Is Tesla Overvalued?

With plans for the Model 3 ramping up into high gear, excitement around Tesla Motors (TSLA -3.55%) is building at whirlwind speed. But while the company clearly has huge potential for growth, its valuation takes that possibility into account. So is Tesla, at its current price, still a buy?

In this week's episode of Industry Focus: Energy, Sean O'Reilly talks with Motley Fool contributor Daniel Sparks about investing in Tesla today. Find out what Tesla has going for it in terms of growth, a few areas they're definitely going to have to work on, some of their most significant risk factors, and more.

A full transcript follows the video.

This podcast was recorded on May 12, 2016.

Sean O'Reilly: Is Tesla overvalued? We dive in on this energy and industrials edition of Industry Focus.

Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Thursday, May 12, 2016, and joining me via Skype, to decide once and for all if Tesla is massively overvalued or just getting started on its path to world domination, is Motley Fool contributor Daniel Sparks. Good morning, Dan!

Daniel Sparks: Hey, Sean, how's it going?

O'Reilly: Pretty good. I don't know, maybe you heard this on the news, but we're on, like, day 15 of rain and clouds in D.C. I have to ask, what is it like in Colorado right now?

Sparks: It's finally getting sunny, which is nice. We had a foot of snow on the first of May. It was a wild start to the summer.

O'Reilly: I will stop complaining now. [laughs]

Sparks: Sounds good. [laughs]

O'Reilly: We're talking about Tesla today, it's been a long time coming. We don't really talk about this hugely important company nearly enough on the energy and industrials show. You're kind of Mr. Tesla on Fool.com. Full disclosure: You own one, so you're probably a little bit biased, and I do think listeners should be aware of that. 

Sparks: Yes.

O'Reilly: But, first thing we have to talk about is valuation. I don't think I'm going out on a limb to say that this puppy is priced for perfection.

Sparks: Yeah, I would have to agree the stock is pricey. That's something you won't see in my articles, is me recommending the stock. Not that I'm...

O'Reilly: A bear.

Sparks: ...advocating anyone to sell, but I do own shares, and I'm happy to own shares, but I haven't bought shares in a while. 

O'Reilly: They're on track to sell 80,000 cars this year. Where are they in terms of valuation, compared to other automakers? I mean, Ford (F 0.17%) sells 17 million cars a year, BMW sells 2 or 3 [million], I think. Where does everybody stand?

Sparks: That is a good way to quickly put it in perspective. We have a $28 billion market cap for Tesla. They're on track to sell just 80,000 cars a year. So, right away, we know this stock is priced for growth. A lot of people want to get in early on a stock like Tesla, because there's so much growth ahead. But investors should always pay attention to things like this. It was getting in early when this sort of growth wasn't priced in. At $28 billion, the growth is priced in. That's what's happened. The market does accept that Tesla has a big opportunity ahead of it. Right off the bat, you need to recognize this is the stock priced for growth.

Now, there are some areas we could look at where the stock could live up to this valuation. Some particular areas I like to think of Tesla growing into its valuation are the optionality that comes with a CEO like Elon Musk, and the optionality that comes with a powerful brand with a first-mover advantage that really has carved out a niche for itself. So that's an area we could talk about.

O'Reilly: OK. What are the reasons to be optimistic that they could actually warrant the valuation that they're being awarded right now? You have GM (GM -0.05%) being valued at $48 billion; that's only $14 billion more than Tesla. BMW's at $50 billion, another premium automaker. What does Tesla have to do in order to deserve this?

Sparks: First of all, there is that growth they want to live up to. And we could talk about that in a little bit, because they did recently announce they were going to double down on their growth goals. We'll come back to that, it's more of a topic in itself. As far as the optionality, you look at companies like [Amazon.com (AMZN -1.14%)] as the perfect example of optionality. I'm not saying Tesla can mimic that or mirror it.

But perhaps a concentrated version of how Amazon has expanded into different areas is how investors are thinking about Tesla. You look at Tesla, first of all, you have software. Tesla develops its own software, its own hardware, builds its own computers in the factory. The vehicles are far more vertically integrated than most auto manufacturers'. Elon Musk only wants to increase vertical integration. They're dipping their toes in energy storage.

O'Reilly: That seemed to come out of nowhere, just one day, "Oh, Tesla announces the Powerwall." I'm like, "What the heck is the Powerwall?"

Sparks: Right, and they've been really quiet about it. But the business is a success so far. Sales are growing. In fact, they're on pace this year for the energy storage business to already be a positive contributor to their operating cash flow. Then we have Tesla as a supplier as something that could happen someday. They're far ahead of anyone else in setting the foundation for building batteries, for building the components of electric cars. And then there's the unknown, the optionality that they could enter areas we haven't really thought of. That's kind of what happened to Amazon over time. There's areas that they expanded into that we would have never guessed. When you have a visionary like Elon Musk at the helm, those are things you can understand.

This isn't just pure speculation, that they'll probably expand into other areas. It's almost certain. The brand is extremely powerful. Elon Musk has expressed interest in doing things like autonomous vehicles and vertical integration; all these things get mentioned.

O'Reilly: Is it conceivable to you that Tesla starts licensing out parts or software to other manufacturers, or like city buses or something? I know Musk has actually talked about how we need to rethink public transportation. Is that what you're alluding to?

Sparks: I think there will be things coming in the future. A good example we could turn to is autonomous vehicles. He's alluded to the fact that Tesla probably wouldn't rely or partner with someone like Uber, that they would actually become that middleman, as far as providing some sort of an autonomous service in the future. Whether they do it or not, it's still speculation.

They're putting their actions where their mouth is, when it comes to autonomous driving and vehicles like that. It's the only car you can get in that can change lanes automatically on the highway. Frankly, you can't really drive a car without changing lanes on the highway in the first place.

O'Reilly: Yeah, you had that great piece, was it last year, where you actually let your Tesla drive you on the freeway?

Sparks: I did 61 miles without touching the wheel. I did have to touch it to let the car know I was there, occasionally. That's a good example. I couldn't have done that without changing lanes. It's a huge advantage, where they're at. They're pushing it aggressively. They kind of exploded on it. The Model S was actually far behind, then they just exploded right into the lead position. I think they're really going to be aggressive about pushing that in the future. That's an area of optionality we see with the company.

When you integrate your own software, you vertically integrate the hardware that powers the software, and you're increasingly vertically integrating your cars, it just presents new opportunities that other auto makers might not have, especially in this time of transition for automobiles. That's how I look at optionality, and I think that's one reason not to sell the stock if you already own it.

O'Reilly: Got it. You do think competition could theoretically be a good thing for Tesla?

Sparks: Yeah, that's another area. I've actually always been excited about competition. Elon Musk has pushed that view, too. Not very aggressively, surprisingly.

O'Reilly: Well, but he open-sourced everything.

Sparks: Exactly. So he's taken the actions, but he doesn't really talk about it very much. But I'm pretty sure that Tesla is very happy to see competition, and not just because of their mission to reduce emissions over the long haul. But because Tesla needs help convincing consumers that this is the mass-market way to go. It's not even something that, as a Tesla owner, I try to convince anyone of. There's no convincing someone that electric cars make sense. It's just something you kind of have to experience. Being a Tesla owner has made me believe even more that we need competition. We need other electric vehicles on the road. Because for every customer it takes away from Tesla, I think it could expand the total addressable market for fully electric vehicles even more.

O'Reilly: The more commonplace electric cars become, the more likely it is that the layman will buy Tesla.

Sparks: Exactly. That's one of the interesting things that could potentially lower risk, in my view, of Tesla, is competition. Especially now that we see that there's obvious demand for it, after the Model 3. Tesla's growth is a risk, but at the same time, the fact they're pulling in these competitors and competition could spur demand for the total market.

O'Reilly: Awesome. We pretty much have to talk about their accelerated growth plans. Earnings came out, they were not that super-great. They had a slew of executive departures, including the VP head of manufacturing or something, I forget the guy's exact title. But, on the same day, or a couple days after during the earnings call, Musk announced that Tesla had moved its 500,000 production goal from 2020 to 2018, two years ahead of schedule. Given Tesla's history of slightly falling short of its goals -- the Model X has been plagued by delays -- do you think this is realistic or not?

Sparks: First of all, we'll just turn to why. It does make sense that they push this production goal. They wanted to build up to 500,000 vehicles per year by 2020. They pushed it to 2018. It makes sense that they did. The question is why. But after receiving their 400,000 deposit-backed reservations, not orders, that was a clear signal that the demand story for Tesla continues to look optimistic. But just because the demand is there doesn't mean they're going to be able to pull it off. This is something investors should think about. Like you said, the Model X came along with a lot of issues. The greatest issue, for sure, was when it comes to product development, the car was arguably two years late. That's a huge deal.

O'Reilly: It wasn't because of the falcon-wing doors. [laughs]

Sparks: Yeah, it was a range of issues. Now, you could say that Tesla decided to focus more on the Model S as sales began to take off. Prior to the Model S launch, the only significant number really mentioned was that they expected to sell around 20,000 cars a year. It's clearly exceeded that. Last year, they sold around 50,000 Model S. But there were more issues, and Tesla has admitted to that. There were problems. That does present some risk to the Model 3. Now, Elon Musk in the last earnings call was quick to say, "Don't relate Model X production to Model 3. They're very unrelated." And it is fair to say that the Model X was probably one of the most complex vehicles ever made. In fact, GM actually said one time --

O'Reilly: Didn't they buy one?

Sparks: -- it was impossible to produce. So even their competition would agree, it's incredibly complex. And then, the Model 3 was built from the ground up to be easy to produce. There's a possibility they can do this. It's going to create a lot of risks, because they're going to need to raise capital. We could get into some of those risks toward the end. I would say there's a possibility it could happen, but the fact is, we are speculating. They're producing 80,000 cars per year now, and Tesla's hoping they could produce 500,000 per year in just a few years. This is speculation, this is what it looks like. You look at the history, and it's unclear that they're able to pull this off.

O'Reilly: Did you hear that theory that was floating around the Internet, that Musk knows he won't reach the 2018 goal, he just did it to get a sense of urgency all throughout Tesla HQ?

Sparks: He talked at length about that during the earnings call. And I think that comes back to this L.A. Times article. Elon Musk and the L.A. Times have been going back and forth for years now. They have a long history of duking it out in the form of articles and tweets. Basically, I think the basis of that article was, they went into the risk factors section of Tesla's most recent 10-Q. Obviously, any investor who reads 10-Qs and 10-Ks knows that you're obligated to lay out risks and worst-case scenarios. And every company, no matter how bullish the CEO might be, lays out very bad scenarios in the risk factors section and puts it all out there, because they have to. So that's the basis of that. But he did mention, in the most recent call, that this is an aspiration, but they are confident that they can get close to it.

O'Reilly: What do you think the risks are? You do think they're revolutionary. They're doing something that's impossible. GM has admitted that the Model X, like you say, is practically impossible to make. They did buy a model just to get a look at it, didn't they? I didn't make that up?

Sparks: Yeah. I think that's normal for automakers to do. Happened with the Model S, too.

O'Reilly: What do you think are the risks to owning Tesla, in light of new growth goals?

Sparks: There are the obvious risks, like, competition could come in and demand could fall. We kind of talked about that a little bit. Specifically to the business, when it comes to bigger goals, it's not positive and rosy. There's some significant problems that come along with that. Tesla alluded to all of these in its most recent letter. One of them is higher capital expenditures. Tesla is not producing any operating cash flow right now, and typically needs to fund its capex with outside funds.

Let's talk about capex for a second. This year, they expected to spend about $1.5 billion on capital expenditures. That was actually down slightly from last year, which was a good thing. I was happy as a shareholder to see that. They still have these huge growth goals, but they're able to actually spend less this year. Then, in the first quarter, they held to that. Their capital expenditures fell 47% sequentially, and they were showing some huge discipline in their spending. But alongside these goals, they're going to have to spend more. They announced they're going to have to spend 50% more than they thought. Instead of $1.5 billion, they're going for $2.25 billion this year. Capex is jumping way up from last year. That's a problem.

O'Reilly: Is that because of the Gigafactory?

Sparks: No, that's just everything related to their enhanced goals. The Gigafactory has already been quite an aggressive investment. I'm sure that some of that is going toward the Gigafactory. But mostly, we're talking Model 3 development, paying the suppliers to make sure they're hitting their deadlines, tooling the factory, things like that. That's going to be a lot of what this is going toward. Then, the expensive salaries of Silicon Valley.

O'Reilly: Naturally. [laughs]

Sparks: Yeah. Higher capex this year, that's a big risk. And it is a risk for a company like Tesla, which doesn't have operating cash flow. That leads us into the next risk, which is their delayed cash flow goals. We're also talking, not just higher capital expenditures, but higher operating expenses this year. You'd have to double-check me, but I think they were planning for operating expenses to increase about 20% this year, now they're saying somewhere from 20% to 25%. That extra 5% is a pretty big deal when, like I said, you don't have operating cash flow.

This had led them to delay their cash flow goals for this year. Their cash flow goals, to put it in perceptive, were not to be cash flow positive on a free cash flow basis. We're talking core operating cash flow, which is actually a non-GAAP metric that Tesla has, that basically accounts for the money coming from their asset-backed line. That's kind of a longer story. It's not a good cash situation. They're going to be spending more cash, delaying the cash flow goals to be nearly positive operating cash flow this year. Those are two big risks. The final one is, they're going to have to raise more capital. Obviously, not producing operating cash flow, they're going to need to either have an equity sale or go to the debt markets, which either means diluted ownership for shareholders or more debt. This is a lot of increased risk. If they pull it off, could be more reward. But huge risk, too.

O'Reilly: Got it. What do you think the prospects are of a capital raise coming around? 

Sparks: I think it's almost certain. Management emphasized that they're trying to do as much as they can with their own funds. But having a buffer is important. They're going to try to de-risk as much as they can by raising equity. They haven't specified exactly how they're going to raise capital. I suspect it would be raising equity, given the valuation of the stock. But, it's not entirely sure, because the stock is down by double-digit percentage points, somewhere around there, from when they last raised equity.

O'Reilly: They had $1.4 billion in cash in the bank as of March 31. Accounts payable was $1 billion. So they're definitely going to need to raise some cash. 

Thank you for your thoughts. You get the final say. New money, you don't seem to think they should step up to the plate and buy into Tesla?

Sparks: I mean, the stock is down recently, so that makes it a little bit better buy. As far as buying high-price stocks like this, I usually prefer to put a little bit in, get my feet wet, see how I feel. If the stock goes down more, maybe buy some more. That's how I'd approach it at this time. But I definitely wouldn't be selling. Their execution compared to their aspiration sometimes falls short. But if you just put away those aspirations and look at what Tesla's doing, it's some pretty big stuff.

O'Reilly: Awesome! Well, at the very least, you definitely recommend their cars.

Sparks: Yeah, I enjoy the car.

O'Reilly: Awesome. Thanks for your thoughts, Dan. We'll catch you later.

Sparks: Thanks.

O'Reilly: Have a good one! If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dan Sparks, I am Sean O'Reilly. Thanks for listening, and Fool on!