Why Tesla's Big Drop Could Be Your Big Opportunity

Tesla Motors (NASDAQ: TSLA  ) has been one of the most volatile stocks in the market this year. Recently, Tesla stock has dropped more than 35% from its yearly high, despite a solid earnings report that confirmed the company's long-term growth trajectory.

However, Tesla has a solid technology lead in the electric vehicle market. Moreover, there's no indication that Tesla owners (or prospective owners) are worried about the car's safety, despite a few recent vehicle fires. Indeed, the Model S has the best safety rating of any car ever tested! Tesla's recent drop therefore makes the stock more attractive for investors who believe in the company's long-term potential but missed out earlier this year.

No longer priced for perfection

Just two months ago, Tesla was priced for perfection. To justify its valuation, Tesla not only needed to maintain its momentum in the luxury car market, but it also needed its 3rd generation "affordable car" -- which is expected to go into production in 2017 with a $35,000 price tag -- to be a huge success.

Tesla may be able to create a sustainable competitive advantage through its purchasing scale in the battery market, as well as the close association of its brand with EVs. However, two of the top global automakers -- General Motors (NYSE: GM  ) and Volkswagen -- have shown a keen interest in becoming major players in the EV market. They already have big scale advantages in purchasing and distribution.

As a result, I think it would be rash to invest in Tesla on the assumption that it will dominate a large market of affordable EVs, while earning a healthy margin in the process. However, at the current market price, Tesla doesn't need such a high level of success in the mainstream market to generate a good return for investors.

The promise of the high-end

Instead, most of Tesla's valuation today can be accounted for by its prospects within the luxury market (and to a lesser extent, powertrain development for other EV makers). That's a much more comfortable situation for investors, since Tesla has already demonstrated this year that it can build highly successful luxury vehicles.

Tesla's Model S has been a huge success, with demand outstripping supply (Photo: Tesla Motors)

This year, Tesla will deliver around 21,500 Model S vehicles . Tesla's sales have been held back entirely by supply constraints (particularly for battery cells) rather than demand. In fact, Tesla recently stated that U.S. demand has already hit 20,000 vehicles per year, and international sales are just ramping up. The company expects Model S demand to exceed 40,000 units per year by the end of 2014, with supply roughly catching up to demand by that point .

In late 2014, Tesla will introduce a second model to its lineup: the Model X crossover. The Model X hasn't gone on sale yet, so it's impossible to be sure of the demand, but given the global popularity of SUVs today, it would not be surprising for it to equal Model S demand . (Especially as a zero-emission SUV!)

The Model X crossover is expected to go into production late next year (Photo: Tesla Motors)

By 2016, when manufacturing of both models has fully ramped up, Tesla could be selling 80,000-100,000 luxury vehicles annually. The company is already well on the way to hitting its 25% gross margin (excluding ZEV regulatory credits) target in the current quarter. Increasing the production rate could push gross margin even higher: perhaps to 30%.

Assuming an average selling price of $90,000-$100,000 -- below recent ASPs -- Tesla could be generating $2 billion-$3 billion in gross profit from its two luxury cars by 2016. That's up from an annual run rate of just over $500 million last quarter ! Even if operating expenses double between now and then, it would still put Tesla on track for pre-tax earnings of around $1 billion in 2016.

Foolish wrap

Even at Tesla's current valuation, it will need to produce growth beyond the 2016 scenario I laid out in order to pay off for investors. (Tesla is currently valued at around 20-30 times its hypothetical 2016 after-tax earnings.) However, whereas Tesla's peak valuation implied a near-certainty that Tesla would be selling hundreds of thousands of "affordable cars" before the end of the decade, today's valuation does not require five to 10 years of flawless execution.

Tesla is certainly not a "safe" investment for risk-averse investors. But for long-term investors who are willing to accept significant risk in return for a big growth opportunity, Tesla is starting to look good again.

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Read/Post Comments (36) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 20, 2013, at 11:41 AM, Decoy0527 wrote:

    I think you are exceedingly optimistic about Tesla's prospects. Most Tesla longs fail to accept that the car is unique only for the moment and with a very, very small niche market. If it turns out that the EV becomes a mass market product, world class auto manufacturers (Mercedes, Audi, Toyota, BMW) will enter the market and gone is anywhere near a 25% operating margin.

  • Report this Comment On November 20, 2013, at 11:58 AM, todamo13 wrote:

    Seems to me the profitable luxury niche is a good place to be. BMW is a good example, and they have not been put out of business by commodity car companies like Toyota...

  • Report this Comment On November 20, 2013, at 12:03 PM, plange01 wrote:

    tesla stock should finish this year over $200

  • Report this Comment On November 20, 2013, at 12:08 PM, ffbj wrote:

    There was a recent article on the Fool with a headline saying is Tesla a value stock? At the time the stock was around $140 Now it is at $120 I guess the answer to last weeks headline could be a simple though emphatic,No!

    You don't even mention price in your article, and the comments about evaluation, while interesting, really offer no compelling argument about whether it is worth buying, the stock, at this price.

    Sentiment was extremely optimistic previously and now it is just the opposite. I think it is a reasonable value at $120 but I would not buy it here. Could we see another quadrupling in value from here...lets see to $480 per share? I think Elvis has left the building the show is over, go home.

    Though my guess is we will see another half-a-dozen articles on Tesla before the week is out.

    One guideline I follow is to avoid hot, i.e. talked about stocks, though I did buy JCP at $7 just seemed way too cheap.

    As far as the company itself I think they are the premium electric car company and will continue to be the leader in the industry and will continue to exist and create compelling vehicles.

  • Report this Comment On November 20, 2013, at 12:55 PM, drax7 wrote:

    I have reached a similar conclusion, 100,000 cars for a net profit of 1 billion. With a multiple between 30 and 50, before mass market car.

    This drop presents an investment opportunity.

  • Report this Comment On November 20, 2013, at 2:42 PM, Trololololo wrote:

    Where I live (Orange County, California), Tesla Model S cars are increasingly common. I live near some very affluent neighborhoods, and penetration of the Tesla Model S with the ruling class is obvious. Owners I speak with (once I am allowed past their bodyguards - snark) are wildly enthusiastic about their Teslas. It reminds me of the early switchers who jumped from Windows to the Mac.

    While the Tesla Model S is beyond the means of many Americans, the rapid acceptance within its target market impressed me to buy some shares of the company's stock. We might feel kicked in the gut at the moment, but stock ownership is a marathon, not a sprint. Your strategy might be different than mine, but I believe that in a few years, my decision (and I am a typically a cigar butt investor) will be justified.

    I've learned to not bet against a great leader. Be it a Jack Welch, Warren Buffett, Steve Jobs, Bill Gates, Sam Bassoul or Elon Musk, some business leaders succeed with brains, vision and stubborn commitment to doing what's right. I believe that Elon Musk has that stuff.

    What I have to stomach is that Tesla is a story stock, and companies like these can be easily whipsawed by sentiment. Bears, short sellers, hedge funds and the media are all too eager to plant negative stories, regardless of the truth that may lurk behind a darker headline. Often, I've had my best success investing in unsexy companies that don't garner media attention, but which quietly go about their business. Tesla is too sexy to avoid the media spotlight, and for that, we pay a price in volatility.

    I shunned investing in companies like Amazon and Netflix because I could not understand their valuation, yet they have been great long term investments. Viewed in that context, I think Tesla has the chance to do well. But to realize that, I have to buckle up - it will be a fast and often bumpy ride up the road.

  • Report this Comment On November 20, 2013, at 3:50 PM, Rif27 wrote:

    I'm curious where the author gets his expected average selling price of Tesla's cars-- $90,000 and up? The Model S doesn't sell at that rate overall, and the new Model X will be more affordable still. The numbers he suggests are way off. This stock is completely overvalued and will crash in the next few months.

  • Report this Comment On November 20, 2013, at 4:33 PM, damilkman wrote:

    Just a funny comment about betting against great leaders. If you had betted against Tesla himself you would have won big. Make your decision on the company and the product not the leader running it. Great people make mistakes too.

  • Report this Comment On November 20, 2013, at 5:56 PM, TMFGemHunter wrote:

    @Rif27: Thanks for the comment. First, just to be clear, I'm excluding the effects of lease accounting. That said, if you look at Q2, which had the lowest revenue per car sold out of the past year, Tesla was still getting an average of over $106K per delivery.

    There's a button on the website that allows you to start with the performance package and add on all of the "recommended" options, and that takes the price up above $120K... and I'm pretty sure that's after the $7500 federal tax credit. Obviously, most people aren't getting quite that many options, but Tesla is a luxury car, and most buyers have been going for heavily optioned packages.

    Also, while the ZEV credit contribution is declining, Tesla does get other emissions credits, which I believe are in the range of $3K-$4K per vehicle.

    I would expect the ASP to decline somewhat over time, as the early adopters are probably more likely to take the most expensive packages. I don't expect the Model X to be much cheaper than the Model S, though. I'm already allowing a 15% drop in ASP over the next 2-3 years, which I think is fairly conservative.

    Adam

  • Report this Comment On November 20, 2013, at 5:59 PM, TMFGemHunter wrote:

    @ffbj: I don't think any 1 week or 1 month (or even 1 year) move in a stock can invalidate the case that it's a "value" stock. Just look at Netflix; the stock has had a bizarre tendency to lose half or more of its value pretty frequently. Yet it's done very well over the long-haul. (I should note though that I am quite bearish on Netflix; unlike Tesla, I think Netflix is clearly overvalued.)

    Adam

  • Report this Comment On November 20, 2013, at 6:20 PM, xetn wrote:

    I can see that Tesla has ripped the rug out of the car market with its huge 3rd quarter 5500 units. And without the zero emission credits, it probably would have been much lower.

  • Report this Comment On November 20, 2013, at 6:43 PM, tombland wrote:

    @Rif27, actually Tesla did say that the Model X will be slightly more expensive than the Model S. A Tesla won't be more affordable until the Gen III arrives...

  • Report this Comment On November 20, 2013, at 6:46 PM, tombland wrote:

    @xetn, I think you're getting mixed up. ZEV credits have no bearing on units sold. They're what automakers receive for selling emission free vehicles.

  • Report this Comment On November 20, 2013, at 6:50 PM, cmalek wrote:

    "I don't think any 1 week or 1 month (or even 1 year) move in a stock can invalidate the case that it's a "value" stock."

    Neither can it validate it.

  • Report this Comment On November 20, 2013, at 6:51 PM, Gary7m wrote:

    I think that the recent fires that have occurred with Teslas, in the short term, are going to cause Tesla a lot of heartache. Three fires doesn't seem to be a big deal, but if you extrapolate those three fires to Toyota Camrys, the number would be about 380 fires, which is untenable for a car company.

    In addition, I haven't seen any figures on warranty or repair costs, both of which significantly can affect the public perception of a particular brand.

    Finally, the luxury car market can be extremely fickle.

    GP

  • Report this Comment On November 20, 2013, at 7:25 PM, theeseer wrote:

    When the QE stops in March and valuation actually matters again this is a 50 buck stock. When there is a national power grid for the car and IF the other car giants don't crush Tesla and Elon comes to his senses and authorizes dealers then maybe just maybe this stock will see legitimate highs.

    Meanwhile its just a seesaw HFT favorite. Scalp up and then Scalp down. Stay away or get "Scalped".

  • Report this Comment On November 20, 2013, at 8:41 PM, DinkSinger wrote:

    In response to Gary7m

    If Toyota Camry's have the typical fire rate of U.S. passenger vehicles, there were more than 770 Camry fires in the six week period that the three Tesla fires occurred. They just aren't news, because they are so common.

    Another factor is that in the three Tesla fires the design of the vehicle contained the fire in the area in front of the passenger compartment. The cars informed their drivers of the emergency, instructed them to pull over, in at least one case directing the driver to the nearest exit from the highway so he could safely exit the vehicle, and then shut themselves down.

    As Elon Musk pointed out "arsonists tend to favor gasoline. Trying to set the side of a building on fire with a battery pack is far less effective."

  • Report this Comment On November 20, 2013, at 9:58 PM, xuqi wrote:

    Geroge Clooney complaining about Tesla "being always stuck on road side" & recent fires have given ammunition to shorts. CEO Elon Musk has done very poor job interacting with media over over these allegations. Shorts are able to turn the tide on TSLA. For momentum stocks valuation doesn't matter, direction of stock move matters and TSLA is pointing down!!!

    disclaimer: I am holding sizable chunk per my account size. I saw decent gains momentarily but holding bags with sizable losses at moment. Have thought about dumping few times, but always "ran out of luck" to get rid of TSLA.

  • Report this Comment On November 21, 2013, at 1:01 AM, sliderw wrote:

    Actually, TSLA was priced for perfection times two. Now it is priced for perfection.

  • Report this Comment On November 21, 2013, at 3:50 AM, singaporenick wrote:

    Tesla is a great product but it is going to have to survive against very powerful forces represented by the oil & gas/auto industries.They have plenty of allies,including paid-for congressmen,who will do their utmost to talk the product down with dis-information,.

  • Report this Comment On November 21, 2013, at 5:07 AM, observerbob2013 wrote:

    The big problem for Tesla is still the long ramp-up time and the high cost.

    Toyota quietly sells Prius and has done so for some years now.

    I agree that Tesla have a very attractive product but there are only so many people who want a car like this at the price.

  • Report this Comment On November 21, 2013, at 9:14 AM, Jason87467 wrote:

    There goes the media again! Hyping a company that in reality can not compete with the big boys long term. With all the hype, one would think Tesla is a big company. Some in the media says Tesla is a threat to GM. That is the craziest analogy I've ever heard. There you have a company who has sold less than 20k electric cars being a threat to the big boys is just plain crazy.

    I predict when the big boys comes out with their equivalent of a Tesla, Tesla will be in serious trouble and will either find a big boy partner or file bankruptcy. Wake up folks. This is not like a company making a small object like a cell phone. Assembly lines takes many billions and many years to build....something Tesla can not afford. Time will tell.

  • Report this Comment On November 21, 2013, at 10:12 AM, TMFGemHunter wrote:

    Jason: Tesla already owns an assembly line. It bought a former Toyota/GM joint venture factory that was churning out half a million vehicles per year at its peak. So far, Tesla hasn't needed all of that capacity because it doesn't have enough components to build more cars than it's already making.

    However, the company is already looking into restarting one of the moving assembly lines to boost production rates when the Model X is ready to go (late 2014-early 2015). And if the company goes forward with its plan for a mass market car, it has plenty of runway in its existing factory to build up that business.

    I don't think the "big boys" will come out with the equivalent of a Tesla at any time in the foreseeable future. Two of the big boys -- Toyota and Daimler -- rely on Tesla's technology for their own EV efforts. In any case, you should read up on battery costs: Tesla has a huge advantage here, and while I'm not sure if it's sustainable in the very long-term, it's not going anywhere for the next few years.

    Tesla is a growth company, and has to be viewed that way. The fact that it's building 21,000 cars today is virtually irrelevant. The real question is how big the long-term market is. There's not a clear answer to that question, but I think there is plenty of evidence that the long-term market is many times larger than Tesla's current production.

    Adam

  • Report this Comment On November 21, 2013, at 3:44 PM, TMFFischer wrote:

    One thing I would remember to guard against is anchoring on the recent high. What did that high price represent? Did it have some real meaning? Probably not. If you weren't anxious to buy TSLA at $120 on the way up, why be anxious to buy at that same price today just because the stock has now fallen from $190? Just a thought! All that matters is today's valuation and what you think the company will be worth down the road -- not where the stock has been in the past.

  • Report this Comment On November 21, 2013, at 4:06 PM, EvanBuck wrote:

    Great point @TMFFischer.

  • Report this Comment On November 21, 2013, at 7:10 PM, awallejr wrote:

    Kind of curious. Any responders as well as the author even own a Tesla? That doesn't make it a prerequisite to post an opinion but sure does help in actually deciding if the product is great.

    I remember the Delorean. Beautiful car but no real mass following due to price. Clooney dising the car doesn't help either.

    Aside from its looks, I still don't see it outselling the hybrids.

  • Report this Comment On November 21, 2013, at 7:28 PM, TMFGemHunter wrote:

    @awallejr: Unsurprisingly, I don't own a Tesla; I haven't even seen one in person. I actually don't think owning or using a product is helpful for determining if a product is "great". If anything, it's likely to bias you one way or the other based on your first impression. I can say that everything I've seen from Tesla owners suggests that they love the cars... though again, that's not so surprising.

    I don't know why everybody insists on comparing Tesla to Delorean. The Model S is a nice-looking car, but that's not really why people buy it. It's a green "statement" car. I also don't see Tesla outselling the hybrids, but why does that matter? As I discussed above, if Tesla can sell 100,000 Model S and Model X vehicles annually in the 2016-2017 timeframe (which would give it a global market share of a little over 0.1%), it could earn pretax profit of around $1 billion. That makes today's $15 billion valuation seem pretty reasonable, considering that there are significant growth prospects beyond that level.

    @TMFFischer: That's a very important point. However, I would add one thing: we've seen two more quarters of results since the last time TSLA was at $120. Tesla has made big strides on automotive gross margin in that time frame, and it has also provided more clarity on 1) long-term growth plans, and 2) ongoing demand trends. Pretty much all the news has been good from my perspective, so I'd be willing to pay significantly more for Tesla today than I would have 4 months ago.

    Adam

  • Report this Comment On November 21, 2013, at 8:43 PM, Yoshimaroko wrote:

    What happens when the subsidies, such as selling their "carbon credits" run out? Without them, they would be in the red, right now.

    Just a thought.

  • Report this Comment On November 21, 2013, at 10:13 PM, awallejr wrote:

    <The Model S is a nice-looking car, but that's not really why people buy it. >

    I submit that is exactly why they bought it. Rich people buy new toys. As the years go by we shall see the comps and I suspect they will disappoint because the novelty will wear off. Just like the Delorean.

  • Report this Comment On November 21, 2013, at 10:28 PM, djtetsu wrote:

    Every argument here has a set price on how far that argument will be correct in. It's interesting how APPL peaked way high, came down, and there was a buying opportunity at 450ish. One hundred + teens I'd say you're looking at an opportunity.

  • Report this Comment On November 21, 2013, at 10:49 PM, TMFGemHunter wrote:

    @Yoshimaroko: I can't really "handicap" the odds of various regulatory credits going away. What I can say is that the revenue from selling Zero Emission Vehicle credits has fallen off significantly in the past two quarters, but it's been fully offset by gross margin improvements as the cost of production comes down.

    It's pretty normal in the manufacturing world that production costs decline as output increases (at a certain point, you could have dis-economies of scale, but it usually takes a while to get there). So if Tesla can quadruple production in the next 3 years or so -- which is roughly the trajectory I expect -- there should be plenty of additional gross margin improvement. This offsets any loss of regulatory credits.

    Somewhat off topic: this is how government credits and subsides are supposed to work in theory. When you want to promote an industry, you give it some support to get it up and running, and in a reasonably short time it can stand on its own two feet. I believe Tesla will be able to succeed with or without regulatory credits over the long haul.

    Adam

  • Report this Comment On November 22, 2013, at 7:25 AM, Yoshimaroko wrote:

    Thanks, Adam. Now we watch. Here's to success.

  • Report this Comment On November 22, 2013, at 10:45 AM, Souperfool wrote:

    Unlike Amazon and Netflix, producing cars is a very capital-intensive business with limited scale. Profit margins will certainly fall as the other luxury manufacturers enter the market. Unlike the early movers on the web, where new business models with incredible scale were created, TSLA has no such innate advantages. TSLA is therefore headed into a very difficult future, imo.

  • Report this Comment On November 22, 2013, at 11:31 AM, TMFFischer wrote:

    @TMFGemHunter: Good point re: two more quarters of information since the last time TSLA was this price. True! That said, Tesla is a bit like Apple in that it sells few products so each needs to be a big hit, and each new roll-out will likely lower margins initially. And we've since seen proof that, perhaps even more so than Apple, supply constraints are likely going to be a long-term challenge for Tesla, especially when it comes to lithium batteries (as well as selling product at volume around the world, not just in the U.S.). Meanwhile, we have hydrogen cars right around the corner. Aside from the passenger airline industry, is there a more competitive, capital-intensive industry than automobiles? Not that I can think of right now. I wouldn't bet against Tesla today, but like 3D printer manufacturers, it's a manufacturing business, in the end. That's almost surely going to limit the long-term potential (ROE, margins, growth, etc.) in ways that Google, say, or Amazon, were not limited. It's just a tougher business and will likely deserve lower value multiples than other "new age" businesses... Once the excitement wears off, it's making cars that use a different type of juice to go, juice that has it own pluses and negatives...

  • Report this Comment On November 22, 2013, at 5:57 PM, TMFGemHunter wrote:

    I don't think Tesla will have the same margin issue as Apple. It's true that the third generation affordable car would almost certainly carry a lower margin, but that would be a secular issue, not a one-time thing. Presumably, the significantly larger addressable market would justify the lower margin structure.

    Looking at the Model X specifically, my guess is that it will debut at the same or a higher gross margin. It's built on the same platform as the Model S. To continue the Apple analogy, this makes it sort of like the iPhone 4S vs. the iPhone 4, the introduction of which led to the best gross margins in Apple's history. Any initial uptick in cost is probably fully offset by the fact that early adopters will take higher-end packages.

    In the super-bull case -- which I view as a long shot, but plausible -- the best comparable for Tesla is Intel. In this scenario, Tesla is the first to scale for large auto batteries, and develops a huge manufacturing and technology advantage. As a result, every automaker that wants to build an electric car just buys the battery from Tesla. That could be a recipe for 11 figure profits at some point down the road. Just a thought...

    Adam

  • Report this Comment On November 23, 2013, at 10:44 PM, reddog1 wrote:

    Find out who can build a perfect car battery and you will have the winner of the century.

    Also, when movie stars start saying the donated their S to a charity for auction, the yip appeal may be gone.

    R

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