Tesla Inc (NASDAQ:TSLA) recalled more than 60% of the cars it manufactured last year.
Shares of California-based electric car manufacturer Tesla Inc (NASDAQ:TSLA) had a strong bullish rally in the past six months, gaining more than 50% in this period and surpassing General Motors (NYSE:GM) and Ford (NYSE:F) as the most valuable car company in the United States. Apart from the general market rally, the close proximity of CEO Elon Musk with Trump administration, the positive news about its Gigafactory, the recent beat on delivery numbers and to an extent developments on the Model3 front have contributed to the bullish rally. However, the rally has also brought back the focus on Tesla stock valuation.
While this debate is an old one, the recent rally has further exaggerated Tesla's valuation multiples, leading to sharp debates about what Tesla is actually worth. Bulls like Piper Jaffray's Alexander Potter, who while agreeing that TSLA stock's valuation is rich by traditional valuation method's, has a price target of $365 on Tesla stock. He argues that Tesla stock enjoys strong loyalty from shareholders and customers alike. On the other hand, bears like Barclay's analyst Brian Johnson believes that Tesla bulls are living in a "real life matrix" and are blind to the reality that the company faces several significant challenges. And it is true, Tesla is facing challenges on several fronts, from operational to legal.
Tesla Inc reputation takes a hit with the recall.
Yesterday, Tesla announced a voluntary recall of 53,000 Model S and Model X manufactured in 2016 for faulty electric parking brake assemblies on reports a small gear might fracture, preventing the brake from releasing. According to Tesla, about 2% of the recalled cars have the problem and it would not have led to any safety concerns.
Tesla doesn't expect the recall to have any material financial impact for the company. However, it surely will damage company's reputation and further strain on Tesla's already overburdened service infrastructure. Tesla is expected to take up to six months to fix the problems in all the cars. And the timing of the recall, just when the company was going into the production of Model 3, is not helpful either. Model 3 customers, who are more likely to use Model 3 as their first cars, are not likely to be forgiving of quality and service issues, unlike the current Tesla owners.
Model 3 execution remains a big concern.
In the medium term the success or failure of Tesla's mass model car "Model 3" will be the main driver behind TSLA stock. Tesla is expecting to drive to profitability on Model 3. Any major lapses including delays on delivery could tank the stock. Tesla has received nearly 400K pre-orders for this car. The company is likely to start producing the mass market sedan by July, earlier than what many had expected. The company is targeting the production of 500,000 vehicles next year, up from just 84,000 last year.
However, there are still questions around the steep production ramp and huge amount investments required. Goldman Sachs recently downgraded Tesla stock to sell and cut its price target as it sees Model 3 deliveries getting pushed to next year. In a note, Goldman Sachs said that "Model 3 launch curve a concern, operating margin dilutive at current cost, and reservation conversion may be hindered by higher selling prices. We believe the Model 3 will have a more subdued launch curve than the company is targeting as some suppliers have expressed concern around final designs not being locked down". It expects Tesla to achieve mass market volumes (i.e., above 100k annualized run-rate) in 4Q18 a year later than what Tesla is targeting.
Autopilot upgrade going as planned.
Apart from the execution risk, Tesla Inc is also facing legal challenges. Hagens Berman Sobol Shapiro LLP, a class action litigation firm, filed a class action lawsuit against Tesla for misleading customers about its Autopilot technology. In October last year, Tesla had announced an Autopilot upgrade called Enhanced Autopilot (EA), or Autopilot 2. At that time it had said that all Tesla cars would be equipped with sufficient hardware to support "Full Self-Driving" capability when the software was ready. The update was expected to happen by December last year. However, Autopilot 2 has still not reached the level of Autopilot 1.
The lawsuit accuses Tesla of "knowingly selling nearly 50,000 cars with nonfunctional Enhanced Autopilot AP2.0 software that still has not met Tesla's promises, including inoperative Standard Safety Features". The lawsuit also claims that the Autopilot 2 update is "essentially unusable and demonstrably dangerous". Many customers have expressed their frustration over the delay in the update in spite of them already paying the $5000 activation charges. However, in a testament to Tesla's customer loyalty, only three customers have joined the class action lawsuit. Though, more customers tend to join a lawsuit as it progresses.
Many analysts previously expressed their concern around Autopilot 2 update, which gave the impression of Tesla being much ahead of the competition in the autonomous car race. Barclay's analyst Brian Johnson had said in a note that "Tesla’s roll-out of autopilot doesn’t necessarily mean that it’s ahead of its competition -- rather it’s just willing to use its customers as beta testers".
Don't short Tesla Inc stock yet.
In spite of the challenges relating to model 3, high valuation and yesterday's recall, it might not be a good idea to short Tesla stock yet. Tesla stock is in middle of a bullish rally and any negative news is unlikely to affect the stock by much. As Piper Jaffray's Alexander Potter put it "We sympathize with bears – but their (arguably rational) arguments probably won’t matter". On the other hand, any positive news could drive Tesla stock much higher.
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