Is Tesla like Apple?
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Tesla reported first quarter earnings last month, with the headline being that the company cut vehicle prices to prioritize volume over margins. This stands in contrast to what’s been said on earnings calls in the past. Just two quarters ago management emphasized that the company could achieve both strong volume growth and automotive gross margins above 20%. These margins instead came in at 18%, down over 1100 basis points from this time last year. There are a few different ways to interpret this compression:
The auto-business is a cyclical industry and we’re headed into a recession. Interest rates are also now meaningfully higher, increasing the cost of auto-loans. Price cuts are the best way to stimulate demand given the macro-environment.
Chanos, and other short-sellers, are right that Tesla is currently over-earning. These price cuts are one of many, and over time the automaker’s operating margins will trend much closer to GM’s or Ford’s, or from 11.4% down into the mid single digits.1
Tesla’s increasingly optimistic about the full-self driving opportunity and the margins it can earn in that business. These price cuts are one of many, but because it’s now about getting cars into the hands of as many people as possible to maximize the future software business.
Some combination of all of the above.
Before expanding on the above points, I’d like to make it clear that I don’t have an opinion on Tesla either way, but find the dialogue between the bulls and bears pretty intriguing. This piece is an attempt to sketch out the differences between both sides, rather than to convince you one way or the other. It’s also worth noting that betting against Elon has at least historically been a poor choice, even when there’s rigorous analysis informing that bet. Returning to the points made above, (1) is at least true to some degree, but how much it matters depends on whether (3) is also true. Short-seller Jim Chanos appears pretty skeptical of this claim, and views Tesla as fundamentally a car company:
“We think that the number one, the luxury car market is much smaller than people think. And number two, even though the other OEMs have been slow on the uptake, they are coming and competition will increase and most cars will be EVs by the next five to 10 years. And it's a tough business.
It's a low return on capital business. It always has been. He caught the sweet spot to his and his shareholders benefit and to the short seller's detriment, but now he's gotta maintain it. And I think that's increasingly difficult because his investors are still looking for 40 to 50% growth for the next, you know, decade. And that means that pretty much he's gonna be the entire car industry, you know by the early 2030s and we just don't think that's gonna happen.”2
“Tesla still trades at almost 10 times revenues and 30 times gross profits. So it's trading, you know, like a SAAS company, but it is an auto company. It has gross margins of 30%. Now the risk they have is that almost every other auto company in the world has gross margins of 20%. And so Tesla, which is earning, you know, trading at just a monster multiple, is also trading on a monster multiple of a profit stream that is going to get competed. And that is the risk of Tesla that becomes, you know, just an established EV company amongst a whole bunch of established EV companies.”3
There are two thoughts that come to mind here, and they both have to do with how bearish investors used to evaluate Apple. The first concerns Chanos’ claim that Tesla needs to become the entire auto-industry in order to justify its current valuation. This is true if the auto industry remains structurally similar to what it is today, but that won’t necessarily be the case. Those who evaluated Apple’s opportunity based on the TAM of Nokia ended up misjudging the growth opportunity, as Charlie Songhurst has pointed out in the past:
“One of the things you realized is there was a bunch of investors that sort of thought Apple was overvalued when it was sort of a hundred, 200 billion market cap, because they took the TAM of Nokia and said, even if they take all Nokia's market share, this business can't be big because phones only sell whatever it was back then. And they couldn't intuit the increase in pricing power that were are going to get from turning the phone into a computer. And the West Coast, VC community immediately intuited that.” 4
Tesla’s not an exact analog to Apple, and the recent price cuts call into question the amount of pricing power the company really has. That being said, auto-makers aren’t typically evaluated based on the high-margin, recurring software business their cars could later create, which is precisely what Tesla says it should be evaluated on. Analyzing Tesla as though it’s a car company like any other misses this.
There’s also a question as to how successfully existing auto-makers will manage their shift to EVs. Tesla produced 1.4mm electric vehicles last year. By contrast, GM hopes to produce 1mm EVs by 2025, and Ford hopes to hit 600,000 by late this year and 2mm by 2026. In other words, there’s a significant amount of execution risk for both these businesses, just as there was for Nokia at the time of its pivot to smartphones. Paul Enright, who was previously an investor at Viking Global, had this to say about Nokia’s challenges in the face of Apple.
“If you go back way back, this is probably my favorite one to always use, but when the iPhone was coming out and people were wondering how big the iPhone was going to be, and whether it can take on traditional incumbent cell phone carriers, everyone had this view of Nokia that they had iterated over their 70 years. They weren't always a cell phone maker either, right? They were always well-run. They always figured it out. And what people didn't realize is that every time they iterated, it was a hardware company. And hardware companies pivoting to hardware decisions, generally good outcomes. Nokia was a hardware company with a software problem. Hardware companies have a hard time figuring out software problems. Apple was always selling hardware products, but they were doing it within a vertical software solution. And the market had Nokia in this bucket for a really long period of time of they'll figure it out. We were thinking, no, they're in the bucket now that they can't figure it out.”5
In Tesla’s eyes auto-makers not only have to pivot to EVs, but also have to self-driving cars. Ford and GM have existed since the early 1900s, but, just as Nokia had always produced hardware, have always produced internal combustion engines with humans behind the wheel. Shifting to battery-powered vehicles with a significant software component is unlikely to come without growing pains. This has already been evident with GM and the Chevy Bolt, which was famously recalled after some vehicles spontaneously caught fire.
That being said, the bull case for Tesla based on its potential high-margin full-self driving software business would be more compelling if it was in first place among the auto-makers in this regard. Intuitively, it would seem that Tesla has the upper hand building software. It’s a company built by technologists, giving it a meaningful advantage in recruiting for and executing on its AI efforts. It also collects vast amounts of data from its vehicles, which is a critical advantage when building and improving upon models. However, GM and Ford are not oblivious to their own lack of technological expertise, which is why both companies have made significant investments in autonomous vehicle startups. Ford’s efforts have not met much success, and the company, in concert with VW, recently wrote down the value of its billion dollar investment in Argo AI to zero. GM, on the other hand, has invested billions of dollars in Cruise and seen some results thus far, with Cruise CEO Kyle Vogt announcing last week that its autonomous vehicles are now running 24/7 in San Francisco. Walmart is also an investor in the business, and partnered with Cruise to offer self-driving grocery delivery in parts of Arizona. While the AV company is currently far from a financial success, its strides in the self-driving and robotaxi space are ahead of Tesla’s, which has yet to roll out a vehicle that can drive itself or a robotaxi business on top of that.6 It’s true that GM isn’t primarily a software company, but it’s also true that management had the humility to realize that, and this humility has for now put it ahead of the competition.
The bull case for Tesla would also be more compelling were there not so much regulatory risk. While not everyone predicted Apple’s shift from a hardware business to a hardware plus services business, there wasn’t a concern that the government might prevent such a shift from occurring. This is not the case with full-self driving, which will likely face significant regulatory hurdles. This only needs to slow the transition to AVs for it to hurt Tesla, which would then look a lot more like just a car company rather than a car and software one, with margins and a valuation to reflect that.
It’s worth nothing that currently Tesla’s margins will trend downwards because its energy generation and storage business is growing faster than the automotive segment but margins are much lower. Telsa’s CFO has emphasized they hope to get to 20%+ gross margins for the energy/storage business over time, but are not there yet.