Seeking Alpha
Long only, deep value, growth at reasonable price, carmakers
Profile| Send Message|
( followers)  

It's nice to see that Tesla (NASDAQ:TSLA) bulls are finally moving from arguing that Tesla can't be valued to actually making attempts to calculate Tesla's possible value. This is still an improvement but more work needs to be done on their side before they can calculate Tesla's value more accurately. Recently, an article claimed that Tesla would be worth $500 per share even in conservative estimates. The article argued that:

"Tesla is targeting 25% gross profit margins beginning in Q4 of this year (excluding ZEV credits, so even higher with ZEV credits). Let's assume zero ZEV credits to again remain conservative. At around $80,000 per car, that's $20,000 in gross profit margins.

Next, again from Elon Musk:

I have high confidence that we can create a compelling [COGS] for around $35,000, compelling meaning a 200 mile range.

This means Tesla can drop the price from $80,000 to $55,000 and still keep its gross profits of $20,000 per vehicle. At $55,000, the Tesla car is far more affordable. At $55,000, it's no longer a super luxury car, yet it is equally as profitable to Tesla. Deduct another $3,000 for gas savings from the free supercharging stations and add in any other state or local various subsidies and credits available and the cost gets even cheaper. The monthly financing and other expenses will be less than many BMWs or Mercedes vehicles."

Moreover, the author goes on with the calculation below:

"500,000 annual vehicles forecasted.

$20,000 per vehicle gross profit margins.

$5,500 per vehicle R&D + SG&A.

Comes to $7.25 billion in profit.

Take out 30% in taxes (some bears have used 25%).

Leaves $5.075 billion in net income.

Use a 12 P/E ratio similar to often-compared General Motors and Ford (while ignoring the fantastic growth of Tesla) = $60.9 billion"

Now, there are several problems with this calculation and I will point them out in this article and provide a more reasonable calculation.

Problem 1: Tesla's 25% gross margin only applies to Model S

Model S is the only car that is expected to have a gross margin of 25%. In fact, only the high-end version of Model S, which is selling for $85,000, is expected to have margins as high as this. In the last quarter, Tesla had a gross margin of 25% including the tax credits. Excluding the $51 million of ZEV credits, Tesla's gross margin falls to mid-teens. So, even the company's most expensive model on the road doesn't have a gross margin of 25% yet, and it is expected to have these margins by the end of this year if everything goes correctly. Even if everything works out perfectly and the high-end Model S vehicles get 25% gross margin, this will not pass to the future models that are expected to be cheaper. You simply can't take the gross margin of the most expensive car a company sells and claim that its cheaper models will have the same margins. If Ford (NYSE:F) generated the same margins it does on F-150 on every other vehicle it produces, the company's net earnings would more than double.

Problem 2: Tesla doesn't have the capacity to produce 500,000 vehicles

The article claims that Tesla currently has enough space to produce 500,000 vehicles; therefore, it shouldn't need a lot of capital in order to ramp up its production to this number. This statement couldn't be farther away from the truth. Having enough space to build 500,000 vehicles is not the same as having enough capacity to build 500,000 vehicles. Currently, Tesla's factory has enough room (in other words space) to produce 500,000 vehicles but it doesn't have the tools, machinery, employees or materials (in other words capacity) to produce these cars. Currently, Tesla's capacity is limited to about 6,000 vehicles per quarter. If the company had more capacity, it would create more cars and kill the backlog, but it simply doesn't. A company needs far more than empty space to ramp up its production. Producing cars is one of the most capital intensive things a company could ever do and I can guarantee you that Tesla will need billions of dollars to ramp up its production from 6,000 to 500,000. Where will this money come from? It will come from either dilution or borrowing. Tesla simply doesn't have enough profits to invest into ramping up production.

Problem 3: Is there demand for 500,000 electric cars per year?

Less than 50,000 electric cars are sold annually around the world. If Tesla wants to sell 500,000 cars per year, it will have to increase the demand for the entire electric car market by about 100 times. Right now, Tesla is supply-limited rather than demand-limited but currently we are talking about very small numbers. Finding demand for 10,000 cars is a much different story than finding demand for 500,000 cars. Tesla bulls always talk about how Tesla doesn't spend any money on marketing but they forget the fact that the company will have to spend tremendous amount of money on marketing if it wants to increase its demand from 10,000 cars to 500,000 cars. You can sell several thousand cars per quarter by word of mouth, but you really need to reach the mainstream and gain their acceptance to sell half a million cars per year.

Problem 4: Where is the timeline?

The article claims that Tesla can eventually sell 500,000 cars, and maybe it can; however, we need a timeline. When investors use calculations such as "discounted cash flow analysis" they have to have a timeline to value a company correctly. Whether Tesla reaches 500,000 cars in 2015 or 2025 will make A LOT of difference in calculating the company's true value. For example, if we are expecting to gain 10% annually from a stock investment, we have to discount 10% from its projected peak price for each year in order to reach today's fair value. If Tesla reaches 500,000 cars in 2025 as opposed to 2015, that can skew the calculations so much that the variation could be as large as 500%.

For example, if Tesla earns $1 per share this year and increased its earnings every year by 50% for the next 10 years, applying a 11% discount rate values the company at $258.99. But if the company grows by 150% per year for 5 years, applying the same discount rate values the company at $629. Do you see how much difference timing makes?

Problem 5: Probability of success isn't 100%

Just because Tesla says it will eventually have the capacity to build 500,000 cars and sell them at high-margin doesn't mean it is guaranteed to happen. There are so many variables that can affect whether this will actually happen or not. Tesla could fail to raise enough capital to increase its production capacity, gas could get so cheap that demand for electric cars could fall further, Tesla might not be able to raise awareness and demand for electric cars, there might be shortage of batteries, another major car company could start offering more electric cars, government regulations might hurt Tesla's business (such as not allowing it to sell cars without dealerships or asking it to recall a large number of vehicles after an incident) and so on. I am not saying any of these will happen but there are so many unknown variables that we can't just say "well they say they will produce 500,000 cars so we will value them as if they are producing 500,000 cars already." That's not how it works.

Then what makes sense?

There can be several different calculations to value Tesla depending on how you think the company will perform. If Tesla is eventually able to sell 500,000 cars, a large majority of these cars will be cheaper Generation III cars. These cars will not carry the margins that a high-end Model S does.

If Tesla sells 400,000 Generation III cars at 35,000 each with a gross margin of 15%, 50,000 Model S cars with a gross margin of 25% and 50,000 Model X with a gross margin of 25%, this gives us a total gross profit of $4.1 billion. In car companies, typically half of gross margin turns into operating margin and even less than that gets translated into net profits after paying for debt and taxes. While Tesla doesn't have any debt, it will have to face either debt or dilution in order to ramp up its production to 500,000 cars per year. Tesla's net earnings out of a $4.1 billion gross profit will be close to $1.6 billion. Multiplying this by 20 gives us a target market cap of $32 billion which translates into $264 per share. We are not done though. We have to discount for how many-ever years we have to wait for this price target to be reached. After all, if Tesla's eventual fair value will reach $264 per share but this will not happen for another 15 years, the investors are gaining very little for taking a huge risk.

If we say that Tesla will reach its goal of 500,000 cars per year in 5 years and we expect to gain 10% per year from our investment (keep in mind that if someone invests their money into a stock as volatile and risky as this one, they will usually expect returns much higher than 10% per year), this values Tesla at $155 per share. If the eventual goal will be met in 10 years, this values Tesla at $92 per share. If we say that Tesla's chance of success is 80% (rather than 100%) we still have to discount for that, which means Tesla's fair value will range from $73 to $124. If you believe that the probability of Tesla's success is higher or lower than 80%, you can adjust the calculations based on your estimate of the probability of Tesla's success. Just keep in mind that probability of a given event can't pass 100%.

There are so many unknowns and so many moving parts in the Tesla story that it is impossible to value the company using metrics that may or may not come true in 5-15 years. No matter how you cut it, Tesla is priced for absolute perfection with no chance of slightest failure. Tesla is priced as if it is already producing and selling 500,000 cars per year with no supply or demand issues and that it is getting as good margins as Porsche while at it. This is a very risky stock and as an investor, I would make sure I am well-aware of all the risks before making any buying or shorting decisions.

Source: Dear Tesla Bulls: That's Not How You Calculate Tesla's Value

Additional disclosure: I am also long TSLA options straddle.