For a growth stock like Tesla (NASDAQ:TSLA), the two sides of the growth coin are scale and scalability. It first needs to reach a critical scale to benefit from mass production, recuperation of fixed costs, and also fend off competition effectively. It then needs to be scalable at the same time. As it becomes bigger, it can still find plenty of lucrative opportunities to invest in and not suffer from diminishing returns.
The thesis of this article is that TSLA, at its current stage, still possesses this dream combination for growth, as you will see in the next two following sections. And its newly added capability to produce 4680 battery cells in-house will further boost its scalability going forward, which will be detailed in the third section of this article.
TSLA has passed the critical scale
In an earlier article, I argued that TSLA has passed the breakeven point from the perspective of production. The main argument there was that it has been able to increase its profit per car sold while it keeps cutting the unit sale price. In this article, I will make the argument from a different perspective, using the metrics of ROCE (return on capital employed) and MROCE (marginal ROCE). The graph below shows the ROCE for TSLA during the past few quarters on a TTM basis.
The details for ROCE are in my earlier articles. In short, the calculation considered the following items as capital invested: working capital (including payables, receivables, inventory) and net PP&E (property, plant, and equipment).
As you can see, the chart shows an accelerated expansion of ROCE in recent quarters, a strong indicator of passing the critical scale to me. More specifically, its ROCE has hovered at a relatively low level around 10% to 11% from the third quarter of 2019 to the second quarter of 2020. To put things into perspective, the overall economy’s ROCE is about 19% (estimated based on its ROE, return on equity). So, at that time, TSLA’s profitability was only about half of the overall economy.
Then it took off from there and expanded dramatically to the current level of 42%, by almost 4.2x times from its relatively low level about 3 years ago. Now, its profitability is more than twice the overall economy. You will see that the MROCE, discussed immediately below, will be even more telling.
TSLA is still in the stage of scalability
Detailed background information on MROCE can be found in my earlier article here. And a brief summary is provided here to facilitate this discussion for readers who are new to this concept.
What the MROCE concept captures is a basic law in economic activities: the law of diminishing returns. A business will first invest its money in projects with the highest possible rate of return. Therefore, the first batch of available resources is invested at a high rate of return – the highest the business can possibly identify. The second batch of money will have to be invested at a somewhat lower rate of return since the best ideas have been taken by the first batch of resources already, and so on. And finally, the end result is a diminishing MROCE curve as shown.
For growth investors, diminishing return and declining MROCE is a sign of maturity and saturation. So let’s check the MROCE for TSLA as shown in the next chart. The method is detailed in my earlier article (link above). It essentially involved taking the derivative on the ROCE data shown above. During years when there were large fluctuations, a running average was taken to smoothen the fluctuations. The smoothing also makes fundamental sense as many capital projects have a lifetime longer than 1 year.
The results below clearly show that TSLA has passed the critical scale, yet diminishing return has not caught up yet, far from it. As mentioned above, its ROCE has been accelerating from about 10% to 42% in the past few years, and the average has been about 30.8% since 2020 as shown. On the other hand, as you can see, its MROCE has been substantially higher. Its ROCE was the highest from the third quarter of 2020 to the first quarter of 2021. It reached 119%, then peaked at 283%~261% in those quarters. To me, that’s a sign that approximately signaled the timeframe it passed the critical scale. These are the quarters it benefited the most from the scale of economics.
All told, its MROCE has been 144% over the past two years, substantially above its average ROCE of 30.8%. And currently, its MROCE is at 96%. In other words, its profitability would further expand from here because a diminishing return has not caught up yet. Its ROCE will eventually converge to 96% if the current status maintains.
Inhouse battery production will further boost scalability
Looking ahead, there are several key catalysts to keep supporting its scalability. A key theme is TSLA’s plan and determination to produce many of the key components in-house, including battery cell and microchips. In particular, TSLA has long recognized that batteries can be a bottleneck for it to scale up its production and deliveries. As an example, it started the inhouse production of 2170 cells back in 2017 in earnest. As you can see from the announcement made back in 2017 (the emphases were added by me):
Production of 2170 cells for qualification started in December and today, production begins on cells that will be used in Tesla’s Powerwall 2 and Powerpack 2 energy products. Model 3 cell production will follow in Q2 and by 2018, the Gigafactory will produce 35 GWh/year of lithium-ion battery cells, nearly as much as the rest of the entire world’s battery production combined.
Fast forward to 2022, TSLA reached an important milestone in the past quarter: the in-house production of 4680 battery cells. A little battery 101 here first. The batteries are cylindrical in shape, and the series number represents the dimensions of the cell. So, for example, a 4680 cell measures 46 millimeters in diameter and 80 millimeters in height. The energy a cell can hold is proportional to its volume. You can easily confirm that each 4680 cell can hold about 5x the energy of each 2170 cell.
With this background, we can better appreciate the significance of the 4680 cell production. First, of course, the in-house production of both 2170 and 4680 are critical pieces of TSLA’s overall strategy for vertical integration. Furthermore, by enabling a 5x capacity boost, 4680 allows TSLA to use a fraction of the 4680 cells for the driving range compared to the 2170 cells. Such a reduction in numbers will produce higher-order effects, which are often nonlinear, to other benefits. For example, it could reduce production costs, simplify logistics, streamline production and assembly processes, et al. And all these benefits will undoubtedly lead to better scale and scalability down the road.
Final thoughts and risks
The core thesis of this article is that TSLA, at its current stage, still possesses the two dream traits for a growth stock: rapidly expanding ROCE and no sign of diminishing return on MROCE.
Looking ahead, several key catalysts could keep supporting its scalability and further boost profitability, notably its capability to produce key components in-house such as the battery cells (and also microchips are in the blueprint). Compared to its existing 2170 capability, its new 4680 cells enable 5x energy capacity and a drastic reduction of the number of cells needed for the same driving range. It could reduce costs ranging from production to logistics in nonlinear ways and paves the way for better scale and scalability down the road.
Finally, risks. TSLA also faces many key risks, both in the short term and long term.
In the short term, there is a realistic chance of a recession. According to The Verge, Elon Musk reportedly just ordered a hiring freeze and also a 10% staff reduction at Tesla. At the same time, rising costs for raw materials, labor, and logistics will keep their pressure on cost and production in the near term. Notably, prices of raw materials have skyrocketed due to the unfortunate combination of inflation and the Russia/Ukraine war. According to Barron’s, key raw materials for making batteries cost more than 40% YTD before the war broke out, and has increased another 13% since then.
TSLA is now also at a huge valuation premium relative to other automakers such as General Motors (GM) and Ford (F) as you can see from the following chart. Besides these domestic players, TSLA valuation is also at a premium compared to overseas players such as XPeng (XPEV) and NIO (NIO). The combination of macroeconomic uncertainties, high valuation premium, and also intensifying competition could trigger large price volatility in the near term.
In the longer term, TSLA’s plan to mass-produce 4680 batteries may be delayed. As a THQ article argued, the reasons for delay include (the emphases were added by me):
- Tesla’s facing a lengthy process to ramp up the manufacturing of its batteries — complicated by plans to use a new manufacturing technology called dry electrode coating
- Insiders reckon the stakes are high since prices of battery raw ingredients like nickel are hitting record supply fears, stemming from the Russia-Ukraine conflict