Tesla: Calm Before The Interest Rate Storm

Tesla, Inc. (NASDAQ:TSLA) soared last week after its earnings call, from a low of $101.20 three weeks ago, and rebounded 76.85% to a share price of $178.97. The earnings call contained many subtle, yet very important and alarming clues that seemed to be rather overlooked by most.

We will explain why investors may want to tread carefully with Tesla, Inc., and perhaps wait for volatility to subside, due to the impact of higher interest rates and an impending consumer recession, which has not yet fully sunk in.

Demand Headwinds?

In terms of demand, the question right now is not necessarily whether Tesla will have enough demand, but rather how much pricing power they have vis-à-vis their 2023 output. Gross margin is a very important factor in that calculation.

If we look at Tesla’s gross margins, they peaked at 32.9% in Q1 2022, and dropped to about 25.9% in Q4. That’s quite a difference, because in Q1 Tesla did $16.86BN in sales, and $21.31BN in Q4, but made the same gross revenue attributable to such margin decline. Fortunately, Tesla has tremendous operating leverage, with OpEx. remaining almost miraculously flat over the past few years.

But the reduction in gross margin does signal to us that demand may not be as elastic as previously estimated by Tesla executives. We think the next platform, where we could see vehicles produced for $25,000 or $30,000, will be crucial if Tesla wants to drive up profits, and make up for it in volume, given that the market for premium EVs is only so big.

As for margins, an analyst asked during the call about rumors that gross margins for cars would fall below 20% and that the average selling price (ASP) would fall below $47,000 after price cuts, to which management replied:

So there is certainly a lot of uncertainty about how the year will unfold, but I’ll share what’s in our current forecast for a moment. So based upon these metrics here, we believe that we’ll be above both of the metrics that are stated in the question, so 20% automotive gross margin, excluding leases and rent credits and then $47,000 ASP across all models. (Zachary Kirkhorn, CFO)

Management also confirmed its intentions to produce 1.8 million vehicles by 2023, so we take all those 3 parameters in this valuation to set out the low bar of what Tesla definitely expects to deliver in terms of results. We think this is a conservative approach given the many uncertainties. At 1.8 million units, an ASP of $47k and a gross margin of 20%, that would mean $16.92BN in gross profit. If OpEx increased linearly as it has over the past 2 years, we would expect about $8BN in OpEx, which would bring operating income to about $8.92BN.

In our view, that is a scenario that could play out in a fairly severe recession, but it has been set as a benchmark by Tesla itself, which they could certainly beat. The reason we put that scenario on the table is mostly due to our foresight about where the economy is going, and Elon Musk’s comments. Currently, in terms of car sales, both in Europe and the U.S., things don’t look so bleak. Fortunately, EVs are the least dirty shirt of all, still going strong.

We think Elon has also already given some small hints about what the automotive landscape looks like at the moment, sort of implying that he would not be surprised if Tesla shares fell to “surprisingly low levels.”

As I said in the last call, there’s going to be bumps along the way and we’ll probably have a pretty difficult recession this year, probably. I hope not, but probably. And so, one can’t predict the short-term sort of stock value, because when there’s a recession and people panic and the stock market then prices of stocks, worth value of stocks can drop sometimes to surprisingly low levels. (Emphasis added.)

About a recession, he had the following to say:

Yes. My guess is, if there is — if the recession is a serious one and I think it probably will be, but I hope it isn’t, that would lead to meaningful decreases in almost all of our input costs. So we expect to see deflation in our input costs most likely, which would then lead to, yes, better margin. I’m just guessing here. So, this is — that would be my guess. (Emphasis added.)

Consequently, Elon Musk also thinks the U.S. is on the brink of a severe recession. Despite such comments, investors did not seem to act cautiously, especially after seeing the stock rise 75%+ in no time.

We think this volatility will persist. On the other hand, there is a possibility, that when we enter a recession, commodity prices tend to fall, as Elon thinks. On the other hand, according to strategists, commodity price inflation accelerates the world’s transition away from fossil fuels by making renewables more competitive.

We doubt that statement a bit, because the demand for certain commodities such as lithium and copper has a very different dynamic now than in the past, while the demand for lithium-ion batteries and energy storage currently seems essentially infinite. Tesla itself is working toward 1,000 GWh.

That’s still a long way off, as production of 1.31 million vehicles in 2022 would have required about 100 GWh+, according to our estimate. If Tesla were to exponentially double its lithium production, along with every other automaker, we believe it would be difficult to see production drop significantly, as we believe demand will continue to outstrip supply for quite some time.

However, management also seems to believe that these types of commodities are expected to remain high in 2023.

On the raw materials and inflation side, where lithium is the large driver there and this was a meaningful source of cost increase for us, we’ll have to see where lithium prices go. And we’re not fully exposed to lithium prices, but I think in general, is what we’ve seen from our forecast here, cost per car of lithium in 2023 will be higher than 2022. So that’s a headwind that would have to be overcome to return back to those levels. (Emphasis added.)

Near-Term Valuation

In the field of investing, there is a well-known saying that goes: look down, not up. This implies that investors should always strive to minimize the loss of principal. With that in mind, we will examine what the downside might look like under stressful conditions, as we saw in late 2022.

The usual indicators of economic turmoil, such as the 2-10-year yield curve or the 3-month 10-year yield curve, are deeply inverted, most since the 1980s. Combined with two consecutive quarters of negative GDP and a large amount of excess liquidity being withdrawn from the monetary system, and the long and variable lags of monetary policy, this will create interesting conditions in the 2H 2022.

However, going back to the bear case of about $8.92BN in operating income, we think investors are still willing to assign a higher multiple to the stock, as has been the case in the past. Tesla has always traded at a premium, whether that is because of its growth or an upbeat outlook is for another debate.

At a multiple of 30x, the stock would come out at $267.6BN, or only $84.74 in a rather worst-case scenario, closer to the $101.20 of 3 weeks ago. However, there is something to be said that it could be even lower if we look at statistics such as free cash flow. Tesla generated $7.6BN in FCF, currently trading at nearly 74x 2022 FCF, while it had industry-leading margins especially in 1H.

It is hard to find other companies at the same level as Tesla, producing the same output when it comes to EVs. In our opinion, BYD (OTCPK:BYDDF) comes closest to Tesla, which produced 911,140 EVs with pure batteries, or 1.86 million total plug-in vehicles. We understand that Chinese companies have been trading at a discount to U.S. stocks lately, due to geopolitical factors, although the discrepancy with Tesla is much larger compared to, say, other U.S. tech stocks versus Chinese tech stocks. The Hang Seng has a P/E ratio of 12.43 compared to 21.76 for the S&P 500 (SPY).

On an LTM basis, BYD had $6.15BN in FCF, similar to Tesla as you can see in the chart below, but the company only has a market cap of $106.7BN. This means that, taking into account the U.S. stock premium, some might justify a valuation closer to $200BN, in times of distress. Or, as Musk would say, in a recession “the value of stocks can sometimes fall to surprisingly low levels.”

If it ever gets close to BYD’s relative valuation, and that bridge is closed, we do not rule out a scenario in which Tesla could touch that $200BN market cap, or $63.34 per share. That is mainly why we are currently giving a hold rating, because the risk of losing principal in the short to medium term could be quite high, in a market that is still in its early stages.

We have also not yet seen the impact of competition on margins, as they are extremely slow in their transition to EVs, not counting certain Chinese EV manufacturers. Here’s what management had to say about their Chinese competitors:

In the vehicle space, even though the market is shrinking, we’re growing and EVs have doubled almost year-over-year. So, like it ever keeps up with the trend of EVs is going to be our competitor. The Chinese are scary; we always say that. (Emphasis added.)

Elon also gave his input:

I think we have a lot of respect for the car companies in China. They are the most competitive in the world, that is our experience and the Chinese market, it is the most competitive. They work the hardest and they work the smartest, that’s so for the China car companies that we’re competing against. And so we would guess, there are probably some company out of China as the most likely to be second to Tesla. (Emphasis added.)

The issue of a buyback has also been on the table since Tesla was trading well above $200 but did not break through because they wanted to play it safe, with a potentially severe recession around the corner. About their $20BN balance sheet, he had the following to say:

The cash is earning a ridiculous return, a good return. So it’s like nontrivial. And the interest rate actually in the $20 billion is earning like quite a good amount.

On the one hand, it seems a bit paradoxical to us. Currently, the highest interest rate is 4.79% on a 6-month Treasury note, it’s a bit strange to call that a good amount compared to the promised 50% revenue growth from Elon and his team. Though, we can totally see why Tesla doesn’t want to do a buyback after the bouts they had in 2008 and 2018, nearly bankrupt.

But having no confidence in issuing a buyback, and having sold $40BN worth of shares himself, doesn’t exactly scream downside protection and “extremely undervalued” stock to us.

Interest Rate Headwinds

About interest rates and the Federal Reserve, Elon had something remarkable to say toward the end of the talk that we don’t think anyone really spoke about. He said the following:

I’ve made this point on Twitter a few times. I’m sure a lot of people on this call understand the fact — the basic value of a security is a function of the risk-free rate or we’ll see how risk-free it really is but the T-bill rate. So if you’ve got — I think the — I recall correctly, the S&P 500 has a long-term rate of return of roughly 6%. And so I think that needs to be very cautious about having Fed rates that potentially exceeds 6%. (Emphasis added.)

The suggestion that “we’ll see how risk-free it really is” caught us somewhat by surprise, but it does confirm that serious economic turmoil is imminent. Or perhaps it refers to a hypothetical first default by the U.S. of the $31.4T debt ceiling recently reached.

Outside an economic downturn, we personally consider it likely that other events will occur as unintended consequences, such as a liquidity crunch like March 2020, turmoil in the Treasury market or something that might break through, such as the shadow banking/ Eurodollar system. Ray Dalio also warned earlier this week that the dollar-dominated world order is “fading.”

So when it comes to policy mistakes, we believe the risks are higher than ever. Remember that interest rate hikes take at least 12 months to have a widespread economic effect, and 18 months to be fully felt. Inflation is already starting to fall, and these increases at a record pace are not likely to be fully felt until 2H 2023. It may be in the interest of Tesla and the economy if the Fed proceeds cautiously.

Interest rates and auto loans, as a function of GDP, at about 5.5% of GDP, have almost never been higher. Consumer debt in general is at historically high levels. The impact of a Federal Funds rate above 5% can be felt harder, knowing that in the past, debt was much lower than GDP when interest rates were even higher.

Applying this specifically to Tesla, there is a significant headwind that these higher rates create. We have not yet experienced interest rates being raised this far from near zero, but the effect on auto loans is already starting to be felt.

The chart below shows the correlation between the Federal Funds Rate in red, the financing rate on 48-month auto loans in blue and total auto sales in green.

The first thing to note is that there is usually a 3% spread between Federal Funds and loan rates, unless the interest rate is close to zero. If we have a Federal Funds rate of 5%, it is reasonable to estimate that loan rates will be near 8%, if not higher.

Auto loans have been around 4.5% for the past 8 years. That difference will be felt. For example, if we take a standard Model Y, at 4.5% you would end up paying about $7,880 in interest, versus $14,470.

That’s a difference of about $6590, or a 10.45% increase in the total price when purchased with a loan, due to higher rates. Without taking into account the possibility of declining car sales due to higher unemployment, etc.

On Tesla’s website in the US you can currently get an APR of 5.34%, and in the EU we could find a rate of about 2% APR on a standard Model Y. For people with lower credit scores trying to buy an affordable car, the impact is even greater. As the Fed and ECB continue to raise interest rates, we see this as a serious headwind.

As you raise the price, the percentage of people that can afford the car starts to drop exponentially. (Elon Musk, Tesla owners Silicon Valley podcast)

Energy Is Currency

Aside from the relative valuation and near-term headwinds, we also would not sell or short Tesla at these prices. With near infinite demand for green and renewable energy storage, Tesla’s headwinds in vehicle demand may soon turn into tailwinds as an energy manufacturer.

For reference, over the past more than 10 years, the cost of lithium-ion batteries has fallen, according to Wright’s Law. That means that for every cumulative doubling of the number of units produced, the cost falls by a constant percentage. At about $100/kWh, EVs reach the same sticker price as internal combustion vehicles, and it no longer becomes economically justifiable to buy those ICE vehicles, since both the initial selling price and the cost of ownership are cheaper for EVs.

Prices currently average $151/kWh, although some manufacturers in China were already close to $100/kWh by 2022. Recently, commodity prices have heavily depressed the natural decline in battery cell prices. During the Q3 earnings call, Elon Musk told investors that once the 4680 battery cell is fully integrated, he believes there is a path to $70 per kWh cell.

What’s crazy is that, with the “inflation reduction act“, Tesla as a manufacturer of battery cells could receive credits worth $35/kWh. They currently work together with Panasonic and had this to say:

In the case of Panasonic domestic manufacturing, we’re splitting the value of the credits. So it — the value of credits this year will not be gigantic, but I think it could be gigantic — we think it probably will be very significant in the future. (Elon Musk, Q4)

At 500 GWh, for example, those credits alone would be worth $17.5BN. Not only would that be a game changer, it would make Tesla one of the leaders in mass production of batteries. We think this is crucial, because we firmly believe that the future will be a combination of battery cells, wind and solar.

This could certainly be a case like Amazon, which some analysts were bearish about in the early 2000s because Amazon’s business model then had low margins as an Internet wholesaler. Just as Tesla could see its margins shrink, we believe they will continue to use their cash flow and technological edge to expand as a conglomerate in the areas of energy, robotics, artificial and perhaps self-driving.

In Tesla’s case, it’s a positive feedback loop, even in terms of AI and computing power. Even if it fails to maintain its industry-leading operating margins, they still have the benefit of their AI, data collection, energy and manufacturing/ automation. When training AI models, if you have access to a world-class team, renewable energy, computing (Dojo) and robotics, you are well-prepared to lead in the AI race as well.

As we mentioned many times before, we want to be the best manufacturer. But really, manufacturing technology will be our most important long-term strength. (Elon Musk, Q4 Call)

The Bottom Line

With a consumer recession around the corner, a hawkish Fed, and uncertainty surrounding Tesla’s pricing power, it may be a good idea to exercise some caution and not chase trends and volatility. On the other hand, much can be said about Tesla’s important long-term outlook.

One thing is certain: if it’s bad for Tesla, imagine what it will be like for all the other legacy car manufacturers who riddled in debt and have not been in this situation since before 2008…. Here is a quote from the earnings call to sum everything up, about if interest rates were to get closer to 6%:

Basically, the Fed is the risk of crushing the value of all equities, which is quite a serious, danger. (Elon Musk, Q4 Call)

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.