Tesla has released its much-anticipated Q3 results.

“Alright, so Q3 was our best quarter in history.”

Those were the opening words of Elon Musk on the Tesla Q3 earnings call. A sales record combined with free cash flow of $1.4bn is certainly impressive, but as ever I remain concerned about the hype around this company which does not operate in a competitive vacuum.

Hundreds of new Electric Vehicle (EV) models are expected in the next few years. The world’s finest automobile manufacturers aren’t going to sit by and let Tesla dominate the EV space forever.

I have another concern too: the man himself.

Musk’s closed his intro on the earnings call by suggesting they move to questions. Tesla’s director of investor relations had to remind Musk that the CFO of Tesla also had a few things to say. It may seem like nothing, but it’s another reminder of the single biggest risk to Tesla – Musk is a bigger brand than the company and he knows it.

I get nervous whenever I see a listed company dominated by an individual.

Tesla is the EV market leader

The company is the standard bearer for the EV market, enjoying market share approaching 20%. Around three-quarters of this share is attributable just to the Model 3, Tesla’s runaway success.

Whilst progressive Europeans like to fancy themselves as being at the forefront of the EV wave, the biggest market in the world is actually China. More than a million EVs are sold in China each year (nearly 5% of total car sales in China) and the government wants to increase that to 20% – 25%. This policy is a direct response to pollution issues in China and led Tesla to set up a Gigafactory in that country.

This year, Tesla has delivered just under 320,000 cars worldwide. To reach the goal for the year of 500,000 units, Tesla will need to deliver a Q4 with 25% growth on its record Q3 performance.

Regulatory credits

The EV wave has been driven forward by government support. Environmental regulations favour EV companies and allow Tesla to sell “regulatory credits” to other manufacturers.

Think of it as a shopper loyalty programme where you can sell your points for good behaviour to other shoppers. They are choosing to buy your points instead of the products that award the points.

Tesla’s automotive revenue for the past 9 months is $17.9bn, of which $1.2bn is regulatory credits. That means over 6.5% of revenue is earned from these credits.

It might not sound like much but remember that there is no additional cost to these credits for Tesla. If the regulations changed and the credit opportunity fell away, the impact would hit Tesla’s bottom line profit.

Tesla’s operating income for the past 9 months is $1.4bn. Now imagine if the $1.2bn in credits wasn’t there – suddenly not such a small impact, is it?

If for any reason there is a change of heart among governments and regulators towards EVs, Tesla’s business will unravel. The company isn’t particularly profitable based on consumer demand alone. Obviously, the investment case is that this will change over time, but it’s a risk worth highlighting.

Tesla’s share price is consolidating

The share price reacted positively on Thursday morning after the results were released, but then cooled down to close the week 5.6% down. After a volatile period in September where the share price dropped from nearly $500 to $330 as part of a broader market sell-off, Tesla seems to have consolidated around the $415 – $450 mark.

Manufacturing capacity

As this table from the Q3 results presentation shows, Tesla’s manufacturing capacity pipeline is strong:

Berlin and Texas should start delivering cars next year. Musk commented in the earnings call that Berlin will probably be the first battery cell production line that operates at scale.

Musk spent a lot of time in the earnings call discussing Tesla’s manufacturing capacity, which is important because that’s where the old-school car manufacturers are strong. He also said “S-curve” a lot, which is a standard focus area for Musk.

Imagine an S turned on its side and with the ends cut off. That’s the image you need in your head for the journey that Musk believes Tesla is on.

A lot of pain is taken initially to set manufacturing up and make mistakes (bottom of the S). Margins are poor in this phase and there are production issues that are sometimes only discovered later. For example, Tesla is now recalling 30,000 vehicles in China that were manufactured between September 2013 and January 2018.

It’s not just a Tesla issue. Leading manufacturers are experiencing these challenges with EVs. Hyundai is recalling over 25,000 Kona vehicles for potential fire risks.

As lessons are learned and technology is refined, production starts to scale (middle of the S). This improves volumes and margins, putting a smile on the faces of shareholders. For example, Tesla’s operating margin has more than doubled in the past year, from 4.1% in Q3 2019 to 9.2% in Q3 2020.

Importantly, the company starts to generate free cash flow as manufacturing improves. This is where Tesla is starting to play, generating $1.4bn in free cash flow in Q3 2020, the company’s best result yet.

There’s a point at which the benefits start to tail-off. That’s the top of the S. This is the position that internal combustion engine (ICE) manufacturers find themselves in with their traditional products that they’ve been producing for decades. Tesla will also reach this stage at some point in future.

What about solar?

Some see the automotive business as a distraction more than anything else, focusing instead on the potential for the energy business. They have a point.

This excerpt from Tesla’s results commentary speaks volumes:
“We continue to believe that the energy business will ultimately be as large as our vehicle business.”

Tesla can now implement a solar roof for you in 1.5 days. That’s genuinely incredible technology and is driving strong growth in solar deployments – more than double in Q3 vs. Q2. The business isn’t operating at scale yet but it looks interesting for the future.

Am I buying yet?

I’ve lost out on significant growth in Tesla this year but I’m still not buying at these levels.

Group revenue for the past twelve months is $24.3bn and Tesla’s market cap is $392.7bn. That’s a trailing revenue multiple around 16x.

Ford is trading on a revenue multiple of 0.25x and General Motors 0.46x. Toyota and Volkswagen are at fairly similar levels. Investors are paying a ridiculously high premium for Tesla over other automotive manufacturers, many of whom also have EV strategies and a loyal customer base.

“But Tesla is a tech company!” I hear you cry.

Netflix is on a revenue multiple of 9x. Microsoft is trading at 11.6x. Amazon, a tech company with a retail sales model that at least has some similarities to Tesla (i.e. mainly earns gross profit rather than subscription fees) is only trading on a revenue multiple of 5x.

The energy business is the most exciting part of Tesla but I still cannot justify paying three times more per Dollar of revenue at Tesla vs. Amazon. It tells you something about the current valuation that Tesla announced its best-ever quarter and the share price barely flinched.

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