If you're ever looking to start a day-long discussion, simply ask a group of investors the following question: Is Tesla Motors (NASDAQ:TSLA) overvalued at a market cap of $32 billion on sales of just $3.2 billion in 2014?
Arguments supporting the company's current market valuation mostly lean on growth projections -- and for good reason. Fellow Fool Daniel Sparks recently explained how Tesla Motor's ambitious growth plans (selling up to 500,000 vehicles by the year 2020) could be realistically achieved through careful execution. Meanwhile, the first Gigafactory will have the manufacturing capacity to support 500,000 vehicle sales every year, in addition to stationary energy storage, which could further boost growth.
Arguments for Tesla Motors being overvalued usually point to the awkward comparisons between the company and more established competitors (Ford Motor Company owns a market cap of $57 billion and notched sales of $144 billion last year), or they bring up the dreaded topic of market demand. Fellow Fool Adam Levine-Weinberg recently argued that the Model 3, which needs to sell in the hundreds of thousands to achieve the end-of-decade sales goal, is more likely to compete with other luxury brands once higher-capacity batteries and more interior add-ons are priced in, effectively pricing Tesla Motors out of the mass market.
Both sides have a valid case to make. But no matter how you view Tesla Motors, it's important for investors to not make the mistake of thinking that the completion of the Gigafactory alone will result in instant growth or success. Investors in another high-growth industry have found that out that hard way several times in recent years.
If you build it, will they come?
Make no mistake about it: If Tesla Motors has the demand for 500,000 vehicles per year by 2020, then the Gigafactory will be an absolutely critical part of that growth. At full tilt, the Gigafactory is designed to produce 35 GWh of energy storage devices annually, and assemble an additional 15 GWh annually. It will require close to 8,300 metric tons of lithium per year -- equivalent to a 175% increase from current global lithium supply. Who can argue with massive manufacturing capacity like that? Everything points to tremendous growth on paper.
On paper. That may be exactly the problem.
The arguments made today by some investors and Wall Street analysts as to how the Tesla Gigafactory will create awesome growth once at full capacity are strikingly similar to arguments made in recent years in support of industrial biotech companies. Take the most recent example, renewable oil manufacturer Solazyme (NASDAQ:TVIA), which engineers algae to produce various oils tailored to specifications for a range of applications.
Like Tesla Motors, Solazyme entered high-margin luxury markets first (in this case, cosmetics) before making its way to the bigger end of the funnel, where larger market opportunities resided. Like Tesla Motors, Wall Street analysts penciled in spectacular growth for Solazyme, which was expected to be driven by new manufacturing capacity. This pushed the company's market valuation to frothy levels compared to metrics measuring performance, unnecessarily pricing in execution and demand that had yet to be proven.
In mid-2013, the average of 10 analyst opinions called for Solazyme to achieve $282 million in total revenue in 2014. Investor excitement was riding high. As the first commercial-scale facility opened its doors in early 2014, the company's market cap soared past $1 billion despite generating just $106,000 in revenue the year before from the same products expected to be produced en masse. And why not? Annual manufacturing capacity was about to leap from just 1,280 MT in early 2014 to over 120,000 MT by the end of 2015, once the facilities reached steady-state operations.
The huge expansion of manufacturing capacity pointed to awesome growth. On paper.
The only thing missing was demand for tens of thousands of metric tons of renewable oils. Turns out, that's pretty important to demonstrate before making growth projections. Solazyme generated just $60 million in revenue last year (only $13 million from mass market products), in part due to a lack of market demand, demonstrated by relatively small offtake agreements disclosed by management. The company announced a strategic pivot last November and now sports a market cap under $250 million.
To be fair, the company also faced production delays and higher than expected production costs, which further slowed manufacturing expansion. And there are certainly differences. Tesla Motors has Elon Musk, sells directly to consumers (Solazyme's customers are mostly other companies), and competes in a completely different industry. However, also consider that selling products into a diverse range of markets -- cosmetics, fuels, drilling lubricants, textile lubricants, foods, and more -- hasn't helped Solazyme demonstrate demand.
Nonetheless, this remains a cautionary tale for Tesla Motors investors pinning too much hope on the Gigafactory's completion alone. Prioritizing manufacturing capacity as the key to growth while overlooking market demand has led to similar letdowns for investors in other industrial biotechs, in previous lithium ion battery companies, and countless other companies and industries.
What does it mean for investors?
Yes, the Gigafactory will play an important role in the growth of Tesla Motors, but it's more of a supporting role. Simply having manufacturing capacity online doesn't mean sufficient demand exists in markets to fully utilize that manufacturing capacity. It's an important distinction to make -- one that many industrial biotech investors, including myself, wish they had more fully understood and thought critically about.
Bear in mind this is a neutral analysis. There's still time to prove that demand exists -- or doesn't -- for vehicles that will soon roll off assembly lines at Tesla Motors. Investors should gain insight into the feasibility of the company's growth plans by gauging execution and real-market demand in the next several quarters and years.
Just remember this: Demand is king.