Investors have been aggressively bidding up shares of Tesla over the past couple of years, and there is a good reason behind this. The company is the leader in the electric automobile revolution. It is the dominant player in this rapidly growing space that analysts think can take over the gasoline automotive industry in the next couple of decades.
It is for this reason that Tesla shares trade with a $28 billion market capitalization despite the fact that it doesn’t earn any profits and despite the fact that it has just $2.1 billion in sales. But while investors feel this valuation is justified, I think that an extremely optimistic scenario is being priced in. Nevertheless, there are reasons to be concerned. Sure, the company will grow its business over the next several years, but the enormous gains to be had have already been realized, and investors are now better off selling and finding the next big thing.
There are several reasons for this.
The first is that the company’s Q1 sales growth deteriorated dramatically from the previous year. Sure, 10 percent sales growth year over year is impressive, but it by no means justifies the current valuation. With a stock trading at 13 times sales one would expect at least 50 percent to 75 percent sales growth, and 10 percent isn’t even close.
The second is that there is a lot of competition in the automotive space. While Tesla is the leader in the electric car space, there are several other well-funded companies in the industry that want a piece of the action such as BMW and General Motors. Over time every major car company will have its own line of electric cars, and it is unlikely that Tesla will be able to stay out ahead to the extent that it is right now. Once investors realize this they will start to price in slower growth and this means that the stock price will decline.
Third, the automotive industry is highly cyclical. People don’t buy a lot of cars during a recession. As a result automotive companies often show steep losses and they are forced to lay off a lot of people during a recession. These companies’ stock prices also fall very hard. A recession could hit Tesla especially hard considering the high prices of its cars. While it has a secular tailwind driving its sales the headwind of a recession is not priced into the stock, and this is a significant risk.
Finally, Tesla’s electric cars contain lithium-ion batteries. These batteries contain a lot of graphite, and in particular an especially rare kind of graphite called large flake graphite. Most of the world’s graphite production comes from China and only about 2 percent comes from North America. This means that there is a risk that we will see a supply shock in the graphite market, and this would impact Tesla’s ability to produce electric cars. While it can use a synthetic substitute, this substitute currently costs more than twice as much as the natural product, and a shortage of the latter can drive the price of the former significantly higher, and this would hit Tesla’s margins.
Ultimately Tesla is a great company that is a leader in innovation. But like so many growth stories out there too many investors are aware of it. At the same time they are overlooking these risks because they simply want to own a piece of the company without analyzing it using basic fundamental investing criteria such as cash-flow generation. It follows that they have bid the stock up to an unreasonable level and that it is highly vulnerable to the downside once the hype dies down.
Disclosure: Ben Kramer-Miller has no position in Tesla or in any of the stocks mentioned in this article.