Source: Bloomberg

Tesla (TSLA) has garnered a huge amount of attention from the media, consumers and investors over the past four years and continues to do so today. Its stock valuation is the subject of lots of debate but the bull case is predominantly hinged on the strong growth the company has shown in shipments of its first two production cars, the Model S and Model X, with great anticipation ahead of the production launch of its more mass market oriented Model 3 series later this year.

While investors tend to get enamored with high growth companies, we thought it was interesting that a low growth company, Ferrari (RACE), has outperformed Tesla, the hyper growth company, since it went public in October 2015. As the Bloomberg graph illustrates, Ferrari stock has returned 64% while Tesla has returned 46% during that time period despite the fact that Tesla’s revenue growth is expected to average 10x Ferrari’s over then next 4 years. Many would probably scratch their heads at this phenomenon and ask, “How could that possibly make sense?”! We believe the answer lies not in the relative growth numbers but the Return on Invested Capital (ROIC) prospects of the businesses, the more powerful economic metric when it comes to long-term returns for shareholders of businesses.

As passionate as I am about stocks, my passion for cars is not far behind. And no car company has been as exciting to track as Tesla since it debuted its first volume production car, the Model S in 2012, blowing away auto journalists’ and customers’ expectations of the 100 year old concept of what a car is supposed to be. Moreover, its brilliant CEO Elon Musk has done what was considered impossible to do — bring to market clean electric vehicles that customers would not only find alluring (cars have always been a mix of passion and utility) but would also be willing to pay a premium for given their early stage in scaling technologies like the battery and manufacturing volumes. Within 3 years, the Model S became the best selling vehicle in its category in the US and the world with nearly 25% and 20% market share, respectively. Further, US market share had risen over 30% by 3Q16.

 

Given how discerning these luxury buyers are when they can choose any $100K vehicle they desire for the amenities, performance and status, Tesla’s quick rise to market share dominance in the category is a strong testament to its strategic execution in design, marketing, engineering, and capital acquisition and deployment in a category that relies on technical and manufacturing expertise, brand power, distribution, and large capital deployments. Starting a new car company that could succeed by trouncing its high end competitors, especially an electric car company at that, was probably one of the challenging feats to pull off in the modern world. And yet, Tesla has done it and set its sights on getting to the next order of magnitude in volume with the upcoming production ramp in the midsize luxury vehicle market with the Model 3, which already has over 400K preorders with accompanying $1000 deposits for each… sight unseen let alone test-driven.

Bleeding Edge Performance….

Style+Utility….

©Tesla

Unmatched Hardware+Software Technology….

©Tesla

Zero Emissions….

Clearly Tesla has done a lot of things right involving big bets in technology, positioning, distribution, and investment that others had failed to make (high end performance/luxury positioning, vertical integration of key bottlenecks – building supercharger networks and battery Gigafactory, focus on superior safety, direct distribution/no dealer network, low maintenance model, software-driven/autonomy focus with iterative/licensing model vs traditional hardware based 7 year cycles, etc). In fact its success has driven almost every major car manufacturer to invest in EV and autonomy platforms to compete. Government regulation has been a huge impetus with increasingly stringent emissions standards and incentives, but clearly Tesla’s business positioning, engineering, and business model has blazed a path that conventional automakers were not really considering viable. Now nearly every major automaker is investing full steam ahead to prevent their own future diminution or demise. Check out the market share Tesla has achieved in the Model S segment again… 20% in 3 years!

And the midsize workhorse market is next… its not just the luxury segment, but also the non-luxury mid size segment that will also be available for the Model 3 to compete against given the range of likely price points, experience with Model S buyers, and the highest customer satisfaction/loyalty ratings Consumer Reports has ever measured. In this segment, the declining battery costs and lower operating costs will make the Model 3 (as well as other competitive EVs) even more compelling financially against non-EV competitors.

Tesla had been the most exciting public car company… until Ferrari went public in October 2015.

©Ferrari

Of course Ferrari has been many a 15-year-old’s dream car and a very few (read exclusive) successful 45-year-old’s trophy car. It is much more about emotion, passion, and experience than transportation and an entirely discretionary purchase. The sound, the speed, the F1 racing legacy (400MM global fans), and the shapes are all part of the experience that come with a Ferrari.

©Ferrari

Of course we haven’t mentioned a very important aspect — being part of an elite club. There have only been 7-8K Ferraris sold annually for the last 5 years (fewer in prior years) and estimates put the number of millionaires and billionaires at 15-35MM globally (depending on methodology), the target buyers. In order to buy the latest high-demand Ferrari or a limited edition supercar, you have to own one first — being able to front the cash is not enough. 2/3 of new Ferrari buyers are repeat buyers. An ASP of $250K-$1MM+. These are incredible statistics that bode well for the makings of a highly profitable defensible business.

In fact, when it comes to its very limited edition supercars like the LaFerrari, Ferrari’s million dollar sale prices still leave a lot of money on the table for its elite cadre of customers who see the resale value of their cars rise multiples of their purchase price.  For example, LaFerrari went into production in 2013-15 with 499 vehicles sold for over a million dollars.  Resale values were in the $3MM range immediately after they went into production and more recent sales indicate a value of $5-7MM just a couple of years later.  It’s no surprise that the two most expensive cars ever sold at auction are both Ferraris as are 7 of the top 10 and 15 of the top 20!

Whereas Tesla aims to bring its stylish, high tech, everyday highly utilitarian, green-clean cars to the masses, Ferrari aims to keep its race inspired cars exclusive and exclusively for driving pleasure.

©Ferrari

Tesla started from the top of the pricing and volume pyramid and is working its way down while Ferrari is happy to stay at the top. The result is a huge disparity in expected growth rates, with Tesla aiming to grow its production volume from 80K cars in 2016 to 1MM by 2020 or 88% CAGR, while Ferrari is looking to get to about 9K cars by 2019 from 8K in 2016, or a 4% CAGR, and targeting a number over 10K units over time. Both currently sell cars with ASPs in the 6 figures, though Tesla’s ASP will likely fall to about 50K as it scales its higher volume Model 3 towards the 1MM unit goal.

Given the disparate growth goals, with Tesla targeting 22x Ferarri’s goal, the stock performance of the companies is astounding, with Ferrari up 64% since it went public in October 2015 and Tesla up 46% during that same time frame.

While Tesla’s $142K Model S P100D production car can match Ferrari’s exclusive $1MM+ LaFerrari 0-60, its stock has not been able to keep up. Which begs the question, why? We posit that the difference lies in the return on invested capital expectations of the two companies.

As the reader can probably tell, we are big admirers and believers in Tesla’s achievements and capabilities. However, as investors, it is hard to value the company given its nascent business model. We can get some idea of what it could look like, but given the very different business model Tesla has relative to traditional automakers (direct distribution, supercharging infrastructure, battery plants, high software content, EV powertrain, etc.) and the onslaught of competition on the horizon from the major automakers, including historically successful and scaled brands, its hard to have much confidence on the ultimate economics that will accrue to Tesla. There are strong signs that the auto market will be disrupted and valuations across the auto industry certainly seem to point to it, but its hard to know what a super successfully scaled Tesla will look like economically 10 years out.

These are not issues for Ferrari. It is an entirely discretionary luxury good, with a strong brand and experience. This is the heart of its moat and drives the underlying economics of its business. There is very little guess work involved in understanding the nature of its business and how it is likely to evolve, especially with a management team focused on preserving its moat and economic characteristics. As a result, Ferrari shows an exceptional ROIC of ~100% with very little incremental capital required for it to grow its business at the rates it targets. The low capital intensity results in strong free cash flow generation, which is at the heart of any company’s long term value. By comparison, the average S&P 500 company has about a 10% ROIC. Incredibly, Ferrari’s ROIC is in the same league as high IP content, asset light companies such an Apple (AAPL), Google (GOOGL) or MasterCard (MA). Most analyst compare it to high margin, highly valued consumer luxury goods companies like Hermes (RMS FP), Richemont (CFR VX), and LVMH (MC FP) instead of the traditional capital intensive automakers for the same reason.

Tesla, on the other hand, has a business whose ROIC is undeterminable at this point given the rapid growth it has exhibited and the very capital intensive nature of its growth going forward. It is scaling out from the high end, low volume to the mass market, which necessarily appears to have structurally lower ROIC. Will it have the ROIC of Ford at ~8-10%** or BMW at 17-20%** or Porsche’s at 30-40%**? We can get some idea by comparing the volumes and ASP ranges for each of these manufacturer’s to get at potential return structure (see source notes in table below).

Certainly there appears to be a pattern here that indicates an inverse relationship between ROIC and volume. ASP is of course a strong determinant of volume since lower prices open up sales to larger numbers of consumers, while lower volume desirable cars command higher ASPs and margins.

One caveat is that an electric powertrain has an inherently lower level of complexity (electric motor vs internal combustion engine, single speed vs 5-8 speed gearbox, significantly fewer parts) and a cost heavily driven by the the battery costs. However battery costs are expected to fall rapidly over the next 5-10 years with scale and improving technology. In addition, Tesla has a high software component to its cars that deliver tangible value to the customer such as its Autopilot semi-autonomous driving software for which it charges 5-10% of base car ASP, which drops directly to the bottom line. As volumes scale, software driven features such as a fully autonomous upgrade, Uber like service features, or even supercharging/battery swap fees may bring in incremental high margin revenue to a fixed asset/cost base. On the other hand, the economics of battery plants and solar panels/roofs (without any value-added proprietary technology, integration, or user interface driven excess profits) may be profit/ROIC dilutive.

Getting back to the stock performance we’ve seen so far, we’ve had many conversations with investors about Ferrari and Tesla and why we own Ferrari but not Tesla despite our positive views on the latter. By far, most see Tesla as a high growth company accompanied by a high return (albeit also very volatile) stock. From our perspective, Tesla could very well end up owning a significant share of the very large auto/transportation market, but how much it will end up winning and importantly what those economics will look like are unclear. This makes it hard to know how to value the business with any level of certainty or margin of safety. Instead, it is a much more straightforward bet that Ferrari will continue to inhabit the dreams of many a 15-year-old and collection of a few 45-year-old enthusiast looking for the particular experience it delivers, with predictably fantastic economics inherent to its business model. At the end of the day, we as shareholders of a business care about the stream of free cash flows a business we own will generate, for which a determinately high ROIC is a much stronger driver than high revenue growth and an indeterminate future ROIC. Of course for a given level of ROIC, higher growth is more valuable than lower growth. And there is certainly a trade off between the value incremental growth adds vs incremental ROIC.

So far though, the market appears to have come to our view that Ferrari’s slower growing highly profitable business has been the more undervalued, higher prospective return company than the faster growing, world changing Tesla.

Employees, principles and/or clients of Ensemble Capital own shares of Apple (AAPL), Alphabet (GOOGL), Ferrari (RACE), MasterCard (MA), and Tesla (TSLA).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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