last valuation.
It was a dark time for Tesla, Tesla stock prices dropped about 40%,
the sky was full of dark clouds and things didn't look good for the company.
There were questions about whether it could grow, questions about whether it could make its debt payments.
So with those questions in place
I did my valuation of Tesla in June of 2019
I adopted what I thought were fairly conservative assumptions,
and you can make your own judgement whether they're conservative or not,
to get to a value of about $190 per share.
(02:34) We'll quickly review the story I was telling for Tesla in June of 2019.
It was a story to success,
in terms of growing from being a company with about 22 billion in revenues
to about 100 billion in revenues over the next 10 years,
with margins improving to the 75th percentile of automobile companies,
about 10% margins,
and requiring a lot of reinvestment to get that,
the reinvestment I computed by assuming that for every dollar of capital they invested they'd get two dollars of revenues.
The value that I got was about $190,
the stock was trading in $186 when I did the valuation.
But while I was doing the valuation some bad news came out
the stock dropped below $180 and I put in a limit buy that was executed at $180.
(03:20) I remember when I bought Tesla at $180, I was cautioned by all-time value investors
that I wasn't giving myself enough margin for safety;
After all my value is $190, the stock is $180, that's not much of a margin.
And my pushback was the margin of safety sometimes misses big issues.
In the case of Tesla, I think the big issue that's missed by looking at that margin of safety
is that the tail of distribution is on the upside,
there are potentially far more positive surprises than negative surprises.
So I was buying the tail and I felt that at $180 I was getting a good bargain.
(03:54) Now I'll make a confession, when I bought the stock at $180
I didn't think it would turn around
In fact, I was convinced that it was - more bad news are coming,
the momentum is all against it,
but I got incredibly lucky - that's the word to describe it.
This wasn't great timing, it wasn't some insight I had
I just got lucky.
Because almost on my sell (?), the stock turned around,
and it went up and up and up.
In fact yesterday, just before the earnings report came out, the stock was trading at $581.
From $180 to $581 in seven months, and I knew I had to revisit my valuation.
(04:30) So I took a look at what's happened since June of 2019
that might or might not explain the surge in the price.
The first is, those questions about growth have not quite gone away but they've taken a back seat,
because it looks like Tesla is rediscovering some growth,
not the stratospheric growth that you saw four or five years ago,
but decent enough growth that you can map out a plan for them to continue to grow.
So this is return to growth.
The second and this is I think one of the bigger changes that Tesla has,
one of Tesla's problems through its entire life
has been an inability to meet delivery deadlines
and have a supply chain that actually works.
And for the first time in its life, I thought Tesla turned its attention to operations.
You saw production without drama.
Remember that a couple of years ago when you had the drama of
"could they produce 5000 cars a week or couldn't they?"
That was gone, they were actually matching -
they were actually delivering cars close to what they were promising,
and they actually got the production plant that they were building in Shanghai online quicker than was expected.
So you could see operating improvements.
And finally, and I know this is going to sound small-minded of me,
but Elon Musk turned quiet during this period.
You are saying, "so what?"
Well Elon Musk is both the company's biggest strength and its biggest weakness.
Let's face it, there would be no Tesla without Elon Musk's vision and views about the future,
but he's also an impediment to the company in terms of creating distractions.
Tesla is a story stock,
and Elon Musk has been responsible for creating distractions in the story,
whether it's going after a diver in Thailand
or talking about a different business model.
So that relative silence from Musk I think
helped the investors focus in on what Tesla's biggest strength is,
there is still a core story that's a strong story.
(06:25) Now there's one other issue with Tesla that I think is worth examining
which can explain why the value can move pretty dramatically.
I've long argued that there are two different numbers in the market:
There's the value that comes from cash flows, growth, risk and fundamentals,
and price that is set by demand and supply,
and I've argued that those two mechanisms can yield very different numbers.
In the case of Tesla, there's a feedback loop from price to value,
let me explain what I mean.
First, remember Tesla has about 13 billion dollars in debt,
now that 13 billion dollars in debt was there in June of 2019, it's still there in January 2020
but here is where the stock price makes a difference.
A chunk of that debt is convertible debt, and when the stock price rises, the debt becomes less onerous,
in other words, as the stock price rises, the default risk at death for Tesla actually decreases.
And this shows up in two places, one is as a lower default spread and lower cost of capital
and the second is in terms of the probability that they will fail.
There was talk about failure in June of 2019 that they wouldn't be able to make their debt payments,
that's kind of moved away because the stock price has gone up.
The second feedback loop that occurs, this is another positive,
is Tesla's a company that will need to raise external capital to grow,
even if you're an optimist,
because to get from half a million cars or 400,000 cars to two million cars would require production,
production will need facilities to be built that require capital,
and if the stock price is higher, you need to issue fewer shares to raise capital.
So as prices rise, there's a positive feedback effect.
(08:07) There's one potential negative feedback effect.
Tesla has a lot of options outstanding,
a big chunk of those options actually were granted to Elon Musk
by a Board of Directors that didn't know what they were doing, I think.
There were 32 million options outstanding.
You'd think, "so what?"
As the stock price rises the value drained from that options becomes greater
So there's a negative feedback effect.
(08:30) So I'm going to try to factor those in to revalue Tesla in January 2020.
First, let's look at the base year numbers.
In this table I've compared what the base year numbers look like in June 2019 to Jan-20.
No huge movements and it shouldn't -
there's been only 7 months between those numbers and 3 earnings reports.
The revenues have increased by about 9%, not bad, but not as good as it used to be three years ago, four years ago,
but certainly better than what some people were predicting in June of 2019.
The operating margins have become less negative,
in fact, in the last quarter Tesla's operating margins actually turned positive,
nothing to write home about yet,
but that plus makes a difference.
And in terms of cash and marketable securities,
there's a big jump between June of 2019 and Jan-20,
again a fact that's going to reduce default risk.
The number of shares pretty much stayed stagnant.
And I should note that the Jan-20 numbers, I'm using the earnings release from yesterday,
and those are not complete numbers yet.
So I'll wait and revisit those numbers from the full 10-K
when the full 10-K gets filed.
(09:41) We go through the changes I made in my forecast,
because that's what's going to drive my value as of January 2020.
First I'm forecasting more revenues in the future.
Now you can look at the growth rate,
but the growth rate actually is a less - it's not as good an indicator as looking at the expected revenues I have 10 years out.
In June 2019 that number was 102 billion in 10 years.
Now I'm predicting 126 billion, close to 126 billion.
What caused the change?
Part of it is Tesla's growth - return to growth,
part of it is the struggle the traditional auto companies seem to be having making inroads into the EV market.
I've also improved my operating margin from 10% to 12%,
that's a pretty strong move because 10% is already the 75th percentile,
now making Tesla a even more profitable company with a 12% margin,
I'm getting more optimistic in my story.
On the sales to capital ratio which measures how efficient I am investing,
the long term numbers have stayed around 2.00 - which is good for an automobile company,
but for the next five years, I actually allowed Tesla to grow with relatively low reinvestment
and here is why: according to the Tesla earnings release yesterday,
they now have capacity to produce about 640,000 cars,
which is well ahead of what they would need to produce for next year and perhaps even the year after.
They're getting a little breathing room in terms of adding capacity
because they've got ahead of the capacity they need.
So to the extent that I trust Tesla,
I'm allowing them to get three dollars of revenues for every dollar of capital invested.
There's been a drop in the cost of capital, very little to do with Tesla
but more because of what's happened in the market.
First, risk-free rates have decreased by about half a percent.
In addition, equity risk premiums have dropped from between June and now
and you can see that from my website.
The overall effect is the cost of capital for Tesla as a company has decreased from what it was in 2019.
One final change. In 2019, because of Tesla's troubles
and the debt that they had seemed like something that could get them into serious trouble,
I've lowered that probability of failure from 20% in June of 2019 to 10% now.
Overall, I'm telling a much more optimistic story about Tesla and not surprisingly,
the value reflects it.
The higher revenues help, the margins help, the lower cost of capital helps,
but they all feed into a value per share of $427.
(12:11) Now part of you are saying,
"can the intrinsic value change that much in seven months?"
We've been told intrinsic value is stable; we've been told wrong.
A company like Tesla, intrinsic value can and should change.
In fact, to show you where the change is coming from, here's what I did.
I went back to my June 2019 value, which is $190 per share,
and made one change at a time.
First I changed my base year numbers,
in terms of revenues and operating income, that cause an increase of about $24 per share.
Then I lower the cost of capital that increase the value by another $66 per share.
The higher revenue growth increases another $58 per share.
Improving the margin has the biggest move, it increases my value by about $115 per share,
accounts for 44% of the overall increase in value per share.
Drop in the probability of failure increases my value by about $28.
Change in the net debt with the higher cash balance increases the value by about $20.
And finally, the only negative here, is because the stock price has gone up so much,
those 32 million options outstanding are a bigger drain on value.
The overall effect is an increase in value of about $259 per share,
if you take into account the fact that you now have essentially all of these positive ingredients working on it.
(13:32) So, what now?
I'll make a confession, I went into this valuation hoping
that I could continue to hold on to Tesla for at least a few more months.
Two reasons: one is it's nice to have a winner,
you like your winners in your portfolio.
In fact, when the stock has done this well, you want to hold on for a little longer.
The second is more pragmatic. I've held the stock for about seven months,
if I sell now, those will be short-term capital gains
and at least in the US I get taxed with an ordinary tax rate.
If I can hold on for about five months more, it becomes long-term capital gains,
save me about 20% of my gains and taxes, that's a pretty substantial savings.
Well that might be what's driving the optimist in my numbers.
You are probably saying, "why are your revenue so much higher?"
I'd be lying if I'd say the good feeling in the market is not affecting my valuation,
but even with those optimistic assumptions,
the value per share that I got, $427, and I did this after close of trade yesterday,
was lower than the closing price of $581
and then once the earnings report came out, the after-market price jumped to $650.
I can't get there even with my optimistic assumptions.
It is true that I could do some what-ifs, right?
I could raise the revenues to 200 billion, play with the margins,
but the keyword is "play", those numbers are possible but they're not -
I don't think they are plausible or probable, it will be game-playing,
and it's one reason why I don't like to do what-if analyses.
(15:03) You are saying, "well don't I have to deal with uncertainty?"
There's a better way to do it,
and you might have seen me do this in prior valuations.
So I took Tesla and I did a simulation.
I built it around four distributions,
one for revenue growth, where I let the revenue growth vary from 15% to 35%;
one on operating margins, where I essentially allowed for the margin to be different from 12%, lower and higher;
one on sales to capital in that first five years,
where you could disagree with me about how much they would need to reinvest, either on the optimistic side or the pessimistic side;
and finally one on the cost of capital.
With those distributions, you see my value distribution for Tesla.
Now the way I use this value distribution is to look at those percentiles at the bottom.
Now remember that at the $650 stock price in the after-market trading
I'm close to the 90th percentile of my value.
Could Tesla be worth more than $650?
Yes, but it's not plausible or possible at least according to my assumptions.
(16:07) So my decision, you know, as I said my decision was delayed by the fact that I want to hold on
I did look at options; I said maybe I can buy some put options
to delay taking my capital gain,
but options on Tesla are so incredibly expensive given how much volatility priced into them
that it's too expensive for me.
So reluctantly I am selling my Tesla,
in fact, I sold it this morning.
Close to the open I put in a limit sell at $640,
it got executed within 15 minutes of the open.
But my Tesla holding is gone, and as with my (order in) June 2019,
in the near term I don't expect the stock to drop,
in fact I expect it to keep going up,
the momentum is good, the mood is exuberant, it's going to end up...
So in the near term the price will probably continue to go up,
perhaps I'm leaving money on the table, but I have no regrets.
Now as I describe it, I came to play the value game
and I have to stay true to that game.
If I now start to play momentum, I'm playing the pricing game,
and frankly I'm not very good at it, there're people much better at it.
And finally, you know, I liked having Tesla in my portfolio
for the obvious reason that it made money for me
but also because it's an exciting company.
So I'm selling it with some regret and sad that it's leaving my portfolio
but here's the way I console myself:
This isn't a permanent parting, it's a separation, and my view is
that sooner or later Tesla is going to be back in portfolio
because given how mood and momentum shifts in the stock,
it can be undervalued six months from now.
So, now watch out for my next update!
Thank you for listening to me.