Where Is Tesla's Long-Term Upside?

Last month, my colleague Sean Williams laid out the bear case for Tesla Motors (NASDAQ: TSLA  ) . In the article, he argues that as good as Tesla's Q2 earnings results were, they couldn't possibly justify Tesla's valuation at nearly $20 billion.

Tesla is making electric cars a reality.

Sean points out that this implies that Tesla is worth around $850,000 for each of the 21,000 cars it will produce in 2013. He also notes that even if Tesla boosts its production by a factor of 20, it would still be twice as expensive as Toyota Motor (NYSE: TM  ) on a value per car basis!

Yet a 20-fold jump in production is just what Tesla bulls expect. In fact, they expect it to happen fairly soon: not next year, but before the end of the decade. The Tesla factory in California has a nominal capacity of 500,000 vehicles per year, and Tesla CEO Elon Musk expects to use all that capacity and more (eventually). If Tesla manages to grow into its current production capacity by 2018, would that justify its $20 billion market cap? Or would the company need to keep growing well beyond that level to justify buying the stock today?

Tesla 2018: the high-end
Obviously, there is no guarantee that Tesla will meet the lofty goals investors are setting. The company has missed a variety of production milestones in the past, although it has always rallied to come through in the end. As it continues to grow, there will be more headwinds, such as securing an adequate supply of batteries. However, let's assume that Tesla surmounts these technical challenges, so that demand becomes the limiting factor.

Tesla believes that there is enough demand in the market for it to ramp up Model S production to a pace of 40,000 units per year by the end of 2014. As it expands its Supercharger network and adds more retail stores and service centers, Tesla expects incremental demand beyond that level.

The Tesla Model S sedan (courtesy of Tesla).

The addition of the Model X crossover in late 2014 will spark additional demand, although it will probably also cannibalize Model S demand to some extent. In any case, it seems challenging for Tesla to sell more than 100,000 high-end (i.e. priced above $70,000) luxury vehicles per year any time soon. Porsche, a well-established high-end luxury automaker, sold just 141,075 vehicles last year.

Tesla 2018: the low-end
As my colleague -- and Tesla bull -- Daniel Sparks wrote last month, the real key to Tesla's growth is the coming of a lower-priced model. which could go into mass production by 2017. On Tesla's most recent earnings call, CEO Elon Musk said he saw a "clear path" to producing a $35,000 car with a range of at least 200 miles.

However, such an "affordable" car would be much less profitable than the Model S or Model X. While Musk thinks Tesla could potentially rival Porsche with gross margins of 50% or so, that would only be possible if Tesla can maintain its Porsche-like average selling price of roughly $100,000.

A $35,000 car is more likely to have a 15% gross margin. Tesla cannot afford to compromise on quality, so it must start at a quality baseline consistent with other cars in that price range, such as BMW's 3-Series, Daimler's Mercedes C-Class, or General Motors' Cadillac ATS. The additional cost of batteries and an electric powertrain (compared to a standard internal combustion engine) add additional costs for Tesla. Moreover, if Tesla grows as expected, its vehicles will no longer be eligible for the $7,500 federal tax credit in the U.S., which begins to phase out after a manufacturer produces 200,000 plug-in or all-electric vehicles.

Pulling it together
If Tesla can really sell 400,000 "affordable" cars in 2018 for $35,000 while at a 15% gross margin, this would translate to just over $2 billion in gross profit. By contrast, Tesla's operating expenses are currently at a $450 million annual run-rate. However, with Tesla going from one product today to three to four products in 2018 and growing sales more than 20-fold, operating expenses could easily soar to $2 billion or even more by then.

In other words, while a cheaper car will dramatically boost volumes, and could contribute $2 billion to gross profit, much or all of that revenue will be offset by corresponding increases in operating expenses. To produce billions of dollars of free cash flow -- which is essentially what Tesla's valuation implies it will do -- Tesla will really need to boost gross profit from its high-end vehicles to Porsche-like levels.

Is that possible? Perhaps. It's plausible enough that I won't risk shorting Tesla at this point. But it doesn't make Tesla a buy, either. Everything has to go right just for investors to earn a market rate of return.

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Read/Post Comments (17) | Recommend This Article (10)

Comments from our Foolish Readers

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  • Report this Comment On September 10, 2013, at 3:15 PM, AlaaSadek wrote:

    May I ask what is the future of transporting goods from one side of the USA to the other for free?

    What effect will that have on the world? If someone were to come and say that we all could call eachother round the whole world for free, no one would have believed that before skype came in 2003. Now if I tell you that you will be able to transport goods for free very soon in the USA and the EU will you believe me?

    What do you think Adam?

  • Report this Comment On September 10, 2013, at 4:01 PM, JEnsign57 wrote:

    Electricity isn't free. Tires aren't free. Wear and tear aren't free. Oh, and Teslas aren't trucks, let alone trucks capable of hauling 60,000 lbs of freight. Other than that, I'm sure it will make the world a better place.

  • Report this Comment On September 10, 2013, at 4:05 PM, highgrowthcarson wrote:

    The critical, and at this point almost the only important variable is the cost and weight of batteries. If, as some say, battery chemistry is basically intractable and the $350/kwh or so that Tsla now spends will only decline very slowly, if at all, and that battery weight won't come down much either, than tesla won't be able to profitably make a 35k car or even a 40k car.

    However, if battery costs come down, to say 200/kwh and the batteries get significantly lighter (a lot of the power in the present batteries are basically used to haul the heavy batteries themselves around) then tesla might easily make a 35k car with a 30 or 35% gross profit margin.

    Think about it. EV's are so much simpler. No uber-complex engine. No transmission. No starter motor. No complicated system of belts and flywheels. No fuel system. Etc. Etc. Etc. Minus the cost of the batteries, a good estimate is that an EV costs around half of what a comparable ICE costs to build.

    Batteries are the story. Since tesla has checked pretty much every other box by this point. Batteries are pretty much the only story.

  • Report this Comment On September 10, 2013, at 4:53 PM, CrazyDocAl wrote:

    One thing I disagree on is that a cheaper version that Tesla may come out with wouldn't have to compare to a BMW 3 series just because the price is similar. It would have to compare, if not best, similar selling EVs at that price range. With the Germans now getting into the EV market things are going to get even more crowded.

    History can tell us something about batteries. 20 or so years ago battery powered tools started selling well. The construction industry embraced them. Over the years they have exploded with newer better versions yet the price of the batteries hasn't come down. In fact the top of the line batteries are more than twice the cost of the older ones while not offering extended run times.

    Another example is laptops. The batteries have not come down in price. The devices have just learned to manage the power better. That means Tesla will either have to cut it's range to meet it's price target (and remove it's best selling point) or price it higher.

  • Report this Comment On September 10, 2013, at 11:18 PM, OneHundredxFifty wrote:

    Batteries are coming down in price. Margins should increase for the S Series and it is reasonable that the new one could hit their numbers.

  • Report this Comment On September 10, 2013, at 11:39 PM, brocktonjohn wrote:

    I have read several articles on Tesla in this and other forums/blogs. Almost all focus on range limits, battery weight, and price per car vs. valuation of the company. None have discussed, in depth, the value of the deals Tesla has made with M-B, BMW, and Toyota to provide powertrains and power management software. Maybe Tesla can't ramp up to 400K/units per year, but those other 3 already do, and they are buying Tesla's powertrain for their EV's. That will mean more cash to Tesla, without selling additional units.

  • Report this Comment On September 11, 2013, at 1:28 AM, gowanz wrote:

    While I am unlikely to buy shares in Tesla at the present price, I am full of admiration for the technology used to design and manufacture the model S.

    I am also aware of how this vehicle and its entrepreneurial owner and engineers have captured the public imagination; not only with the efficiency of the car, but in solving the public's anxiety over range. They have established Supercharging infrastructure to allow drivers to eventually travel all over the USA. There is also the new network in Norway, as part of the gradual expansion to Europe.

  • Report this Comment On September 11, 2013, at 2:13 AM, btc909 wrote:

    It's all going to come down to the batteries. If Tesla can't get away from Lithium whatever I see this as an expensive niche brand. I see the main problems for Tesla is the source of Lithium and the cost.

  • Report this Comment On September 11, 2013, at 10:54 AM, TMFGemHunter wrote:

    I agree that the biggest impact on Tesla's success/failure is the trajectory of battery prices. If batteries really do become much more efficient (cheaper and lighter) in the next few years, then Tesla could become a big mainstream player. If Tesla also gains a significant cost advantage because of its purchasing scale in the battery market, then I could see Tesla being a real rocket stock.

    However, I've seen plenty of plausible arguments that it will be hard to push battery costs down. I'm not an electrical engineer, so I can't evaluate the merits of these competing arguments very well. I'd prefer to invest in something where I have a better sense of "what's going on".


  • Report this Comment On September 11, 2013, at 5:59 PM, khlebnikov wrote:

    The following excerpt from a well-researched article by Thomas Fisher in Green Car Reports concludes that Tesla is likely already paying well below $200/kWh for its batteries. This makes high margins on a $35K Gen III entirely possible, particularly as battery prices continue to come down prior to launch. Here's a link and excerpt:

    "The market for lithium-ion cells is fundamentally a black box. Only companies that purchase huge quantities of these get the lowest available prices.

    Depending on which battery-pack size it builds, Tesla uses about 6,000-8,000 cells per pack. Because it is nowbuilding 400 or more cars per week, that would be in the neighborhood of 3 million cells per week.

    In fact, it's likely that Tesla Motors may already be one of the largest buyers of these cells in the world.

    In addition, the company's simplifications to its cell design likely saves a fair chunk of change.

    It's not unreasonable to think that less advanced, but high-quality 3100mAh cells are now indeed selling for $2 per cell (or $180/kWh). If the cheaper Tesla-designed, cap saves even a dime per cell, that would cut the price to around $170 per kWh."

  • Report this Comment On September 11, 2013, at 9:47 PM, colleran wrote:

    I just bought a position in Tesla today. I did not do it based on any assumed future metrics because I don't think those can be used against such a disruptive company. Like any disruptive company, the future is very hard to predict. What Tesla has accomplished with the Model S is extraordinary. I expect more extraordinary vehicles in the future.

  • Report this Comment On September 12, 2013, at 12:59 AM, MaxTheTerrible wrote:

    My take on TSLA is fairly simple - it's a car company that needs to sell cars (a lot of them!) to make a profit. With such lofty expectations already built-in at current prices I would not touch TSLA stock with a [insert your big number here]-foot pole; I wouldn't short it either in real life (only in CAPS), b/c there are enough people, aparently, who is eager to throw money at it.

    Now, TSLA *can* actually grow into its crazy valuation, but in order for that to happen it needs to: 1) make a true breakthrough in battery technology ("30 seconds" charging, for instance); 2) create a rock-solid patent protection around it; 3a) start producing these super-efficient-super-cheap new electric cars and/or convince every other car company to start licensing the technology at ridiculously high prices, and 4) have nationwide charging station infrastructure on the ground (be that developed by TSLA alone or by some sort of joint venture with others).

    On a personal note, I would never buy TSLA vehicles simply b/c I enjoy driving cars with a manual, which electrics will never have (however archaic that may be).

  • Report this Comment On September 12, 2013, at 10:59 AM, flightning wrote:

    I once thought Tesla would fail...

    But, Tesla is so much more than a car. If they build the charging infrastructure, own the fast recharge technology and build high quality and eventually affordable cars, it's like they own the entire market. Every other car company would license their charging technology just to have an EV on the road. That sounds kind of like Standard Oil and Ford Motors all in one. You could also include the huge demand for batteries that Tesla has, which should allow them to buy at huge discount compared to their competitors, and they almost have a lock on the industry. Combine that with the fact that Elon Musk has proven his business skill in at least 3 separate successful companies in 3 separate industries and you have a very compelling stock.

  • Report this Comment On September 13, 2013, at 12:21 AM, jaksterh3 wrote:

    Has mkt cap per car always been a metric? I see these statistics getting thrown around about tesla's value per car it produces a lot. I don't see the value in this bc of the stage that tesla is in and bc tesla is a different co than Toyota.

  • Report this Comment On September 16, 2013, at 6:08 PM, TMFEnochRoot wrote:

    Adam, among the data points you discuss here, one easy one to rebut is the $35k, which you seem to assume is an ASP rather than a base MSRP. I invite you to consider what the ASP of a 3-Series BMW competitor is likely to be; it's not actually the base $35k, right? Unless you believe, for example, that all BMW sells for its 3-series is the 320i RWD model with no options.

    2 data points you might find useful here:

    1) The current ASP on Model S is ~94k (NOT including GHG or ZEV regulatory credits, just the car itself) against a ~$70k base MSRP for the model. So that's an average 1.35x attach rate for options, and prices for options have recently been rising (quite unique among auto manufacturers to see that kind of pricing power.)

    2) Porsche, among the most successful at getting customers into an optioned-up car, has about a 1.4x attach rate for options across its product line.

    So what do you think is a likely ASP for Model E? What does that implies for your gross profit forecast (and on down the line to bottom line earnings), even if your assumptions about gross margin on the model turn out correct?



  • Report this Comment On October 19, 2013, at 11:05 PM, Glen8ak wrote:

    Are there any articles in the Fool that do NOT lead to a sales pitch? I feel like a FOOL alright

  • Report this Comment On November 09, 2013, at 12:00 AM, RyanPeckyno wrote:

    Sure, it is a disruptive company but it is over-valued and in need of a correction. If it goes down to, say, $70/share, then I might consider purchasing shares. Until then, however, I will stay away. Once a significant market opporunity emerges, all of the other companies will fight for market share. And at that point I suspect that there will be -- for all intents and purposes -- little product differentiation.

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