Market Musings - November 7, 2017
We continue our blog series: Market Musings, Volume 1, Edition 4, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Clash of the Titans II: General Motors at $42 versus Tesla at $306.
As mentioned in MM.I.3 (yesterday's blog), often people try to justify a company's stock price by resorting to blanket qualitative arguments with no consideration of valuation. Qualitative arguments, however, fail to account for the fact that while Company X may indeed be a screaming buy at $X per share, it is quite likely a strong sell at 100X $X per share. Or, to put it another way, "what the wise man does in the beginning, the fool does in the end". Somewhere along the valuation curve qualitative arguments that made Company X a buy at one price cease to support a buy (or continued hold) at a higher price. With that preamble, we herein compare and contrast two auto manufacturers, one beloved by investors (Tesla, ticker TSLA) employing qualitative arguments about "owning the future of transport and renewable energy", and the other disdained by investors (General Motors, ticker GM) using arguments along the lines of "they suck, went bankrupt in 2009 and bailed out by the government, lumbering bureaucracy, beholden to ICE gas guzzlers" etc. As per yesterday's blog, we invert (attention investors: always invert!) the investment equation by asking "Under what scenarios will TSLA justify its current valuation?" and the same for GM.
TESLA WHAT-IF SCENARIOS: First take TSLA, whose stock is up about 1,000% over the past five years, and now sports a market cap of $51.4 billion and an enterprise value (or EV) of $69.8 billion. Let's assume that investors are correct that TSLA will enjoy huge revenue and earnings growth far into the future, given its presumed lead in the electrification of passenger vehicles in the United States and potentially worldwide. Assume, for instance, that TSLA's losses decline from 2017's expected -$6.30/share to -$1.45/share in 2018, in line with analysts' current expectations (source here); then assume TSLA's earnings turn positive in 2019 at $2.00/share, thereafter grow by 30% per year through 2025 and 15% annually from 2026 through 2036. These are pretty optimistic earnings assumptions for a company that has never turned an annual GAAP net profit for any of its 14 years of existence (in this scenario the company would earn a profit of about $7.5 billion in 2036). So what would the value of this 2017-2036 earnings stream be worth, if we discount it back to a net present value (via the "NPV" function in Excel) using a 5% discount rate? Approximately $27.8 billion, or $42 billion below the current EV and $23.6 billion below the current market cap. Too pessimistic, the TSLA bull argues? What if we bump up TSLA's earnings growth percentages to 40% annually for 2020-2025 and 20% annually for 2026-2036 (in this more bullish scenario, the company would earn a profit of about $18.8 billion in 2036, double GM's 2016 net income)? Then the company's earnings stream would be worth approximately $58.6 billion, or $11.2 billion below the current EV and $7.2 billion above the current market cap.
Thus we find, employing our reverse engineering method, that even with these foregoing massive growth assumptions, TSLA has minimal upside to large expected downside from the current market valuation. (Note that the vast majority of a company's value to investors depends on what happens in the next 20 years, rather than years 21+, due to the time value of money as well as the inherent uncertainty in predicting financial results decades into the future.) In fact, in order to obtain just a 10% annual return over the next two decades from the prevailing market price of $306/share (i.e., assuming TSLA stock trades at $1,870/share in 2036), one would need to assume earnings of $125/share in 2036 at a 15 P/E multiple, representing an annual earnings growth rate of around 27.5% for 2020-2036 inclusive. Does such a high EPS growth rate for such a long period seem like the most reasonable outcome to expect for TSLA, given that the company operates in a capital-intensive industry with cut-throat pricing and with an onslaught of electric vehicle competition expected to hit the market during the next five years? Buyers of TSLA today are answering "yes" to that question--we will happily take the other side of that trade.
GENERAL MOTORS WHAT-IF SCENARIOS: Next take GM, whose stock has mostly treaded water since its 2010 IPO (considering that a bull market has prevailed ever since, such stasis shows that investors don't seem to care much for the company). GM currently has a market cap of $59.7 billion and an EV of $70 billion. Let's assume, in keeping with the market's dislike of the company, that GM's earnings never grow--ever--off of next year's $5.92/share level expected by analysts (source here). In this no growth scenario, GM's 2017-2036 earnings stream (discounted back to a present value at 5%) would be worth $105 billion, or $35 billion higher than today's EV and $46.3 billion (or over 75%) higher than the current market cap. But maybe, argue the GM bears, the analysts are being too optimistic and GM's earnings going forward will only be $4.50/share per year from 2018 onwards (despite reaching $5.91/share in 2015 and $6/share in 2016). In this scenario, GM's 2017-2036 earnings stream would be worth $81.7 billion, still well in excess of GM's current EV and market cap. In fact, in order for GM's aggregate earnings from 2017-2036 to approximate GM's EV of $70 billion, an investor would need to assume both (A) $4.50 per share in earnings in 2018 and (B) a 4% decline in earnings annually for the 2019-2025 period and flat earnings for the ensuing 11 years. Is this really the most likely outcome for GM over the next two decades? We don't think so, and are thus happy to be long GM, which (unlike TSLA) has the ability to use a $5 billion repurchase authorization to buy back the company's (in our view) undervalued shares for the benefit of remaining longs.
DISCLOSURE: Long GM, short TSLA.