Last week, the analysts of Goldman Sachs released their best and worst case scenarios for Tesla (TSLA). It looked like the investment bank's worst case scenario was too optimistic and its best case scenario was too pessimistic. Here is my take on the best and worst case scenarios for the company. In this article, I will try to be as objective as possible, while attempting to consider all possible angles and variables I can think of.
I have been long Tesla on and off in the last year. I bought it when it was right under $30 and had to sell it at $55 as the covered calls I wrote got exercised. Shortly after, I got new shares at $57 and sold at $74. Since the stock's price has passed $80, I haven't touched it. I have never shorted this company (or any company for that matter) in my life since I am a "long-only" investor (even though I tend to "short" myself by writing covered calls).
Why am I explaining my position in the stock? Well, there is one thing I noticed about Tesla investors recently. A lot of Tesla investors seem to get their emotions get the best of them, and this is very dangerous in the stock market. Back when Apple (AAPL) was trading at $700, a lot of people (including me) claimed that it was the best stock in the world, that it could never fall and that sky was the limit for the company. As a result, a lot of investors got burned when Apple fell to $300s. Even though Apple had (and still has) one of the strongest fundamentals in the market, it was a bad idea to be emotionally attached to the company. Today, a lot of Tesla investors are emotionally attached to their investment. Whenever someone criticizes Tesla in any way (or tries to offer an objective analysis of the company) the investors seem to blame the person for "being a short" or "trying to manipulate the market." A lot of times, investors of Tesla tell others that "they don't get Tesla." People should be more open to criticism and objectivity, especially if it can save them money in the long run. Before anyone claims I am a short who got burned in Tesla's rally, I would like to remind you that I've never shorted Tesla and I've actually made money going long in this stock in the last year (even though I don't own any shares anymore).
Will Tesla's advantages disappear as it grows?
In order to make a healthy estimation of Tesla's future business, first, we have to look at the company's business model. Currently, Tesla enjoys a number of advantages that other car companies don't really have, which is great for the company. As Tesla grows, it will be interesting to see how many of these advantages are sustainable though.
Tesla's first advantage over the competition is the tax credits. These credits will be phased out as the company sells more cars. To be specific, the tax credits start shrinking considerably once a car company sells 200,000 electric cars. Keep in mind that this number only includes the cars sold in the US. Sooner or later, the tax credits will come to an end, which may or may not hurt Tesla's revenues in the future. On the other hand, the company's CEO Elon Musk says that a gross margin of 25% excluding tax credits is pretty possible for Tesla.
Tesla's second advantage over the competition is the fact that it doesn't have to deal with the unions. All big car companies have unions that influence working conditions of employees, such as wages, benefits, working hours and the conditions under which employees can be terminated. The unions usually have a lot of power and they can seriously hurt a company's profitability (as we saw with the big three American car companies in 2008). Currently, Tesla doesn't have unions but there is no guarantee that it will never have them. Tesla is located in California which is known to be pro-unions. As Tesla grows, its employees may want to unionize.
Tesla's third advantage is that it doesn't have dealerships; therefore, it keeps all the bread it earns. Currently, it may be relatively easy to manage a small inventory of cars; however, as the company grows, it may need to get dealerships. Selling 5,000 cars and selling 500,000 cars are completely different things, and most people (pretty much everyone with small exceptions here and there) still buy their cars from dealers. In order to move from a "niche player" to "mainstream," Tesla might have to open some dealerships, cutting into some of its profits.
Finally, Tesla's fourth advantage over the other car manufacturers is that it spends very little money on marketing whereas other car companies spend loads on this item. I can't even remember the last time I watched TV for an hour and not see a car commercial. Now, Tesla might not need to spend a lot of money on marketing, but this will come to a change when the company starts selling cars in higher numbers. When you have to sell only 10,000 cars, you can find buyers, but when you want to sell 500,000 cars, you have to advertise and let (the mainstream) people know that you are there.
It's not all bad though. As the company grows, it may have expense items it didn't have before, but it is also likely to become more efficient and be able to take advantage of the economy of scale. As companies grow and learn to build their products more efficiently, their operating costs tend to come down. As the company grows, Tesla's operating costs must come down in order to offset the new expense items that weren't there when it was a startup company.
On a related note, since Tesla cars don't have traditional engines, these cars will not require as much maintenance or fixing. This can be both good and bad for the company. This is good because the company will be able to keep a larger chunk of its warranty money than other companies. This is also bad because Tesla will not be making much money from replacement part sales, which is very crucial for most car companies.
The best case scenario for Tesla
The best case scenario for Tesla would include the company becoming a mainstream player. In this scenario, Tesla builds all kinds of vehicles from compact cars to SUVs, from trucks to police cars. This would signal a "green revolution" where electric cars steal a lot of market share from traditional cars. Tesla could offer different cars at different pricing points. By this time, Tesla's average sale price could be as low as $40,000 (if it were to "go mainstream") and profit margin could be around 15%. If the company sold 1 million cars, its net profit would be $6 billion. This would value the company around $75 billion (higher than Ford or GM).
The worst case scenario for Tesla
In this scenario, Tesla fails to make a profit without government incentives and it goes under. The shareholders are wiped out. I don't think this is likely to happen; however, we have to think of every possibility. I love how Goldman Sachs' "worst case scenario" also envisioned the company to be highly profitable.
Which Scenario is more likely to happen?
I can imagine Tesla being very successful but the best case scenario is still highly optimistic. If Tesla ends up growing large enough, it will have new costs to deal with, such as dealerships, marketing and the unions. Also, if Tesla becomes highly successful, it will take the notice of other car companies who will try to imitate Tesla's business by producing their own highly-attractive electric cars. Currently, most big car companies don't see much future with electric cars, but if Tesla were successful enough to sell 200,000-300,000 electric cars per year, the large car companies wouldn't simply ignore this. Of course, Tesla would get a head-start like Apple did in 2007, but we don't know how long it would take other car companies to catch up to Tesla.
I personally think it is very difficult for Tesla to reach a gross margin of 25% while making electric cars affordable, but at the same time, I also know that Elon Musk has accomplished a lot of things people didn't think was possible. This is why I will be cautiously watching Tesla's margins over time to see where they are going.
Another thing we need to consider is the demand. We really don't know how much demand there is for Tesla cars around the world at the moment. Last year, the company had less than 10,000 reservations but this is acceptable since the production rate was very small too. As the company produces more cars and as the cars get more affordable, Tesla will see a stronger demand for its cars, but we have no way of knowing the exact demand it will be getting. It is nearly impossible to look at the first 10,000 cars produced by the company and try to predict how much demand there will be for the next 500,000 cars. The first adopters of Tesla have high income, many of them have more than one car and some of them were strong believers of the electric car project. When a car company sells 5,000 cars, it can be called a "niche" but as the company transforms into "mainstream" it will be attracting different groups of people with different demographics, which is very difficult to predict. Then again, given the quality and beauty of these cars, they are likely to gain fans fairly quickly. We just don't have a way of knowing how many people with high enough income will be getting these cars. This is just another uncertainty to add to the mix.
Realistically, I can see Tesla peaking at 250,000 cars per year with an average sale price of $45,000 and net profit margin of 10%. This would result in a net income of $1.13 billion for the company. In addition, Tesla would be generating revenues from selling electric car components to other carmakers, which can take the company's net earnings to $2.00 billion. Assigning Tesla a P/E ratio of 12.5 would make the company's market cap $25 billion, which nearly double of today's market value of $13 billion. Could Tesla outperform my estimations? It is very possible, but there are too many unknowns and too many moving parts to make a clear estimation. We may as well be in the middle of a "green revolution" and Tesla might just be able to change the world. One thing is for sure, Tesla will need to do a lot of work and go through a lot of growth to justify today's share price in addition to future share prices. A lot of growth that may or may not happen in the next 3-4 years is already baked in Tesla's price at the moment. If the price -somehow- falls below $100, I will be happy to acquire new shares of this company, but this may not happen anytime soon.