Tesla's Moat Rating Gets a Boost

After upgrading Tesla’s TSLA economic moat rating to narrow from none and accounting for good third-quarter results, we have raised our fair value estimate to $319 per share from $195. About 41% of the increase is from the moat upgrade, while nearly all the rest is from increasing our estimate of total vehicles delivered through 2029 by about 37% to 22.7 million. This change leads to more scale and an increase in our midcycle operating margin to 12% from 11%.

Tesla has a chance to be the dominant electric vehicle company and is a leading autonomous vehicle player as well as a vertically integrated sustainable energy company with energy generation and storage products, but we do not see it having mass-market volume this decade. Tesla’s product plans for now do not mean an electric vehicle for every consumer who wants one, because the prices are too high. The Model X crossover released in late 2015 starts at about $80,000, the Model S sedan’s starting price is $69,420, the Model 3 sedan starts at $37,990, and the Model Y crossover starts at about $50,000. Tesla’s U.S. customers no longer receive the federal tax credit.

Tesla’s gigafactories may become terafactories as the company seeks to expand its cell capacity to 3 terawatt-hours by 2030 from 0.1 terawatt-hour in 2019. A new factory in Shanghai, wholly owned by Tesla, opened in late 2019 with capacity as of fall 2020 for 250,000 Model 3 units and another 150,000 units for Model Y on line in 2021. Gigafactory Berlin (3 and Y) is under construction until 2021, as is a Texas plant for the Cybertruck and Y. Tesla’s global vehicle capacity as of fall 2020 is about 850,000. Tesla sold about 368,000 vehicles globally in 2019, and by 2030, CEO Elon Musk targets annual volume of 20 million, about double the size of Toyota and Volkswagen Group. We think global mass adoption of pure electric vehicles is still years away, but Tesla is the leader in the space.

Tesla will have growing pains, recessions to fight through before reaching mass-market volume, more competition, and needs to pay off debt. It is important to keep the hype about Tesla in perspective relative to the company’s limited, though now growing, production capacity. Tesla’s mission is to make EVs increasingly more affordable, which means more assembly plants must come on line to achieve annual unit delivery volume in the millions. This expansion will cost billions a year in capital spending and research and development and will be necessary even during downturns in the economic cycle.

Why We Think Tesla Has a Narrow Moat Our moat rating upgrade comes from two of our five moat sources: intangible assets and cost advantage. Tesla's brand cachet is not likely to be impaired anytime soon as other automakers move into the battery electric vehicle space because we expect Tesla to keep innovating to stay ahead of startup and established competitors. The Model S now offers over 400 miles of range and the plaid mode performance upgrade available in late 2021 will enable the sedan to do 0-60 mph in under 2 seconds and have over 520 miles of range. We think Tesla's autonomous program is also well ahead of many other automakers. We think Musk was very smart to not only design a great-looking car, but also have Tesla right away sell vehicles at a premium price point. This created tremendous media publicity for Tesla beyond its customers, which we think created a halo effect for Model 3 and Model Y demand when they were introduced, as well as for the Cybertruck, which we think is ugly, but that ugliness is ironically part of its appeal. We think that if Tesla had started with a mass-market vehicle, it probably would have failed, as too few people would have known about the car and would have been willing to pay for the brand. We also think Tesla benefits from a first-mover advantage in electric vehicles that let it build factories and vehicles from scratch and create processes that legacy automakers will likely find hard to match.

The ability to possibly reduce battery cell costs by 56%, as outlined at the company’s Sept. 22 Battery Day event, suggests a cost advantage that incumbent automakers could take years to catch or may never catch, as they won’t want to build many new factories from scratch as Tesla is doing. Legacy automakers are gradually transitioning to BEV production from internal combustion engines, but we expect they will be saddled with legacy ICE costs and people costs for a long time. Our return on invested capital projections for Tesla are well above our estimated weighted average cost of capital even in our bear-case scenario. The moat upgrade assumes Tesla continues to grow. We see low risk of material value destruction and more reasons to upgrade the moat than to keep waiting for further improvement.

We think Tesla’s gross margin, all else constant, would have a negative mix shift over time as the cheaper Model 3, Model Y, and a planned $25,000 vehicle become the vast majority of volume, but battery costs should also decline significantly. These reductions and adjusted gross margin calculations we’ve done comparing Tesla with German automakers--along with Tesla’s unique factory-owned stores enabling the company to get retail pricing rather than wholesale pricing--are in our view a cost advantage over other automakers and lay the ground for the moat widening once Tesla’s volume allows more scale of its R&D and overhead expense. A similar scale argument can be made for the energy business. Though long term there’s nothing stopping an ICE company from being a BEV-only company and narrowing Tesla’s cost advantage, we see legacy companies as having legacy cost structures around ICE vehicle programs that cannot be eliminated overnight, as these programs are needed to keep those companies profitable while also developing BEVs.

The other cost advantage comes from the customer side via total cost of ownership, as the cost of electricity for a year versus the cost of gas is not even close. Model S owners’ electric costs are a fraction of what ICE owners pay for gas, per our calculations. Our annual cost calculation done in January 2020, defined as electricity/gas, insurance, and maintenance, shows the Model 3’s cost per mile to be about 15% less than the BMW 330i’s.

Immense Uncertainties Remain Investing in Tesla comes with tremendous uncertainties due to the future of electric vehicles and energy storage. In a recession, investors may not want to hold the stock of a company whose story will not play out until next decade, or Tesla could fail to raise capital when it needs it. Until an electric vehicle far cheaper than the Model 3 goes on sale in mass volume, there is no way to know if consumers in large volume are willing to switch to an EV and deal with range anxiety and longer charging times compared with using a gas station. Tesla is fighting a state-by-state battle to keep its stores factory-owned rather than franchised, which raises legal risk and could one day stall growth. Other automakers are entering the BEV space. If the company's growth ever stalls or reverses, we would expect a severe decline in the stock price because current expectations for Tesla are immense, in our opinion. With a young, growing company, there is always more risk of diluting shareholders or taking on too much debt to fund growth. Tesla also has customer concentration risk, with the United States and China constituting about 64% of 2019 GAAP revenue, up from 56% in 2015.

We see immense key-man risk for the stock, as Tesla’s fate is closely linked to Elon Musk’s actions. Should he leave the company or if the Securities and Exchange Commission bans him from running Tesla--he already is barred from holding the chairman role for three years following a 2018 settlement with the SEC on civil securities fraud charges--we would not be surprised to see the stock fall dramatically. Also, Musk has 18.5 million Tesla shares as collateral for personal debt. Selling this block of shares quickly may cause a rapid fall in the stock price. Tesla will soon have formidable EV competition that it’s never had before from German premium brands, GM, and Ford. It’s uncertain if Tesla vehicle owners will also want solar panels and batteries in sufficient volume to justify buying SolarCity. Given the many uncertainties regarding Tesla today, including COVID-19 and the debt load, our fair value uncertainty rating will remain very high for a long time.

Since its 2010 initial public offering, Tesla has used convertible debt financing as well as frequent secondary equity offerings and credit lines. At year-end 2019, the company has $3 billion in unused committed amounts under credit lines and financing funds. At times, the stock has been so popular that we think the company could dilute shareholders and the stock would not suffer. Two offerings in 2020 totaling over $7 billion support that premise. The stock also increased in value after the August 2015 announcement of an equity offering, likely due to cash burn concerns being eased. Offerings like the $2.3 billion February 2020 stock sale and $5 billion in September 2020 add to Tesla’s growing cash pile, which gives the market optimism that Tesla can keep growing.

Total debt at year-end 2019 was about $12.5 billion of principal, with $4.6 billion of that amount nonrecourse debt mostly backed by SolarCity’s asset-backed security issuances and a warehouse line secured by cash flows from vehicle leasing contracts. Recourse debt maturities between 2020 and 2024 total about $6.1 billion. No major maturities occur in 2020, but 2021 maturities total $1.4 billion with a $1.38 billion convertible bond maturing in March 2021. Management said some convertible debt will be put to the company in the fourth quarter due to the stock’s upward run. The conversion price of these notes is $359.87 per share, but our reading of the debt footnote says Tesla would pay the principal back in cash. In August 2017, Tesla issued $1.8 billion of senior unsecured notes due in 2025 at only 5.3%. The deal was the company’s first straight bond offering. Musk said in 2018 that Tesla will pay its debts off rather than refinance, which if achieved would alleviate our balance sheet concerns, but the May 2019 debt offering delays Musk’s debt-reduction goal. Tesla has raised over $7 billion of stock in 2020, so we think for now the balance sheet is in good shape with $14.5 billion of cash as at Sept. 30.