Tesla runs a lucrative operation
First, the positive. As Tesla Motors Inc (NASDAQ:TSLA) ramps up production, the company’s manufacturing process benefits from greater economies of scale. This, of course, is no surprise — it’s a basic rule of thumb in business. But to what degree will Tesla benefit?
Already, the company has “reduced the hours required to build a car by almost 40% from December to March,” asserts Tesla’s first-quarter letter to shareholders.
Tesla Model S undergoing assembly. Source: Green Car Reports.
This, along with a number of other benefits associated with scale and $68 million in sales (12% of revenue) of its zero-emission vehicle credits, or ZEVs, helped the company double its gross margin from last quarter, to 17%.
In the first quarter, Tesla Motors Inc (NASDAQ:TSLA)’s gross margin of 17.15% outperformed a number of auto manufacturers. Ford Motor Company (NYSE:F) , for instance, reported a gross profit margin of 16.21% during the same period — and that was on sales of about 1.5 million vehicles. To make this comparison fair, however, it’s important to note that Tesla’s core auto business’ gross margin was just 2% in the quarter, according to Morgan Stanley’s Adam Jonas. ZEV credits were a major contributor to the company’s 17% gross margin, says Jonas.
But here is where things get really interesting. In the first-quarter letter to shareholders the company reaffirmed its guidance for a gross margin of 25% by the fourth quarter of 2013, “assuming zero ZEV credit revenue”.
Valuation
Can Tesla Motors Inc (NASDAQ:TSLA)’s improving gross profit margin save the company from the Street’s lofty expectations? Probably not by itself, but it’s definitely a start.
A gross margin of 25% is about 1.46 times the company’s current gross margin of 17.15%. Taking Tesla’s first-quarter gross profit of 96 million and multiplying it by 1.46, Tesla Motors Inc (NASDAQ:TSLA) could earn a gross profit of 140 million every quarter at today’s revenue levels and with a gross profit margin of 25% — that’s 560 million annually. In other words, Tesla trades at 25 times a very conservative estimate of 2014 gross profit. Conservative or not, 25 times 2014 gross profit is a significant premium. Ford Motor Company (NYSE:F) trades at just three times its trailing-12-month gross profit.
It’s about expectations
Tesla Motors Inc (NASDAQ:TSLA) will need far more than gross margin improvements to grow into its valuation. Fortunately, gross margin improvements are not the end of the story for Tesla. Last quarter alone the company’s sales increased by 83% from the prior quarter. Can sales growth and gross margin improvement combined save the stock from its valuation?
The average analyst estimate for Tesla Motors Inc (NASDAQ:TSLA)’s 2014 revenue is 2.32 billion. Assuming a gross margin of 25%, Tesla’s gross profit would equal 580 million in 2014. At today’s price, that means Tesla is trading at about 23 times its 2014 gross profit, assuming a 25% gross profit margin and 2.32 billion in revenue (146% higher than Tesla’s trailing-12-month revenue of 945 million). This is definitely a lofty expectation.
As Tesla’s stock continues to rise, I’m withdrawing my buy recommendation. Importantly, however, I don’t believe this means current investors should sell. I’m a big believer in holding onto companies as long as they are meeting or exceeding my original thesis — and Tesla hasn’t failed me on that front. In other words, I don’t sell good businesses (no matter the valuation), but I do consider valuation when I make an initial buy decision.
As price increases relative to the underlying fundamentals, risk increases too. Tesla is too expensive to buy, but as a business firing on all cylinders I wouldn’t sell it and pay taxes on my gain yet either.
The article Is Tesla Motors Valuation Getting out of Hand? originally appeared on Fool.com.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Ford Motor Company (NYSE:F) and Tesla Motors Inc (NASDAQ:TSLA). The Motley Fool owns shares of Ford and Tesla Motors Inc (NASDAQ:TSLA).
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