Can Tesla Motors Inc. Justify Its Lofty Valuation?

  • Tesla stock has been selling off since the company's latest earnings call.
  • The selloff appears tied to the apparent overvaluation of Tesla stock.
  • How will Tesla stock get some much-needed reprieve?

Tesla Motors Inc. (NSDQ:TSLA) delivered impressive Q1 2016 results, managing to exceed bottom line expectations of analysts. Tesla posted first quarter revenue of $1.6B, up 45.5% Y/Y and in-line with the consensus on Wall Street while EPS of -$0.57 was a cent better than estimates. Tesla delivered a total of 15,510 vehicles during the quarter consisting of 12,851 Model S units and 2,659 Model X units. Tesla reiterated its earlier position that it intends to deliver 80K-90K vehicles in the current year which it says will be achievable due to a significant production ramp during the back half of 2016.

Despite the healthy report, Tesla shares have lost almost 7% since then. This development appears rather befuddling considering that the company had managed to bag close to 400k Model 3 orders going into the earnings call, representing more than $14B in future orders in what the company has hailed as the biggest product launch ever. That feat appears even more impressive when viewed in the light of Tesla relying almost entirely on the cult personality of its brand to garner that mountain of orders. So what's the rant by investors this time around? In one phrase: valuation concerns.

CEO Elon Musk has in the past said that Tesla shares are overvalued, comments that usually led to the shares tanking. Although he made no such remarks during Tesla's latest earnings call, those concerns are always on the back of the minds of investors. At a market cap of $31B at the time of the earnings call, Wall Street was valuing Tesla at $620K per vehicle sold in 2015 and about $63K for every vehicle that Tesla hoped to sell by 2020 as per earlier estimates (500K deliveries). Although Tesla's valuation based on vehicle sales has improved considerably over the past one year when Market Cap per Vehicle Sold exceeded $1M, it still towers above the other automakers like the tallest kid in class.


Source: Deutsche Bank Research

During its earnings call, Tesla said that it hoped to deliver 500K vehicles in 2018, moving its earlier target a full two years ahead. The current market cap works out to $56K per vehicle sold in 2018. That's still rich but tolerable for an auto company that's growing its top line at 40%+.

The big problem here is that given Tesla's spotty track record when it comes to meeting delivery dates, all bets are off whether the company will be able to ramp Model 3 production fast enough to meet its lofty target. Even long-term Tesla bulls such as Morgan Stanley are not so sanguine. Morgan Stanley recently cut its 2016 and 2018 delivery estimates for the company though the firm maintained its $333 price target (60% upside). Morgan Stanley estimates that Tesla will deliver only 70K vehicles in 2016, 10K less than the company's lower end guidance. Meanwhile, the analyst sees Tesla delivering a mere 108K units in 2018 vs. 500K as per Tesla's updated guidance.

Meanwhile, Wall Street is tinkering with the possibility of a capital raise by Tesla to fund the huge expected Model 3 production ramp:

Stifel Nicolaus: "We think a capital raise would be completely reasonable in light of higher initial Model 3 demand than expected. In terms of the guidance, though loosely mentioned in the past, we view the 2,000 units/week production rate at the end of 2Q16 as a modest improvement vs. prior expectations (from 2Q15/3Q15 shareholder letters), which called for a 1,600-1,800 units/week average throughout 2016 and 2k units/week by year end."

Baird: "We continue to model zero Model III deliveries in 2017, and increased our 2018 Model III estimate to ~160k (up from 40k), and total deliveries to 300k versus TSLA’s 500k vehicle target."

Deutsche Bank: "Investors are well aware of Tesla’s propensity for aggressive projections. That said, there is no question that this [growth plan] represents a significant development."

RBC Capital Markets: "Tesla is increasingly asking the equity investor to sign up for a complex manufacturing ramp (5x in 2 years) the likes of which we don’t believe has ever been seen before. This brings both elevated expectations and execution risk."

Tesla recently disclosed Model 3 production risks in its latest 10-Q:

"We have no experience to date in manufacturing vehicles at the high volumes that we anticipate for Model 3...and plans for the build out of our production facilities...and various aspects of component procurement and manufacturing plans have not yet been determined."

Further the company warned that should one or several of its assumptions turn out to be out of the ballpark:

"our ability to successfully launch on time and at volumes and prices that are profitable...may be materially and adversely impacted."

Many investors and analysts are drawing close parallels between Tesla's ongoing problems with Model X ramp and heightened Model 3 expectations. Tesla's first quarter Model X deliveries came in below expectations as the company continues to struggle with manufacturing difficulties for the snazzy vehicle. Tesla though has said that basing Model 3 production on Model X is poor analogy because Model X is way more complex to manufacture and has some inherent complexities that Model 3 does not have to worry about.

Regarding the expected huge increase in CapEx and possible debt raise/stock dilution as Tesla tries to generate new capital for Model 3, fellow Amigobulls contributor Alex Cho has done a good job analyzing the possibilities and permutations in this article here.

Ultimately, I think that valuation concerns will continue dogging Tesla stock until the company demonstrates that it can actually transition from a niche manufacturer to a mass producer of EVs in two years flat.

But Tesla stock can still get some reprieve nevertheless.

Tesla Profitability and Tesla Energy in Focus

Tesla shares surged more than 10% in early February when the company told investors that it expects to become GAAP-profitable as early as the fourth quarter of 2016. There is a strong possibility that Tesla was basing this on the huge expected production ramp for Model S and Model X during the second half of the year.

It's important to note that Tesla made that prediction before Model 3 was unveiled. Model 3 pre-orders have far surpassed even the company's wildest expectations. Tesla warned during its earnings call about possible cash flow problems stemming from huge Model 3 CapEx. So we can reasonably assume that profits will now take a backseat for the time being as the company builds out production capacity to handle the huge volumes.

Tesla's profit projection, however, reveals some valuable nuggets. About a year ago, Musk had said that the company would not be able to turn a profit until it was able to achieve production volume of 500K units. Tesla was projecting to turn a profit later this year on less than 100K deliveries. This tells you that the company probably received an unexpected windfall, part of which the can be found in the company's first quarter report:

''By improving our capital budgeting, we reduced capital expenditures by 47%from Q4 to $217 million, without compromising our future growth prospects. Q1 capital expenditures were primarily for increased production capacity, Gigafactory construction, and customer support infrastructure.''

The second is that Tesla's energy business could be taking off faster than earlier projections. Tesla did not talk much about this new business during its latest earnings call other than saying the company will commence cell production at its Gigafactory later in the year. Tesla reports revenue for the energy business, along with powertrain sales, service revenue, and pre-owned Tesla vehicle sales, under the Service and other category. This category posted revenue of $120.984M, up 160% Y/Y. There are two reasons why this category is growing so fast: robust sales of used Tesla vehicles and a rapidly maturing energy business.

Tesla started accepting trade-ins of older Tesla vehicles for new car sales during Q2 2015. The used car business has been doing very well, with demand for used cars frequently outstripping the volume of trade-ins received:

"The number of pre-owned Tesla vehicles that we sold in Q3 exceeded the number of customer trade-ins that we received," said management "leading to a 17% sequential reduction in trade-in unit inventory."

The segment had hit sales of $33M by the second quarter after launch and growing at more than 50% Q/Q.

The second reason why the Service and Other segment is growing so fast can be chalked up to the energy business. I had discussed Tesla's energy business in this article here. For Tesla to achieve the $35K price target for Model 3, it will have to lower current battery production costs by more than 20%. The company reckons it can achieve this through massive scale at its Gigafactory. This will allow the company to gain a competitive advantage in the energy storage business over rivals such as Panasonic. Tesla had predicted that its energy business could reach more than $1B in sales by 2017.

Investor Takeaway

Investor concerns regarding Tesla's apparent overvaluation are not likely to go away until the company is able to demonstrate that it can deliver on its promise to hit the 500K production target by 2018. Tesla stock, though, can get some much-needed reprieve if the company's energy business is able to achieve $1B in sales or something in the ballpark in 2017 as per the company's projections. Tesla stock could be destined to remain range-bound until then. Nevertheless, if Tesla is able to somehow achieve profitability later in the year, you can expect the stock to rally to new highs.

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