There's A Lot More Fuel In The Tank Than You Think

Aug.26.14 | About: Tesla Motors (TSLA)

Summary

Two catalysts that will increase gross margin and translate to a higher net income.

Tesla's efforts to increase capacity and reduce costs of components will result in higher gross margin.

Strategic partnerships will slowly become a significant revenue source for Tesla.

Overview and Thesis

Tesla Motors, Inc. (NASDAQ:TSLA) designs, develops, manufactures, and sells electric vehicles and electric vehicle power train components. The company operates a network of 80 stores and galleries in North America, Europe and Asia. Tesla differentiates itself from competitors by the ownership experience that it provides to its customers. Tesla recognizes its revenue mainly from sales of Model S and Tesla Roadster, including vehicle options, accessories and service.

We will soon witness a change in TSLA's revenue breakdown and see the share of revenue gained by sales of batteries increase along with an increase in partnerships with peers. The increase of revenue, sourced from these two catalysts, along with a significant reduction of costs of batteries will translate to a stronger gross margin, which will drive higher growth of net income.

Capacity and Cost Reduction

TSLA plans to build a gigantic battery manufacturing plant (gigafactory), which will answer the need for more batteries due to increasing demand for Tesla vehicles, and the need to reduce the cost per battery. We've all heard different opinions and discussions regarding the gigafactory, but there's one detail that we can all agree on. It's not a question of if, it's a matter of where and when. Let's leave the discussion of the whereabouts of the factory aside and try to focus on how the gigafactory will benefit TSLA. With the continuing increase of demand for TSLA vehicles, domestically and globally, it is undeniable that TSLA will have to present a solution for the need for more batteries, the necessary batteries' cost reduction, and the great potential that TSLA has to become a supplier in this field.

TSLA announced that the company should achieve an annualized delivery rate of 100,000 cars by the end of 2015. In order in to increase the chances of doing so, TSLA completed a new final assembly line and added additional automation in its Fremont factory body shop. Those improvements increased TSLA's manufacturing capacity to produce more than 1,000 vehicles per week. Moreover, this line of assembly is flexible enough to build both Model S and Model X. The company is seeking to further improve its capacity by upgrading its paint shop and building a new body shop. All that is left to talk about is the batteries.

The cost of the batteries is an ongoing concern that TSLA has been trying to deal with from the beginning. Although its battery costs are considered the best-in-class, when a company aims to increase volumes as sharply as TSLA, it has to reduce costs in order to create a profitable process. As of now, it seems that by 2020 TSLA will be able to reduce the cost per battery by more than 30% at full capacity. Tax benefits aside, considering this planned significant cost decrease, the rise in revenues as a batteries supplier and the surge in demand in Europe and China, I believe that TSLA shouldn't only achieve its 500,000 batteries per year target for 2020, it must get to this level of manufacturing if it wants to compete equally with the big players. TSLA chose wisely to partner up with Panasonic, due to its lack of experience in the production of lithium-ion cells, and because of the division of capex, which will end up being at around $2bn out of a total investment of $4-$5bn. I believe that the gigafactory is one of the cornerstones for TSLA's future success and that reducing cost of components is an important goal in order to maintain a sustainable leading position in the global EV competition versus peers such as BMW's i3 EV.

Strategic Partnerships:

Strategic partnerships can generate significant revenue to any company; you just need to find the right partners. Besides creating enemies, a company should also make alliances in order to create additional revenues sources. Due to its vast knowledge and experience in the field of EV, TSLA joined in some strategic partnerships in order to recognize more revenue. Well, now it's time to enjoy the fruits of those agreements. Daimler engaged in an agreement with TSLA in the fourth quarter of 2011, which said that TSLA will assist Daimler with the development of the Mercedes-Benz B-Class EV. The agreement was based on TSLA's success to complete and deliver Daimler prototype samples. The successful completion of the prototype would gain the company $33.2mn in revenue. According to 2Q14 report, TSLA managed to deliver prototypes to Daimler and recognized revenues of $10.2mn and $2.8mn in HY2013 and HY2014, respectively. Although $2.8mn seems to be an insignificant addition for TSLA's revenue, we have to recognize two advantages. The first advantage is an additional source of revenue that will be added to TSLA's sales breakdown from this particular partnership. The second advantage is the recognition of TSLA as a leader in its field and the need of other auto manufacturers to use TSLA's development services and establish long-term profitable partnerships.

Another successful strategic partnership was with Toyota (RAV 4 EV program- July 2011) and is planned to end in FY2014. According to the agreement, TSLA supplies validated electric powertrain systems. I am assuming that we are all familiar with this long lived agreement (and its details), so let us focus on the results. In HY2013 and HY2014, TSLA generated revenues of $27.7mn and $31.3mn in automotive sales revenue, respectively. Once again we see a successful partnership that generates solid revenue for TSLA. I cannot further stress (than I already did) the importance of these partnerships and their great potential for future supplying agreements.

Conclusion:

All in, I believe that although TSLA is a company that many people love to hate, in order to better understand the company we have to step out of the box and try to think about where does the Palo Alto car manufacturer is heading to in the next 5-8 years. We are witnessing a significant surge in global net orders of the Model S, which is mainly driven by stronger footprint and increasing consumer awareness. Tesla in constantly improving its Supercharger network in order to decrease concerns of drivers regarding the time that it takes to charge the battery, and the distance that a Tesla can go for. Furthermore, bullish analysts like me expect a hockey stick increase of sales in China. And if this is not enough, the numbers can talk for themselves, the company improved its gross margin for the three months ended 30 June, 2014, to 27.7%, which shows a solid improvement from the 24.8% level same period last year. When you factor in all these components, and include the possible increase of sales due to the launch of the Model X (in 2015), you come to realize that TSLA has more upside than people think. An increase in gross margin is, and will be, mainly driven by higher vehicle production volumes, manufacturing and supply chain efficiencies, and components cost reductions. All that TSLA needs to do is to maintain its performance and live up to its promises.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.