Tesla: China And The Road To 30%+ Gross Margins

| About: Tesla Motors (TSLA)

Tesla Motors (NASDAQ:TSLA) is ready to enter the largest car market in the world! China deliveries are set to begin within a few weeks. The best part about beginning Model S sales in a new country, from a business standpoint, is the influx of high gross margin cars. These high margin cars are the 85 kWh version and the 85 kWh Performance version. Typically these high margin vehicles provide a boost in the average selling price for a short amount of time. After the initial phase, the 60 kWh packs start being shipped and the ASP declines over time. According to the Model S online design studio in China, only the 85 kWh and P85 kWh are available to order. This means that at least while demand holds up, Tesla will only be offering its most profitable cars in China.

Elon Musk has outlined a target of 25% gross margin in Q4 of 2013 without including ZEV credits. In the past, the ZEV credits added significantly to the gross margin. Including the ZEV credits, the gross margin was 24.8% for Q2 2013 and it was 23.9% for Q3 2013. Without these credits the margin slipped down to 14% in Q2 and 21% in Q3 2013. According to the shareholder letter for Q3 2013, this jump was achieved through "Strong average pricing, driven by more highly optioned European deliveries and a mix shift towards 85 kWh battery pack cars," in addition to, "process efficiencies, design improvements, and reduction of waste in the supply chain." Forbes mentioned in August of 2013 that the North American demand is shaping up to be 20,000 units per year with Europe and Asia both at 10,000 units per year. Although, as recently as Thursday, the 23rd, Elon Musk mentioned that the sales in China could match the sales in the U.S. by 2015. As long as Tesla Motors continues to sell only 85 kWh cars in China, they will have a rather healthy ASP and gross margin going forward. If Europe and North American sales stay flat, two-fifths of the global Model S sales will guarantee to be the higher gross margin cars. The most important thing to keep in mind with that is that Tesla is set to achieve 25% gross margins in Q4 without a single delivery to China. That gives me every expectation that once deliveries start in China, the gross margin could exceed 25% and potentially top 30%. This would be in conjunction with better pricing on materials because of higher production. Tesla currently pays more per part than other manufacturers due to the vast difference in production.

The reason why I am so focused on the 30% gross margin target is because that specific number is listed as an incentive for compensation to the CEO, Elon Musk. One of the qualifications is to have a gross margin of 30% for four consecutive quarters. Considering we know that Elon Musk is more focused on making the Gen III affordable and less focused on the gross margins for the vehicle, he has a small window to achieve in the four consecutive quarters. I believe that with the addition of the sales in China that goal might be achievable from Q1 through Q4 of 2014. The Model X is set to begin delivering in small amounts by the end of 2014 and more meaningful production in the beginning of 2015. If there are no hiccups along the way with supply issues this year, this is the best chance they will have of hitting those four consecutive quarters.

The pricing of the Model S in China was just released and it is extremely aggressive. The Mercedes S-class, which is also in the F-segment, is priced at $206,000 in China and only $93,000 in the U.S. This huge price hike is not because of VAT, taxes, or even shipping. It is because Mercedes can make double the profit in China. In a blog post on the Tesla Motors website, they outline the fairness of not charging more to consumers in China. I think this aggressive pricing also has a lot to do with Tesla wanting to hit the ground running in China. Elon Musk has mentioned that the Model S sells itself, so there is no need for the advertising campaigns that other automakers produce. When a consumer purchases a car, they give test drives to all of their friends and the consumer ends up acting as a sales representative. The quicker Tesla Motors can make a dent in the luxury car segment in China, the faster the brand will grow. In 2011, the Mercedes S class sold 31,000 units in China and their SUV family sold almost 55,000 units. This shows that the luxury SUV market is strong in China, and once people start to see the Model S popping up in wealthy areas, the Model X reservations will be even easier for Tesla to obtain.

Another reason Tesla will be welcomed with open arms in China is the recent smog issue that has impacted the ability for individuals and companies to acquire license plates. These programs reserve a certain amount of license plates for fuel-efficient cars which the Model S and future Tesla vehicles should qualify for. If China wants to work towards fixing the problem, Tesla will be one of the leading brands to promote the cause. It appears with the low price of the Model S compared to competitors, Tesla wants to get on the good side of China. This will open the door to the plethora of consumers in the country for future vehicles. Elon Musk commented in a phone interview with Bloomberg that Tesla Motors "would eventually build cars in the country." If Elon wants support from China, he certainly has taken the correct steps so far.

The recent run-up in stock price for Tesla Motors shows that investors are now less concerned with the minor fire incidents and more concerned with what lies ahead. There are quite a few upcoming catalysts for Tesla including the final decision from NHTSA, the announcement of the giga-factory and the Q4 Earnings. The price per share is less than 10% off of its all-time high and at last count the short interest is back over 30 million shares. This high number of shares sold short contributed to the 300%+ gains last year. Can Elon Musk force another "tsunami of hurt" on the shorts? If the market takes all of these catalysts positively, then we could get quite the ride in the short term.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TSLA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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