Ray Kroc who brought McDonald’s in 1964 once famously said to Harvard MBA students that “Ladies and gentlemen, I’m not in the hamburger business. My business is real estate.” So, why are we starting with McDonald’s in an article that’s meant to discuss Tesla? Let’s explore.
First, let us look at McDonald’s example that has now franchised most of its restaurants. At the end of 2018, the company had $23 billion as net property and equipment—70% of its total assets. Under its conventional franchise agreement with he franchises, it charges rent for these properties that’s either a base rent or a cut of sales. In fact, many activist investors in the past have demanded that McDonald’s spin-off the real estate assets for better price discovery. So, what we see as a world-leading burger chain is actually camouflage for a REIT. Can we draw a parallel with Tesla? Let us see
According to Tesla, its “mission is to accelerate the world’s transition to sustainable energy.” Looking at Tesla’s current position, over 90% of its revenues come from selling electric vehicles. Last year, it sold 367,500 electric cars and this year it completed a milestone of selling a million cars since its inception. That’s no mean achievement but Tesla’s car sales are a fraction of leading automakers. For instance, Toyota alone sold 10.7 million cars in 2019. However, Tesla’s market capitalization soared passed Toyota’s amid the frenzied rally.
Now, one thing is quite clear. Markets are not valuing Tesla as an automaker. This brings us to the key question. Which Business Is Tesla actually into?
Tesla’s CEO Elon Musk believes that its energy business could grow multi-fold. “I think long term, Tesla Energy will be roughly the same size as Tesla Automotive. So I mean, the energy business collectively is bigger than the automotive business,” said Musk during the company’s Q2 2020 earnings call. Musk had expressed similar views in the Q3 2019 earnings call as well. Incidentally, Tesla posted a surprise profit in that quarter and has since posted a net profit for four consecutive quarters, meeting a key condition for inclusion into the S&P 500.
Tesla stock has risen 435% over the last year, including a 238% gain in 2020. This month, the stock rallied on the expectation of inclusion into the S&P 500. Some even compared it to the surge in Yahoo stock after it was included in the S&P 500 in the late 1990s. In Six Reasons EV Stocks Look in a Bubble I had noted why the rally in electric vehicle stocks smells of a bubble.
But then, are markets valuing Tesla as a mix of a solar and an automotive company? Looks unlikely again. First Solar, a leading solar company in the US, makes a net profit margin in single digits. Looking at automotive companies, again the profit margins are in single digits. Companies having single-digit profit margins and high capital expense cannot have the kind of valuation that Tesla is currently trading at.
Elon Musk also touched on the profitability angle during the company’s Q2 2020 earnings call. In response to a question over the tradeoff between growth and profit margins, Musk said, “So yes, we need to not go bankrupt. Obviously, that's important because that will fail in our mission, but we're not trying to be super profitable either.”
He added, “Obviously, profitability is like 1% or something, this 1% or 2%. It's not crazy. Last quarter, it was only like 0.1%. So we want to be profitable. Like I think just we want to be like slightly profitable and maximize growth and make the cars as affordable as possible, and that's what we're trying to achieve.”
Realistically speaking, by selling cars and energy products alone, Tesla can never get the kind of margins that tech companies get. But then, Tesla fans treat the company as a tech company, and comparing Tesla to an automaker earns critics the ire of an ever-growing army of Tesla fans.
Looking at its current business, it could be hard to classify Tesla as a tech company. It looks an automotive company that also sells solar and energy storage products. That said, in the future, could Tesla be in the business of selling software?
Elon Musk expects the FSD (full self-driving) cost for users to rise above $100,000, from the current cost of $8,000. If that were to happen, Tesla would become the only automaker earning more from an ancillary product than the vehicle itself. But wait, would FSD be the ancillary product, or would Tesla cars themselves would be ancillary and people would buy Tesla for its FSD or the software part of the car? Can Tesla sell its FSD to other automakers in the future? These are questions that we need to answer if we are to classify Tesla as a software company. Obviously, the answer is YES if you are a Tesla fan and a straight NO if you are a detractor. All said, it is tough to imagine every Tesla user shelling out $100,000 for the FSD option.
Batteries are another key aspect of Tesla’s business and the company has its annual battery day. Now, there is little denying that Tesla has a lead over other automakers in battery technology. Can Tesla then be in the business of selling battery technology to other automakers in the future? Quite likely, and we have examples in the automotive industry where Fiat Chrysler’s diesel engine technology was used by some Indian automakers, including the market leader Maruti Suzuki. However, Maruti has since developed its own diesel engine.
Again, given the centrality of battery technology in an electric vehicle, it looks highly unlikely that other automakers would outsource the function to Tesla till eternity.
In the past, I have argued that Tesla stock cannot be valued the purist way. Meanwhile, not only the electric vehicle stocks but the whole universe of growth and tech stocks is trading at what I would call insanely high valuation. Find Tesla overvalued? Look at the valuations of Zoom Communications and Shopify. We seem to be entering a new phase where GARP that hitherto was growth at a reasonable price has got rechristened to growth at a ridiculous price. Read Growth Stocks and the New Definition of GARP for more analysis.
Before I sign off, Tesla is also into the business of regulatory credits. The company's regulatory credits doubled year over year in Q2 2020 helping it post a net profit in the quarter. As Toni Sacconaghi of Berstein commented during Tesla's second quarter earnings call " I know your margin has been 5% over the last 12 months, but it's actually less than 1%, excluding EV credit. So it's a 4-point contribution right now. "
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