Tesla: Strong Upleg Could Ahead (NASDAQ:TSLA)

Tesla, Inc. (NASDAQ:TSLA) experienced a strong rebound in production and delivery growth in Q3 2022, which translated into increasing free cash flow (“FCF”) for the electric vehicle (“EV”) company. I believe in Tesla’s rapid free cash flow and free cash flow improvement Flow Conversion could ultimately lead to a sharp appreciation in the company’s shares. Year-to-date, Tesla shares are down about half their value due to many interconnected factors, including factory closures in China, supply chain challenges, and inflation that makes commodities more expensive. With Tesla enjoying a strong production recovery in Q3 22, I believe Tesla’s valuation has become too cheap given its prospects in the electric vehicle industry and I think the risk profile is heavily skewed to the upside!

Tesla exceeded earnings from Q3’22

Tesla reported third-quarter 2022 results in October, which came in better than expected based on earnings. Tesla remained solidly profitable in the third quarter and reported earnings per share of $1.05, beating the consensus of $1.00 per share. Revenue, however, was slightly disappointing.

Massive production recovery in Q3’22

Tesla produced 365,923 electric vehicles in the third quarter, up 42% sequentially as production restarted after outbreaks of COVID-19 forced plant closures in the previous quarter. The Model 3/Y accounted for approximately 95% of Tesla’s production volume in Q3 ’22. Total shipments in Q3 22 were 343,830, a growth of 35% over the previous quarter. Tesla achieved these results on improved plant utilization as well as strong volume growth driven by robust customer demand for Tesla’s electric vehicle products.

The ramp-up of Model 3/Y led to a massive recovery in free cash flow

The Model 3/Y ramp is driving Tesla’s free cash flow growth, and while Tesla saw revenue and FCF decline in Q2’22, Q3 brought back much of lost production volume. As a result, Tesla is likely to post new production and delivery records in Q4 ’22. My guess is that Tesla could produce between 380,000 and 390,000 EVs in Q4 alone and surpass the 400,000 EV production threshold in Q1 ’23. Tesla also said it expects annual output growth of about 50% this year.

Tesla posted free cash flow of $3,297 million on total revenue of $21.5 billion in Q3 2022, which translates to a 15.4% FCF margin … which is 4.2 times higher than in the second Quarter 22, as Tesla manufacturing suffered from COVID-related plant closures. Tesla’s free cash flow margin growth is also largely due to a return to full production. What stood out in Tesla’s Q3 ’22 earnings report was the improvement in Tesla’s conversion of operating cash flow to free cash flow. The FCF conversion ratio – which shows how much money from operating cash flow is “converted” into free cash flow – improved from 26.4% in Q2 2022 to 64.6% in Q3 22. The improved conversion rate shows that that Tesla’s Q3 ’22 production recovery has fundamentally improved the company’s free cash flow prospects.

Now that production of Tesla, specifically the Model 3/Y, has resumed, I believe Tesla’s new baseline quarterly free cash flow level is $2.7 billion to $3.3 billion.

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(Source: author)

A company’s free cash flow can be used in three ways: (1) paying down debt, (2) investing in new products and innovations, and (3) stock buybacks and dividends. For Tesla, I believe that points (2) and (3) will be relevant in the future. Tesla is rapidly ramping up EV production and the free cash flow generated from growing deliveries will be used to ramp up the Model 3/Y and develop/launch the Cybertruck, which is expected to be available in mid-2023.

Additionally, Elon Musk has started toying with the idea of ​​buying back $5 billion to $10 billion worth of Tesla stock, which would be the first-ever stock buyback for the electric vehicle company. A share buyback is usually seen as a sign that management believes its shares are undervalued, and could kickstart Tesla’s shares into a new upward trend. Given that Tesla’s stock has revalued nearly 50% this year, I believe the introduction of a share buyback could help mitigate the negative sentiment saturation that’s also been created for Tesla’s stock.

Operating profit margin growth despite industry challenges

Along with improved free cash flow margins, Tesla saw its operating margins grow, driven in part by higher volumes and higher average selling prices. Despite lower production levels due to COVID-19 and massive supply chain challenges earlier this year, Tesla has successfully navigated these circumstances and managed to increase its operating profit margin to 17.2%, showing an improvement of 2.6pp over Q2’22 .

Tesla’s valuation is cheap

Tesla’s valuation isn’t outrageous considering how quickly the company is growing its shipments and revenue. Tesla is expected to sell $117.6 billion worth of products in fiscal 2023, representing a 41% compound annual revenue growth rate. Additionally, estimates for Tesla’s expected earnings for fiscal 2022 have increased, showing growing analyst confidence in Tesla’s production ramp-up, particularly for the Model 3 and Model Y. Based on earnings of $117.6 billion shares of Tesla traded at a horsepower ratio of 4.8X…which is well below the 1-year moving average of 7.9X.

Tesla’s stock is also attractively valued based on earnings … considering Tesla is already profitable — it posted $3.3 billion in earnings in Q3 — and ramping up production. Tesla has a P/E ratio of 31.3X, which isn’t crazy for an electric vehicle company that’s already making big profits.

Tesla also began hiring new employees for the Cybertruck, Tesla’s next electric vehicle, in November. Tesla will produce the Cybertruck at the Gigafactory in Texas, with production expected to begin in fiscal 2023. The Cybertruck already has well over 1 million reservations, and the launch of Tesla’s latest model could be an upside catalyst for Tesla’s stock.

Tesla’s valuation compared to other EV companies might be considered high, but the EV company is the undisputed leader in the electric vehicle industry and has an unrivaled production volume. No other EV company has Tesla’s size, capitalization, product range and manufacturing footprint.

Most of Tesla’s competition consists of smaller start-ups that serve clearly defined niches, such as pickup trucks, sport utility vehicles or luxury sedans. However, shares of Tesla are now even cheaper than shares of Lucid Group (LCID) and Rivian Automotive (RIVN) due to the nearly 50% downward re-rating in 2022… and Tesla is profitable.

Risks at Tesla

The biggest commercial risk I see for Tesla is a slowdown in the Model 3 and Model Y production ramp-up or delays in production of the Cybertruck. High inflation, which makes commodities more expensive, and constant disruptions in the supply chain are risks for Tesla and also for the share. I would change my mind on Tesla if the company experiences new unforeseen production shortages related to the Model 3/Y ramp or if the company experiences a sharp free cash flow collapse.

Limited impact of recession, Taiwan risk

I believe a recession would not have a major impact on Tesla’s potential in the EV market as the regulatory environment and customer attitudes have shifted sharply in favor of EVs in recent years, including in China, whose government has announced To achieve net-zero emissions by 2060. However, since Tesla has built a giga-factory in Shanghai to meet Chinese demand for electric vehicles, the electric vehicle company faces political risks in the event of a major China-Taiwan conflict.

Final Thoughts

Tesla’s manufacturing successes and free cash flow growth in Q3 22 are underestimated, especially the improving free cash flow conversion ratio. What makes Tesla attractive as an EV investment is its low valuation based on earnings, strong recovery in free cash flow, and Cybertruck’s imminent start of production, which could reignite interest in Tesla. A potential share buyback of up to $10 billion could also launch Tesla shares into a new upward move. Given that Tesla shares have lost nearly 50% of their value this year, I believe the risk profile is heavily skewed to the upside!