Source: Tesla Motors.
Editor's note: Because of a mathematical error, a previous version of this article provided an incorrect gross-profit projection for Tesla for 2014. The Fool regrets the error.
Tesla Motors (TSLA +0.70%) at $190? One year ago no one would have believed it. The stock is up about 500% over the past 12 months. With the stock hitting all-time highs again, it's time to look at the electric car-marker's valuation. While a number of articles have made a great case for the stock's overvaluation, very few have attempted to understand why the stock could actually deserve a valuation that defies gravity.
At Tesla's price today, the devil's advocate has received enough attention. On that note, it's time to call in the ... angel's advocate.
The bear case for Tesla's stock is easy. It's rational. It usually goes like this.
- Whip up some standard valuation metrics -- price-to-earnings, sales per car, price-to-sales, whatever.
- Consider growth opportunities.
- Acknowledge monstrous growth as a gamble.
- Compare to auto peers.
- Shake head in disbelief, concluding the stock is wildly overvalued.
What's wrong with the typical bear case?
Despite rational cases for Tesla's overvaluation, investors shorting the stock continue to get burned. Instead of quickly concluding that Tesla is simply defying gravity because it's an irrational bubble, let's dig a bit deeper.
Here's the important facet of Tesla's valuation that the bear case often overlooks. Tesla doesn't need to report lucrative earnings to please the Street. In fact, it could be more than a decade before Tesla reports a net profit margin (earnings divided by sales) that is comparable to its peers.
No meaningful earnings, and the Street seems perfectly content; has the market lost its mind? Not at all. Actually, it makes a lot of sense.
If Tesla was reporting a lucrative net profit margin, I would be worried about the company's future competitive position. To gain a foothold among the big dogs, Tesla should be spending every dollar of gross profit possible. R&D, capex spending, SG&A -- bring it. Spend as much as possible.
Tesla is a small player. To compete with players such as Ford, GM, and Toyota, Tesla is going to need to achieve greater manufacturing scale than its current levels. Even more, with guidance for production and sales to double from 21,000 Model S in 2013 to more than 40,000 Model S in 2014, there's no reason for Tesla to aim for a meaningful net margin today.
Sure, earnings do matter. But as a small player, Tesla should focus on growing its scale and let earnings surface later on. Of course Tesla doesn't want to overspend -- but with sales growing as fast as they are today, investors shouldn't hope for a handsome net profit margin.
Hedging temporary competitive advantages
If there were competitors on Tesla's heels today, it would make sense for the company to be more conservative with spending, but there's not.
In fact, the company has two key short-term competitive advantages going for it that hedge the company's short-term success. For this reason, Tesla basically has soaring demand locked in for the next several years. This makes heavy spending a wise decision, not a risky bet.
Model S charging. Source: Tesla Motors.
The first competitive advantage Tesla sports is its dramatic lead on charging infrastructure. The Tesla-owned Superchargers are, on average, 16 times faster than most public charging stations. After an announcement earlier this year to boost construction, Tesla plans to have Superchargers within distance of 98% of the U.S. population by 2015.
But it doesn't stop in the United States. The expansion is just as aggressive internationally. A few weeks ago, Tesla launched onto the scene in Europe, when 90% of Norwegians gained access to a Supercharging station. Then, in a press release, Tesla laid out the details of its plans for its Europe expansion:
By the end of 2014, 100 percent of the population of Germany, the Netherlands, Switzerland, Belgium, Austria, Denmark and Luxembourg will live within 320 km of a Supercharger station, with about 90 percent of the population in England, Wales and Sweden living within the same distance of a charging station.
That 320 km, of course, is well within the range of the 480 km-rated range of a Model S.
Model S. Source: Tesla Motors.
Tesla's second competitive advantage lies in the car's award-winning performance. Tesla's 265-mile battery range is far ahead of its electric counterparts from various other brands. Even more, Tesla was able to achieve this while racking up a number of other accolades, including Motor Trend Car of the Year, Consumer Reports' highest rated car ever, and the highest safety rating from the NHTSA.
Groundbreaking range and impressive performance together give the Model S an undeniable value proposition. And it shows in the marketplace. For the first half of 2013, the Model S captured 10% of the large luxury-car market in the United States. The share would have probably been higher if it wasn't for supply-chain bottlenecks. Even today, Tesla remains supply-limited, selling every car it makes.
With short-term demand pretty much in the bag thanks to an aggressive Supercharger expansion and award-winning car, Tesla should be spending aggressively to ramp up infrastructure, manufacturing, and demand.
How to value Tesla
So with earnings out of the picture, how can we value Tesla? One way is to look at the company's gross profit.
By the fourth quarter of 2013, Tesla believes it can achieve a gross profit margin of 25% on sales of 21,000 vehicles, annually. With a 25% gross profit margin basically already in the bag, and an aspiration to achieve margins that rival Porsche, it's reasonable to assume Tesla can achieve a 30% gross profit margin in 2014 on its projected sales that "could exceed 40,000 units per year" (we'll estimate 42,000).
These assumptions give us a 2014 gross profit of about $2.3 billion. At today's price, therefore, Tesla is trading at about 10 times this 2014 estimate for gross profit.
If the company brings the car to market in three years and maxes out its Fremont, Calif., factory's production capacity of 500,000 cars per year five years from now, Tesla's gross profit would be considerably higher by then.
Assuming the company's average selling price for its cars declines to $50,000 and Tesla reached 500,000 cars annually and maintained a 30% gross profit margin, Tesla could report a gross profit of $7.5 billion in five years.
That would put Tesla at about 2.9 times an estimate for the company's gross profit five years from now. Today, Ford trades at about 3.1 times its current gross profit levels.
If Tesla is able to accomplish this in five years, however, the business' incredible performance up to that point would probably merit a premium greater than the conservative valuation automakers have today. So let's assume, five years from now, Tesla's disruptive business model earns a premium to gross profit that is one and a half times that of Ford today.
Under these assumptions, Tesla would trade at $288, giving investors an annualized return of about 10% over the next five years.
The x-factor
This scenario leads to several conclusions.
First, there is a potential bullish scenario that could yield investors a meaningful return -- even with shares trading at $190. Even more, Tesla has done nothing to disprove this wildly positive scenario. And even though I tried to paint an extremely bullish scenario as the angel's advocate, there's always a possibility that Tesla could even outperform these expectations. For instance, Musk has mentioned that Tesla may open new manufacturing factories in Asia and Eruope, too -- a fact I didn't even take into consideration.
Second, as just a possible outcome at the higher end of the spectrum of possibilities, a bet on the stock today is speculative -- so I would avoid buying shares.
Last, shorting Tesla stock could be even more dangerous than buying shares. As long as this possible scenario is looming, the stock will likely continue to trade at valuations that make very little sense -- let's call it Tesla's X-factor. It's an American Cinderella story; the company is defying all odds. The X-factor, therefore, could lead to wildly bullish valuation metrics for decades, leaving investors shorting the stock wanting.
At $190, buying Tesla would be a gamble, selling Tesla would be rational, holding Tesla would be speculative, and shorting Tesla would be downright dangerous.
