Thesis and background
After 2021, there should be no doubt about the profitability of Tesla (TSLA). As announced in the company’s recent earnings report (emphasis added by me):
In 2021, we achieved the highest quarterly operating margin of any OEM by volume, showing that Electric vehicles can be more cost effective than combustion engine vehicles.
Additionally, we generated $5.5 billion of GAAP net income and $5.0 billion of free cash flow in 2021 – after spending $6.5 billion to build new factories and other capital expenditures.
Now, looking to the future, you will see that there are at least two good reasons for optimism:
- First, you will see that TSLA has clearly passed the critical scale pivot point. Its profit is poised to skyrocket from here as it now begins to reap the benefits of production scale and margin expansion. Since it has overcome the hurdle of fixed costs, the additional production will only entail mostly variable costs, and profits will therefore grow at a faster rate.
- Second, in terms of valuation, there is no doubt that the company is highly valued today. At almost 18 times sales, it is valued in both relative and absolute terms (the overall market is valued at around 3 times sales). However, given its accelerating earnings growth, it may exceed its current valuation in the next few years.
TSLA broke even
The following graph clearly shows that Tesla passed the breakeven production pivot point around 2018. This graph plots the average CFO (operating cash flow) per vehicle as well as the average unit price per vehicle since 2015. You can see very clearly that Tesla was able to make an improving profit per vehicle when the unit price (i.e. the price of each vehicle) actually DECLINED. This is a clear indicator of breaking even, as explained in more detail below.
Profit is a function of volume, price, and cost, as shown in the following figure. Costs come in two forms, fixed costs and variable costs (denoted by F and M * V in the figure, where M is the marginal cost of producing one additional unit and V is the volume of production). Fixed costs include items such as plant and equipment (especially their depreciation) as well as most capital costs (such as interest charges). Fixed costs have been incurred from the start and do not vary with the level of production. A production company must first break even to make a profit. After exceeding the critical sales volume, fixed costs are spread over more and more units and profit margins will improve. And to see next, that’s exactly what happened and is happening with TSLA.
Fixed Cost and Variable Cost of TSLA
The following chart shows my analysis of TSLA’s fixed and variable costs. Note that the plot is done in logarithmic scales. As you can see, the blue line shows his total income based on the total number of vehicles delivered. And again, in reality, such a relationship is usually a linear relationship under a logarithmic scale (meaning the relationship appears to be a straight line under a logarithmic scale). Now the orange line shows my estimated cost of revenue.
And as you can see, the break-even point happened somewhere near 100,000 vehicles (where the blue and orange line intersect). Also, by extrapolating the orange line to the left, you can see that the fixed cost is around $2 billion. Any cost beyond the fixed cost is mostly a variable cost, as indicated by the green arrow. The difference between the blue and orange lines is the net profit. By calculating the slope of the orange line, we can also determine the variable cost at around $40,000 per vehicle for TSLA.
On a logarithmic scale, these numbers above are hard to see. So in the next section, we’ll tabulate those numbers to take a closer look.
TSLA Earnings and Return Projections
This next table essentially summarizes what we’ve discussed so far, except in tabular form this time. It is made on the basis of the key fundamental parameters that we have obtained, namely the fixed cost and the variable cost.
Based on these metrics, we can also make projections for TSLA’s revenue and earnings in the future. To summarize, the key parameters are A) the fixed cost is $2 billion and B) the variable cost per vehicle is $40,000. Finally, I also assumed that operating expenses were 13% of total sales and that the average vehicle price was $58,000, which is in line with its current levels. Note that these latter assumptions also make my following analysis more conservative, as the operating cost would also be diluted per vehicle as Tesla sells more units.
As this table shows, based on the fixed and variable costs determined above, EBITDA profit would be approximately $10.7 billion for the 930,000 TSLA vehicles sold in 2021, very close to the actual non-compliant number. GAAP of $11.6 billion.
The second most important uncertainty is its production growth. Just a bit of historical context to show how much uncertainty there is.
- Tesla’s total vehicle volume was just over 100,000 in 2017, and it delivered a total of 930,000 vehicles in 2021. In terms of vehicle deliveries, its growth since 2017 has been a spectacular CAGR of 67 % per year.
- For 2022, it should deliver 1.42 million cars.
- the margin of uncertainty widens as we look further. TSLA management’s goal is 20 million by 2030, already quite ambitious in my opinion, about 25 times the volume of 2021 and a growth rate of 43% CAGR per year. According to ARK Invest CEO Cathie Wood, Tesla can sell 20 million vehicles a year by 2025. And Morningstar analysis assumes that Tesla will only deliver about 5.7 million vehicles by 2030, well below management’s target.
I’m going to assume a more moderate CAGR of 30% for the next 5 years – I prefer to err on the side of being conservative. And you can see that “even” at a CAGR of 30%, the company can rise above its current high valuation quite quickly.
At present, there is no doubt that the company is dearly valued. At almost 18 times sales, it is valued in both relative and absolute terms (the overall market is valued at around 3 times sales). However, as the chart above shows, given its trading fundamentals and even under some conservative assumptions, its price-to-sales ratio would be around 4.9x in a few years.
Plus, in terms of the EV/EBITDA multiple, it’s about 83x lower than its current price and leverage – again quite expensive. But in a few years it will be around 26x. To put things into perspective, the fair valuation implied in the analyzes of several leading institutions (such as Bank of America) is around 60x to 100x EV/EBITDA.
TSLA investing involves risk. At a high level it has a strong speculative flavor and is certainly not for all investors. To detail some major risks:
- Again, it is very difficult to predict the growth of its production. That’s not something particularly wrong with TSLA. It’s just usually hard to predict things that are developing at a rapid pace. As mentioned above, TSLA management’s ambitious goal is 20 million by 2030, representing a growth rate of 43% CAGR per year from 2021. It is highly uncertain that such an ambitious goal may or may not be achieved. For example, Morningstar’s analysis assumes that Tesla will only deliver about 5.7 million vehicles by 2030, well below management’s target. This is why my analyzes assume a more conservative 30% CAGR, which will translate to approximately 3.1 million vehicles by 2025.
- Its ongoing production expansion plans are experiencing delays. Giga Shanghai is producing cars, but only at a partial capacity significantly below its target capacity. Its Giga Berlin and Texas are still under construction and Giga Berlin has experienced many delays.
- In the short term, TSLA and other automakers continue to be hampered by the global shortage of semiconductor chips and shipping port congestion. It is unclear how these short-term interruptions can renormalize.
- In the longer term, competition in the field of electric vehicles is also intensifying. TSLA’s market share in some major markets is under severe pressure, not only from established automakers, but also from electric vehicle companies in the United States and abroad. Traditional players, in particular Volkswagen (OTCPK: VWAGY) and the Ford (NYSE:F) Mach E is taking market share in the EU and US, respectively. In China, another key EV market, NIO (NYSE: NIO) is currently Tesla’s biggest competitor, followed by Li Auto (NASDAQ:LI) and XPeng (NYSE: XPEV). It is uncertain whether TSLA can maintain its competitive edge in the electric vehicle space longer term.
Conclusion and final thoughts
After 2021, there should be no doubt about Tesla’s profitability. Profit is poised to skyrocket after breaching its production threshold and surpassing its current lofty valuation over the next few years. Specifically,
- It has clearly passed the critical scale pivot point, recouped the fixed cost, and now started reaping the benefits of production scale and margin expansion. Its average operating cash flow per vehicle has improved while unit prices have DECLINED – a clear indicator that it has exceeded the break-even point.
- Its break-even point is estimated at nearly 100,000 vehicles and the variable cost at around $40,000 per vehicle for TSLA. As production is expected to increase further as output from established plants in Fremont and Shanghai is maximized, fixed costs will be further diluted and profits accelerated.
- Finally, new factories in Austin and Berlin and fully self-contained software add additional option and growth potential for shareholders.