Placing a Value on Tesla

This morning I watched a fascinating debate on the YouTube channel “Tesla Daily” between Rob Maurer and David Trainer. Rob is a self-confessed Tesla Bull, a columnist on The Street who hosts this excellent and influential YouTube Channel. (full disclosure – I am a subscriber and Patreon supporter of his). David is a respected, long time Wall Street analyst, the founder and CEO of New Constructs, an independent financial analyst, and a self-confessed fan of the Tesla car and its founder Elon Musk; However, in contrast to Rob, David has a very sober view of the current stock price, considering it highly speculative. His firm has authored a note warning that Tesla is “the most dangerous” stock for the investors with fiduciary responsibility.

What struck me as I listened to the debate was that both Rob and David appear to talk past what I consider to be the root cause of the current Tesla stock price, and its probable future value. Elon Musk is famous for insisting on looking at every problem from first principles – and even more famous for being so successful in the application of those principals. Let’s follow Elon’s dictum here to learn why Tesla’s stock has reached such stratospheric levels and evaluate whether it is likely to remain as high or even grow further.

In the matter of the Tesla valuation, I believe the first principle that governs is the Innovator’s Dilemma, which for brevity we will refer to as InDi. It underpins the entire value proposition represented by Tesla, not just in the gigantic global automotive market, in transportation in general, and perhaps – ultimately even more importantly – in the global energy markets.

InDi is not well understood by the analysts, and is seldom accorded significant value, which is perplexing as it is an extremely well understood process. It was formulated by Clayton M. Christensen while Professor Business Administration at Harvard Business School and popularized by him in many writings. Christensen writes:

When disruptive technologies emerge, dominant, well-run companies often stumble. These companies tend to use the same sound business judgment that has guided them through previous changes, including:

  • Listening to what current customers want
  • Providing more and improved versions of what customers want
  • Investing in projects that promise the highest returns

However, in the face of disruptive innovations, these strategies don’t produce the same results. This is the innovator’s dilemma: The approaches that lead to success in adopting most innovations lead to failure when confronting disruptive innovations.

Elucidating on those key finding, Wikipedia adds the following woes to the incumbent’s situation, (each of which readily identifiable with the OEMs!):

  • Small markets struggle to impact an incumbent’s large market
  • Disruptive technologies have fluid futures, as in, it is impossible to know what they will disrupt once matured
  • Incumbent Organizations’ value is more than simply their workers, it includes their processes and core capabilities which drive their efforts
  • Technology supply may not equal market demand. The attributes that make disruptive technologies unattractive in established markets are often the ones that have the greatest value in emerging markets

On the other hand, consider the position of the challenger:

  • They develop the disruptive technology with the ‘right’ customers. Not necessarily their current customer set
  • They place the disruptive technology into an autonomous organization that can be rewarded with small wins and small customer sets
  • They fail early and often to find the correct disruptive technology
  • They allow the disruption organization to utilize all of the company’s resources when needed but are careful to make sure the processes and values were not those of the company

It is easy to recognize the role of Tesla in these qualities. Finally, Wikipedia points out:

  • Disruption is a process, not a product or service, that occurs from the fringe to mainstream
  • Originate in low-end (less demanding customers) or new market (where none existed) footholds
  • New firms don’t catch on with mainstream customers until quality catches up with their standards
  • Success is not a requirement and some business can be disruptive but fail
  • New firm’s business model differs significantly from incumbent

Success, in simple terms, Christensen says, is “correlated with a business model that is unattractive to its competitor”. This is brilliantly true in the case of Tesla vs. OEMs.

Rob provides a telling example of this when he points to the direct sales model of Tesla, capturing the profit margin that would otherwise go to the dealer. David Trainer argues that the dealership network of the OEMs is a strength, allowing the OEMS “concentrate on their main business”, providing them with broad distribution. What eludes David is that this same dealer network becomes uneconomic in an EV world, as the service and spare parts business on EVs are not 10% of that of an ICE vehicle. In simple terms, the dealership can only be run at a loss, and Tesla’s online sales are a significant advantage. Early evidence is that OEMs have been unable to persuade their dealership network to sell EVs, contributing to the woeful sales of legacy OEM sales of their electric vehicles. The dealership network is at the core of the OEM business model that would be legally, culturally and financially impossible to voluntarily sever; yet with it, the OEM EV future is probably doomed.

Another example of the business model problem is the “deep supply chain” mentioned by Trainer as a significant advantage to OEMs. Unfortunately for them, this may be the most serious problem for the OEM business model. It is this supply chain that inhibits the development of a vehicle, with an integrated battery/drivetrain/HVAC/computer system, a vitally necessary step to creating a competitive EV offering (and the reason for the failure of so many “Tesla Killers” to date). The key intellectual property of OEMs retain is their internal combustion engine designs, possibly the only component – apart from the sheet metal – that they develop and manufacture in-house. Ironically this is the technology that is of least value – in fact no value – in this new market.

To compound the problem, the challenge is not just a matter of replacing an internal combustion engine with an electric motor, and simply adding a battery in the stead of a gas tank. Instead it is a highly complex problem of redesigning the drivetrain and vehicle into a single, comprehensive whole. Depending on a supply-chain network to provide this does not permit the iterative design/development necessary to rapidly evolve successful solutions to this very difficult problem. With well evolved, century old technology, depending on supply chains for R+D of everything but the engine made sense: but the situation has changed, and dramatically so; disruption is now occurring. OEMs development cycles traditionally stretch to years. Tesla iterates its designs from month to month to month.

Large OEMs are not given to iterative design/development. This is a longer discussion, and perhaps key in differentiating Tesla from the incumbents. It is sufficient to point to the continuing and growing technological leadership of the company’s vehicles over the incumbents. It is instructive that the industry has not yet been able to manufacture a car to compete with the Tesla Model S, first sold seven year ago.

One could cite many other startlingly clear examples of InDi in the Tesla versus all the others debate. This is also true of Tesla’s work in the energy markets, but I won’t do that here, it is all well documented, and Rob is probably more of an expert than I am in this field. Instead I want to return to the question raised at the outset: the problem of valuation. How does one value stocks of InDi companies, stocks that David Trainer is sure to label, as he has with Tesla, as the “most dangerous” of all stocks.

The answer, of course, is “with great difficulty.” Aswath Damodaran, the “Dean of Valuation”, NYU professor famous for valuation methodology, talks about his struggle – and consistent failure – to value Amazon, that well-known bookseller

Oh yes, of course I know Amazon is not a bookseller. But in the early days we were told – by professors of valuation – that Amazon would have to sell all the books sold in the world to justify its valuation. Amazon taught us several important points. It proved the Christensen principles “Disruptive technologies have fluid futures”, and “Disruption is a process, not a product or service, that occurs from the fringe to mainstream”, and probably a few more besides. What is more important about the Amazon example, is the admission made by Damodaran in the article cited above, of the extreme importance of this fact:

“Bezos …telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.”

“I have consistently under estimated not only the innovative genius of this company, but also its (and its investors’) patience.”

So here we arrive (finally) at my thesis. Like Jeff Bezos, Elon Musk has defined clearly his objectives, methods and objectives. He wrote them down – they are available on the Tesla web site in articles entitled “Secret Master Plan” and “Master Plan (Part Deux)” written 14 and 4 years ago respectively. Tesla has followed the strategic path set out with remarkable fidelity.

Tesla has created an innovative, rapid learning machine to create products with enormous market appeal and success, in gigantic global markets, and delivered using novel but efficient business models.

The cars started out as expensive, appealing to a coterie of ecologically aware, well-off customers, but have moved significantly down the cost scale, and dramatically widened the appeal of the product. In the past two years the firm has found its stride in producing and delivering in mass and is in the process of demonstrating its ability to scale, and have consistently driven down the price – and cost – of the mass production vehicles. It has built and successfully brought to production in a record time (at several times the speed of the legacy OEMs) a massive factory in China. It is in the process of – simultaneously – building three gigantic factories across the world and is demonstrating a confident touch in those buildouts. Also Tesla is finding ways to drastically reduce costs of manufacture and evolving new and emerging products into related, but huge markets (as prescribed by Christensen.)

All Good. Rob aced these points. Here is the miss: Tesla DOES NOT INTEND TO MAKE PROFITS in the foreseeable future. Tesla has said in many forums that it intends to minimize profits. It’s in the published Master Plan. Elon said in a recent conference call that the objective was to show no more than 1% or so of profits. He, like Jeff Bezos, understands that the disrupter is focused on market share, not profitability. Tesla intends to, and is on a clear track toward dominance of the Automobile market. NOT THE EV SECTOR – THE ENTIRE AUTO MARKET. Calculating the EV sector as a percentage of the auto market, then calculating Tesla’s market share is missing the point. Tesla intends to ensure that the entire auto market becomes an EV market. In this I have little doubt they will succeed, in a leadership role, and in less than ten years. ICE cars are the flip phones of 2030. Value that.