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Tesla Charges Ahead

We boosted our valuation on an improved profit outlook, but the EV maker still isn’t a buy.

We recently increased our Tesla TSLA fair value estimate to reflect our brighter forecast for the company’s long-term automotive profitability, thanks to increased vehicle deliveries, higher average vehicle prices, and lower unit production costs. We continue to believe that Tesla has the potential to disrupt the automotive and power generation industries with its technology for electric vehicles, autonomous vehicles, batteries, and solar generation systems.

Tesla is the largest battery electric vehicle maker in the world. In less than a decade, it went from a startup to a globally recognized luxury automaker with its Model S and Model X vehicles. The company also competes in the midsize car and crossover SUV market with the platform that is used for its Model 3 and Model Y vehicles. Tesla plans to sell multiple new vehicles over the next several years, including a platform that will be used to make an affordable sedan and SUV, a light truck, a semi truck, and a sports car.

Tesla’s strategy is to maintain its market-leading status as EVs grow from a niche auto market to mass consumer adoption. To do so, the company is undergoing a massive capacity expansion to increase the number of vehicles it can produce. Tesla also invests around 6% of its sales in research and development, focusing on improving its market-leading technology and reducing its manufacturing costs.

For EVs to see mass adoption, they need to reach cost and functional parity with internal combustion engines. To reduce costs, Tesla focuses on automation and efficiency in its manufacturing process, such as reducing the total number of parts that need to be assembled in a vehicle. It will also move upstream into battery production, with a goal to reduce costs by over 50%. To reach functional parity, EV will need to have adequate range, reduced charging times, and availability of charging infrastructure. Tesla’s extended-range EVs are already at range parity with ICE vehicles and should improve further with plans for batteries to improve energy density. Tesla also continues to increase its supercharging network, which consists of fast chargers built along highways and in cities throughout the United States, European Union, and China.

The company is attempting to take a larger share of its customers’ auto-related spending, which includes selling insurance and offering paid services such as autonomous driving functions. It also sells solar panels and batteries used for energy storage to consumers and utilities. Tesla is well positioned to grow in the expanding solar generation and battery storage market.

Narrow Moat From 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 the company to keep innovating to stay ahead of startup and established competitors. The Model S Plaid, the most upgraded version of Tesla’s luxury sedan, offers 390 miles of range, at the high end for electric vehicles. Further, the car does 0-60 mph in under 2 seconds and has 1,020 horsepower, putting it in a rare class of performance among all autos regardless of powertrain. By focusing on the luxury auto market first, Tesla was able to create tremendous publicity that reaches beyond its customers. This generated strong consumer demand for its subsequent vehicles at lower price points, such as the Model 3 and Model Y. As other new vehicles are launched, such as the Cybertruck or the platform that will produce the affordable sedan and SUV, we expect the company’s strong brand will continue to generate consumer demand.

Tesla’s high-tech vehicles have the ability to receive drivetrain and other updates via Wi-Fi or a cellular connection, and customers do not have to visit a store for many service needs. Tesla will instead pick up the vehicle from home and often return it the same day, while providing a fully loaded loaner for no charge, or visit the customer’s home or work and service the car there. This much easier experience helps Tesla’s brand equity and has been accomplished with little to no spending on advertising, which is rare for a consumer brand. This strong brand equity has also carried over to Tesla’s energy generation and storage business, where the company can charge a premium for its fully integrated solar panel, inverter, and home battery storage systems sold to consumers.

Tesla’s proprietary technology also contributes to its intangible asset-driven competitive advantage, given EVs’ innovative, highly engineered nature and because patents for EV technologies hold somewhat less value due to the ability of competitors to create alternatively designed but ultimately similar products. Since launching the Model S in 2012, Tesla has produced the best EVs on the market. The company invests nearly 6% of sales in R&D to maintain its best-in-class range, which is well ahead of the competition on a miles/kilowatt-hour basis, and continues to improve other vehicle specifications such as power. Tesla is also investing heavily in its proprietary autonomous vehicle technology and building one of the world’s largest supercomputers to train self-driving artificial intelligence. With R&D spending in line with its peers, Tesla should be able to maintain its proprietary technological advantage.

In the coming years, Tesla will face increasing competition. Automakers plan to electrify their fleets by adding EV versions of existing vehicles and creating new platforms. However, we see EVs becoming a greater proportion of auto sales, growing to 30% by 2030 from 3% in 2020, which will expand the market as EVs rapidly take share from internal combustion engine vehicles. As new models are introduced, Tesla’s technological advantage and the strength of its brand will remain intact, which will allow the company to continue to charge a premium price for its EVs.

We also think Tesla benefits from a cost advantage thanks to manufacturing scale. Tesla’s total vehicle volume has grown from just over 100,000 in 2017 to nearly 600,000 (on a trailing 12-month basis as of the first quarter of 2021). During the same period, the company’s average cost of goods sold per vehicle has fallen 55% from $84,000 to under $38,000 and gross profit margins have expanded from 23% to a little under 27%. While some of this is due to manufacturing a greater proportion of midsize cars and SUVs versus luxury autos, the majority of the decline has come from the company’s focus on reducing manufacturing costs through scale. Legacy automakers are gradually transitioning to BEV production from internal combustion engines, but we expect they will be saddled with legacy ICE costs for a long time. Even as legacy automakers begin to produce more EVs, we expect Tesla will continue to have a lower-cost operation as it has outlined a plan to reduce battery cell costs by 56% over the next several years. With the company’s cost per vehicle set to fall, incumbent automakers may take years to catch up to Tesla, or never do so, as they won’t want to build many new factories from scratch like Tesla is doing.

We think Tesla’s combination of intangible assets and cost advantage will persist and allow the company to generate excess returns on capital. We see the potential for Tesla to outearn its cost of capital over at least the next 20 years, which is the measurement we use for a wide economic moat rating. However, the second 10-year period carries significant uncertainty for both Tesla and the broader automotive industry, given the rapid advancement of autonomous vehicle technologies that could transform how consumers use vehicles. As such, we view a narrow moat rating, which assumes a 10-year excess return duration, as more appropriate.

Tremendous Uncertainties

Electric vehicles could remain a niche segment if mass-market consumers do not adopt the new powertrain technology because of its higher costs and worse function (range, recharge time, and availability of charging). EVs could also be disrupted by other powertrain technologies. The automotive market is highly cyclical and subject to a sharp demand decline based on economic conditions.

As a market leader in EVs, Tesla is subject to growing competition from traditional automakers and new entrants. With more EV choices, consumers may view Tesla less favorably. The company is investing heavily in capacity expansions that carry the risk of delays and cost overruns. It is also investing in R&D in an attempt to maintain its technological advantage with no guarantee that these investments will bear fruit. The CEO owns about 21% of Tesla’s stock and uses it as collateral for personal loans, which raises the risk of a large sale to repay debt.

Tesla faces several environmental, social, and governance risks. As an automaker, Tesla is subject to potential product defects that could result in recalls. We see a moderate probability and moderate impact should this occur. Other risks involve human capital. If Tesla is unable to retain key employees, such as CEO Elon Musk, its favorable brand image could decline. It also faces the risk of its employees unionizing. Management has made statements against this, but it could force the company to pay higher wages, hurting profitability. We see a low probability but moderate materiality for both of these risks.

Additional ESG risks include potential patent litigation as the company relies on new technology to improve its EVs and energy storage systems. We see a low probability but moderate materiality should this occur. Tesla may also be faced with regulatory issues in some U.S. states due to laws that require automakers and dealers to be separate. We see a moderate probability but low materiality.

Exemplary Capital Allocation

We rate Tesla’s balance sheet as sound. The company’s revenue is subject to high cyclicality, and the majority of its debt and financial lease obligations are due within the next three years. However, with a healthy balance sheet and cash exceeding total debt, Tesla should be able to meet its financial obligations and either repay or refinance its upcoming debt.

We view management’s investments as exceptional. Tesla’s aspirational goal is to expand its EV volume from roughly 500,000 units in 2020 to 20 million by 2030. To do so, the company is investing in new factories around the world, especially in the U.S. and EU. Given strong consumer demand, we think the capacity expansion plans make sense. We are also in favor of the company’s focus on reducing manufacturing costs on a per unit basis while investing to maintain its technological advantage. To reduce costs, Tesla makes its own batteries, with plans to expand its own battery cell production from an annual capacity of 100 gigawatt-hours in 2022 to 3 terawatt-hours by 2030. The battery will also be incorporated into the structural design of the EV. Tesla’s battery improvements aim to enable a 56% reduction in the cost per kilowatt-hour, a 54% range increase, and a 69% reduction in investment per gigawatt-hour.

We are in favor of the focus on reducing costs, as this should enable Tesla to keep its cost advantage intact as large legacy automakers electrify further this decade. Reduced manufacturing costs should enable Tesla to increase profit margins for its existing vehicles and produce an affordable sedan and SUV at a profitable level in the future. We also think management is smart to look at adding ancillary revenue streams such as selling insurance and autonomous driving software, both of which can increase total customer spending.

We see shareholder distributions as appropriate. Tesla does not pay a dividend and does not repurchase shares. Instead, the company has used the capital markets to issue stock, most recently at value-accretive levels. Given that Tesla is investing heavily in expanding its vehicle and battery production capacity, we think the best use of capital is internal reinvestment to fund organic growth rather than shareholder distribution. As such, we don’t think Tesla should pay a dividend or repurchase shares anytime soon.

CEO Musk’s compensation comes entirely from stock awards. Under the current plan created in 2018, Musk can earn up to 101.3 million stock option awards (split adjusted, at a price of $70.01 per share) in 12 tranches based on meeting revenue, EBITDA, and market capitalization targets. While we understand the revenue and EBITDA targets for a growing company, we would prefer a return on invested capital metric be added in future equity awards.

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