Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Tesla rises 7% on record deliveries
Peter Garnry
Chief Investment Strategist
Summary: Tesla shares are up 7% in pre-market trading as the EV-maker announced better than expected Q2 deliveries increasing 83% y/y and BYD reported battery electric vehicle deliveries up 95% y/y in Q2 highlighting the blistering growth rate in EV adoption. The biggest lower is the oil market with World Economic Forum estimating that EV adoption across 2 & 3 wheelers, passenger EVs, commercial delivery vans, and buses will reduce oil demand by 2.5 million barrels per day by 2025. In this equity note, we also look at Tesla's valuation and what it will take in terms of growth and profitability to justify the current level.
Key points in this equity note:
- Tesla and BYD deliveries of BEVs rise to new record in Q2 almost doubling from a year ago. The two carmakers are on track to become the two largest carmakers in the world during the EV transition.
- Oil is the biggest loser of the rapid EV adoption with the largest EV-makers already having reduced oil demand by 0.2% over the past three years. 2 & 3 wheelers in Asia have reduced oil demand even more.
- For Tesla’s valuation to make sense in a steady state starting in 2033 the EV-maker must generate $29bn in free cash flow and grow revenue to $484bn translating into 17.1% annualized growth over the coming decade.
Another record quarter for Tesla on aggressive price cuts
Tesla and BYD have both announced Q2 delivery figures pushing to new records with Tesla delivering 466,140 battery electric vehicles (BEVs) and BYD delivering 352,163 BEVs up 83% and 95% y/y respectively highlighting the breath neck pace of adoption. The aggressive pricing strategy of Tesla and BYD is working to drive higher volume, but the key question of course is to what extent these higher volume at lower prices will impact gross and operating margins. While prices on BEVs have been cut the price on lithium carbonate used in manufacturing lithium-ion prices has increased 34% over the past three months ending the collapsing prices on the valuable chemical making up a key input cost for BEVs. The delivery figures and ramp-up by Tesla and BYD are also suggesting that these two companies are racing to become the two biggest carmakers in the future when the car industry has converted completely to BEVs. Tesla shares are up 7% in pre-market trading.
Oil is the biggest casualty in EV boom
The oil market has been on a rollercoaster journey since the pandemic broke out in early 2020. From negative prices on extreme low demand during the initial lockdowns to the reopening bottlenecks and crazy demand pushing oil prices to above $120/brl. Recently oil prices have moved in a tight range between $70/brl and $80/brl as the OPEC+ oil cartel led by Saudi Arabia does everything to control and maintain higher prices by cutting supply. A weaker demand from China has naturally played its role on the demand side, but growing electric vehicle adoption is increasingly impacting oil demand.
In the BP Energy Outlook 2023 report, it is estimated that oil demand may fall from around 100 Mb/d (million barrels per day) to a range of 20-75 Mb/d depending on the scenario with net zero target being the low end of the range. A lot of the reduction in oil demand will come from changing road transportation shifting to being electric.
An average gasoline passenger car consumes 10 barrels of oil per year. If we sum our figures of delivered battery electric vehicles (BEV) since Q1 2020 from the 8 largest EV-makers then the total figure is 8.3mn BEVs. This corresponds to around 0.23 Mb/d reduction in oil demand or around 0.2% of total oil demand over the past 13 quarters. While the demand reduction from BEVs is not a lot at this point investors should note that prices are set by marginal changes and in a market equilibrium lower oil demand, even by a small amount, can change the price quite a bit.
Using figures from Volvo’s recent quarterly results we can see that global ICE volume sold is down 16.8% while BEV volume is up by 24.8% y/y. Volvo’s BEV volume figures are too low as our figures from the top EV-makers are suggesting BEV volume growth was 48% y/y in Q1 2023. But it still gives an indication that ICE volume globally has peaked and will likely remain in a continuous decline in the years to come. In a recent World Economic Forum prediction it is estimated that electrification of transportation will reduce oil demand with around 2.5 Mb/d driven the most by 2 & 3 wheelers in Asia (1.1 Mb/d) and 0.9 Mb/d from passenger vehicles. The remaining big issue on transportation is trucking that is a heavy user of diesel and here the technology adoption will take longer to catch up due to higher energy requirements.
How to square Tesla valuation in 2033?
Tesla has been extremely successful and executed beyond expectations for many years. The high equity valuation implies still high expectations for the future and in order to gauge if they are realistic we will look at what numbers Tesla have to deliver over the next 10 years. Keep in mind that these figures are not exact and are only meant as a mental exercise to understand expectations and the future.
In a steady state a mega cap company in the US equity market would likely be priced at 8% annualized nominal growth rate. If we assume Tesla reaches its steady state in 2033, then we can so reverse engineering of this return expectation. If we assume global inflation will be 3% annualized beyond 2033 and we assume 2% annualized productivity growth then it leaves 3% for dividends and buybacks which in the current market are roughly split as 2% dividend yield and 1% buyback yield. If we assume that Tesla wants financial maneuvering then it will not return all of its free cash flow (cash flow generated from operations minus capital expenditures) to shareholders, then the free cash flow yield in the steady state could be 3.5%.
With the current market value of $830bn that would mean $29bn in free cash flow in 2033. Tesla made $7.6bn in free cash flow in 2022. What would that require in terms of revenue? Volkswagen generates around 3.8% in free cash flow on its revenue and if we assume Tesla can become more efficient, with higher free cash flow generation coming from other businesses including charging network, then it may generate 6% which would then lead to $484bn in revenue in order to generate the $29bn in free cash flow.
Based on expected revenue of $99.9bn in 2023 that would translate into 17.1% annualized revenue growth rate over the next 10 years. How realistic is that? Our main problem is that we have no recent examples of a consumer company selling hardware at these prices globally to a mass market selling a new technology in an existing industry. But we can try to establish a benchmark. In 2011, Apple hit $108bn in revenue and the subsequent 10-year revenue growth rate was 12.9% annualized. This growth rate was obtained by a company with lower priced consumer hardware and selling digital goods on the way, so not completely comparable to Tesla. In addition, Apple was operating in an industry with little meaningful competition.
Tesla will experience increased competition over time and while the company is right now looking to become the market leader in the future car industry based on only electric vehicles the revenue expectations are still steep. Based on the numbers we have just presented, and under assumption that markets are rather efficient, then it is clear that the market expects Tesla to generate a free cash flow to revenue margin above 6%. In any case, expectations are very high for Tesla and as an investors we have no good examples in the past to lean on in terms of judging the likelihood of Tesla succeeding in delivering those revenue figures by 2033. Latest Market Insights
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