Tesla Motors (TSLA) has been a fairly controversial stock ever since its 2010 IPO, as its critics and supporters argue over Tesla's profit potential, its relevance, and even the utility of its cars. For Tesla's critics, what is effectively Elon Musk's most famous venture is little more than a pipe dream, a futile exercise in unworkable technology financed by taxpayers. And to Tesla's supporters, the company represents a paradigm shift in the automobile business, and they believe that the company will emerge as America's 4th automaker, alongside the "Big 3" of Detroit. With Tesla's Q1 2013 results on May 8, we believe that Tesla will indeed take its place as America's 4th automobile manufacturer. Tesla has created a recipe for success in the automobile market of today, as well as the automobile market of tomorrow, with clear strategies for both. Since our last buy recommendation on Tesla Motors on January 8, shares of the Model S manufacturer have risen by over 151% driven by continued positive news flow on both financial and operational fronts. And although shares of Tesla are at all-time highs on the back of solid Q1 2013 results and the company's secondary offering, we believe that further upside is likely in the long term as Tesla continuities to showcase growth and the investment thesis regarding the company is de-risked. We reiterate our long-term buy recommendation on Tesla, and believe that should a pullback materialize, investors should consider adding to or initiating positions in Tesla Motors.
Some Thoughts on the Politics of Tesla
Before we delve into Tesla's Q1 results and why we see further upside, we would like to take some time to address the politics of Tesla. Many of Tesla's critics argue that it is unconscionable that taxpayer funds are being used to subsidize the development of Tesla's cars, something made all the more unconscionable by the fact that taxpayer funds are being used for electric vehicles, a product line that is predestined to fail. For many, Fisker Automotive (as well as Solyndra) serves as a stark reminder of the cost of such subsidies, and with over $400 million in Department of Energy loans on its balance sheet, Tesla has certainly been a beneficiary of government assistance.
We have always been ardent believers in the idea that politics and investing do not mix, and that it is inappropriate for investors to impose their political views on their investment portfolios. An investor who refused to invest in Tesla simply because it was a recipient of government assistance missed out on meaningful profits through their intransigence. In any case, those who criticize Tesla's receipt of government loans and assistance are missing a crucial aspect of American industry: Tesla is but one of countless American companies that benefits from government assistance. The federal government pays for terrorism insurance for the airline industry, it assists with the development of oil & gas fields, and provides assistance for railroad maintenance. The government's "helping hand" is not limited to new technologies such as electric vehicles or solar panels. It reaches mature and profitable industries as well, and we believe that there is no reason to single out Tesla as a poster child of the perils of government subsidies to American industry. Admittedly, when Tesla first began to receive government loans, the risk that these loans would not be paid back was above average. However, since then, Tesla has proved that it has what it takes to succeed, reach profitability, and in the long term, maintain profitability. And with its May 15 announcement of an offering of both equity and debt (more on this later), Tesla will repay its Department of Energy loan years ahead of schedule. We would also like to note that the subsidizing of new industries, be they in energy, transportation, or other sectors, is an American tradition dating back to the creation of the United States. When the coal sector was first being developed, many companies received government assistance, and many more filed for bankruptcy. The same is true of oil & gas, as well as any number of the industries and sectors that have served to reshape the American economy. We urge readers and investors in Tesla, be they long or short, to not conflate their personal views regarding Tesla's receipt of government assistance with its investment potential, for the 2 issues are distinctly separate, and this article will be focusing on Tesla's investment potential.
Q1 Financial Review
For the first quarter of 2013, Tesla posted revenues of $561.792 million and pro forma EPS of $0.12, with both measures beating consensus estimates that called for revenues of $492.02 million and EPS of $0.04. Tesla's GAAP gross margin rose to 17.15% in Q1 2013, up from 7.79% in Q4 2012 (Q1 2012 gross margin of 33.84% is skewed by higher levels of development services revenue relative to automotive sales). On a pro forma basis, stripping out the effects of $68 million in ZEV (zero emission vehicle) credits sold to other automakers, Tesla's gross margin for the quarter came in at 5.04%. However, Tesla reiterated its forecasts for reaching a gross margin of 25% by Q4 2013, even without the effects of ZEV credits. On the company's Q1 earnings call, CEO Elon Musk and CFO Deepak Ahuja discussed in detail the steps Tesla has, and will take, to reach its gross margin targets. From December 2012 to March 2013, Tesla has cut the number of hours needed to manufacture a Model S sedan by 40%, and CFO Deepak Ahuja has said that further improvements are in the pipeline. In addition, Tesla is working to create a more efficient and less costly supply chain, with many of its suppliers already able to lower the cost of their components. That, combined with continued improvements in Tesla's manufacturing processes, should allow the company to meet its gross margin targets, even with the elimination of ZEV credit revenue. Notably, a gross margin of 25% would be far higher than that of either Ford (F) or General Motors (GM); Ford's 2012 gross margin was 11.05%, GM's was 6.69% (Fiat does not disclose comparable margins for Chrysler).
Tesla's balance sheet continues to strengthen alongside its business, and the company was cash flow positive in Q1 2013, generating $64.079 million in operating cash flow during the quarter. Tesla is forecasting breakeven cash flow for Q2 2013 due to timing issues. Although Tesla is forecasting to build 5,000 cars in Q2, only 4,500 will be delivered, due to the timing of shipments to Europe (the issue is immaterial to Tesla's full-year delivery target, which was raised from a prior 20,000 to 21,000). Tesla ended Q1 2013 with $214.417 million in cash & equivalents (which excludes $21.763 million in restricted cash related to Tesla's Department of Energy loans), and debt of $439.626 million. However, on May 15, Tesla announced an equity and note offering that would serve to bolster the company's balance sheet. The company is offering $450 million in convertible notes due 2018 (underwriters have the option to purchase up to $67.5 million in additional principal), as well as 2,703,027 shares of common stock (underwrites have the option to purchase an additional 405,454 shares). In total, this offering is expected to raise $830 million, and Tesla has committed to using a portion of these proceeds to repay its Department of Energy loan, with interest well ahead of schedule, although an exact repayment schedule has not been determined. Tesla's shares rallied nearly 9% on news of this offering. But how can that be? Aren't companies supposed to see a drop in their share price when announcing a secondary offering, particularly when they have rallied as much as Tesla has? Under normal circumstances, that would be the case. But this offering is more than a simple capital raise. First, CEO Elon Musk is purchasing $100 million more of Tesla's shares in conjunction with this offering, which will meaningfully increase his 23.6% stake in Tesla (worth nearly $2.5 billion as of the close of trading on May 16; Musk's net worth is said to be $4.5 billion). Secondly, Tesla's decision to repay its Department of Energy loan with this equity and debt offering will likely strip away some of the political controversy surrounding Tesla. The argument that taxpayers should not subsidize Tesla holds a good deal less weight when Tesla has no taxpayer-funded loans on its balance sheet. With a strengthened balance sheet, Tesla will have the financial firepower to continue investing in manufacturing processes, its global expansion, as well as the development of the Model X (production is forecast to begin in late 2014).
Moving Beyond the 1%
To the great displeasure of Tesla's critics, many of the company's supporters argue that through Tesla, electric cars will finally be proven as a viable product, and that Tesla represents a paradigm shift in the automobile business. We, however, have held a slightly different view. While we are certainly bullish on Tesla, our bullishness has stemmed from the fact that we view Tesla's Model S as a luxury indulgence. In our last article on Tesla, we analyzed the median income of the city of every Tesla gallery in the United States, and showed that Tesla has strategically chosen to place its galleries in some of the most affluent neighborhoods in the United States, with median incomes in many reaching six figures. And the locations of Tesla's international galleries confirm this trend. Tesla's European and Asian galleries are located in many of the wealthiest cities in Europe and Asia, such as Milan, Zurich, Hong Kong, and Tokyo. We received some criticism for our view that Tesla should be thought of as a luxury company, but we stand by our claim. And with many news stories covering the fact that Tesla has outsold the Audi A8, the Mercedes S-Class, and the BMW 7 series, it is clear that the view that Tesla is a luxury automobile company is widespread (the fact that the Model S outsold these models is largely irrelevant, for if Tesla is compared to BMW, Audi, or Mercedes on a company-wide basis, it is still far behind any of these luxury companies).
And it is important to understand that such a view is not a strike against Tesla's performance or potential. Tesla has been able to create a great deal of value for its investors by building a premium automobile, and the company does not need to be the vanguard of a "green revolution" in order to continue its success. In fact, on its Q1 conference call, CEO Elon Musk himself stated that, "if our car was exclusively available for purchase and not via financing I think that maybe accessible [sic] to 1% or roughly 1 million U.S. households." Elon Musk went on to say that with Tesla's new financing initiatives the Model S would become accessible to the top 10 million American households. In effect, Tesla's CEO is himself stating that for the time being, Tesla is catering to an upscale clientele. We fail to see any reason why such a view is a negative. And in fact, Tesla's decision to begin by targeting the luxury segment of the automobile market is an essential element to its success. There is a reason that global automobile manufacturers such as Toyota, Nissan, Ford, or GM segment their brands. The cachet of Lexus, Infinity, Lincoln, or Cadillac would be tarnished if they became mixed with the core brands of these manufacturers, for the premium pricing of such luxury models is sustainable by maintaining the cachet of the brand in question, as well as the "experience" of being a part of said brand.
Since Tesla only has one brand, such a segmentation strategy cannot work. Therefore, the next best alternative is for Tesla to do all it can to not alienate the high end of the market, for it is much harder to convince luxury buyers to pay a premium price for a brand that has come to be associated with the lower end of the automobile market than it is to expand a premium brand. It is possible that in the very long term, Tesla will one day segment itself in the same way that other automakers do, with different brands for different price points of the EV market. But for the time being, we continue to view Tesla as a luxury automaker, and see it as a core element of Tesla's success. We expect that once Tesla begins selling the Model S in Europe and Asia, investors will see that the Model S is selling to a similar clientele as here in the United States (to be fair, the higher cost of gasoline in Europe will make the Model S a more viable alternative for a wider portion of the market, given more favorable economics).
Elon Musk stated on Tesla's Q1 call that the company expects at least 10,000 units of demand per year in Europe, and 5,000 per year in Asia, a number that could be "much bigger" if China is included. Moving beyond the luxury market is a long-term goal for Tesla, and the company has said that within 3-4 years, it will be able to sell cars in the price range of $30,000-$40,000, which will move Tesla into a much wider market. As 2013 progresses, we expect more color on both the Model X and Tesla's longer-term plans as investor focus moves beyond the Model S and towards the company's future plans.
A Takeover Target? Narrowing the Possibilities
Critics of Tesla are likely to recoil in horror at the idea that any automaker would pay billions to acquire a company as pointless and overvalued as Tesla. Why would any automaker pay well over $10 billion to acquire a company that is selling cars based on such flawed technology? The answer can be found, once again, in Tesla's position as a luxury automobile manufacturer, and, assuming that it can meet its gross margin forecasts, its industry leading margins. Consider the cases of Ford and GM, which we break down below (assumptions: 2012 gross margins for both Ford and GM, and a forecasted 25% gross margin for Tesla, utilizing 2014 revenue estimates for all 3 companies)
Ford, GM, and Tesla (in Millions of $)
2014 Estimated Revenue
2014 Implied Gross Profit
Tesla's estimated 2014 revenue is just 1.72% of Ford's, and 1.49% of GM's. But, when gross profits are considered, the ratio jumps to 3.88% for Ford and 5.55% for GM. While Tesla would not be very accretive to a global automaker's top-line, the impact on the bottom-line would be more pronounced, especially for automakers with a high level of emphasis on luxury sales. CEO Elon Musk has gone on record as saying that there have been "occasional discussions" with companies that he declined to name. And although Musk himself has played down the likelihood of a takeover of Tesla, should an offer come along, the board would be compelled to consider it, for although Elon Musk is Tesla's largest shareholder, he does not retain majority control over the company. We believe that if a takeover offer for Tesla is presented, it will come from one of 2 places: either an existing luxury automobile company such as BMW (BAMXY.PK) or Daimler (DDAIY.PK) (parent of Mercedes-Benz) seeking to capture a new portion of the luxury market, or it will come from a company such as Fiat (FIATY.PK) that wishes to bolster its luxury division, possibly to offset weakness in its core business.
While Ford and GM were used in the example above, we believe that the likelihood of either company making an offer for Tesla is low. GM is focusing on its own line of electric vehicles via the Chevrolet Volt and the newly unveiled ELR coupe (both of which have gasoline engines as well), and Ford is continuing to implement its "one Ford" restructuring plan, and an acquisition of Tesla, certainly a major undertaking, would not be conducive to the company's restructuring goals. We do not believe that investors should purchase shares of Tesla solely on the belief of a takeover. But, such a move is not outside the realm of possibility. Tesla has made clear that there is demand for the Model S, and as the company continues its international expansion, interest in Tesla from larger automobile companies is likely to increase. And with a highly concentrated shareholder base, there is room to outmaneuver Elon Musk should an offer that he opposed be made public. Tesla's 5 largest institutional investors control 36,306,897 shares, or 31.42%, of Tesla's 115,552,703 outstanding shares. And Tesla's 10 largest shareholders control nearly 42% of the company's outstanding shares, meaning that it would be possible for the company's institutional investors (led by Fidelity with a 14.87% stake) to muster a majority vote should an offer be presented.
Valuation & Conclusions
With shares of Tesla now above $90, the question that must be asked is whether or not further upside is likely. We believe that in the long term, there is still upside to be realized. Tesla is currently forecast to post EPS of $0.06 for all of 2013, but given the fact that Tesla's pro forma EPS for Q1 2013 came in at $0.12, we believe that these estimates will be raised in the days and weeks to come (as a frame of reference, Tesla posted a loss of $3.20 per share in 2012). And for 2014, Tesla is forecast to post EPS of $1.07. Longer-term estimates provided by NASDAQ (albeit with a lower number of analyst models included) call for 2015 EPS of $1.67, and 2016 EPS of $2.34 (NASDAQ's estimates call for losses in 2013 and below consensus EPS in 2014, but this is due to the fact that only 3 analyst models were used to compute these averages, versus 9-10 for Tesla's 2013 and 2014 estimates, provided by Yahoo! Finance). The table below breaks down the most reliable EPS estimates for the years 2013-2016, and the implied growth rates (data is current as of the close of trading on May 16, 2013).
Tesla Consensus EPS Estimates
Tesla is by no means a "value stock" in the traditional sense of the word. But that does not mean that shares of Tesla are overvalued at $92.25 (their May 16 closing price). Tesla's forecasted EPS growth rates suggest that at these levels, shares are not overvalued, and there is room for estimates to rise as further details about the Model X are revealed and Tesla continues to show progress in meeting its gross margin, delivery, and global expansion targets. And although short interest in Tesla has fallen from over 40% down to 17% as of May 13, that is still far above the less than around 4% average short interest for Russell 1000 companies. Notably, Barclays, which raised its price target to $90 on May 16, notes that upside to $137 is possible if Tesla is able to successfully expand its addressable market.
Investors should not expect that Tesla will easily repeat the gains that it has seen in 2013. But, that does not mean that Tesla should not be seen as a core holding in a growth-oriented portfolio. Tesla has built a platform for success in both the automobile market of today and the automobile market of tomorrow. The company has found success as a luxury-focused company today, and has laid the groundwork for an expansion into a wider market in the future. Tesla's financial position has strengthened, and the company has the resources it needs to continue investing in the Model S, Model X, and its longer-term plans. Tesla Motors is indeed becoming America's 4th automaker, and we do not believe that Tesla has reached its full potential, either as a business or as an investment.