Tesla and the Blind Spots of Wall Street

As part of a shift in my writing, I am going to start talking a bit more about my own views on stocks (and stuff outside of stocks) and on the trades that I've made. I'll start with my latest trades on Tesla, where I bought some shares in late November and early January.

 

Tesla has been a hot stock lately. The company reported 4Q earnings two weeks ago, and while the stock declined 6% afterwards, the stock remains up 39% since November. What has driven the improvement?

Let's first outline the ongoing bull/bear debate.

 

Bears believe Tesla is juggling too many balls in the air

We should start with the bear thesis, as this is the dominant position for most sell-side analysts and much of the media surrounding the stock. As an example, among the sell-side analysts, 2 have buy ratings, 5 have neutral ratings, and 7 have sell ratings. It's important to note how rare it is to see this many sell ratings on a stock given the nature of sell-side research. Here's a summary of each bank's views. Note that this is a bit lengthy; if you're looking for a more concise summary, scroll down to my commentary below it.

 

The bear thesis is essentially that Tesla is juggling a number of production goals, and there's a very low chance that they hit all of them by 2017 and 2018. As they miss these goals and targets, their capex needs will continue to grow, forcing the company to make additional capital raises and diluting shareholder value. As a reminder, Tesla is juggling:

  • Gigafactory launch targets (including its pack and station production goals)
  • Ambitious Model 3 launch and volume goals in 2017
  • Ambitious total production goals in 2018 (500K units)
  • Reconfiguring its Fremont facility
  • Solar City integration
  • Producing solar tiles
  • Developing Tesla's autonomous driving system
  • Ramping Buffalo facilitiy and Assembly 2
  • Plans for three more gigafactories
  • Aggressive expansion of its supercharger and service network

With a vertically integrated model that consists of Tesla producing most of its own parts (as opposed to other car manufacturers that primarily outsource part production), Tesla's production goals are dependent on the slowest produced piece for the car. And with 95% of Tesla's parts unique to its own car, there is little to fall back on should they have any issues with parts. This only compounds the chances that Tesla will miss its goals.

The company is also still relatively inexperienced compared to the other auto manufacturers. Tesla is still in the early innings of converting itself into a manufacturing-focused company. While they have made significant strides in terms of vehicle production, they remain far behind other car manufacturers; in 2016 Tesla manufactured 84K cars compared to your typical auto plant that produces over 250K cars. And Tesla continues to fall short of its targets. Just last quarter, Tesla fell short of its goals by ~3K cars.

On top of all these concerns, Tesla is also likely to need to raise additional cash in the next year. While Musk has noted that they will not need to raise cash for the Model 3, he clarified recently that they may still raise cash to derisk their situation. And this was recently reiterated by Musk on Tesla's 4Q earnings call. With another potential cash raise, it could dilute shareholders further.

As a result, analysts have TSLA falling well short of its 500K production target in 2018, with estimates around 200K. Additionally, analysts do not expect TSLA to significantly ramp Model 3 production by late 2017. As the company falls short of its goals and runs into production snags, the company will become even more unprofitable, bleed more cash, and need to raise more money. Growth will be further pushed out, lowering the value of the company. And importantly, investor confidence will erode, which would hurt Tesla's ability to obtain more financing and ultimately depress the elevated valuation on the stock.

While this is the crux of the bear thesis, there are also other concerns regarding: 1) EV market size, 2) competition from other tech companies and car manufacturers (many of which are releasing their own EVs), 3) slowing model S/X demand, 4) potential cannibalization of the other models when model 3 launches (at a significantly lower price), and 5) Model 3 gross margin concerns as Tesla already struggles to hit its 30% gross margin target on cars that already cost $100,000+.

 

I bought Tesla for two reasons: low expectations and a long-term investment horizon

The list of negatives is pretty daunting, and I admittedly begin to question my investment after thinking through the numerous execution risks that are looming in the near-term. But what are the positives for bulls?

The bull thesis is wrapped around the strong Tesla brand, Elon Musk's visionary management, manufacturing automation, self-driving cars, and the growing scale of electric vehicles. This argument is well-documented online, and so I won't spend too much time detailing it. Instead, I want to talk a bit more about the more differentiated reasons on why I bought the stock (although I do agree with the other commonly-cited reasons as well).

The biggest reason for my purchasing the stock at the time was that expectations for Model 3 production and 2018 total production had gotten too low. Take a look at the table above again. With most analysts very negative on the stock, one could argue that the stock and investor expectations already take into account very bearish projections. In fact, expectations were even lower back in November when I initially bought the stock (before the run up). As an example, most analysts project auto production falling well short of the 500K target in 2018. The company doesn't need to actually hit its 500K target; it only needs to meet or beat the bar that's set by investors, which was really low at the time. The same could be said for many of the other issues listed above:

  • Expectations for the Model 3 to launch this year in 2017 seemed to be low despite the fact that Musk continued to believe that they would launch in 2017. While this has risen recently, many banks still do not believe it will ramp as much as the company expects in 2H17
  • Just about all banks, even the ones with Buy ratings, already expect Tesla to raise additional capital in 2017, and potentially even in 2018

This argument is supported by Morgan Stanley's analyst, who published a note shortly after upgrading the stock noting investor feedback to his upgrade. In it, he noted that "Model 3 volume investor expectations for 2017 appear materially lower than we expected."

It's further supported by how the stock reacted when Tesla reported its 4Q/full year deliveries, which fell short of the bottom end of its guidance by ~4K deliveries. The stock was up 5% the next day. While this may have been due to several other factors as well (this was on the eve of their Gigafactory tour and also coincided with a buy-rated initiation from Guggenheim), it is worth considering just how obvious it is that Tesla will not hit their stated targets. After all, WSJ published a large, front-page article detailing Musk's propensity to set unrealistic production goals, and then miss them. And no analyst has Tesla achieving their stated production targets in 2018.

Despite these low expectations, over the last several months, there has been growing confidence among investors that Tesla could beat the low bar that investors have set and ramp production of the Model 3 in 2017:

  • Gigafactory appears to be on track after several analysts attended a gigafactory tour by senior management. Musk noted that the gigafactory is on target to achieve its goal of reducing battery costs by 30%
  • On the latest 4Q call, Musk noted that they continue to expect Model 3 to launch and ramp production in 2H17
  • Demand for Model S and Model X remain strong, somewhat dampening concerns that demand had been moderating for Model S vehicles

With the stock now up significantly since its trough, I believe the risk/reward is much more fairly balanced in the stock. When I initially bought the stock, I viewed the risk/reward as skewed towards the upside given the low bar and the signs of evidence that they could potentially exceed that bar. And should they miss those bars, I felt confident enough that the company's competitive advantages (strong management, nimble tech startup advantages, electric vehicle benefits, strong brand, lead in self-driving cars, etc) over incumbent auto manufacturers would eventually get them there longer term and with a significant advantage. And in that scenario, I'd be willing to wait this out as an individual investor with a longer-term investment horizon.

 

Valuation involves lots of moving pieces; stock likely to move based on operational targets

Most sell side analysts use DCFs with exit multiples to value Tesla, while some use multiples based on 3-5 year earnings and EBITDA estimates. However, given the number of assumptions and moving pieces involved - car production estimates, margin estimates, capex estimates, capital raise estimates, all projected out by 10-15 years - I believe that this view can ultimately make investors lose sight of the big picture for the stock. It's just too hard to get all the inputs down and have reasonable confidence in the price target that's spat out.

Ultimately, Tesla's near-term and longer-term valuation will hinge significantly on whether they are able to hit operational targets (such as total car production and Model 3 roll out). These production estimates will ultimately determine a significant portion of the variability in future earnings, and in turn, impact the stock's valuation. 

 

Wall Street's Blind Spots

The explanation that expectations appear to already be baked into the stock, and that my investment horizon is sufficiently long enough, seems like an unsatisfactory explanation for the stock rise and for my own bullishness. However, these two reasons are especially plausible in my mind because of how Wall Street works.

First, a word about Wall Street. I believe that sell-side equity analysts in general know more about the stocks than most investors out there, and I have a great deal of respect for what they do and the value that they add (which, contrary to popular opinion, is not in the price targets that they put out). However, as someone who has worked in the industry and on several research teams, I believe there are certain blind spots that prevent them from fully assessing the value of a stock in select situations. 

 

Blind Spot 1: Consensus expectations

One such blind spot is that analysts often do not have a great sense of investor expectations, which are the ultimate benchmark that companies must beat to send the stock higher. There are several reasons for why I think this happens.

First, sell-side analysts don't look at each other's reports often enough to understand where consensus expectations are. In fact, most don't look at each other's reports at all. A part of this is because many banks have policies in place that prevent the equity research departments from looking at each other's reports (exactly why this is is a bit unclear to me, but it is likely due to regulatory measures).

Second, institutional investor expectations (as opposed to other sell-side analyst estimates and expectations) is one of the hardest things to measure. Investors often are not the most forthright about their expectations for competitive reasons. As a result, no one really knows what the true consensus is out there. 

Because it's so difficult to figure out where actual investor expectations are, it is often easiest for sell-side analysts to focus on management's own guidance targets. Often times this isn't an issue as investor expectations can be relatively close to management guidance. However, in Tesla's case, I believe the actual investor expectations are significantly lower than management's own guidance. And it appears that sell-side analysts may have missed this. (The quote above from Morgan Stanley's analyst supports this view.)

 

Blind Spot 2: Investments that require a longer-term investment horizon

The other blind spot is in investment horizons. This isn't really a blind spot per se, but it is an issue of incentives that might allow a retail investor without an information advantage to outperform those on Wall Street. The buy side (hedge funds, long-only funds, etc) is ultimately beholden to its investors. If their returns drop significantly, they run the risk of increased withdrawals from investors as people panic at deeply red returns. This puts pressure on active money managers to focus on the near-term drivers of stocks and focus less on the longer-term outlook. And as a result, money managers may stay away from a company with a strong long-term outlook if there are near-term concerns. 

As it relates to Tesla, I believe the longer-term outlook is strong enough to give me the confidence to park my money in the company. To some extent, investors do give Tesla credit for its longer-term ambitions as the company trades an extremely high valuation despite not having positive earnings. However, I believe companies like Tesla with attractive longer-term prospects but shaky near-term issues can still present mispriced opportunities that are available to retail investors, but not to institutional investors. 

As a result of these two blind spots, I believe the risk/reward is skewed towards the upside, even if Tesla doesn't manage to hit Musk's ambitious goals in the near-term. The first blind spot - investor expectations - is arguably no longer an opportunity for Tesla as the stock has moved up significantly and now prices in higher expectations for the Model 3 and total car production in 2018. However, the second blind spot - longer-term investment horizons - is what makes me more comfortable holding onto Tesla despite a more balanced risk/reward profile in the near-term.