- Tesla Motors is mostly supported by low interest rates and heightened investor sentiment.
- However, those trends won’t always prevail with near-term risks to valuation not fully priced in.
- The backdrop of data and continuation of production ramp deters the shorts, but added upside also seems unlikely.
Tesla (NSDQ:TSLA) has been resilient in response to negative headwinds, but with supportive macros and improving broad market sentiment, investors are looking for any opportunity to add to riskier positions.
Key macro themes keep the stock afloat
The mentality of investors on the buy side is mostly driven by interest rates. In this specific market environment investors can quite literally rationalize any type of argument for buying shares in an unprofitable yet story driven narrative. Now, I’m not knocking down on TSLA, but I do view the risk to reward as less substantial given the stock is trading near my $232.92 price target.
Joseph Spak from RBC Capital Markets made some fairly compelling points on valuation:
For a stock that moves more on sentiment than anything, that’s something for everyone. While we like the company’s disruptive path and opportunity, we can’t recommend adding to positions now given mismatch between the near-term risk and longer term payoff.
That being the case, the recent stock returns are mostly driven by sentiment as opposed to an improved backdrop in fundamentals. The argument for buying stocks on a broad basis is mostly driven by a low-interest rate environment, which will likely continue given patterns of decelerating GDP and sustained weakness in inflation metrics. Since the Fed is data-dependent it’s not surprising that rates won’t rise in the face of a nervous Janet Yellen.
Here’s what the economists at Bank of America Merril Lynch mentioned in a recent report:
History similarly shows it will be tough for stocks to advance meaningfully if bond yields rise. More pertinently for the next twelve months, the relationship also suggests that should higher interest rates coincide with higher stock valuations in coming quarters that will only happen if bubble valuations in bond rotate into bubble valuations in stocks (last seen in the late -90s). More likely, higher bond yields mean lower equity returns from starting valuations.
The prevailing market bias is towards low interest rates, which is fueling speculation that outperformance in the fixed income market should also translate favorably for equities as derived by various historical data points. There are very few cases where the broad market is able to generate high rates of sustained returns on invested capital when interest rates are at all-time highs, so the returns exhibited by stocks tend to be more subdued. That being the case, the usual inflation levers aren’t working given the excessive liquidity of bank balance sheets, which reduces the money multiplier we’d witness coming out of recessions.
As such, the bias points to low rates and high stock returns. In this environment investors are willing to buy shares in more speculative names, but the moment the Fed raises its targeted interest rate, the sustained investment paradigm of TSLA’s management team will quickly translate into massive cost deleveraging given the high dependence of low interest to fuel sustained capacity additions in both its battery and solar panel plant. In that scenario, the stock isn’t just correlated to broad based sentiment, but the heightened cost of capital points to a more diminished investment cycle and a heightened hurdle for achieving profitability.
Putting into perspective Tesla’s predictions on autonomous vehicles
Elon Musk goes on the conference call every quarter mentioning the rapid improvement in AI functionality. However, the aggressive timeline for driver assistance systems implies more of a softer implementation of autonomous functionality in the immediate three-year time frame, and perhaps full autonomous functionality in the year 2020 or beyond. I believe the regulatory hurdles are a bigger bottleneck than the successful engineering of either the software or hardware.
Patrick Archambault an analyst from Goldman Sachs points to the regulatory challenges of full autonomous vehicles.
Here was the key highlight:
Despite the recent negative events surrounding the company’s Autopilot system, Tesla stressed the importance of continued testing of autonomous driving technology, following recent NHTSA statements that “no one incident will derail” development of a safety enhancing technology. In addition, Tesla expects that worldwide regulatory approval will require roughly 6bn miles, while current fleet learning is taking place at a pace of 3 million miles a day. This would translate to 5.5 years if the pace of current learning stays constant, although we expect mileage to increase meaningfully.
It’s worth noting that the requirement of 6 billion miles is quite lofty. But then Tesla’s autopilot systems seems well ahead of that schedule, so instead of releasing full automation I believe an incremental release of driver assisted software will occur over the next two to three years.
Moving through iterative generations sounds like the most methodical way towards full regulatory approval.
Industry trends in the automotive space
In the past couple days, the analysts at Credit Suisse released a report pertaining to auto industry sales. While TSLA is primarily constrained on the supply side with demand for its cars relatively robust when compared to peers, it’s worth noting that these trends support demand for the Model 3.
Here’s what was stated in Credit Suisse’s report:
July SAAR (seasonally adjusted annual rate) grew 5.4% y/y a deceleration from Jun SAAR of 6.5% y/y. YTD Auto SAAR is tracking up 4.5% y/y ahead of our estimate of 3.0% y/y. In addition, YTD Semi Auto Rev is up 5.7% y/y – implying content growth of ~1.5% and full year Rev that is at least tracking our 6% estimate. July SAAR benefited from strength in China, up 30.2% y/y versus up 21.7% y/y in June, which more than offset a more modest showing in the US and Europe – the former grew 0.7% y/y while the latter declined 2.0% y/y, the first y/y decline in over 3 years.
I believe emerging market trends are supportive of sustained production ramp for Model 3. While the company aggressively forecasted that they can reach half a million units, the company may opt to ramp production growth at a more accelerated pace given the backdrop of supportive macro. Furthermore, this goes back to the corollary that added demand only translates into heightened Capex spend. In other words, Tesla’s investment phase will likely continue at a brisk pace, but the risks to rapid expansion in a capital intensive business model is the cost of interest.
In other words, the ramp up phase for Model 3 also coincides with a time frame whereby the fed might actually tighten interest rates. Foreseeing multiple years into the future is not the forte of most economists, but it’s worth noting that this scenario isn’t here permanently, and that at some point the Federal Reserve will eventually respond to macro data points.
The risks posed by higher interest rates implies a future point where Tesla’s management will retrench and look to deleverage the balance sheet. We haven’t seen any intentions of this yet, but there are limitations to production growth going forward despite heightened consumer interest in the Model 3.
Investors should be approaching this name with a degree of skepticism in the near term given the various concerns I have raised. However, betting against the name would be disadvantageous. The incremental data on auto industry plus ramp-up of production supports a bullish thesis. But the risks posed by interest rates and sustained operating losses doesn’t make this a compelling opportunity for everybody.
Right now, the stock is trending at the high-end of my value range, and as such I’m removing my buy recommendation. I’m re-rating the stock to a hold as the mounting risks, uncertainty and fully-priced in fundamentals make this opportunity less attractive for the duration of 2016.