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Electric carmaker Tesla (NASDAQ:TSLA) zoomed past the Street's expectations when it reported second quarter results Wednesday afternoon. Revenue exceeded consensus estimates, growing 14-fold year-over-year to $405 million. Adjusted earnings per share swung to a profit of $0.20, well above the loss expected from consensus expectations. The firm wasn't free cash flow positive like it was in the previous quarter, but CEO Elon Musk noted that the negative operating cash flow was mainly a timing issue as several ZEV credits sat in receivables.

Demand Is Robust

We had no doubt about the strong demand for Tesla's vehicles--the surprise during the quarter was to see the superb execution from the EV maker. Tesla was producing 400 vehicles per week during the first quarter, but bumped that number up to 500 vehicles per week during the second quarter. This allowed Tesla to deliver 5,150 vehicles, well above the firm's internal expectation of 4,500 units.

Importantly, the firm was able to add to its loaner fleet, ready some vehicles for third quarter shipment to Europe, and add vehicles for test drives. During our last visit to a Tesla dealership, customer service explained to us that the firm sometimes doesn't have cars available for test drive because demand is so strong; thus, having a larger fleet helps eliminate this issue.

Tesla's new financing program accounted for 30% of all sales during the second quarter, displaying that the underlying demand was stronger than the total revenue. Deferred revenue due to lease accounting totaled $146.8 million. Though we thought the portrayal of Tesla's financing plan was a bit extreme, adding flexible payment options has clearly boosted Model S demand. As Musk noted in his letter to shareholders:

"If demonstrated demand in North America and Europe is matched by similar demand in Asia, annualized sales for Model S could exceed 40,000 units per year by late 2014."

A 40,000 unit run-rate by the end of 2014 would a doubling of unit sales on a year-over-year basis.

But What About Costs?

We don't think demand will be an issue for Tesla, but even robust revenue expansion means nothing if the firm cannot convert it to strong earnings growth. During the second quarter, non-GAAP gross margins grew sequentially to 22%, even as the firm received lower ZEV credits. Non-GAAP gross margins excluding ZEV credits improved 8 percentage points, and Musk seems confident that the firm will be able to reach its 25% automotive gross margin goal by the fourth quarter.

It certainly appears the firm could gain some of that margin from improvements in supply-chain performance. Musk addressed a few of Tesla's issues on the cost side, saying:

"Very often, we will shift to marketing ideas and certain other things but obviously I kind of spend trying to figure out how to make more comps (sales) and the things that prevent us from doing are our supply of parts, essentially. 90% of our suppliers are able to ramp-up and 5% have some difficulty and 4% have a lot of difficulty and 1% just can't and so we have got to replace those or in-source those items. You can't supply, give people a car that's 99% complete, unfortunately and there are several thousand unique parts in the car."

With demand surging, we think suppliers will find it in their best interest to meet the needs of Tesla, specifically if it can have a large impact on the company's financial performance.

Looking ahead, production is predicted to rise in the third quarter, and Tesla plans to deliver over 5,000 Model S vehicles. The automaker predicts improved ASPs (average selling prices) thanks to European Signature Series deliveries and strong 85kWh vehicle demand. Non-GAAP gross margins are expected to be in the low-20% range, though 25% seems achievable during the fourth quarter.

Tesla also predicts a rise in SG&A expenses and capital expenditures of $150 million during the second half as the firm invests heavily in its supercharger network and additional capacity expansions.

Valuentum's Take

Though Tesla's stock has been on a phenomenal run, we are seeing much improved fundamental performance. Profitability is progressing at a strong rate, and demand for the Model S continues to be superb. Though a mass market model is still a few years away, we think consumers will be eager to see what Tesla develops. Our belief that Tesla can become a competitor to Ford (NYSE:F) and GM (NYSE:GM) has increased following the positive results.

Given improvement in profitability and better than anticipated demand, we intend to raise our fair value for the EV maker, though our valuation of the firm will still come out lower than its current price. Tesla is an enticing growth story, but we'll only consider a position in the portfolio of our Best Ideas Newsletter if we are able to acquire shares at a significantly lower valuation.

Source: Tesla: The Electric Engine That Could

Additional disclosure: F is included in the portfolio of our Best Ideas Newsletter.