Financial Analysis of Tesla Motors

Financial Research Report

The company that I have selected to study is Tesla Motors. The reason for studying this company is that my investment advice practice has received a lot of calls about this company in particular. This is a company that has generated a tremendous amount of "bullish buzz" this year (Brumley, 2015). Opinions among the analyst community are decidedly mixed about Tesla stock. Some analysts view the stock from the lens of an automobile company, where Tesla is a niche player struggling to gain a foothold in a highly-competitive industry, or view it through the traditional lenses of profits and cash flow, and determine that Tesla stock is grossly overpriced (The Street.com, 2015).

Yet, others are bullish on the company because they see it as having disruptive technology (Boyadjis, Rassweller & Brinley, 2014). The CEO, Elon Musk, is a rock star CEO capable not only of generating a lot of hype for his companies, but also capable of acquiring financing for his companies, something that can take Tesla to a point where it actually generates positive operating cash flow. The bulls see a $9 trillion global automobile market, envision a post-carbon future, and see Tesla has owning a substantial market share in the post-carbon auto market, something that would position the company as substantially undervalued today. The bears counter that Tesla is not actually that disruptive, again arguing against its present valuation (HBR, 2015). But for this debate, my customers want to talk about the stock, and that is why it makes for such an interesting case study.

Investor Profile

Not all investments are suitable for all investors. One of the important tasks that a financial manager must do is to perform a risk assessment on a client prior to making investment recommendations. Typically, the breakdown of investor risk tolerance characteristics begins with demographic factors such as age, gender, income, and education. There are logical reasons for this. People have different financial needs at different stages of their lives, and such needs are typically reflected in their risk tolerance levels. For example, someone who is in their thirties and just starting a family is going to be motivated by a time horizon that begins with buying a home (short-term or medium-term) to longer-term objectives such as college and retirement. Someone who is in early retirement has a much different risk tolerance, because they no longer have any earning capacity, and need to ensure that they have enough money on which to survive. The very old, on the other hand, may well have their investment money earmarked for their heirs, which again changes the risk profile of the account.

There is also empirical evidence to support the idea that people's risk preferences vary by several different demographic characteristics. The most significant were gender, marital status, occupational status, income, race and education. It was found that age is not actually a significant factor in the risk tolerance of the investor, contrary to common belief (Grable, no date). The financial manager can take age into account on his or her own, however, and typically will separate out risk tolerance from the other demographic factors. . Age matters where it affects the time horizon of the investments.

In general, equity investments are riskier than debt investments, among the common classes. Equity investments fluctuate both on their own (firm-specific risk) and with the market (market risk). Thus, most companies see the value of their shares fall when the market falls, though there are always exceptions. The market risk is a beta of 1.0, so the further a firm's stock is from 1.0, the greater the deviation between the movement of that firm's stock and the general market. Firms with very low betas are very stable, those with high betas are very unstable. One of the reasons why Tesla receives so much press is not just the buzz surrounding the company but the volatility of its stock. The financial media caters more than anything to the active trader, and active traders love big name volatile stocks, so the financial media talks about Tesla a lot in part because of its volatility. The current beta of Tesla stock is 0.64, which indicates that this company tends to move in the same direction as the market, but weakly. This actually makes the stock useful in a portfolio as a means of countering other stocks that move more in line with the broad market. The low beta for Tesla basically means that its movements are not all that well-correlated with the broad market.

The higher risk associated with equities in general mean that they are better-suited to investors with a high risk tolerance and a longer time frame. This philosophy applies even more to Tesla Motors, when one examines the company's operations. Tesla is not profitable, and it has a high burn rate. The company does not at present have a demand problem, but rather a supply problem It cannot built capacity fast enough, but is determined to keep production in-house. This is creating a cash flow problem for the company as it is not making enough money to fuel its expansion. Normally, a company with a beta where Tesla's is tends to be a fairly stable company (i.e. Walmart), but Tesla is not even projecting a profit for several years. There is no question, even among the company's bulls, that if Tesla is to become profitable and to realize its market potential, such things will not happen for several years. Thus, the time horizon for Tesla shares is much longer than the beta would indicate, but financial analysis bears this out. The only sort of investor who should be interested in Tesla right now is someone with a high risk tolerance and a very long time horizon -- the company could just as well be the next Blackberry as the next Apple.

Moreover, Tesla should be part of a broader portfolio. The client that will own Tesla will include it as part of a diversified portfolio of equities. The target client is probably male, has a good education and earns well, as these are all characteristics associated with risk-taking. Tesla will be a high-growth stock, and one of the riskier ones in a balanced portfolio.

Financial Ratios

A good way to investigate the health of a company is via its financial ratios. There are several different categories of ratios, each based on the company's financial statements. All publicly-traded companies need to publish financial statements according to a consistent reporting format, and using generally accepted accounting principles (GAAP). The purpose of the financial statements is to accurately reflect the financial condition of the company, and to provide a basis for comparability between companies, for a wide range of stakeholders. In particular, comparability is an issue with Tesla. Many bearish analysts evaluate Tesla strictly against other car companies, where bullish analysts tend to accept the proposition that Tesla is in a completely different situation from most of those, and that the operational differences between Tesla and other automakers makes comparability absurd -- not the least of which is that most automakers are mature, slow-growing entities while Tesla is not.

There are several categories of financial ratios that can be calculated and these categories inform the analyst about different aspects of the company's financial condition. The basic categories of financial ratios are the liquidity ratios, solvency ratios, efficiency ratios, market ratios and the profitability ratios (Loth, 2015). The liquidity ratios evaluate the company's ability to meet its financial obligations for the coming year. Some common liquidity ratios are the current ratio (current assets / current liabilities), the quick ratio and the cash ratio. The quick ratio is the value of current assets less inventories over current liabilities, and the cash ratio is cash over current liabilities. The current ratio makes the most sense for Tesla, because it can reasonably expect to move all of its outstanding inventories -- the company's demand exceeds its production capacity. Thus, all categories of current assets can be used to evaluate its liquidity. The current ratios for the past three years for Tesla are:

2012

2013

2014

Current Assets

Current Liabilities

Current Ratio

0.97

1.87

1.52

These figures tell us two things. First, Tesla is growing rapidly, as the growth in both the current assets and current liabilities has been substantial over the past three years. Further, the company is liquid. A current ratio of 1.52 is perfectly reasonable for any company, and indicates general good liquidity.

The solvency ratios evaluate the long-term health of the company. This is important because there can sometimes be a significant difference between the short-term and long-term health of the company. The short-term is mostly about cash, but in the long run it is about capital structure, and the balance between equity and debt as sources of financing. The cash flow statement indicates that Tesla had positive cash flow from operating activities in 2013, but not in 2012 and 2014. This means that in two of the past three years the company has needed external financing to fund its business. That can affect the amount of debt that the company holds, unless it taps the equity markets. Tesla has been active in both the debt and equity markets in recent years. The debt/equity ratio is one of the ways of evaluating whether a company has too much leverage or not:

Debt/Equity Ratio

2012

2013

2014

Total Liabilities

Shareholders' Equity

Debt/Equity Ratio

7.94

2.62

5.42

This figure shows that Tesla generally has a high level of debt. In 2013, it was around two-thirds of the company's capital structure, but that has increased to where the company is heavily indebted. There are reasonable explanations for this degree of leverage, particularly as the current cost of debt is very low. But the other explanation is that Tesla is tapping the capital markets frequently for financing on account of its burn rate, and it is easier and cheaper to acquire debt financing, and it can do so without diluting the equity holdings of the current shareholders, which includes pretty much all the senior managers. Tesla's high level of debt, however, makes it a riskier company to own, because it needs to generate significant cash flow in order to cover those debt obligations before any returns can be paid to shareholders. For this reason and the need to reinvest earnings back into the company, there is no prospect of a dividend on Tesla stock in the foreseeable future -- all gains a shareholder can expect will come in the form of capital gains.

Another category of financial ratio is the profitability ratios. Tesla has never turned a profit in any year since it was founded, which makes calculating these ratios difficult. Nevertheless, it is important to gauge whether or not the company is getting closer to profitability. Knowing how much the company is spending/losing per dollar of revenue is important to the investor. For a company in Tesla's position, the operating gross margin also matters, because that cuts out the costs associated with the growth and administration of the business, and just focuses on the ability of Tesla to sell its products for enough money to cover the cost of making them. It is not necessary that a company be profitable to remain in business, but it must at the very least cover is variable costs, and that is more or less what the gross margin indicates.

Net Margin

2012

2013

2014

Revenue

413256

2013496

3198356

Gross Profit

30067

456262

881671

Gross Margin

7.28%

22.66%

27.57%

Net Income

-396213

-74014

-294040

Net Margin

-95.88%

-3.68%

-9.19%

These figures indicate several things about Tesla's profitability. First, the company's gross profitability is increasing. In 2012, the company's gross margin was very low and as a consequence it lost a lot of money. Tesla was losing almost as much money as its revenues, which led to a very high burn rate and necessitated several successive rounds of financing, both on the equity and debt markets. The company has steadily improved its gross margins, which is a function of having a new product, and of having better economies of scale. There is a very steep learning curve with respect to large-scale auto manufacturing, and many companies can expect to struggle with profitability for years, but at least Tesla is pointed in the right direction. It is worth considering that the company's net margin has worsened in 2014, which may be a sign of increased investment. For a company like this, it is also valuable to consider the most recent changes to these figures. Tesla's 2015 Q3 gross margin was 24.7%, which is a step backwards, and its net margin was -24.55, again taking the company a step backwards. So this is a concern, that in terms of profitability 2015 is not going to be as good a year as 2014 was, and Tesla is going in reverse on these critical measures.

A fourth financial ratio category is the investment returns. Ultimately, investors need to see a return on their investment. There are thousands of investment options, so the decision to buy any one stock should be done at least in part on the principle that the money used in that purchase would not be better used elsewhere. In that sense, the investment returns help to establish what a company is doing to enhance shareholder wealth, by adding value to the money that shareholders have put into the company. Typical measures like ROI, ROA and ROE are basically useless is the sense that they will all equal zero, because Tesla has never been profitable. This is what the bears point to as well, that by objective measures the company is not making money and therefore a positive stock price can only reflect the hopes and dreams of investors that one day the company will be profitable, but based on objective reality equity in Tesla only has intrinsic value to the extent of its book value per share. If an investor is buying Tesla on the idea that the company will be profitable in the future one day, then the earnings per share at least should be going in the right direction. Tesla's EPS figures for the past three years are as follows:

Earnings per Share

2012

2013

2014

EPS

-3.69

-0.62

-2.36

This shows much the same thing that the net margin shows, that Tesla's profitability and returns to investors were trending in the right direction through 2013, but took a step backward in 2014. There are a few possible explanations for this, but first it is necessary to analyze the cash flow from operations to see if these profitability and return issues are related in operations or investments in future growth. There is reason to believe the latter is the culprit, as the company announced the development of a new vehicle, the Model X in 2014, and investments in this and other infrastructure could have affected the company's earnings per share in 2014. This is not the case -- the company explains why cash flow from operations declined in 2014 in the following note in their 2014 Form 10K:

"The decrease in operating cash flows in 2014 as compared to 2013 was due to an increase in finished goods inventory primarily due to cars whose delivery slipped from Q4 of 2014 to the following year, an increase in raw material inventory balances at year end necessary to meet our planned production requirements for Model S in Q1 of the following year, higher operating expenses in R&D and SG&A."

So some of the increase was related to increased production, but some of it was materials that were ordered, turned into cars, but not delivered on schedule. This type of performance shortcoming is ultimately detrimental to the company and is the sort of red flag one looks for in the financial statements, and it was identified through the process of ratio analysis.

A fifth type of financial ratio is efficiency ratios. From the above quote from the annual report, it would seem that the inventory turnover ratio is a good one to investigate. The inventory turnover ratio evaluates the rate at which the company converts its inventory to sales, and it calculated as the cost of goods sold divided by the average inventory. This ratio can be more difficult to calculate when the inventory level changes rapidly, as is the case with Tesla, but nevertheless when a company's inventory management starts to affect the other aspects of its financial statements there is reason to look at the inventor turnover to see what else can be learned. The inventory turnover ratios for the past three years at Tesla are as follows:

Inventory Turnover

2012

2013

2014

COGS

Starting Inventory

50.1

End Inventory

Inventory Turnover

1.20

2.56

1.79

Once again, this ratio indicates that the company's performance essentially peaked in 2013. As it added new products into production and pre-production, Tesla's ability to work efficiently has diminished. One can only hope, if one is long Tesla, that these are growing pains. The inventory turnover shows that while the company is more efficient in 2014 than it was in 2012, that inventory turned over more quickly in 2013. The increase in finished goods inventory in 2014 did not help the company, nor did entering into new businesses.

Overall Assessment

For all its promise and hype, an analysis of the financial statements highlights several issues with Tesla. Not the least of which is the reality that it was a more efficient, more profitably company in 2013 and is now headed back in the wrong direction in terms of its metrics. In 2013, the case could at least be made that this was a company that was trending in the right direction. It had a new product that was selling, and all of the key metrics were improving. Since that point, the key metrics have diminished. The company's inventory turnover, liquidity, solvency and profitability have all declined.

It is difficult to pin down exactly what the issue is with Tesla. The company's products are popular, and demand is not an issue for the company, but operationally it is facing some significant growing pains. It has added new products, including the development of the Model X and the upcoming Model 3, and the home batteries that were unveiled earlier this year. All of these things, plus the buildout of a battery factory in the Nevada desert, have all contributed to cash burn at Tesla. Perhaps worse, these different ventures have started to spread the talent thin at the company. When it was able to focus on just one product, Tesla was on the right track financially, but there is the very real possibility that the company is taking on too much, too fast, and the financials are showing the effects of that.

The reasons why Tesla is struggling matter. While it is reasonable to accept the bull argument that Tesla is too different from conventional automakers to evaluate against them, the reality is that the company in 2014 underperformed against itself. The quarterly statements for 2015 show the same downward performance trend. An objective investor realizes that the current intrinsic value of Tesla is next to nothing. Its book value per share is $10.04 (MSN Moneycentral, 2015) and the current stock price is $220.01, so the market is clearly not looking at intrinsic value with Tesla. But to realize on the positive investor sentiment about the future of the company requires that the company is at the very least headed in the right direction. Are there causes for optimism? Sure there are, in particular the strong growth rate of electric vehicles, which is estimated at 23% in 2014, a rate that is considered to be sustainable over the medium term (Block et al., 2014). Combine that with the fact that Tesla is the undisputed technology leader in the field, to the point where the company felt compelled to release its patents in order to spur growth in the industry by allowing others to catch up to it (Wharton, 2014). If the industry grows as expected, and Tesla has a leadership position, that is obviously cause for optimism, and it seems that the stock price is based almost entirely on that optimism especially given what is now a two-year downturn in the young company's financial ratios.

Risk Management

Tesla would have to be considered a high risk stock, and therefore one that needs to be part of a diversified portfolio. It would be the risk element in that portfolio. This is more due to the nature of the stock as a company whose value is almost entirely speculative. Objectively, with a beta of 0.64, what Tesla brings to the table is an asset that only loosely moves in line with the market, for better or worse. The overall net effect is that the beta is fairly low, indicating a stable company. In practice, this mostly means that there are a lot of Tesla bulls who prop up the value of the stock. Its 52-week range swings from 181.40-286.65, indicating that the company's is more volatile than the beta indicates. As a small company in an emerging business, it is reasonable to conclude that Tesla is a risky, growth-oriented technology play, more than a mainstream automaker at this point. As such, it fits in a niche role in a diversified equity portfolio. Tesla is only really suitable for investors with very long time horizons as even the company's bulls accept that it will take years before Tesla can earn enough to justify its current stock price -- that price is basically pricing in the next five years or more of earnings for the company, well past the launch of the Model 3. Investors who are risk averse or have a time horizon of less than 20 years are not recommended to hold Tesla Motors, even in the context of a diversified portfolio. From the investor's point-of-view, inclusion in a diversified portfolio is the only reasonable way to manage the risk associated with this stock, and anybody uncomfortable with the idea of paying twenty times book -- knowing the possibility of this company failing is very real -- has no business owning Tesla shares under any context.

There is another strategy that can work for some investors, and that is the covered write. With this strategy, the owner of a stock writes a call at a point below the current price. The owner of the share pockets the income from the write, and if the call is not exercised then the owner keeps the shares. If the price falls, the owner will have downside protection, as they will be compelled to sell at the strike price. The covered call does not eliminate downside risk, but mitigates it via the call premium the owner receives. A strategy like this, with options, is definitely not suitable for investors who are not experienced and understand options, so this strategy does not really make Tesla a more accessible stock.

Recommendation and Conclusion

While there are many people interested in Tesla, and there is excitement on the street about investing in this company, the reality is that it is a difficult stock to recommend. People who already hold Tesla shares should not sell, and in truth such investors are probably well aware of the long-term time horizon, or they are day traders. But inexperienced investors or those who cannot properly diversify the risks of owning Tesla should not own this stock. As part of a diversified portfolio, it can be a valuable addition because of its upside, but only for investors who have a very long time horizon (in excess of twenty years) and a high level of knowledge about investments, and the risk tolerance to match. For anybody else, the risk is too high, because quite simply on the basis of its actual financial performance and value, Tesla is dramatically overpriced. You are paying for a future that has not arrived, and may never arrive, and only people who genuinely understand that, and who can afford to lose everything, should invest in Tesla.

Refernces

Block, D., Harrison, J., & Brooker, P. (2014). Electric vehicle sales for 2014 and future projections. Electric Vehicle Transportation Center Retrieved November 23, 2015 from Boyadjis, M., Rassweller, A. & Brinley, S. (2014) Tesla Motors: A case study in disruptive innovation. IHS Quarterly. Retrieved November 23, 2015 from http://blog.ihs.com/q14-tesla-motors-a-case-study-in-disruptive-innovation

Brumely, J. (2015). Tesla Motors: Like it or not, Tesla stock is losing steam. Investor Place. Retrieved November 213, 2015 from http://investorplace.com/2015/11/tesla-stock-losing-steam-tsla/

Grable, J. (no date). Investor risk tolerance: testing the efficacy of demographics as differentiating and classifying indicators. Retrieved November 23, 2015 from http://scholar.lib.vt.edu/theses/available/etd-92497-55640/unrestricted/ETD2.PDF

HBR (2015). Tesla's not as disruptive as you think. Harvard Business Review. Retrieved November 23, 2015 from https://hbr.org/2015/05/teslas-not-as-disruptive-as-you-might-think

Loth, R. (2015). Financial ratio tutorial. Investopedia. Retrieved November 23, 2015 from http://www.investopedia.com/university/ratios/

MSN Moneycentral (2015) Tesla Motors. Retrieved November 23, 2015 from http://www.msn.com/en-us/money/stockdetails?symbol=TSLA&ocid=qbeb

Tesla Motors 2014 Annual Report. Retrieved November 23, 2015 from http://ir.teslamotors.com/secfiling.cfm?filingid=1564590-15-1031&cik=1318605

The Street.com (2015). Tesla Motors. The Street.com. Retrieved November 23, 2015 from http://www.thestreet.com/quote/TSLA.html

Wharton (2014). What's driving Tesla's open source gambit? Knowledge @ Wharton. Retrieved November 23, 2015 from http://knowledge.wharton.upenn.edu/article/whats-driving-teslas-open-source-gambit/