Justin Sullivan
In our recent series of articles on Tesla’s stock (NASDAQ:TSLA), we outlined some of the key observations as well as catalysts that would potentially push it below the $150 level. The following analysis will dive into key watch items heading into the new year, as well as their implications for the stock’s valuation prospects following a whirlwind end-of-year for Tesla.
With the stock having breached the $110-level earlier this week, following a seven-day losing streak not seen since 2018, markets have seen Tesla’s valuation succumbing rapidly to the broader market rout that has been unfolding throughout 2022. Since Tesla reported its third quarter delivery miss, market concerns over looming demand risks have gradually materialized in the months since, with everything ranging from voluntary production curbs at the Shanghai facility to the rare offering of discounts in the U.S. being key catalysts to the stock’s recent downslide.
The close-to-70% wipe-out this year, which has only started to gain pace in recent weeks, draws question to whether the stock could potentially breach the $100-level given ongoing macroeconomic uncertainties and an operating backdrop marked by waning consumer demand heading into the new year. The following analysis will discuss some of the key focus areas heading into the new year for Tesla’s stock – including China’s demand environment, the looming recession, as well as still elevated input costs – as well as their implications from a valuations perspective to gauge whether a sub-$100 opportunity could become a near-term possibility to capitalize on the electric vehicle (“EV”) pioneer’s longer-term growth prospects.
China Demand
Demand risks are becoming increasingly prominent in China, one of Tesla’s core markets. Following a series of rare marketing tactics – counting direct marketing spend on TV ads, as well as price cuts – the latest production curbs at Tesla’s Shanghai facility underscores the impact of China’s unravelling macroeconomic climate on the EV maker’s near-term growth outlook. However, the second half of 2023 could be a key positive catalyst for Tesla, especially considering potential for broader improvements to China’s macroeconomic backdrop that has currently been a drag on consumer confidence.
After a bout of speculation over excess capacity at its Shanghai plant in the immediate aftermath of completing a previously planned expansion, Tesla has opted for an earlier than expected “end-of-year break” for employees at the facility that would be followed by a “reduced production schedule” in January in favour of an “extended Lunar New Year break”. The development piggybacks on observations of reduced delivery wait times on the most popular Model Y and Model 3 vehicles to as little as a week, down from the previous 20+ weeks earlier this year:
Tesla appears to have burned through its backlog as they are resorting to promotions to move cars and delivery lead times are 1-2 weeks in the majority of the world.
Source: Bloomberg
This has accelerated investor concerns in recent weeks that the “supply problem” that CEO Elon Musk had earlier touted is now rapidly backfiring as a “demand problem”, with related fears eating into the stock’s lofty valuation premium previously attributed to its breakneck growth prospects. The problem with China’s waning demand is more than just a growth concern, but also an indicator of near-term pressures on profit margins. Tesla’s Model 3 and Model Y vehicles currently produced and sold in Shanghai boasts the highest gross margins, reaching 30% thanks to the facility’s market-leading manufacturing efficiency. And China being one of Tesla’s fastest growing core markets has been key to supporting its market-leading gross margins and compensating for other ramp-up inefficiencies, as well as input cost pressures over the past year. With Tesla’s China market now facing macro-driven weakness, as well as growing competition from home-grown brands, the EV titan is expected to experience further softening in profit margins heading into the new year.
Specifically, China softness is expected to remain a drag on Tesla from a fundamental perspective as the nation works through a messy, but much needed, exit from its yearslong COVID Zero strategy to shore up growth and bolster its economy. However, considering China’s record-setting household savings rate in the 30%-range, or close to $2 trillion accumulated this year, the second half of 2023 makes a potential boost period for Tesla as growth confidence returns in the region. Improved optimism for the second half of 2023 in Tesla’s China market is further corroborated by the EV titan’s pricing advantage in the region. Despite recent price cuts, Tesla’s market-leading auto gross margins in the region, supported by its best-in-class manufacturing efficiency as well as long-term component supply advantage, continues to be a key competitive advantage over peers that are instead turning to price increases to compensate for still elevated input costs. This would not only attract buyers when growth sentiment returns in the China market, but also keep Tesla’s profit margins on par, if not better, than peers’ as competition from both a demand and pricing perspective ramps up over the longer-term.
Recession
Recession continues to be the elephant in the room for all industries. And specific to Tesla, the looming economic downturn is showcasing the EV maker’s vulnerability to cyclical headwinds despite having the benefits of a first-mover advantage, as shown by its years of impressive profitable growth and seemingly inelastic demand that has long been outpacing supply.
The looming recession remains a key propeller of the growing demand risks facing Tesla, turning its supply-driven operations into one that is now looking to better manage excess capacity. This is further corroborated by the stock’s rapidly unwinding valuation in recent weeks, as looming recession risks on top of other Tesla-specific concerns (e.g. Musk share selling, Twitter drama, etc.) continue to overshadow the company’s leadership in capitalizing on “consumers’ enthusiasm for EVs in a future dominated by electric cars”. The consensus 12-month price target for the stock has been slashed by a whopping 10% in a short span of merely two months since November, as expectations for profit margin compression resulting from both recession-driven demand weakness and inflation-driven cost pressures rise.
Looking ahead into the near-term, Tesla’s fourth quarter delivery numbers and forward outlook will be a key tell-tale on how it places among auto peers in the weakening demand environment. Tesla already has a promotional program underway in the U.S., offering a $7,500 upfront discount to buyers that will take delivery of the Model 3s and Model Ys this month. The latest development is likely aimed at frontloading anticipated demand from the federal tax incentive for EV purchases under the Inflation Reduction Act (“IRA”) that takes effect January 1st. But unlike the criteria for qualification under the IRA, Tesla’s promotion offered in December – which includes an additional 10,000 miles in Supercharger credit – will be free from vehicle price and household income threshold requirements, and apply to all tiers of the Model 3s and Model Ys for buyers across all income brackets.
The latest developments underscore that the “epic end of year” that Musk had earlier touted during Tesla’s third quarter earnings call is not going to be as positive as many envisioned. And CFO Zachary Kirkhorn’s warning of “just under 50% growth [on the delivery side] due to an increase in the cars in transit at the end of the year” is likely to take precedent. Considering added pressure from the rapid wind-down in auto demand as consumers prepare for recession, which is corroborated by Tesla’s recent undertakings aimed at boosting year-end deliveries, it is likely that management’s earlier attribution of the anticipated delivery growth target miss to logistic issues alone is no longer valid, underscoring further cyclical challenges in the near-term.
Yet, overall demand remains resilient for lower-priced mass market models. Toyota (TM) continues to experience “solid consumer demand”, with record-setting output in November still a function of supply availability despite mounting macro uncertainties. This supports the narrative that the U.S. economy remains strong despite tightening financial conditions, boosting optimism that even if the looming recession materializes it will be a relatively mild one. And specific to Tesla, resilience observed in new car sales across lower pricing segments indicates the EV maker could still pull on its pricing lever to partially compensate for near-term demand weakness. While this could add pressure to its profit margins like in the case of China as explained in the earlier section, Tesla’s leading efficiency remains a core competitive advantage that could provide sufficient headroom in the bottom-line to help the company weather through the looming macro storm without underperforming peers from a fundamental perspective.
While we expect the fundamental implications of the looming recession to be dire for Tesla, the ensuing valuation implications will likely be more forgiving when compared to violent multiple compressions observed across the board this year. As discussed in detail in a previous coverage of Tesla, valuation multiples are a function of cost of capital, which includes consideration of a risk-free rate that is often benchmarked against long-end Treasury yield. Specifically, the yield on the 10-year U.S. Treasury notes has come down significantly from the 4% range observed in October, hovering in the 3.5% to 3.8% range in recent months despite the Fed’s recent commitment to keeping rates “higher for longer” to ensure inflation is back on track towards the 2% target. This potentially indicates that long-view market sentiment is improving, which moderates discounting on long-end free cash flows that growth names like Tesla have their valuations pinned on, while sensitivity remains on front-end borrowing as the rate hike cycle is expected to last through at least the first half of next year. This would, again, make the second half of 2023 a key focus for investors, as Tesla’s valuation could potentially benefit from the positive catalyst of moderation in Fed monetary policy on easing inflationary pressures.
Inflation
2022 was a year plagued by component shortages and COVID disruptions across supply chains for the auto sector, which also contributed to surging input costs. Specifically, prices for lithium carbonate – a core component in EV batteries – surged to as high as $86,000 a ton this year before recently moderating to the $57,000 range per ton on stabilizing demand in recent weeks. This has caused EV battery prices to increase for the first time after more than a decade of consistent declines, rising 7% on a year-on-year basis.
While the raw material remains in tight supply, with recently declining lithium carbonate prices still far higher than levels observed in prior years, the anticipated slowdown in EV demand over the coming months, paired with “more mine supply” coming online in 2023 will provide an opportunity for rebalancing and moderation in prices. Combined with Tesla’s prescient efforts in locking in long-term purchase agreements on key components for EV manufacturing, which provides it with a core supply advantage, the company is well-positioned to benefit from better input pricing than peers despite persistent inflationary pressures.
The IRA that will be taking effect January 1st is also expected to bring partial relief to Tesla’s bottom line, in addition to potentially salvaging some lost demand due to looming macro weakness. Specifically, Tesla will be eligible for a $10/kWh credit for its internal assembly of battery packs in the U.S. under the IRA, and potentially share some of the $35/kWh credit for production of battery cells in the U.S. with production partner Panasonic (OTCPK:PCRFY, OTCPK:PCRFF). With battery prices currently averaging $151/kWh – and potentially lower for Tesla, given many of its standard range vehicles now run on lower-cost lithium iron phosphate (“LFP”) batteries that contain “no nickel or cobalt” – the up to $45/kWh credit that the EV maker could potentially be eligible for beginning next year would mark an approximate 30% cost discount on the most expensive component of its vehicles. This would drive significant relief in the near-term to Tesla’s profit margin pressures stemming from the persistent inflationary environment as well as ongoing ramp-up cost headwinds at its Berlin and Texas facilities. And as benefits of the IRA flow through alongside easing macroeconomic headwinds expected in the latter parts of next year, we expect Tesla’s market-leading growth story to re-emerge at the wheel again, setting the stage for 2H23 to be a key focus area for investors.
The Bottom Line
Coupled with other developments that are pending resolution at Tesla – including Musk’s tie-up with Twitter, a potential Tesla share buyback, as well as unexpected insider share selling – alongside broader market volatility in response to the looming recession and protracted tightening of Fed monetary policies to counter runaway inflation, the stock is likely to maintain a turbulent theme heading into the new year. But considering the rapid valuation correction observed in recent weeks, we believe much of the near-term fundamental challenges to Tesla’s operations in anticipation of the looming recession and ensuing demand weakness have been priced in. This is further corroborated by the consistent rise in net buy volume on Tesla shares, and a market defying uptrend during Wednesday’s session (December 28) after the stock breached the $110-level, underscoring investor confidence in the company’s longer-term prospects still. It is also consistent with the stock’s recent downtrend breaching our estimated steady-state firm value for Tesla at the $120-range apiece as analyzed in a previous coverage, which considers a perpetual growth rate of about 3.8% under the Gordon Growth model, taking anticipated GDP expansion across the EV maker’s core operating markets as a benchmark.
Tesla Steady-State Firm Value Analysis (Author)
Tesla Steady-State Firm Value Sensitivity Analysis (Author)
Tesla’s current levels in the $110-range implies a perpetual growth rate of about 3% under the same valuation methodology. Even if the implied perpetual growth rate is cut to 1.5%, while holding all other key valuation assumptions constant (e.g. cost of capital, cash flow growth over forecast period, etc.), the stock is likely to trade above $100 still. While the current market climate sets the stage for further volatility in the stock over coming months, we believe Tesla’s valuation remains fair at current levels, and would require a material alteration to its longer-term growth story to take it another leg lower. Considering Tesla’s current share price is likely reflective of implications from the fluid nature of still evolving macro uncertainties in the near-term, alongside other company-specific headwinds that have yet to find resolution, we are reverting to a hold rating on the stock.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
