Does Tesla Have More Upside?

Does Tesla Have More Upside?

By Aristofanis Papadatos of Sure Dividend

Tesla (TSLA) has generated life-changing returns for its shareholders, as it has rallied more than 7-fold in just the last 12 months.

Unfortunately, income-oriented investors have probably missed out on these returns, as the stock does not pay a dividend

However, the absence of a dividend should be expected in a high-growth stock such as Tesla. The big question is whether Tesla stock has more upside potential based on its fundamentals and growth.

Business overview

Tesla started as a small manufacturer of electric vehicles but it has grown its sales at a tremendous pace. Tesla has grown its revenues approximately 140 times over the last nine years, from $204 million in 2011 to $28.2 billion in the last 12 months. This extraordinary growth helps explain the outstanding rally of the stock, which has advanced nearly 20-fold over the last five years. Notably Tesla has reached a market capitalization of $800 billion, which is nearly 7 times the combined market capitalization of $118 billion of Ford (F) and General Motors (GM).

Tesla is trying to broaden its product portfolio in order to become a full-line auto manufacturer. It is also at a critical point, as it posted a meaningful profit for the first time in its history in 2020. In other words, despite its unparalleled revenue growth since its foundation, it was unable to generate a material profit until last year, as it needed a large enough production scale to become profitable.

The third quarter of 2020 was the best quarter in the history of Tesla. The company achieved record production deliveries, revenue and earnings in that quarter. It delivered 140,000 vehicles and thus remained on track to deliver 500,000 vehicles in the full year. Thanks to the ramp-up of its production, Tesla grew its revenue 39% over the prior year’s quarter and expanded its operating margin impressively, from 4.1% to 9.2%. 

It also essentially doubled its earnings per share and nearly quadrupled its free cash flow, from $371 million to $1.4 billion. The generation of free cash flow is paramount, as it will save Tesla from adding to its debt pile and issuing new shares.

Growth prospects

The market of electric vehicles is in the early phases of its secular growth trajectory. According to a research report from Deloitte, the sales of electric vehicles are expected to grow at a 29% average annual rate over the next decade, from 2.5 million vehicles in 2020 to 31.1 million in 2030. Tesla is the market leader in this market and hence it has exciting growth potential ahead.

On the other hand, investors should realize that the prices of the vehicles of Tesla are out of reach for many consumers. Therefore, it could be prudent to expect Tesla to grow its revenue at a somewhat lower rate in the future. In addition, Tesla will face competition from other manufacturers of electric vehicles, such as NIO (NIO), the Chinese manufacturer of electric vehicles. Tesla will also face intense competition from the manufacturers of traditional vehicles, such as Ford (F), General Motors (GM), Volkswagen (VWAGY) and BMW (BMWYY), which will ramp-up the production of their own electric vehicles in the upcoming years.

Nevertheless, electric vehicle market is still in the very early stages of its growth trajectory. As a result, competition will hardly affect Tesla, as it is the leader in this market. Competition will become more important when the market begins to mature, which is still nearly a decade away. Analysts seem to agree on this view, as they expect Tesla to grow its earnings per share tremendously, from $2.48 in 2020 to $10.14 in 2025.

Competitive advantages 

Tesla is the market leader in the production of electric vehicles. The ultra-high-tech interior of its vehicles render the brand the strongest in this market and thus allow the company to appeal to high-end consumers. This is a major competitive advantage.

Investors should always keep in mind that the auto industry is characterized by intense competition. All the auto manufacturers have to spend hefty amounts to produce new car models year after year only to remain competitive. The intense competition is not likely to be an issue in the next few years thanks to the high growth of electric vehicles but it will eventually become an issue when this market reaches a more mature state. 

While Tesla is clearly the leader in this market, all the auto manufacturers are focused on producing electric vehicles in the years ahead in order to remain relevant. Intensifying competition is something investors should keep in mind moving forward.

Valuation

Due to its breathtaking rally, Tesla has reached nosebleed valuation levels. The stock is trading at a trailing price-to-earnings ratio of 343 and a forward price-to-earnings ratio of 198. It is also trading at 28 times its annual revenues. All these metrics are extremely high. Even if one looks in the distant future, the stock is currently trading at 85 times its expected earnings in 2025 and 32 times its expected earnings in 2029. Therefore, the market has always priced more than a decade of growth in the stock.

If Tesla implements its growth strategy with perfect execution, the stock is likely to maintain its ultra-premium valuation for a considerable period. However, it is a very risky investing strategy to rely on a sustained rich valuation of a stock. In addition, whenever an unforeseen downturn shows up, such as a deep recession, the stock could have excessive downside risk, as the market may reduce the valuation of the stock to a more normal level in such a case. 

The valuation of Tesla may be justified for some high-tech stocks, which can grow uninhibited for years, but it is hardly justified for a company in the auto industry, a highly competitive and traditionally low-margin business.

Final thoughts

Tesla is an admirable company and the leader in the market of electric vehicles, which has exciting growth prospects ahead. The company also has an enviable brand strength thanks to the unique interior of its vehicles. As a result, it has offered life-changing returns to its shareholders in recent years. 

As long as it does not face an unexpected headwind, such as a recession, the stock is likely to maintain its positive momentum. However, investors with a long-term investing horizon should wait on the sidelines, as the sky-high valuation of the stock renders it vulnerable to a potential downturn and limits the long-term return potential of the stock. 

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