• David Grammig

Is Tesla Overvalued?

Of course it’s not!

It’s being run by that smart rich guy who's going to Mars.

He’s a terrific chap.

He smokes weed during public appearances. He has argued that humans most likely exist in a video game. He even blasted a Tesla Roadster into space on a massive rocket because… well... we don't really know why.

Once, while in a traffic jam, he even proposed launching a "Boring Company".

The tweet got slightly misinterpreted.

He was half-jokingly suggesting that he needed a boring-tunnel machine to help dig his way out.

Remember the Cybertruck idea?

Well, you can make fun of him as much as you like, but the guy is worth $34 billion.

Yes but is Tesla overvalued?

Good question. Tesla's share price has quadrupled from its lowest point in May 2019. This is an incredible gain.

It's as if Elon Musk has already landed on Mars and is now racing along the Martian surface in his Tesla Cybertruck. What of Earth is going on? (Terrible pun intended).

Let's break this down.

Up until recently, Tesla burnt through cash quicker than an Aussie bushfire.

During the first quarter of 2019 it posted a free-cash-flow burn of a phenomenal $944 million. Since then, however, it has recorded three successive periods of positive cash generation.

The turnaround is remarkable.

The latest fourth quarter figure came in at an impressive $976 million. In fact, cash flow improved so much that it wiped out Tesla’s first quarter misery, ending 2019 with a positive $973 million in free-cash-flow.

Margins also appear to have improved. Over that same period, its EBITDA margin rose from 1.5 percent to 9.1 percent. The company has even posted a profit of 2.3 percent in the fourth quarter, following 1.4 percent profit in the third-quarter.

There is also a sizeable cash buffer of $6.3 billion. This is thanks to improved cash generation and the $2.3 billion it raised last year. It's twelve-month trailing EBITDA ratio has also declined to 3.3, down from a high of 17.2 during 2018's third quarter.

It would appear that Elon Musk has produced a miracle.

Tesla’s market cap stands, while I’m write this, at $173 billion – it’s reaching distance to double Volkswagen’s own $89 billion market cap. For most ordinary people, it’s very difficult to get your head around how this is possible. Tesla in 2019 produced just 367,000 vehicles, while Volkswagen rolled out a massive 11 million.

Is Tesla’s valuation rational or exuberantly?

Tesla operational improvements are worthy of praise. It has achieved a lot in a very short period, which partly explains the explosive rise in the company's share price.

However, there are some issues.

For instance, stock-based compensation in 2019 came to an eye-watering $898 million. Yes, this won't affect cash, but it will be felt by shareholders. And 10 percent of this will come from Elon Musk's ludicrous-mode pay package.

The company also appears to be reducing its capital expenditure, which is what's needed to grow capacity and develop new vehicles.

At the end of 2019, it came in at $1.3 billion – down $1 billion from the start of the year. In fact, Tesla is now investing far less than any of the major auto manufacturers. This is bizarre, at a time when it's Model Y is about to go into production.

The lofty valuations suggest that markets expect very strong future sales growth from Tesla.

Perhaps markets are right. The company has built up an impressive portfolio of intellectual property and has had a huge head start over traditional auto manufacturers.

But it’s going to need to spend to grow.

Perhaps we should temper our enthusiasm for Tesla

Until very recently, Tesla has been raising more cash from selling shares and bonds, than from selling actual cars to customers. It’s done this at breakneck pace, to the extent that it will need to be extremely cash generative in the years to come to justify current valuations.

This appears to be how Tesla is trying to present itself to the market. And, the market appears to be buying it.

Tesla’s argument is that it’s building up a business for an industry that currently doesn’t fully exist yet. In ten years, it most likely will. When it does, this new industry is going to become a multi-billion dollar, if not a trillion-dollar market.

The news flow supports the growth of this industry. We’ve heard everything from Greta Thunberg telling the world to behave to the UK’s plans to ban sales of diesel and petrol cars by 2040.

Tesla has a massive lead on the traditional auto manufacturers. However, they aren’t going to go down without a fight.

Pretty much every major auto manufacturer is planning to launch all-electric equivalents of their combustion engine vehicles.

When this happens, margins are going to drop and Tesla might be at risk of being overtaken.

James Eagle is a freelance investment writer and a capital raiser. Get in touch by email: jamescceagle@gmail.com

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