(By Mani) The margin visibility of Tesla Motors, Inc. (NASDAQ: TSLA) is likely to remain low for some time, given the volatility in vehicle mix. Vehicle mix may weaken in the second quarter given higher penetration of lower battery sizes and regulatory credit revenue, as well as cost reduction uncertainties.
Tesla has massive operating leverage, but it is unlikely for the electric car maker to hit its 25 percent gross margin target until volumes move above 25k units per year.
The management also back-tracked somewhat from their previously stated outlook of 25 percent gross margin for fiscal 2013, now saying that gross margin will "continue to improve towards our 25% target by year-end."
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"We believe volume will remain solid, although current order flow (including an expectation that Europe gets up to US levels when deliveries begin in Summer 2013) implies low-20k unit annualized range in the near-term (current production is at 20k now)," Deutsche Bank analyst Rod Lache wrote in a note to clients.
In order to display its operating leverage, Tesla may need to wait until the Model X launch drives higher volume in late 2014, with earnings and cash flow hovering around zero until then.
Clearly, the fourth quarter was an incredibly complex period for Tesla as production ramped 8 times versus third quarter and costs are running higher-than-expected.
The fairly significant variance in capex and continued operating cost increases are likely to hinder investor confidence in management's ability to predict the near-term margin profile.
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"We'd also note that the substantial cash burn in Q4 and the lower gross margin expectations are likely to spur expectations that another capital raise may be necessary in the relative near-term," Lache noted.
The company ended 2012 with cash of $221 million, Dept. of Energy loan required pay-downs are about $55 million.
"Although Tesla is not including the credits (regulatory) in their 2H13 outlook, we believe they will continue to be a meaningful benefit to earnings and cash flow during this transition period and potentially over the long-term although likely at a lower level than Q4," Lache said.
These credits are currently generated when Tesla sells vehicles in Arizona, California, Connecticut, Maine, Maryland, New Jersey, N. Mexico, NY, Oregon, Rhode Island and Vermont. They are sold to automakers who are non-compliant with Zero Emission Vehicle (ZEV) quotas in these states.
In its 10-K filing, Tesla said revenue from these regulatory credits at essentially 100 percent margin was $40.5 million in fiscal 2012 compared to $2.7 million last year.
However, generation of these credits will likely come down as Tesla's geographic sales diversify (i.e. Europe in the second half) and as average battery size decreases. Demand could also fall as many OEM's are introducing EV's in the U.S. over the next 12 months that are partially targeted at improving ZEV compliance.
In addition, questions surrounding the solidity of Tesla's backlog will likely continue. The company appears to be experiencing relatively substantial deferrals and cancellations, which has compressed order-to-delivery times for certain vehicle configurations. This may not subside until a U.S. leasing program is announced and/or European deliveries begin in earnest later this year.
On the valuation front, upside is possible, but would require a view that volume can get to the 40k – 45k range and a multiple of 10 times, which would imply a stock price in the $51 - $64 range.
"We just don't expect visibility on that level of volume in the next 12 months. Therefore, we would wait for a better entry point to become constructive on the stock," Lache said.
On a long-term view, the stock is a good bet as it has developed a disruptive product and a strong brand name. Its customers are diverse and passionate and are acting as "evangelists" for the car and the company. Over time, Tesla's initial product, which is supposed to have exceeded all expectations as far as performance and technology, will improve in terms of quality, refinement, and driving range.
In addition, improvements in manufacturing efficiency and lower battery costs will lead to lower production costs at the same time that competitive products will likely experience cost inflation.
But, as of now, iStock believes investors should remain cautious on Tesla shares given low visibility on near-term margins and expectations of a secondary offering.