Tesla Motors (NASDAQ:TSLA) is already a remarkable case study. Certainly, it will cause further concern to many over-cautious investors who think that its stock price is exaggerated. In any case, the company has under development a major project that shareholders welcome. And the admiration for its business plan is so striking that it looks like that long term is not so far away.
I have no intention of deeply analyzing the recent 4th quarter report. This work has already been done in other articles. Instead, I will give my opinion about the likelihood of success that may be attributed to Tesla in the long run. For me, current share price of around $250 means that investors are anticipating profit levels that will probably take place within years. For that reason, many people think that there is an ongoing large-scale bubble concerning the value of Tesla shares. With this article I intend to assess whether the price of its shares is irrational or reflects an adequate and smart bet on the future.
First of all, let's look at some metrics that will help us measure Tesla's current market valuation. With Price/Sales of 15, Price/Book of 46, EV/EBITDA of 668, and a forward P/E in December 2015 of 63 - all these ratios may identify a growing company. They are very high and will only be acceptable for a company with huge potential, and whose profits will tend to materialize accordingly. This is precisely the situation we can find in Tesla.
Electric Vehicles and economies of scale
As of 2014, the up-front purchase price of electric vehicles (EVs) is significantly higher than conventional internal combustion engine cars. The primary reason is the high cost of car batteries. However, battery prices are coming down with mass production, and are expected to drop further. Tesla uses its own laptop battery technology for the battery packs of its EVs, which are 3 to 4 times cheaper than dedicated electric car battery packs of other auto makers. This could drive down the battery costs from $700-$800 per kilowatt hour to under $200 over time.
Battery packs using small laptop cells will drive down the cost of Tesla's electric cars. This is crucial as around 70% of buyers would consider buying an electric car, but they are unwilling to pay more for it.
Thus, reducing electric car prices is mandatory for three main reasons:
1. To try to become more competitive and attractive than traditional cars
2. For obvious reasons of commercial competition in the area of electric cars
3. In order to translate the reduction of battery prices in face of technological breakthroughs
One thing is certain: all brands are now losing money on their EVs, which is understandable for being in a launching phase, and to encourage buyers. However, we must not forget that all brands have many other models that make this situation affordable. But Tesla is not going down this path. As an innovative company exclusively in the production of EVs, its purpose is putting technology to work for its core business, and to make profit from it.
However, something else has to be emphasized. The company was listed at a time of crisis - on June 29, 2010, and managed to hang on well. Tesla has been the first American car maker to go public in half a century, and priced the IPO at $17 a share. It was a courageous step of a very innovative company when almost everybody would think that there was a very limited market for Tesla's cars.
After placing in the market Tesla's top-end roadster, and a mass market Model S sedan, it is significant that the company is preparing the launch of a smaller car. While being very interesting to buyers, it will reach Tesla's goal of producing a real mass market electric car in approximately three years.
The basic issue for the viability and profitability of TESLA is not the extrapolation of current margins, reaching a misleading conclusion about the difficulty of a future EV to be offered for less than $40,000. The key issue lies in the dimension of the production, the huge economies of scale, and decreasing battery cost due to ongoing innovation. We can be sure that unit costs will fall greatly, and that innovation will also help to bring prices dramatically down. Several factors should contribute to the proper progress of the project - management, innovation, global economic situation, cost of materials, and regulations on CO2 car emissions.
In the auto industry, a large proportion of revenue comes from selling automobiles. The parts market, however, may be even more lucrative. Another significant portion of an automaker's revenue comes from the services it offers with the new vehicle.
Tesla is planning to build a ~$5B large scale factory. The company will invest ~$2B in cooperation with strategic partners like Panasonic (OTCPK:PCRFY). The Gigafactory is the way to successfully fulfill its production targets and reduce costs through a strong economy of scale. By 2020 it will produce more lithium ion batteries annually than were produced worldwide in 2013 with a cost reduction in excess of 30%.
Base Case Scenario
Let's now consider valuation. EPS's analyst average estimate is currently $1.90 for 2014 and $3.91 for 2015. Clearly, the average estimate of analysts who follow the company is more optimistic than my projection. Indeed, even at an early stage, analysts predict an average increase in EPS of more than 100% from 2014 to 2015. The growth rate in EPS that I use is less than one third of that percentage.
I'll make an approach to the probable value of Tesla's stock at the end of 2020. It is a long enough period to validate or not its current market price. The table below shows EPS growth since 2014 until 2020, which represents a CAGR of 31.9%.
Following what has been stated above about sales, we may have net sales of ~$20B with 425,000 EVs sold in 2020, and other sales accounting for 30% of the total. Using a net margin of 7%, the company will get a net profit of $1.4B and EPS of $10.00. I'll take an adequate multiple of 30x earnings because Tesla, in all likelihood, will continue to grow well beyond 2020. Then, at a 30x multiple against $10.00/share, we arrive at $300 per share by 2020.
It is noteworthy that I have considered a 15% increase in the number of shares outstanding which in consequence would rise to around 141.22M in 2020.
Worst Case Scenario
However, one must be realistic. This investment project entails considerable risks:
1. The demand for EVs may prove to be insufficient to make the project as profitable as expected despite achieving huge economies of scale.
2. Competition is fierce and will increase as time passes by, with sales and margins being hurt by this situation.
3. Net margin can be much lower than I have anticipated above. In 2020, if Tesla will not get a net margin higher than 3%, for example, and if increased dilution will reach 30%, share price may fall to $115 per share at best.
Best Case Scenario
But instead of this negative outlook Tesla can emerge as a real and successful game changer. If the company could become much more than an innovative factory of EVs, revolutionizing the base of several industries, its potential would be truly astronomical. I believe that if this could happen Tesla would be much more than a case study. Indeed, if a new innovative American company would call into question the established industries (oil, auto, electricity) then its valuation would become something larger than we can now anticipate. At this time, we can only discuss if that possibility may become reality in a more or less distant future. However, this revolutionary scenario doesn't yet have a realistic support base. Even so, the mere possibility of a limited development at this level may lead us to think of Tesla's value in the range of many hundred dollars per share.
Charts courtesy of StockCharts.com
At this stage, the technical analysis is almost done by itself. Indeed, it's sufficient to look at the chart to confirm Tesla's stock potential. It's only important to mention that it has only taken 6 months for shares to rise 400% (between April and September 2013). From late November until now they have doubled in value. In line with what I have stated the potential is positive especially if crucial factors materialize.
Tesla has a courageous and very innovative investment project. If market grows in line with expectations, the company has the technical capacity and the financial resources to be a great success. I think that when Tesla CEO Elon Musk discloses its partner members on the Gigafactory project one may be sure that the company's relevance and credibility will grow even further.
However, we are in almost unknown territory, and although risk/reward is favorable, projections may lead to a level of remarkable uncertainty.
To be completely honest, the model "E" and other new models are still shrouded in a lot of doubts so that they can become profitable enough. Everything will have to go well: the Gigafactory construction, market expansion, price competition, achievement of huge economies of scale, and mass production of low cost batteries.
It's an exciting long-term investment, but with serious obstacles along the way. Nevertheless, Tesla is acting quickly and is minimizing the natural uncertainty of the future. While seeing a promising risk/reward I'm still in the sidelines waiting for a possible entry point.
One last note. Tesla may prove to be a technological revolution not only for the automotive industry but also for other energy-related sectors. We may be dealing with a potential gigantic business that cannot be properly measured now but that may have a huge value in the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.