Tesla (NASDAQ:TSLA) operates at the confluence of every major trend buffeting the automobile industry. For many of these trends, Tesla has been in the driver's seat. For example, it was the first to successfully produce a "sexy" electric vehicle with the Tesla Roadster, and it is widely perceived to be a leader in autonomous vehicle operations. This positioning has resulted in the attachment by Mr. Market of a sizeable valuation premium on the stock.
There are strong arguments to be made by both the Tesla bulls and bears on the virtue of this premium. While Tesla has positioned itself on the leading edge of the technological frontier, vehicles have been routinely delayed. Indeed, Tesla's CEO, Elon Musk, has essentially stated delays are a central tenant of the company's production philosophy (as a forcing function for rapid work). Even more importantly than delays, Tesla has experienced a rather disappointing launch of its latest car, the Model X. Delayed, overcost, and subject to numerous recalls, the Model X has hitherto been a mixed bag.
That being said, it is my opinion that these problems are not the reflection of a strategic failure, or of structural uncompetitiveness at Tesla. Rather, they are the manifestation of the company's growing pains as it seeks to upend and dominate the automobile industry. As Tesla continues to scale operations and gain critical experience, success will become increasingly plausible. The true test of the company will come with the launch of the Model 3 next year.
There are reasons to be optimistic about Tesla's prospects in scaling up production of the Model 3. Foremost amongst them is the fact that Elon Musk has significant relevant experience in taking on difficult and complex industrial projects. This was best seen in the case of SpaceX, where out of nowhere the company disrupted incumbents with the lowest cost, most capable offering in its Falcon 9 rocket.
To better explain Tesla's prospects, I will discuss the current market context facing the company, its positioning in this market, and ultimately, the outlook for the production ramp of TSLA's Model 3 sedan.
There are some huge opportunities in Tesla's targeted industries. The EV industry alone has been growing at a 60% CAGR over the last few years, with this high rate expected to continue for the foreseeable future. This is because electric vehicles are the most promising alternative to internal combustion engine powered cars. Given the paucity (to this point) of cheap, high-quality EVs, it would not be unreasonable to expect even faster growth rates in the future. If Tesla can capture significant market share in such a fast-growing sector, this would be a huge opportunity on both the top and bottom lines.
With the Model 3 currently slated for a late 2017 release (likely delays notwithstanding), only GM (NYSE:GM) is planning to release a long-range mass market EV competitor (the Chevrolet Bolt) first. Being one of the first can be an inherently dangerous proposition, however. On the one hand, there is the ability to capture a first-mover advantage in an industry, but on the other, the company will have to act as a guinea pig, and deal with the numerous unexpected obstacles inherent in pioneering a new market.
Luckily, we know that the concept is on sound footing as most major global automakers are investing heavily in the development of cheap, long-range, mass-market electric vehicles. Multiple companies with vastly different approaches to management and different business cases have all found a value proposition in EVs. For example, German automakers appear to now be jumping headfirst into the party. Mercedes (OTCPK:DDAIY) is aiming to produce an EV in 2019, BMW (BAMXY) in 2021, and Audi (OTCPK:AUDVF) is seeking to produce a new EV model each year starting in 2018.
Tesla does face some headwinds in the EV market, however. Currently, buyers of electric vehicles in the United States are qualified to receive a $7,500 tax credit. This tax credit was designed to phase out over time, with expiry coming with the sale of around 200,000 units in the United States. To date, Tesla has sold over 78,000 cars domestically. Given that pre-orders are almost double that of the expected credit limit, the loss of the credit could put a significant damper on demand - especially for a car like the $35,000 Model 3 that is targeting a much broader "stretch luxury" market.
That being said, Elon Musk has exhibited a mastery of utilizing public resources to stimulate the growth of his companies. As currently written, the credit remains available for vehicles sold in the same quarter during which the sales target is reached, as well as the following quarter. Recognizing this, Tesla will likely seek to optimize the timing of the vehicle's release, so as to maximize the number of people that can take advantage of this credit. This phase out has also had the advantage of further incentivizing people to place a Model 3 deposit to help ensure they will get the credit.
Recognizing these opportunities, Elon Musk has sought the operational scale required to successfully execute upon them. Consequently, Tesla's growth has been simply explosive. Since launching the Roadster in February of 2008, Tesla has grown revenues at a compounded rate of 122% a year. The company has consistently and single mindedly focused upon growth even at the expense of profits. One can see the effects of this today, with a Q1 2016 net loss of more than $282 million.
The latest manifestation of this growth is the company's simultaneous efforts to build one of the world's largest factories while also attempting one of the fastest production ramps of any vehicle, ever - even the Ford (NYSE:F) Model T. Insanely, this ramp is to occur on an accelerated schedule from the company's already extremely ambitious plans. From an initial plan of producing 500,000 cars by 2020, Tesla is now aiming to produce 500,000 in 2018, and a whopping 1 million by 2020.
This effort will be enabled by Gigafactory 1, the foundation of Tesla's plans to achieve a 30% reduction in battery costs (far and away the single most expensive component in an EV) through the vertical integration of production. It will assemble the lithium-ion cells produced by Tesla's partner, Panasonic (OTCPK:PCRFY). This is ultimately designed to enable Tesla's goal of producing more than 500,000 vehicles a year by 2018, as well as having batteries available for usage in stationary energy storage applications.
There exists a great deal of uncertainty regarding the company's Gigafactory plans. As covered elsewhere on Seeking Alpha, the current building occupies a relatively small fraction (~14%) of the originally stated size. While Tesla is likely seeking a close temporal match of its battery assembly capabilities with battery demand, the ultimate size of the factory - and the resultant cost savings achievable through scale - remains an open question. The factory is definitely moving ahead though. Panasonic recently announced a major series of hires to help facilitate battery production.
Crazy as it may seem, massively scaling production is fundamental to ensuring the company's survival. At current production levels, Tesla appears to be losing money on every vehicle sold - as measured by net income divided by units sold. However, these losses are driven by largely fixed operational costs. Such costs do not scale linearly with each additional unit sold. As Tesla's production volume increases, operational margins should also increase as the company takes advantage of the economies of scale. Indeed, gross profits, a more accurate reflection of the physical cost to produce a car, have been consistently positive. This argument was laid out well by Kumquat Research, here.
Recognizing this, Tesla has made considerable investments into preparing for future operational scale. Besides continuing the build out of the Gigafactory, Tesla is also scaling up its R&D and SG&A expenses in preparation for future growth. The company also recently completed a major upgrade to its paint shop that will help enable 2018's 500,000 vehicles a year production target. All told, capital expenditures have totaled more than $3.5 billion since the beginning of 2013.
The importance of this ramp is made doubly important by the relatively small addressable market for the luxury class Model S and Model X vehicles. Tesla estimated there are sales of large luxury vehicles in the United States of just 100,000 a year. Tesla has already captured a meaningful share of this market with its Model S.
Furthermore, Model S demand may be flatlining, as highlighted by Paulo Santos. In response, Tesla appeared to be forced to reduce prices by offering a new entry level Model S 60 (powered by 60 kilowatt hour battery) for significantly less ($66,000 vs. $71,500) than its previous 70 KwH version. This comes even as the cost to Tesla of making for the two vehicles appear to be comparables, as they all ship with 75 KwH batteries with an optional upgrade for full utilization in the cheaper version. Initiatives such as this will continue to put downward pressure on margins in exchange for a broadening of the addressable market.
Continued scaling of the Model X, along with ironing out of the car's early kinks, should help boost Tesla's share of the large luxury vehicle market. Even so, this is unlikely to provide enough volume to boost Tesla into profit alone. That would require a vehicle that can target the large global upper middle class - the Model 3. This requirement is a fundamental feature of the company. Indeed, it has been part of the "secret master plan" of the company since at least 2006.
The massive nascent demand for such a vehicle has been demonstrated by the number of deposits placed after the Model 3's unveiling. To date, there have been almost 400,000 deposits of at least $1,000. This funding is technically refundable, limiting its potential for usage as a source of cheap capital - any usage will require a significant margin of safety. That being said, this money should marginally boost the probability of success by improving liquidity.
Moreover, Tesla also recently raised $1.4 billion by selling equity in the capital markets. Capital expenditures can be expected to be massive if the company is to even come close to achieving its goals. This funding should boost an already significant cash pile to approximately $2.5 billion today. Even so, future capital raises are a very real possibility. So far, markets seem to be relatively forgiving of this dilution. The stock price has risen from $207 per share to around $215 a share today.
Will the production ramp succeed?
Investors facing such an unprecedented production ramp will naturally question its chance of success. To do so, they will likely have looked at the most recent product launches. In the case of the Model X, this may be deceptively unfavorable for Tesla. The problems experienced by the Model X launch do not doom the Model 3.
The Model X was launched in September 2015, after having initially been planned for early 2014 delivery. It has incorporated novel features such as Falcon Wing doors and a "Bioweapons Defense Mode", as well as offering industry-beating acceleration in the package of a crossover SUV. As a car, it has been largely well received, with a generally favorable tone on the Tesla Motors Club online forums.
Aspects of the launch have been rocky, however. The car has experienced some quality control issues with several components in the vehicle, necessitating expensive recalls and servicing. Many of these problems are with early production models of the car, and will likely be sorted out as Tesla continues to ramp up production and iron out the kinks. Additionally, longer-term problems have also begun to appear in the Model S - problems that may potentially afflict the Model X in the future. This was highlighted by the news that the NHTSB is collecting information on the apparent suspension issues that some Model S customers have begun to experience.
These problems are likely unique to the Model X, as highlighted in the below quote by Elon Musk from the latest conference call:
"So with the Model 3, as I mentioned on the last earnings call, we're really trying to take a lot of lessons learned from Model X, where Model X, we put a lot of bells and whistles on Model X and a lot of advanced technologies that weren't necessary for version one of the vehicle. And with Model 3 we're being incredibly rigorous about ensuring that we don't have anything that isn't really necessary to make a very compelling version one of the car. We also have a much tighter feedback loop between design engineering, manufacturing engineering, and production."
This is hugely important. Tesla bears have highlighted the significant scale and low margins required by traditional automakers to mass produce cheap cars. Given Tesla's relatively small size, these problems are seen by many as insurmountable. Size may not be the primary determinant of a company's ability to mass produce a product, however. Rather, I believe that success in this arena is driven by process. Importantly, Elon Musk has exhibited a mastery of process at both Tesla and SpaceX (Private:SPACE).
For example, when building the Falcon series rockets, SpaceX has had a single-minded focus on lowering the cost/kg of mass to orbit. The result has been astounding. Since conception in 2002, SpaceX has taken a commanding role in the commercial launch industry - an industry which the U.S. had almost entirely abandoned in the decades before. This has acted as a wake-up call for competitors internationally, as the once dominant Europeans seek new, more competitive launch vehicles.
SpaceX was able to accomplish this through its design philosophy, and production excellence - as described in the above quote. Rather than attempting to simply build upon the approaches that had worked in the past, every problem was attacked from a "first principles" perspective - what was the parameter to be optimized (COST), and what were the theoretical and practical limits on this optimization?
Consequently, the company brought production in house, pressured suppliers to lower prices, and designed a proprietary rocket engine (the Merlin) that could be largely 3D printed, and easily mass produced at low cost. This Merlin engine was then used for every application in the rocket family. Nine identical Merlin engines were used to power the first stage while a slightly modified version was used as the basis for the upper stage.
Furthermore, rather than opting for the exhaustive bureaucratic approach to upgrading its rockets, SpaceX opted for constant iterative improvements and testing as it went along. Reusability, for example, was tested upon completion of a primary mission as opposed to conducting an entirely separate launch. This enabled lower-cost technology development, and faster release cycles.
This fresh perspective has enabled the company to offer a significantly lower price to geosynchronous orbit (GTO) than any other competitor, as seen below. These prices don't reflect the potential for continued launch price deflation on the back of first stage reuse. SpaceX is currently planning to relaunch one of the four first-stage cores that have been landed, sometime in the fall.
Importantly, rocketry is another relatively low-margin industrial market. Indeed, rocketry is one of the few sectors wherein the products are significantly more complex than designing automobiles. There are a huge number of parts that all must act in near perfect unison or the entire product will be lost - at extremely high expense. Management structures must be developed to enable ready information sharing and fast, yet comprehensive checks on the status of company products.
Given Elon Musk's success in leading SpaceX in a sector with such characteristics, it is easy to see the potential positive spillover effect of this knowledge. Indeed, culture is frequently said to start at the top of the company. Luckily for Tesla, the CEO and chief product designer are the same for both companies (Elon Musk), as are many board members. If Tesla can continue to successfully apply the methodologies and approaches developed at SpaceX, the Model 3 will be an unabashed success.
Glassdoor reviews, a powerful but imperfect measure of a company's culture, are generally favorable at Tesla, with a mean rating of 3.6 out of 5. This rating is comparable to other major automakers. The main downsides are stated as a lack of work life balance and long hours. While this can pose a problem to companies through employee burnout, in Tesla's case, it is part of the brand. The "Musk Factor" enables Tesla to attract the best engineers in the world, and incentivize them to put in the work required to accomplish great things.
Indeed, this was seen recently with Tesla's recent hire of Peter Hochholdinger, a long-time production executive at Audi. He is acting as a replacement for two senior production executives who have since left the company or are on the way out. Peter will help to oversee Tesla's manufacturing Model 3 manufacturing efforts. To do so, he will utilize his experience ramping up Audi production in Mexico, and overseeing the manufacturing of over 400,000 vehicles a year.
Finally, investors should recognize the hugely beneficial impact of Elon Musk's brand and relationships in Silicon Valley. Partially as a response to this, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) is essentially backstopping Tesla's credit. This can be seen in some of the dark days of 2013, when the company was on the verge of going under with only two weeks of cash remaining. Elon Musk's friends at Google - Larry Page and Sergey Brin - made a friendly buyout offer for the company. This ultimately proved unnecessary when the company got Model S production under control, and sales skyrocketed.
This just goes to show that while cash burn will continue to be considerable, Tesla as a company is in no risk of going under. Indeed, the founders of Google have shown great faith in Elon Musk, with GOOG taking the lead in a $1 billion investment round into SpaceX last year. Should Tesla need additional funds, it will either have access to public equity markets, or private capital from Elon Musk's network.
Valuation and Conclusion
In summary, Tesla's prospect hinge upon successfully launching the Model 3. There are relevant arguments to be made by both longs and shorts on the probability of success here. Ultimately, it is my opinion that Tesla is well positioned to accomplish its goals - just maybe not in the time frame laid out in the last conference call. Success in ramping up the Model 3 would be a major boon to Tesla's shareholders.
Furthermore, there are two relevant aspects to the current Tesla valuation. Firstly, the valuation still appears to be pricing Tesla as if the company will witness flawless execution on its potential. As with most things in life, perfect execution is unlikely. Rather, the tendency appears to be towards somewhere in the middle. And secondly, investors seem to be treating Tesla as a tech company, not an industrial player in a competitive, low margin, mass market industry. Whether this continues to be the case will have a significant impact on TSLA's valuation moving forward.
I currently hold no position in this company, however, I may initiate a small position in the company in the near future. Given the significant near-term uncertainty, especially with regards to capital expenditures, it may be wise to look to short duration options so as to hedge a speculative long position in Tesla.
Disclosure: I/we 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.