Tesla's Future Charged With Uncertainty

 Tesla Motors (TSLA) has the momentum and charging infrastructure to be the dominant electric vehicle firm, but we do not see it having mass-market volume for at least another decade. Tesla's product plans for now do not mean an EV for every consumer who wants one, because the price points are too high. We think the Model X crossover due in 2015 will start somewhere between $55,000 and $70,000, but will average higher as consumers add options. The Model 3 sedan will start at about $35,000, according to an interview with CEO Elon Musk earlier this year, and will start selling in 2017 or 2018. This price is before any tax credits, but the $7,500 U.S. federal tax credit only applies to the first 200,000 vehicles Tesla produces starting Jan. 1, 2010.

Tesla has said that when its gigafactory--a lithium-ion battery plant under construction in Nevada--is fully operational by 2020, it will be able to produce 500,000 vehicles a year at its sole assembly plant in Fremont, California. Without the gigafactory, Musk said on the July earnings call that the firm can make 200,000 vehicles "if you really push it." Even if demand exists for these vehicles, this quantity is quite small relative to total global auto production, which is likely to reach 100 million units in the next few years. Therefore, we think global mass adoption of pure electric vehicles is still a long way off. In the meantime, Tesla will have growing pains and perhaps more than one or two recessions to fight through before reaching mass-market volume. Even if industry forecasts of sub-1% market share for EVs prove far too conservative, it is important to keep the hype about Tesla in perspective relative to the company's very limited production capacity. Tesla's mission is to make EVs increasingly more affordable in order to bring electric mobility to the world, 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 need to be done even during downturns in the economic cycle.

Growth Runway Lucrative, but Value Destruction Possible
We do not see an economic moat yet because Tesla is still early in its life cycle. This dynamic creates huge uncertainty as to whether the firm will succeed in continuing to make great product at an affordable price and whether enough consumers will make the switch from internal combustion engine and hybrid vehicles. There is evidence suggesting Tesla will succeed, but if not, Tesla will remain an automaker for the wealthy. In a January Automotive News interview, Musk said in regard to Tesla making it, "I think we will, but this is not a bold assertion we unequivocally will. There is a possibility we may not."

Tesla's growth runway looks very lucrative, but this growth also requires constant substantial reinvestment in platforms, the gigafactory--for which Tesla is only spending about 40% of the cost while suppliers pay the rest--and annual assembly capacity, since the current plant in Fremont will eventually be limited to about 500,000 units. During this growth phase there will almost certainly be a recession or two. In times of economic uncertainty, it is difficult to say what Tesla's sales volume will be or what access, if any, the firm will have to capital markets.

For a narrow moat rating, a company must have excess normalized returns more likely than not be positive 10 years from today, and there must not be any substantial threat of major value destruction. All three of our valuation scenarios have returns on invested capital good enough for a moat, with the metric averaging above our weighted average cost of capital of 9.5%, but we also see risk of major value destruction should EV adoption flop or occur much slower than any of our three 10-year forecast periods assume. For that reason, we wait for now to award Tesla a moat, but we see a positive moat trend as a result of the strengthening of the firm's brand and its cost structure.

Although we stress the uncertainty in investing in Tesla today, the company's competitive position is better than some may expect from a tech startup that makes automobiles. Looking at our five moat sources, we see a case for brand (intangibles) and cost advantage as sources of a moat in the future. Some may argue for efficient scale, claiming that Tesla is the dominant pure EV firm. Although Tesla's long range gives it a huge advantage over pure EVs on the market (265 miles EPA range for the 85 kWh battery versus 84 miles for the Nissan LEAF and 76 miles for the Ford Focus), we consider Tesla's competition to be the entire auto industry rather than just EVs. There are far too many automakers all over the world for us to claim that Tesla's market is effectively served by a small number of players.

Musk's own words do not support efficient scale. He wrote in a June 12 blog post announcing that Tesla would not sue companies that use its patented technology in good faith: "Given that annual new-vehicle production is approaching 100 million per year and the global fleet is approximately 2 billion cars, it is impossible for Tesla to build electric cars fast enough to address the carbon crisis. By the same token, it means the market is enormous. Our true competition is not the small trickle of non-Tesla electric cars being produced, but rather the enormous flood of gasoline cars pouring out of the world's factories every day."

Outlook Uncertain for Electric Vehicles
Investing in Tesla comes with tremendous uncertainties due to the future of electric vehicles and energy storage. Until the Model 3 goes on sale, there is no way to know for sure 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 for Tesla and could one day stall growth. The energy storage market for solar does not exist today, so there is very high uncertainty as to whether Tesla's plans will succeed. 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 U.S., Norway, and China constituting about 77% of first-half 2014 revenue.

We see Tesla's fate closely linked to Musk's actions, so should he leave the company we would not be surprised to see the stock fall dramatically. Also, Musk has more than 10 million Tesla shares as collateral for personal debt. Selling this block of shares quickly would cause a rapid fall in Tesla's stock price. Musk has also said that Tesla's stock price looks high and the short-term outlook on it is not clear. Given the many uncertainties regarding investing in Tesla today, our fair value uncertainty rating will remain very high for some time.