Tuesday, October 16, 2012

Tesla's Cars Look Better Than Its Stock

The biggest concern with electric cars is that they might never get you to your destination. That is also a risk with Tesla Motors, TSLA +1.50% the vehicle of choice for many investors enamored of the prospects for battery-powered autos.

Tesla's new Model S sedan, on which the company's immediate future rests, has earned rave reviews. Great products don't always make for great investments, though.

Having risen about 63% since its June 2010 initial public offering and valued at 118.3 times estimated 2013 earnings, Tesla is closer to the tech than auto sector.

Investors are essentially providing it with publicly traded venture capital. Financially, this higher-risk, early-stage nature can be seen in Tesla's high rate of cash burn and recent stock offering to replenish its coffers. It can also be seen in valuations. For example, fully 78% of Deutsche Bank's DBK.XE +3.84% calculation of Tesla's net present value relates to estimated discounted cash flows from 2020 and beyond.

This means a lot needs to go right to justify investing. Tesla is building an automotive company from scratch, selling a limited set of models demanding new infrastructure and changed expectations among drivers to be successful. Tesla's recent downgrade of 2012 production targets, prompting a 10% one-day drop in the stock price, reflects its daunting task. Tesla says, however, it is still on track to deliver 20,000 Model S cars in 2013.

Even assuming supply-chain challenges are resolved adequately, though, there is also demand to consider.

From one angle, Tesla's target looks easy. Jefferies points out that even if electric vehicles accounted for just 0.5% of the vehicle market, this would equate to 75,000 a year. Tesla should be able to secure a large chunk of that.

Even that 0.5% isn't easy. The 25,000 electric vehicles sold in the U.S. this year by the end of August—0.3% of all auto sales, according to Maxim Group—includes not just all-electric vehicles like the Model S, but also plug-in hybrid electric vehicles like General Motors' GM +0.78% Chevrolet Volt.

It is important to remember that various technologies are competing to shift drivers away from oil.

Toyota caused a stir last month when it killed plans for a new all-electric car, saying current battery technology didn't "meet society's needs."

Hybrids aside, it is also possible that none of the competing electric technologies will succeed for some time. Indeed, Lux Research concludes that despite generous subsidies, electric vehicles may remain uncompetitive with traditional cars, precluding significant adoption even over the next decade. Volatile gasoline prices and political support for tax breaks are key determinants.

It isn't just electric vehicles Tesla must compete with. The Model S comes in three basic versions, depending on battery size, ranging from $49,900 to just under $69,900, net of a $7,500 federal tax credit.

At those prices, the car competes with middle, upper and specialty luxury vehicles like the Audi A8, using Ward's Automotive Group's market segmentation.

These segments averaged annual U.S. sales of about 262,000 in the past five years, according to Ward's. Assuming Tesla's sales are mostly in the U.S., that implies it would need to capture about 8% of that market. That may sound small. But consider that Cadillac, Audi and Acura each have around 9% to 10% of the retail market for 2012 model luxury vehicles, according to consultancy Strategic Vision.

Investors enamored of Tesla's vision risk forgetting that it must compete with an established automotive industry. Toyota, GM, Ford, Nissan and others are already releasing competing products and also sell a wide portfolio of traditional vehicles generating cash to absorb inevitable early-stage losses.

There is a parallel with another new-paradigm industry dependent on subsidies: solar-panel manufacturing.

To expand the market, costs must be driven down relentlessly to make the new technology competitive with older, cheaper alternatives. For solar power, this has worked by Chinese manufacturers capturing market share from established pioneers.

The result has been better, cheaper products for consumers and enormous declines in the value of Western first movers like First Solar.

Tesla's vehicles may well help shift the world toward an all-electric future. For investors, though, first movers don't always win the race.

From WSJ.Com