Tesla's Fall - Is Investor Sentiment Finally realigning with Reality?

Schadenfreude is the word that best captures my response to Tesla’s plummeting share price – down more than 50% from its high at the time of Trump’s election. ?There are many explanations for what’s going on.? Elon Musk is now part of a government whose policies are antithetical to Tesla’s original value proposition. The company lacks leadership, given all the other things Musk is doing. Government subsidies for EVs are being removed. Many potential customers are looking elsewhere as a form of protest vote against the Trump/Musk show.

But underlying all these valid explanations is a much simpler story of basic business economics. Tesla is not a tech stock and it never was. It somehow got lumped in with six other high-flying tech stocks (Apple, Amazon, Meta, Microsoft, Alphabet, Nividia) as part of the “magnificent seven,” and this helped sustain its excessive valuation. But now its stock is plummeting its possible to do a proper re-evaluation of its business model. And its not pretty. I don’t have a personal stake in Tesla, and I am always wary of making stock predictions, but its not hard to imagine a valuation based on fundamentals that is 80% lower than its current market value.? Ouch. ?

Here's the problem.? The other members of the magnificent seven are to varying degrees platform companies. Tesla has some impressive software in its cars, and obviously its innovations in battery technology were ground-breaking. But ultimately it’s a product company – it makes physical things with many interconnecting components. ?And this matters for several reasons. ?

Firstly, Tesla doesn’t benefit from network effects. ?Unlike Facebook or Google where the service is more valuable when more people use it, buyers of Tesla cars don’t get additional utility from their neighbors and friends buying a Tesla.?

Second, Tesla’s “marginal cost of production” is significant. ?This is basic economics – companies like Microsoft have huge fixed costs when they develop a new operating system, but the variable costs (per user) are close to zero, resulting in increasing returns to scale. Car manufacturers have fixed costs as well, but also large variable costs, resulting in decreasing returns to scale above a certain level. The biggest car factory in the world makes less than 1% of total production.

Third, there are few switching costs in the car industry. ?Tech companies like Apple, Nvidia and Microsoft all benefit from ‘customer lock in’ which makes users wary of switching even if they don’t particularly like the service they are receiving. Not so for Tesla – you can replace it with a VW tomorrow without any adjustment required.

All of which means that Tesla doesn’t really have a ‘moat’ to protect it from competitors.? The big tech companies operate in a world of increasing returns to scale, which gives them high margins and very strong future prospects. Tesla is in the world of decreasing returns to scale, where it has to fight for market share in an increasingly crowded market. In the language of business strategy, the ‘blue ocean’ Tesla created twenty years ago is now a ‘red ocean’.

The only moat Tesla ever had was a perception that it was one step ahead of its competitors, and that Elon Musk had additional tricks up his sleeve, such as autonomous vehicles or robotaxis.? With his attention focused elsewhere, other competitors are equally well placed to succeed in these emerging areas.? And Tesla isn’t even the best EV on the market anymore. ?Chines manufacturers like BYD are lower cost and premium brands like BMW,VW and Daimler offer comparable levels of range and quality.

I am not predicting the demise of Tesla – it still has a very strong range of products. But it is not going to dominate the electric vehicle market. It had around 21% global market share in 2021, but has been falling gradually since then, now around 17%, and will likely be surpassed as market leader by BYD this year. Tesla will likely end up as one of a dozen major car manufacturers across the world. It could also end up as an acquisition target a few years from now.

Tesla transformed the car industry in a good way. It made EVs a mainstream product, and it inspired others to raise their game. ?But it was never a tech stock and it didn’t deserve to be rated like one.? The economics of industrial production were always going to catch up with it sooner or later, and it looks like we have finally reached the point where investor sentiment realigns with reality.

PS. The eagle-eyed reader might recognize some of these arguments from a blog I wrote three years ago, when Tesla first became a trillion-dollar stock. The market moves in mysterious ways, but in the long run its a weighing machine, not a voting machine.