Justin Sullivan
Despite being the industry leader in electric vehicle (“EV”) sales, Tesla’s (NASDAQ:TSLA) near-term growth outlook – both from a fundamental and valuation perspective – is becoming increasingly uncertain. Blighted by a wide range of challenges spanning macroeconomic headwinds, industry-specific roadblocks, and other Tesla-specific skepticism among investors (e.g., share dilution risks and lack of management focus with CEO Elon Musk’s attention spreading thin across his many ventures), the stock has been subject of turbulence in recent weeks, contesting new 52-week lows not seen since November 2020.
The Fed’s monetary tightening trajectory will be at the top of the watchlist for factors impacting Tesla’s stock over the next 12 months, as it will dictate demand across the company’s key markets – namely, the U.S. and China. How the broader macroeconomic outlook unfolds will also impact Tesla’s margins, as well as investors’ sentiment – a key determinant for how they will respond to company-specific headlines (i.e., whether investors will adopt a “buy-the-dip” or “shun the stock” mentality on Tesla during the risk-off market climate).
While the immediate challenges facing Tesla are likely to push it closer towards our bear case PT of $150, said levels would make a compelling entry opportunity given the EV titan’s medium- to longer-term competitive strengths as previously discussed. Although Tesla will inevitably face accelerated erosion of its market share, and inadvertently, eradication of its first-mover advantage that had helped it build its industry-leading auto margins over coming years as upstarts and legacy automakers alike join in on the electrification wave, the company’s prudent procurement of critical raw material supplies makes a longer-term competitive advantage to hedge against probable risks of another industry-upending component constraint like the auto semiconductor shortage observed over the past year that has roiled auto production volumes, sales growth and profitability.
Fed Tightening’s Impact on Valuations
The Fed’s trajectory on monetary tightening to quell the biggest pace of price increases in four decades continues to add uncertainty on when the ongoing valuation correction that has roiled markets this year will cease. The recent release of mixed key economic data driving the Fed’s policy outlook has only blurred the picture further. Slower-than-expected CPI and PPI figures in October were positive signs that suggest the peak of inflation is potentially behind us, while the biggest retail sales growth in eight months shows the economy is still stronger than what the Fed would like to see before pivoting from its hawkish policy stance.
With inflation still far from the Fed’s 2% target, policymakers are likely to stick with plans for “further rate hikes into restrictive territory until there is structural evidence that demand has slowed and inflation is under control”. Even the most dovish commentary from policymakers as of late points to a higher terminal rate than the 4.25% to 4.5% they had previously anticipated:
‘If the economy proceeds as I expect, I believe that 75 to 100 basis points of additional tightening will be warranted,’ [Federal Reserve Bank of Atlanta President Raphael Bostic] said in prepared remarks for a speech in Fort Lauderdale, Florida, on Saturday. ‘It’s clear that more is needed, and I believe this level of the policy rate will be sufficient to rein in inflation over a reasonable time horizon.’ Bostic’s plan would shift away from 75 basis-point hikes and continue to raise rates to as much as 4.75%-5% over the next several meetings, which he described as a “moderately restrictive landing rate” where the Fed would go on hold for an extended period to continue to put downward pressure on prices.
Source: Bloomberg
In addition to tighter financial conditions ahead, continued rate hikes will also increase the cost of growth and compress investment valuation multiples further, leading to more market turbulence over coming months. From a valuation theory standpoint, continued rate hikes – or essentially, cost of capital – would diminish a firm’s “steady-state value” under conditions when “NOPAT (net operating profit after tax) is sustainable indefinitely and incremental investments will neither add, nor subtract, value”, as well as a company’s “future value creation” that represents the incremental value that investments earn relative to the cost of capital. As discussed in our recent coverage on Tesla, the company continues to benefit from a lofty premium attributed to the “future value creation” portion of its valuation that may not be sustainable for much longer ahead of a rapidly deteriorating macroeconomic backdrop. Meanwhile, its steady-state firm value is likely to see further erosion as well as costs of capital increase with rising interest rates. Specifically, the steady-state firm value can also be denoted by a forward P/E ratio equivalent to 1/firm cost of equity:
A company can continue to grow earnings as it invests at the cost of capital. It will just fail to create value, and hence should trade at its steady-state worth. We can readily translate from the steady-state value to a steady-state price-earnings multiple, which is the reciprocal of the cost of [capital].
Source: Credit Suisse
This would continue to bode unfavourably for equities across the board, particularly those like Tesla that continue to trade at lofty premiums compared to peers with a similar growth profile and capital structure, as the Fed’s aggressive rate hike trajectory persists.
The Fed’s monetary tightening trajectory would also dictate near-term demand for EVs, which Tesla’s performance remains synonymous for. EV demand this year has remained relatively resilient compared to the broader passenger vehicle market, buoyed by the segment’s supply-constrained nature still, as well as stronger purchasing power among its more affluent consumer base (the average EV MSRP this year has topped $60,000, pricing out close to half of American households). But despite the relative resilience demonstrated by EV demand, growing uncertainties over the global macroeconomic outlook is likely to derail the segment’s adoption trajectory in coming months.
The combination of rising interest rates and persistent inflationary pressures are starting to chip away at American household savings, which has fallen from an average of 3.5% in the second quarter to 3.1% in the third quarter. An increasing volume of the population is also turning to credit card spending, with related short-term debt approaching $900+ billion in September. Meanwhile, buying behaviour is starting to favour necessities and services over big-ticket products like new vehicles. This points to a tough demand environment over coming months for Tesla, as its core market in the U.S. reels from the increasingly prominent aftermath of deteriorating consumer sentiment and purchasing power amid tightening financial conditions.
China’s Policy Outlook
Turning to China – another key market for Tesla – EVs remain a bright spot. The Asian nation now accounts for almost 60% of the vehicle segment’s sales worldwide. Meanwhile, local EV penetration has topped 30% based on the latest passenger vehicle sales data from October.
Yet, the country’s strict adherence to an extended and stringent COVID Zero policy, alongside an ongoing slump in its GDP-driving property sector is upending the Chinese economy, which could make a near-term headwind for Tesla:
Specifically, China’s retail sales continued to decelerate, with September exhibiting a mere 2.5% y/y growth, falling short of consensus expectations for 3.3% y/y growth and marking the slowest expansion in four months. Specifically, auto sales are expected to slow, with even the more resilient EV sector forecast to report a deceleration in October sales. The previous anticipation for seasonality-driven demand in the fourth quarter, and pull-forward sales as a result of extended regional tax breaks on eligible EV purchases and the looming end to the nation-wide EV purchase subsidy by year-end are likely further away from realization now as well given the increasingly bleak macroeconomic outlook.
Source: “Is NIO Stock A Buy After Q3’22 Earnings? Keep Your Eyes On COVID Zero”
This is further corroborated by the recent decline in Tesla’s shipments from Giga Shanghai to the local market, with recent price cuts to its vehicles sold in China by as much as 9% following Musk’s concerns over a potential “recession of sorts” in the region pointing to a more marked slowdown in near-term demand. Sentiment remains fragile despite the recent injection of optimism following Beijing’s decision to ease COVID restrictions and property sector policies in hopes of shoring up growth. Ensuing expectations for a potential recovery has already been eclipsed by fears that authorities might reverse recent decisions to ease COVID Zero restrictions after the country reported its first COVID-deaths in months over the past weekend. Expectations for China’s 2022 GDP growth has only become increasingly muted compared to the central government’s earlier target of about 5.5%.
In addition to demand risks, the slowing Chinese market will also weigh on Tesla’s industry-leading auto profit margins. Giga Shanghai is currently Tesla’s most efficient manufacturing facility and produces the highest margin vehicles. With less of these Shanghai-made units sold to the local Chinese market, which accounted for almost a quarter of Tesla’s 3Q22 sales, and at a lower price, the company’s auto gross margins will likely see continued pressure over coming quarters. Having an increasing volume of Shanghai-produced vehicles exported to Europe also suggests risks of stalled capacity in the newly expanded facility in the near-term, exposing Tesla to additional costs of underutilization. While Musk has repeatedly proclaimed that Tesla has a supply problem and not a demand problem, said phenomenon could potentially be unraveling as the global economy faces probable risks of recession over the next 12 months.
Tesla’s Internal Headache
Europe Headwinds- Elevated ramp-up costs over the near-term pertaining to Tesla’s Berlin and Texas facilities is another near-term consideration that could compound its profit risks. Specifically in Europe, the energy crisis linked to the ongoing Russia-Ukraine war not only risks higher production costs in the region for Tesla, but also another core region with slowing demand as the bloc braces for a recession with further economic contraction through early 2023. This, again, compounds concerns for underutilization of capacity in the near-term for Tesla – Europe’s making its own Tesla vehicles in Berlin, while excess units from Shanghai are also being shipped to the region that is now facing an impending slowdown. The near-term pains in Europe are further corroborated by the region’s muted auto sales trends, which remain “far below what was considered normal operating volume pre-pandemic…[with] manufacturers starting to see signs consumers are taking a pause”.
Compressing Margins- Overall, we consider profitability a major near-term overhang for Tesla that could be unfavourable for the stock under the current market climate where investors continue to favour bottom-line expansion over growth. Particularly, Tesla’s lofty valuation premium still reflects the market’s continued optimism over the sustainability of its industry-leading auto margins, which is becoming increasingly vulnerable to a wipe-out in the near-term given protracted inflationary pressures, growing underutilization risks, and slowing demand.
Management Uncertainties- There is also rising discontent among Tesla investors over the dilution of Musk’s attention across his many ventures – the most recent being the high-profile, dramatic acquisition of Twitter. Musk has long been a centrepiece to Tesla’s rise to the top among retail investors. His presence symbolizes both the good and bad – good being he remains the face of pioneering mass market EV adoption with many still linking Tesla’s success to Musk’s direction at the helm; and bad being Musk’s association as a “newsmaker” with anything and everything he says sometimes injecting unnecessary volatility to Tesla’s stock, often taking investors on a wild ride and stirring regulatory scrutiny. While recent reports that Musk has found a successor to potentially takeover his role in managing Tesla’s day-to-day duties in a few years is a positive development, questions over whether he can maintain the undivided attention the EV company needs amid mounting macro and industry headwinds in the operating backdrop remains a key focus area for investors and potential drag on the stock in the near-term.
Share Sale Pressure- There is also a growing risk of continued share sales in mass volumes by Musk to appease his rolling list of reasons, spanning the need for liquidity to settle his personal tax bills to funding his many ventures. Time and again during the past year’s bear market when investors needed him most, Musk has left his promise to “be the last one to sell Tesla” on the back burner. The richest man on the planet has cashed in $36 billion worth of his Tesla stake since last November from selling shares to settle his tax bill on stock options that needed to be exercised at the time, and more recently, 19.5 million shares worth $3.95 billion earlier in the month to fund his Twitter buy-out. His stake in Tesla has fallen from 23% (including stock options) to 14% over the same period.
Recognizing investors’ growing aversion, Musk has hinted at a potential share buyback program in the range of $5 billion to $10 billion beginning next year, which we view as reasonable considering the company’s robust cash flows generated from operations. However, it remains too soon to tell if said relief is coming soon, given Musk’s track record of overpromises and “overly optimistic timelines”, and a “Board review and approval” still up in the air. The skepticism is further corroborated by our back-of-the-napkin comparison to Apple (AAPL) – a similarly resilient peer to Tesla in terms of market valuation performance this year – which launched its inaugural share buyback program valued at $10 billion in March 2012 when it achieved an EBITDA margin of more than 30%, compared with Tesla’s EBITDA margin in the mid-20% range today.
Risks to the Near-Term Bearish Thesis
Despite mounting downside risks facing Tesla’s near-term outlook, the company has had a reputation for its mixed bag of tools to salvage sentiment. As discussed in our previous coverage, Tesla’s initial delivery of the Semi trucks powered by the 4680 cells later this year suggests that a lower price mass market product might be on the way.
Although Musk had previously shut down speculation on Tesla’s development of a $25,000 compact car to better penetrate the mass market and overcome growing competition within the increasingly saturated EV landscape, the card is still on the table for the company to reconfirm the project. This could be a major catalyst for lifting investors’ confidence and helping Tesla’s still-lofty valuation premium weather through the looming macro storm. The lower price mass market product will not only help Tesla better compete against cheaper rival offerings, but also “attract consumer dollars amid an inflationary environment, and accelerate its longer-term plans to sell 20 million vehicles per year”, eliminating the near-term underutilization risks discussed in the foregoing analysis. The 4680 battery cells also boast better economics, which could further jack up its auto margins over the longer-term as production ramps up, and overshadow near-term concerns on profitability.
Final Thoughts
Tesla’s lofty valuation premium amid a volatile market climate, paired with mounting near-term uncertainties over the global macroeconomic backdrop, as well as both industry- and company-specific challenges make an overall bad mix that points to elevated downside risks over coming months for the stock. The EV maker’s 3Q22 performance, alongside recent deterioration in auto demand observed across its core markets (i.e., U.S., Europe and China) is putting our bear case PT of $150 for the stock a likely outcome in 2023. This would represent about 26x Tesla’s estimated earnings, making it a reasonable entry opportunity for longer-term upside potential buoyed by the company’s robust balance sheet, sustained growth trajectory stemming from a favourable secular demand environment for EVs, as well as its supply advantage to satisfy said demand.
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