Many Tesla (TSLA) bears are centered around the argument that other car makers can achieve what Tesla has done in making their future cars. They also believe that if the Gen III from Tesla is successful, there will be intense competition in the marketplace from other car manufacturers. The premium that Tesla trades at is often ridiculed by commenters saying that "Tesla is an auto company, not Amazon (AMZN), Netflix (NFLX) or Apple (AAPL)."
By that logic, Amazon is primarily a retail company. While many major retailers like J.C. Penney (JCP) and Sears (SHLD) are struggling, Amazon is gaining market share and trading at a significant premium. Amazon has revenues nearly equaling America's second largest retailer, Target (TGT), and nearly double those of Sears.
And Netflix is a movie rental company. Netflix has driven all other major movie rental companies out of business. Netflix does have competition from Redbox (OUTR) and Amazon but is the disruptive force in the industry.
Finally, Apple is a hardware company. It competes with other PC makers and device makers in a cut throat low margin industry. It primarily differentiates itself from the rest of the industry by providing a unified, controlled experience all (Hardware, Operating System and App Store) from one source.
Just like these three, Tesla competes with big auto. However, Tesla is not just a car company. Here is what Tesla is:
- A car company: As a car company, Tesla already competes in the luxury segment, which is the highest margin segment in auto manufacturing. It has developed an appealing car that is also green.
- An auto dealership: With their direct sales model, Tesla eliminates the middle man. So all Tesla vehicles are sold at retail by the company itself, automatically providing a margin boost. In addition to boosting margins, the negative connotation people have when visiting a dealer is completely avoided. Also, since cars are built to order, there is no storage and very little inventory cost.
- An EV charging network: I've already covered the supercharging network before and how it is possible for Tesla to make more money per car than major auto companies just from the charging network.
- An auto service company: Tesla auto service, which the company claims is designed to just break even, provides a significant brand differentiator. Unlike dealerships which rely on service profits, Tesla directly services vehicles at cost, providing the consumer peace of mind from price gouging and added service options like a nationwide "ranger service" where a loaner is delivered to you and your car picked up.
- A battery company: Tesla makes a version of its auto battery for electricity storage. Currently SolarCity (SCTY) is its only customer and the business is just beginning, but the potential is big. There is a market for the battery which is expanding as fast as the solar industry. With a future major battery factory in its sight, Tesla might just be the largest producer of battery packs and the largest producer and consumer of batteries in the world.
- A technology licensing and development company: Currently, Tesla supplies technology and components to both Toyota and Daimler for their own electric vehicles - the RAV 4 and the B Class, respectively.
So just like Apple, Tesla is an integrated experience company. Long term, how much better can Tesla margins on autos be? I'll start with assuming Tesla can have the same net margin as BMW - 6.7%. Next I'll assume that not having a dealer network adds about half the 8% dealer markup, putting us at 10.7%. If the supercharging network is even half as profitable as some of my past calculations, we have another 1.7%. That makes it 12.4%.
So at least in theory, longer term Tesla can make a net margin of 12.4% on its auto business. The battery business segment could command even higher margins and the licensing and technology development would be lower. But overall we could potentially see net profit margins far higher than the rest of the auto industry.
For the first model year of a high end car, Tesla in 2013 in North America outsold the entire Maserati brand. The Model S significantly outsold the Porsche Panamera. It also outsold the BMW 7 series and the Mercedes S Class in the US. In other news, Tesla plans to begin deliveries in China in March and right hand drive vehicles in April, continuing its global expansion.
So some years from now when Tesla sells 500,000 cars at 12% margins (at an average price of $60,000 - slightly more than BMW's $56,000), it would be worth $72 billion with a P/E of 20. This doesn't even take into account any revenues from supercharging or their battery business.
Some would argue whether an auto company deserves a P/E of 20. When Tesla reaches the 500,000 sales mark, it probably will still be growing a lot faster than the rest of the industry, at least until it reaches the auto sales of BMW (about 2 million). Now, if Tesla can sell 2 million cars with margins of 12%, it would be worth 144 billion at an auto industry standard P/E of 10.
Calculating the present value with a discount rate of 15% for Tesla selling 500,000 cars in 2021 with 12% margins gives us $27 billion. That is 35% more than the current $20 billion valuation.
While we await fourth quarter results, Tesla has already hinted at 20% higher revenues than guidance and mentioned sales of 6900 cars for the quarter (also 15% higher than guidance). These announcements caused the stock to jump. While both those items are significant, what will be really important to watch will be guidance for 2014 including its plans for battery production. Tesla managed to beat its 2013 guidance of 21,500 cars by nearly a thousand. It sold a total of 22,450 cars for the year.
Also its ramp up was more significant this quarter than the last three quarters with QoQ growth of over 25% compared to last quarter's 7% growth.
Even at these lofty valuations, Tesla is still a buy thanks to the potential of big gains in the future.
Since the only potential EV competition hinted at for Tesla Gen III, the BMW i5, will only have "slightly more" range than the i3, Tesla will likely have a very significant head start in making an appealing, affordable and yet green car. Just like the Model S is outselling high end luxury cars, I expect the Model E to outsell its ICE competition as soon as Tesla can make enough.
Also, since other car makers cannot get rid of the dealership sales and service model and are not invested in EVs enough to build out a charging infrastructure or sell batteries for other purposes, they cannot have margins like Tesla can.