A story of value v growth

Castle Point co-founder Gordon Sims tells a story about two companies; one a value play and the other a growth opportunity. Which one do you think is best?

Wednesday, July 22nd 2020, 8:41AM

by Gordon Sims

The valuations (and possible fates) of two of the world’s best known car manufacturers took a surprising change this month.

If one wanted to identify a growth company in the car manufacturing sector Tesla would likely be top of the list. Unit sales have been increasing near 20% quarter on quarter, they’re dominating a high technology, in favour, sector as the world seeks to reduce carbon emissions, and the product range continues to diversify away from sleek, fashionable cars and into utility battery storage, solar power, and software systems to control them all.

Wrap that up with a company led by a charismatic entrepreneur with interests in philanthropy, space exploration, and ‘friendly’ artificial intelligence and it looks like a recipe for success.

On the other hand, if one wanted to identify a value orientated brand then most New Zealanders would quickly identify with industry stalwart Toyota, the world’s most reliable, and possibly most boring, car brand.

Unexciting to drive, cheap to insure, efficient, reliable, and to many, dull. However, it's those attributes that have led Toyota to sell around 10 million cars a year for over a decade.

Toyota’s financial metrics are relatively easily understood; until 2020 took its toll, revenues have been stable at between $250 and $300 billion for five years, with net income over $20 billion.

FY2021 is looking challenging, volumes will be down, and net income will likely halve. That being said, if an investor has confidence the auto market will regain some degree of normalcy then they can buy Toyota on just 8x average earnings. Not bad for a company that has invested $10 billion a year in R&D and can justify its current market cap, $200 billion, based on the book value of its manufacturing plant and working capital alone.

On the other hand, on July 13 Tesla’s share price hit $1,800, implying a $334 billion market cap, 50% higher than Toyota’s lowly $200 billion.

Both companies have been hit by the covid-19 market sell off, Toyota shares fell 25% in the March quarter, and have only recovered around half of that since.

The Tesla sell off was more brutal than most, down 60% in the sell off, but the rally since then is leaving many, including ourselves, astounded, up more than 400% in four months.

We would agree that the company moving into its first stages of profitability is an important milestone, which deserves some acknowledgement in considering its ultimate value, but the premium being paid for potential future growth is now impressive.

Tesla sold 88,496 cars in the first quarter 2020, recording $5.1 billion in automotive revenues, and for the first time in a first quarter, recorded an accounting profit of 9 cents per share, or 16cps over the previous 12 months.

Whilst Toyota is trading on 8x historical earnings, such are the vagaries of dividing by small numbers that Tesla is trading on 11,250x trailing earnings. Bullish analysts are forecasting year-end earnings, December 2020, at $4.50 per share, a mere 400x.

However, what we think may be getting investors excited is that on those 88,000 cars sold last quarter, Tesla impressively recorded a gross margin of nearly $15k on each one.

When this is combined with a disruptive direct to consumer business model maybe things don’t look so outrageous after all?

Tesla’s production capacity across its three currently operating factories is 690,000 cars per year, there are two more factories in construction now, and four more in development stages.

If (and we admit it’s a big if) those 690.000 cars can be sold through the existing distribution network, at the same gross margin, earnings could be close to $10 billion, and a PE of 30x or 40x looks pretty good.

The ultimate irony of the story however appears to sit with Toyota.

Back in 2010 Toyota sold an assembly plant in California to a certain small start-up, namely Tesla, which at the time had yet to record any revenue from a product line of niche electric sports cars. Part of the settlement of the deal included 2.34 million Tesla shares, valued at $50 million at the time, and the prospect of a joint-venture building an electric Rav4.

Toyota and Tesla decided to go their separate ways in 2016, and Toyota is believed to have sold their holding for around $500 million, a healthy 10 bagger for the stock pickers around the Toyota boardroom, but nothing like the $5 billion those shares were worth on July 13.

The moral of the story? Both value and growth opportunities are out there for the driven investor and be very careful about selling out of a success story too early.

Gordon Sims is a partner of Castle Point. He has a Master of Finance from Massey University, and is a CFA Charterholder.

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