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The value of disruptors is different

Contrary to commentary found in Cuffelinks recently, investors are not naive when they buy shares in ‘expensive’ major global businesses that are using the latest tools to win customers. Those investors have chosen these companies, which now fall into the category of disruptors, because they have outgrown and are continuing to outgrow their nearest competitors. Investors have to pay up (in a valuation sense) to access them.

It's not simply a power train

Earlier this month, Porsche (effectively a division of Volkswagen) announced that it will no longer produce the diesel engine in its popular Cayenne and Macan four-wheel drive vehicles. Investors who had bet that the 2015 VW diesel scandal would just ‘blow over’ were wrong, with Volkswagen off 40% since the cheating was revealed. Exhibiting the same share price trajectory is Daimler Benz, down 30% in three years to €57 per share. It wasn’t caught cheating (and you should unpick that phrase very carefully) but will probably also phase out the diesel over time.

If we were simply considering two companies together, in stasis, making the same electric cars, then maybe the valuation comparison would be closer. But the history of these two competitors, and their existing structures, means that their journeys will be different, and so will their share prices.

So while it may be tempting to simply view the car makers as moving from one power train (internal combustion engine, whether diesel or petrol) to battery or hybrid, it isn’t that simple. Well-established fossil fuel engine companies have extensive supply chains which produce tens of thousands of components, which means that any car maker will have to manage the costs in that process in tandem with the costs in the new process.

Like all manufacturing, how all these parts come together often isn’t just a matter of contract, it’s also about the hundreds of other things that need to come together to get the job done, some of which come with complex arrangements.

New technologies blow all this away – disrupt it, in fact – breaking down the industries just as they eat in to sales, creating new pockets of wealth all along the way.

If it were just as easy as adding on a business, Daimler and VW and BMW would not have fallen in the wake of the diesel problem. They would have rallied in anticipation of the new electric cars they would produce. But the real way it works is that existing managements, boards and shareholders don’t get paid for the value they create through disruption but are still penalised for the coming re-engineering that will be forced upon them.

Other industries are the same

It's the same with Woolworths and Coles. These companies are optimised for sales in shopping centres controlled by Westfield and the like. A significant move online simply cannibalises their existing store sales without reducing the fixed costs of those stores. At the same time, creating an online fulfilment channel can be very expensive. The combination of lower throughput in the physical store and higher costs for online is a drop in profit.

Another example: Foxtel and free-to-air networks are struggling to make their existing one-to-many broadcast television models work, in part because Netflix and others have taught viewers to expect that their favourite content should be available any time, including with a fast forward or pause button. Foxtel can’t offer this with the same economics as its regular pay tv service – it hurts the advertising and subscription funded business model, which is based around as many people watching the programme at the same time as possible.

Globally, Walmart, the car companies, AT&T, and Procter and Gamble are affected. In Australia, it’s Telstra, Fairfax, Coles, Myer, etc. By the way, this is the reason that Murdoch sold out of content creation in the US and UK.

And banking? What will the banks do with their heavy management structures built to corral people during different credit cycles at a time when the world’s understanding of money is that it is truly a digital commodity? How many operatives does it take for a consumer to send money over a mobile phone?

Then we come to Tesla, the subject of a recent commentary on Cuffelinks. The company is capitalised at US$50 billion, 10%-20% below Daimler and VW. But Tesla doesn’t have tens of billions of dollars of capital tied up in obsolete plant or sales channels geared to that plant.

Of course, we know that the market has discounted the value of Daimler, so that its enterprise value is just twice its EBITDA. So in theory, the share price of the company already reflects the current situation. Maybe. But whether Tesla is expensive because it is valued at more than Daimler is not something that can be divined by cherry-picking a few statistics, such as the number of cars produced per dollars of capitalisation.

Meanwhile, Tesla has just produced 80,142 cars in the quarter to 30 September 2018, implying an annual run rate of over 300,000 cars. It will probably produce a million cars by 2022 at US$60,000 per car. Is the market ready for a company which is generating US$60 billion in annual sales, with gross margins in the high teens? Maybe not.

In a perfect world, we could all just buy companies on low multiples and sell them as they went up. But the world is not perfect, and investors must operate according to the circumstances. Wishing the investment problem would go away, and making negative return in the process, isn’t a preferred option.


Alex Pollak is Chief Executive, CIO and Founder of Loftus Peak. This article is for general information only and does not consider the circumstances of any individual.

Graham Hand
October 26, 2018

From the AFR, quoting BMW's Head of R&D:

Fröhlich says even by 2030, about 85 per cent of BMWs will have an Internal Combustion Engine (ICE). "When we are very optimistic and we look at the worldwide perspective … it says 30 per cent of the BMWs will be pure electric or plug-in hybrids and 70 per cent will be combustion. If we assume that half of the electric are plug-in hybrids, 85 per cent by volume in 2030 are combustion engine.

"I think the discussion about electro-mobility is a little bit irrational."

Irrational, really? Yes, according to Fröhlich. He insists an electric drivetrain will never be cost competitive with an ICE. "It is very simple. If you are at full scale, 1 kilowatt hour of battery capacity will cost you between €100 and €150 ($160 to $240). This means if you see cars with 90 to 100 kilowatt hours, the cell cost alone will be €10,000 to €15,000. You can produce whole [conventional] cars only for the cost of the batteries."

Reality check
When everyone wants the rare metals needed for electric cars, he says the price will go up sharply. "It is a [daydream] that an electrified vehicle will cost the same as a combustion engine car, and it is not correct that fast charging will resolve all problems."

Fröhlich says fast charging will damage batteries if done too often.

Warren Bird
October 25, 2018

And I see that Tesla has announced a quarterly profit and their shares have risen while the market is falling sharply.

Interesting times indeed!

October 19, 2018

After driving for five weeks in different European countries, and each hire car provided was a diesel (happy to have but not requested), no car older than 6 months, I think Alex’s decline of diesel is overstated. Seems they continue to dominate European roads, and fuel is so expensive that their greater economy is appreciated. Roy Morgan Research in Australia recently showed diesel cars are gaining market share in the last report, and a Mercedes dealer told me 75% of 4WDs are still diesel.

The AFR this week had a great article via Bloomberg on how Tesla has a great motor but terrible bodywork. Panels that are a single stamping in some cars have 9 welded pieces in Tesla, making the workforce large and inefficient. Mercedes has 100 year history learning how to build cars.

October 19, 2018

Noted, But this is about the legislative response which plays into the engineering response - The Independent this week says "Paris will ban all petrol- and diesel-fuelled cars by 2030, a decade ahead of France’s 2040 target. Copenhagen plans to ban diesel cars from 2019, while Oxford has proposed banning all non-electric vehicles from its centre from 2020." In other words, the diesel problem won't go away. And as i noted in the piece, Porsche has discontinued the diesel motor in the Macan already... My personal view is that the car companies are looking to phase it out, with R and D definitely off the cards.
Execution is a problem, of course, and goes to valuation, but not the central diesel problem/electric solution

Alex Pollak
October 17, 2018

Thanks Warren... We have a picture of how the valuation will play out, and suffice to say we get a price a lot higher than the current using a 10+ year dcf, discounted back at 15%, with a series of other variables which we wont go into now. But it isn't a stretch, and the risk associated with the company is reflected in the fact that we hold it around 2%.

Warren Bird
October 17, 2018

Fair point. It's easy to poke fun at someone else's investment decision.

For me, the price of any asset is the expected future stream of earnings it will generate, discounted to deliver a rate of return.

How is that playing out with Tesla?

The price is $277 per share.
At the moment the company doesn't have any earnings. I think I'm right saying it made a $16 per share loss last year.
How can that situation justify the share price?

OK, here's a scenario.

It keeps making a loss for the next 5 years, but the loss reduces and the company makes break-even by year 5, then makes a small profit of $1 per share in year 6.
After that it experiences strong earnings growth of 10% per annum for about 10 years, when it matures into a long run growth rate of 5% per annum.

Discount that earnings stream to generate 4.7% per annum return and the current share price is about fair value, give or take a $ or 3.

It's a high risk equity for sure.

It requires some brave assumptions about the company coming into profitability and then growing to maturity quite consistently. I'm not an equity analyst let alone an auto analyst, so I've no idea how realistic that is. Alex in this article suggests it's feasible, though my personal concern is that Tesla's losses have been growing rapidly as it's ramped up. Hence my use of the word 'brave' above. But not impossible.

And note that the discount rate assumed here isn't a stellar long run annual rate of return. It's 4.7% per annum.

Thirdly, this stock's duration is 120 years - that is, it's very, very sensitive to changes in the input assumptions. That's risky. If the earnings growth in maturity were to be put at 4% rather than 5%, then Tesla's share price right now should only by $104, not $277.
But on the upside, if the short term growth was 15% before mature growth of 5%, the fair value share price is $413. (I prefer to assess a stock or an index's duration rather than its P/E as a better measure of risk, which I understand as a fixed income person, but which can be calculated even when the P/E doesn't exist as is the case with Tesla at the moment.)

I suspect that most of Tesla's share register is hoping for/expecting a lot better than 4.7% return. If the more optimistic earnings outlook started to be realised they'd get that, quiet quickly. (EG if the losses were eradicated immediately and profit growth materialised as in this model, then you could fair value Tesla at more than $700 per share right now.

So I think Alex is right. If you have pessimistic assumptions about Tesla's future profitability and growth prospects then of course you can't justify its current share price, not even coming close. After all, even when it becomes profitable it has a P/E of more than 200 at today's share price! Not many value managers want to touch such a stock!

But that doesn't mean that a credible scenario can't be painted for the company that not only justifies $277, but gives grounds for investors who can live with the risk of disappointment to include some Tesla in their portfolio for the prospect of outstanding gains. As Alex says, this is understood by the investors who do hold it.

(PS I have used the simple spreadsheet model on which this was based for nearly 20 years. It helped me analyse dot com boom companies, which definitely had no earnings and no earnings prospects. I once gave a presentation titled "what would you pay for a zero coupon perpetual?" that explained why some of the companies around at the time should be avoided at all costs. I find it helpful to cut through all the opinions that are often given about companies or share markets and just do some mathematics.)


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