Tesla: A Valuation Model For A High Gross Profit Automaker

| About: Tesla Motors (TSLA)

Summary

Tesla gross margins as a percent of sales are higher and likely to continue to be higher than they are for other traditional car companies.

Tesla’s price seems to reflect an expectation of traditional SG&A costs.

Tesla’s guidance for the growth rate of gross margin is also driving price.

A model of Tesla’s price per share is offered that depends upon next year’s adjusted earnings and a growth rate forecast.

Introduction

Tesla (NASDAQ:TSLA) currently has a market capitalization of $31 B and a 2014 sales run rate of $2.8 B. Compare that to a car company like BMW, another luxury car manufacturer, whose sales are roughly 36 times larger but the market cap is only 2.3 times higher. How has the market assigned so much value to Tesla, which is currently unprofitable? The answer is potential, and this article will focus on the principle reasons for Tesla's high valuation and develop a model for pricing going forward. Any model developed will be oversimplified yet hopefully can provide some guidance on future prices. The focus will be on treating Tesla as an automotive company rather than a battery or energy storage company as some others have done. Briefly stated, there are several reasons for Tesla's high value to investors.

  • Even with low production volumes, Tesla's gross profit percent of sales exceeds that of traditional automotive companies
  • Tesla's SG&A as a percent of sales will likely be no greater than it is for traditional companies
  • Guidance from Tesla calls for a very rapid growth rate of gross profit.

Gross profit for Tesla and other auto manufacturers

Like most companies in Tesla's early stage of development, the strategic focus is on growth. Consequently, gross profit dollars, defined as revenue minus cost of goods sold (COGS), is being funneled back into growth drivers, such as pushing into new markets like China and England, and new product development such as the Model X or right- hand drive vehicles. For these reasons, SG&A dollars as a percent of sales are high to fund rapid growth. The equity market understands this and doesn't let it detract from equity price. Rather Wall Street's focus is on current and future gross profit numbers and, compared to the other large automotive players, Tesla is large in this respect. Consider the following table which shows the revenue and gross profit numbers for Tesla and 4 traditional automakers. Tesla's numbers are shown for both 2013 and the first half of 2014.

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For BMW and Toyota today's exchange rates of 1.32 $/Euro and 103.9 Yen/$ were used.

The table shows that in 2013, when Tesla sold only 22,500 vehicles, its gross profit % exceeded that for the other car manufacturers. In the first half of 2014, with production rates up about 50% over 2013, the gross profit percentage is up nearly 4%. It is normal for COGS to fall as production numbers increase. Fixed costs per vehicle and component purchasing prices drop as production volume increases. Tesla's gross profit will likely continue to increase as production volumes increase and extend its gain over the likes of BMW and Toyota.

As evidence of continued growth in gross profit, the second quarter 2014 margin was 27.7% and in the last quarter of 2014, vehicle production will rise to a rate of 50,000/year. This information is from Tesla's last 10-Q filing, where it also said "Higher production volume, manufacturing and supply chain efficiencies and component and cost reductions contributed to the year over year increase in gross margin." With high expectations for production growth, gross profits are likely to continue to exceed the automotive pack. Starting in 2017, when initial production of battery packs are scheduled to be produced in the new Tesla Gigafactory, gross margins for Tesla are likely to increase further. As Tesla has targeted a 30% reduction in battery pack costs and estimates of the current battery pack are about 15% of price or 20% of cost, an additional 6% of margin could be added by then. That could establish Tesla's profitability in the range of the best high tech companies and well beyond that of traditional car manufacturers.

SG&A for Tesla and other auto manufacturers

Net income before taxes for a company is approximately equal to gross profit minus SG&A, where R&D costs are included in that figure. In the first half of 2014, Tesla reported an SG&A of $440.8 M, or 32% of sales, which exceeded their gross profit of $368.1 M, generating a net loss. Growth in SG&A dollars is currently high to enable entry into new markets and pay for product development, associated with the new Model X and design adjustments of the existing Model S for right-hand drive markets like the UK and Hong Kong. However, as sales grow, SG&A as a percent of sales will to come down dramatically.

SG&A in 2013, for the traditional companies mentioned above, ranged from 8% for GM to 9.5% for Toyota and BMW. Ford is in between at 9.0%. It will take years for SG&A for Tesla to come in line with these other manufacturers, but the market price for Tesla seems to depend upon that happening. With potential gross margins at 30% and SG&A running under 10%, Tesla could have a net income before taxes of about 20% and that number, which is superior to any car company and most other companies in general, is driving its valuation.

The uniqueness of Tesla's business model could drive a lower SG&A than its automotive competition. Sales costs per vehicle should be lower due to its online approach to sales. Further, its plan to retail its cars with small, no inventory stores and create demand without spending on advertising could keep selling costs low. After it completes its introduction of its current 3 planned models (the S, X and 3), product development costs could drop dramatically. Further its approach of downloading software into its models to update them, rather than replacing hardware to make them seem more current, suggests that model upgrade costs will be reduced. The automotive companies typically spend less than 4% of sales on new products (Toyota for example spent 3.7% of sales on R&D in 2013) and in the not too distant future, Tesla could come in below that.

A Financial forecast for Tesla

Tesla's revenue has been growing rapidly and its gross profit has been growing even faster. The 2013 gross profit is 15 times larger than the 2012 number due to the success of the Model S and other factors. That growth rate will not continue, but it will likely continue at a fast clip. The guidance given by the company suggests that Model X, an SUV, will be introduced in 2015; the lower cost Model 3 will be introduced in late 2017 or early 2018; and the Gigafactory will start production in 2017, coming to full output of batteries capable of supplying 500,000 vehicles by 2021. Based on this guidance from their most recent 10-Q and conservative assumptions on gross margin %, an income statement forecast, down to the gross profit level, through 2020 can be developed. The table also includes projections of common share quantities, where it is presumed to grow at the same rate as it has in the past several years.

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In this projection in 2020, Tesla sells 400,000 vehicles or roughly 0.4% of the global market at an average price of $70,000 with a gross profit percentage of 30% for a 10 fold increase in gross profit over 2014. Gross profit estimates are conservative in light of the previous discussion.

The valuation model

So back to the original question: what sets Tesla's valuation so high? Further, how will it change going forward? As Tesla has a net loss, a simple multiple of a P/E is not meaningful. Basing it on a projected 2015 gross profit reduced by a future projected SG&A of 9.5%, would suggest a P/E multiple of 60 using an after tax estimate. The SG&A adjustment assumes the market is taking this projection into account. I will refer to this as 'adjusted earnings' going forward.

This adjusted forward P/E of 60 is roughly 4 times a more standard multiple of 15. Any model of price for a fast growing company like Tesla would have to account for the higher than normal growth rates. The abbreviated income statement table above suggests a gross profit CAGR of 45% from 2015 to 2020. Using the P/E standard multiple of 15 as stated earlier and proposing that the price will go up linearly with the CAGR for gross profit, the model can be expressed as follows:

Price = 15 x adjusted earnings x CAGR/k

Where k is a constant equal to about 11 and derived from an approximate current Tesla price of $250. The value of 11 suggests that Tesla will enjoy a price premium as long as growth in gross profit exceeds 11%, a realistic assumption.

This pricing model suggests the following

  • Price can increase based on either or both an increase in next year's adjusted earnings or an increase in revenue that leads to a more rapid increase in CAGR.
  • In the future, it is likely that adjusted earnings will increase quickly and that the CAGR will decrease as unit car sales increase. The competition between the two will likely determine whether price increases or decreases.
  • It is possible that gross profits will increase dramatically when production rates exceed the 50 K/year rate, forecasted for this fall's production. If the 10-Q issued in Feb. 2015 indicates a gross profit percent of 30% or higher, expect a bump in price comparable to the increase in gross margin from last quarters value, about 10%.
  • The market reception of the model X and the model 3 will ultimately determine growth rate expectations. Market views of these factors will impact price in the short term due to the impact on the CAGR factor.
  • Based on the gross profit increase in 2016, relative to 2015 and assuming a constant 45% CAGR, a price for 2015 of 300 is predicted. Again, though if gross profits exceed my conservative forecast, price would be higher.
  • I believe that the market will require that Tesla achieve SG&A numbers close to 10% once the car company starts selling in the low hundred thousands of vehicles. This means they have about 3 years to achieve these numbers before Wall Street starts getting nervous and lowers price targets. Once the model 3 is introduced, % SG&A needs to become more similar to that of other car companies.
  • If in the future, Tesla's growth rate drops below 11%, then P/E's multiples will drop below 15, as it for most other car companies. Ford's current P/E is 11.

The model is admittedly an over simplification yet highlights key valuation points. But the basic focus on relating share price now and in the future to high gross margins, an expectation of more traditional SG&A costs and a strong growth rate, are important items to consider when investing.

Additional disclosure: This article is solely the opinion of the author. TSLA is a high volatility stock. Please consider the information provided, but always make your own decisions when investing in securities.

Disclosure: The author is long TSLA.

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.

Additional disclosure: I purchased TSLA at 38 in January 2013 and am hoping it appreciates enough for me to sell eventually to buy one of their cars.