Tesla Motors Financial Analysis: Investment Risk and Ratios

Introduction: Why Tesla?

The company selected for this study is Tesla Motors. The reason for studying this company is that an investment advisory practice has received a significant volume of client inquiries about it specifically. Tesla has generated a tremendous amount of "bullish buzz" (Brumley, 2015), and opinions among the analyst community are decidedly mixed. Some analysts view the stock through the lens of an automobile company, where Tesla is a niche player struggling to gain a foothold in a highly competitive industry. Others evaluate it through the traditional metrics of profits and cash flow and conclude that Tesla stock is grossly overpriced (The Street.com, 2015).

Yet others are bullish on the company because they see it as possessing disruptive technology (Boyadjis, Rassweller & Brinley, 2014). The CEO, Elon Musk, is a high-profile leader capable not only of generating substantial hype for his companies, but also of securing financing — something that could carry Tesla to the point where it generates positive operating cash flow. The bulls envision a $9 trillion global automobile market, foresee a post-carbon future, and see Tesla as positioned to own a substantial share of that market, making the company significantly undervalued today. The bears counter that Tesla is not actually that disruptive, again arguing against its present valuation (HBR, 2015). For investors, however, the central question is whether to hold the stock, which is why it makes for such an interesting case study.

Investor Profile and Risk Tolerance

Not all investments are suitable for all investors. One of the most important tasks a financial manager must perform is 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 those needs are generally reflected in their risk tolerance levels. For example, someone in their thirties who is just starting a family will have a time horizon that begins with shorter-term goals such as buying a home and extends to longer-term objectives such as funding a college education and retirement. Someone in early retirement has a much different risk tolerance, because they no longer have earning capacity and must ensure they have sufficient funds to sustain themselves. The very old, on the other hand, may have their investment assets earmarked for heirs, which again shifts the risk profile of the account.

There is also empirical evidence supporting the idea that people's risk preferences vary across several demographic characteristics. The most significant factors identified in the research were gender, marital status, occupational status, income, race, and education. Interestingly, age alone is not a statistically significant predictor of risk tolerance, contrary to common belief (Grable, no date). The financial manager can take age into account independently, however, and typically separates it from other demographic factors, since age is most relevant where it affects the time horizon of the investment.

In general, equity investments are riskier than debt investments among the common asset classes. Equity investments fluctuate both on a firm-specific basis and in response to broader market movements (market risk). The market risk is expressed as a beta of 1.0; the further a stock's beta deviates from 1.0, the greater the divergence between that stock's movement and the general market. Firms with very low betas are highly stable, while those with high betas are more volatile. One of the reasons Tesla receives so much media attention is not just the buzz surrounding the company but the volatility of its stock. The financial media caters largely to active traders, who favor high-profile volatile stocks, so Tesla receives disproportionate coverage in part because of that volatility. The current beta of Tesla stock is 0.64, which indicates that the stock tends to move in the same direction as the market but only weakly so. This actually makes the stock useful in a portfolio as a counterweight to other holdings that move more closely in line with broad market indices.

The higher risk associated with equities in general means they are better suited to investors with a high risk tolerance and a longer time frame. This principle applies even more strongly to Tesla Motors when one examines the company's operations. Tesla is not profitable and has a high cash burn rate. The company does not currently face a demand problem — its production capacity cannot keep pace with demand — but it is determined to keep manufacturing in-house. This creates a cash flow problem, as the company is not generating enough revenue to self-finance its expansion. Normally, a company with a beta near Tesla's would be a fairly stable, mature enterprise (comparable, for example, to 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 realize its market potential, those developments are still years away. The time horizon for Tesla shares is therefore much longer than the beta alone would suggest. The only type of investor who should realistically consider Tesla right now is someone with a high risk tolerance and a very long time horizon — the company could just as easily become the next Blackberry as the next Apple.

Moreover, Tesla should be held as part of a broader portfolio. The target client who owns Tesla will include it as one component of a diversified equity portfolio. That investor is probably male, well-educated, and a high earner, as these are all characteristics associated with higher risk-taking behavior. Tesla functions as a high-growth, higher-risk position within a balanced portfolio.

Financial Ratio Analysis

A sound way to assess the health of a company is through its financial ratios. There are several categories of ratios, each derived from the company's financial statements. All publicly traded companies are required to publish financial statements in a consistent reporting format using generally accepted accounting principles (GAAP). The purpose of these statements is to accurately reflect a company's financial condition and to provide a basis for comparability across firms. Comparability is a particularly important issue with Tesla: many bearish analysts evaluate Tesla strictly against other automakers, while bullish analysts argue that Tesla's operational profile is so different from those of established manufacturers — most of which are mature, slow-growing businesses — that the comparison is not meaningful.

The basic categories of financial ratios are the liquidity ratios, solvency ratios, efficiency ratios, market ratios, and profitability ratios (Loth, 2015). Each category informs the analyst about a different dimension of the company's financial condition.

Liquidity ratios evaluate the company's ability to meet its financial obligations over the coming year. Common liquidity ratios include the current ratio (current assets divided by current liabilities), the quick ratio, and the cash ratio. The quick ratio is current assets less inventories divided by current liabilities; the cash ratio is cash divided by current liabilities. The current ratio is the most appropriate measure for Tesla, because the company can reasonably expect to sell all of its outstanding inventory — demand exceeds production capacity. The current ratios for the past three years are as follows:

Current Ratio (2012–2014): 0.97 (2012), 1.87 (2013), 1.52 (2014)

These figures convey two important points. First, Tesla is growing rapidly, as evidenced by the substantial increase in both current assets and current liabilities over the three-year period. Second, the company is liquid. A current ratio of 1.52 is entirely reasonable and indicates adequate short-term liquidity.

Solvency ratios evaluate the long-term health of the company. There can be a significant difference between a company's short-term and long-term financial health. The short-term picture is primarily about cash, but the long-term picture is about capital structure — the balance between equity and debt as sources of financing. Tesla's cash flow statement shows positive cash flow from operating activities in 2013 but not in 2012 or 2014. This means that in two of the past three years, the company has required external financing to fund operations, which affects its debt load unless it accesses equity markets instead. Tesla has been active in both debt and equity markets in recent years. The debt-to-equity ratio is one way of evaluating whether a company carries excessive leverage:

Debt/Equity Ratio (2012–2014): 7.94 (2012), 2.62 (2013), 5.42 (2014)

These figures show that Tesla generally carries a high level of debt. In 2013 it improved substantially, but by 2014 the company was again heavily indebted. There are reasonable explanations for this degree of leverage — the current cost of debt is very low, and debt financing avoids diluting the equity of existing shareholders, which includes virtually all senior managers. Nevertheless, Tesla's high debt burden makes the stock riskier to own, because the company must generate significant cash flow to service those obligations before any returns can be distributed to shareholders. Combined with the need to reinvest earnings back into the business, this means there is no realistic prospect of a dividend on Tesla stock in the foreseeable future; all shareholder returns must come in the form of capital gains.

Tesla has never reported a profit since its founding, which complicates profitability ratio analysis. Nevertheless, it is important to gauge whether the company is moving toward profitability. For a company in Tesla's position, the gross margin is particularly informative because it strips out the costs of growth and administration and focuses solely on whether Tesla can sell its products for enough to cover the cost of making them. It is not necessary for a company to be profitable to remain in business, but it must at minimum cover its variable costs — which is essentially what the gross margin measures.

Gross Margin (2012–2014): 7.28% (2012), 22.66% (2013), 27.57% (2014)
Net Margin (2012–2014): -95.88% (2012), -3.68% (2013), -9.19% (2014)

These figures reveal several things. In 2012, Tesla's gross margin was very low and the company was losing nearly as much money as it was bringing in, necessitating successive rounds of financing in both the equity and debt markets. The company has steadily improved its gross margins, partly as a function of having a product in the market and partly from improved economies of scale. There is a steep learning curve in large-scale auto manufacturing, and Tesla is at least pointed in the right direction on gross margin. However, the net margin worsened in 2014, which may reflect increased investment activity. Tesla's third-quarter 2015 gross margin was 24.7% and its net margin was -24.55%, both representing a step backward. This is a concern: in terms of profitability, 2015 appears likely to finish worse than 2014, and the company is moving in reverse on these critical measures.

Investors ultimately need to see a return on their investment. Traditional metrics such as ROI, ROA, and ROE are essentially meaningless for Tesla given that the company has never been profitable. This is precisely what the bears point to: by objective measures, the company does not earn money, and therefore a positive stock price can only reflect investor hopes that profitability will arrive someday. On the basis of objective reality, Tesla equity has intrinsic value only to the extent of its book value per share. For an investor who is buying on the expectation of future profitability, earnings per share should at least be trending in the right direction. Tesla's EPS figures for the past three years are as follows:

Earnings per Share (2012–2014): -$3.69 (2012), -$0.62 (2013), -$2.36 (2014)

This data mirrors the net margin story: performance was trending in the right direction through 2013 but took a step backward in 2014. It is necessary to examine cash flow from operations to determine whether this deterioration is rooted in core operations or in investments in future growth. Tesla's own 2014 Form 10-K explains the decline in operating cash flows as follows:

"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."

Some of the increase was related to expanded production, but a portion was attributable to finished vehicles that were produced but not delivered on schedule. This type of performance shortcoming is detrimental to the company and is exactly the kind of red flag that ratio analysis is designed to surface.

The inventory turnover ratio evaluates the rate at which a company converts its inventory into sales, calculated as cost of goods sold divided by average inventory. This ratio can be more difficult to calculate when inventory levels change rapidly — as is the case with Tesla — but when inventory management begins to affect other aspects of the financial statements, the inventory turnover ratio becomes an important diagnostic tool. Tesla's inventory turnover ratios for the past three years are as follows:

Inventory Turnover (2012–2014): 1.20 (2012), 2.56 (2013), 1.79 (2014)

Once again, this ratio indicates that the company's performance peaked in 2013. As Tesla added new products into production and pre-production, its operational efficiency diminished. The increase in finished goods inventory in 2014 hurt the company, as did expanding into new business lines. While Tesla was more efficient in 2014 than in 2012, inventory turned over significantly faster in 2013. For a long-term investor in Tesla, one can only hope these are growing pains rather than a structural deterioration.

References

Block, D., Harrison, J., & Brooker, P. (2014). Electric vehicle sales for 2014 and future projections. Electric Vehicle Transportation Center. Retrieved November 23, 2015.

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

Brumley, J. (2015). Tesla Motors: Like it or not, Tesla stock is losing steam. Investor Place. Retrieved November 23, 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

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/