Tesla is an Undervalued Growth Juggernaut

[TheTalkingMule]

Around 2012 I got very interested in Germany's solar growth under their feed-in-tariff program. Over the next handful of years solar went from 1% to 8% of German electricity production. Their transition program was so successful it destroyed the three major utility companies and Merkel had to put the brakes on by lowering grid payback rates.

Germans have always known the value of battery storage in a sustainable grid. For 2016 over 40% of residential installs came with battery storage. Their retail electricity rates(~$.30/kWh) were far higher than their FIT grid payback rates(~$.12/kWh), so they simply did what made sense. Store all your excess solar production.

Now they look poised to scale these efforts, and if there is any govt support what so ever, battery storage will spread as quickly as solar did.

Terms of Service Violation

If they can lead the way on grid/residential battery integration and prices drop as expected, we should see the long awaited dramatic global shift to the Tesla model of energy production/distribution/storage. Tesla's potential within the automotive industry is drawfed by what they can achieve in "energy as a service".

$100/kWh Gigafactory costs at the pack level means that in 2022 Tesla can sell/finance/lease you a base Model 3/Y, standard solar, and home battery solution that erases your entire carbon footprint for $699ish per month. That's absurd. Who in their right mind would wouldn't immediately turn your entire energy and transport expense over to TSLA?

 

[strangecosmos]

Companies like NVDA, FB and MU (Micron) with high margins are on this list, but 4 of the 9 companies with the highest returns — almost half — have losses or relatively low margins (NFLX, AMZN, TSLA, MZOR).

I wonder how much this an artifact of differences in accounting and/or different stages of growth. For example, is the cost of producing original content and licensing outside content included in Netflix's cost of goods sold? That would imply Netflix could double its subscribers and possibly double its gross margin. This is an important difference between software companies like Netflix and hardware companies like Apple. If Apple doubles the number of people who buy the iPhone, the gross margin doesn't double.

 

[EinSV]

I wonder how much this an artifact of differences in accounting and/or different stages of growth. For example, is the cost of producing original content and licensing outside content included in Netflix's cost of goods sold? That would imply Netflix could double its subscribers and possibly double its gross margin. This is an important difference between software companies like Netflix and hardware companies like Apple. If Apple doubles the number of people who buy the iPhone, the gross margin doesn't double.

I don’t think accounting treatment explains this. Netflix capitalizes the cost of content (whether licensed or homegrown) and amortizes it — see summary at bottom of post. It also spends $ hand over fist to get content — in fact its cash “burn” is on the order of $3-$4B per year:

Free Cash Flow and Capital Structure
Free cash flow in Q2 totaled -$559 million vs. -$608 million in the year ago quarter. We continue to anticipate FCF of -$3 to -$4 billion for the full year 2018, which implies that our content cash spending will be weighted to the second half of 2018. During Q2, we completed our latest bond deal, raising $1.9 billion. https://s22.q4cdn.com/959853165/fil...ts/2018/q2/FINAL-Q2-18-Shareholder-Letter.pdf​

Obtaining high quality content is very expensive and dramatically impacts Netflix’s profitability and cash flow. As far as future prospects, I wouldn't be surprised to see Netflix’s profitability increase over time but it is by no means a given as obtaining affordable high quality content will remain a central challenge to its business.

Brief description from NFLX’s most recent 10K:

Streaming Content
We acquire, license and produce content, including original programing, in order to offer our members unlimited viewing of TV shows and films. The content licenses are for a fixed fee and specific windows of availability. Payment terms for certain content licenses and the production of content require more upfront cash payments relative to the amortization expense. Payments for content, including additions to streaming assets and the changes in related liabilities, are classified within "Net cash used in operating activities" on the Consolidated Statements of Cash Flows.
For licenses, we capitalize the fee per title and record a corresponding liability at the gross amount of the liability when the license period begins, the cost of the title is known and the title is accepted and available for streaming. The portion available for streaming within one year is recognized as “Current content assets, net” and the remaining portion as “Non-current content assets, net” on the Consolidated Balance Sheets.

 

[strangecosmos]

But on the income statement, the cost of content is included in cost of revenues:

Streaming content amortization is included in and comprises the vast majority of our Cost of Revenues.

So most of Netflix’s cost of revenues is a fixed cost — the cost of licensing content and developing original content. That means gross margin is a function of the subscriber base. The more subscribers, the higher gross margin. That’s the benefit of being a software as a service company. Investors might reasonably expect that once Netflix reaches global market saturation, its gross margin will be similar to other software as a service companies like Facebook.

Similarly, most of Amazon’s revenue comes from retail, but about as much operating profit comes from AWS — Amazon’s software as a service business — as North American retail. (Retail outside North America is currently running at a loss.)

 

[EinSV]

But on the income statement, the cost of content is included in cost of revenues:

So most of Netflix’s cost of revenues is a fixed cost — the cost of licensing content and developing original content. That means gross margin is a function of the subscriber base. The more subscribers, the higher gross margin. That’s the benefit of being a software as a service company. Investors might reasonably expect that once Netflix reaches global market saturation, its gross margin will be similar to other software as a service companies like Facebook.

Content is not a cost that is independent of the number of subscribers. For example, licensing deals with studios and other content providers almost certainly factor in the number of Netflix members and viewers of content -- content providers do not offer fixed license fees for any online content licensee, regardless of the number of subscribers or viewers. This can be seen in Netflix's consistent "cash burn" (to the tune of $3-$4B/year in 2018) from purchasing content -- as it grows content is increasingly expensive as it expands its user base and also expands its content offerings through, for example, homegrown content, as it seeks to attract new viewers. Looked at another way, when it just started its online business, Netflix was able to negotiate some ridiculously good content deals. As it has grown and the business has matured, it has had to pay much more for content leading to continuous cash burn. These increasing costs of content as the business has grown is one factor that drove it to start developing its own content.

Investors obviously hope that one day this will stabilize and the cash burn will end, but over time content is not a fixed cost that is independent of membership. As you note, Netflix does not count the full amounts paid for content as costs in the year they are incurred but instead amortizes them over several years so cash flow is significantly negative even while Netflix shows a modest profit.

Similarly, most of Amazon’s revenue comes from retail, but about as much operating profit comes from AWS — Amazon’s software as a service business — as North American retail. (Retail outside North America is currently running at a loss.)

Amazon has been a public company for 21 years and its share price has skyrocketed over 1000X in that time frame. If You Had Invested Right After Amazon's IPO. But only very recently AWS has provided a significant portion of profits. I don't think it is reasonable to ignore the contribution of Amazon's dominant internet shopping and other low margin businesses to Amazon's ~$1T valuation.

Even with the contribution from AWS, Amazon (like Netflix) has low operating profit margins and high PE, as it has for many years (when not operating at a loss). And investors can't reasonably expect that to change any time soon unless Amazon decides to dump its enormous online shopping business, which is not going to happen and would be foolish. Just because it is a low margin business doesn't mean it is not a great business to be in and very valuable, which Amazon's share price reflects.

According to ycharts, Amazon has a PE (TTM) of 157.68 and Netflix has a PE (TTM) of 168. If a year from now, Tesla has booked substantial profits (as appears likely) it should also support extremely high P/E ratios given its potential for 50% or more revenue growth far into the future as well as margin improvements as a result of increasing operational efficiencies.

In Q4 2018, Tesla will likely be generating revenue at a pace of about $28B/year. q2-q4 2018 financial projections Market cap is currently about $50B. If share price does not rise substantially, the price/sales ratio will drop below 2. That is extremely low for a company growing as fast as Tesla and with its future potential.

 

[strangecosmos]

licensing deals with studios and other content providers almost certainly factor in the number of Netflix members and viewers of content -- content providers do not offer fixed license fees for any online content licensee

So you’re saying that content licenses are a variable cost, not a fixed cost? I didn’t consider that.

Original content, however, is a fixed cost. The production costs for Stranger Things are just what they are, and won’t increase if Netflix gets 10x more subscribers. Original content is where Netflix’s business model starts to look like a software as a service business model.

 

[neroden]

Content is not a cost that is independent of the number of subscribers. For example, licensing deals with studios and other content providers almost certainly factor in the number of Netflix members and viewers of content -- content providers do not offer fixed license fees for any online content licensee, regardless of the number of subscribers or viewers.

They do absolutely offer fixed license fees. Particularly for "Netflix Original" programs commissioned by Netflix, the studios which make them (Netflix is mostly a distributing studio, not a production studio) are *not* paid per view.

 

[EinSV]

@neroden and @strangecosmos, the context here is that based on Loup's data, I questioned in post 20 whether high margins were the key factor for high returns for tech companies as is often assumed to be the case given that:

• the top 9 companies on the chart in terms of total returns were all high growth (>20% annual revenue growth) companies
• none of the top gainers was in Loup's lower growth group, regardless of whether it had high margins or not, even though that group was much larger (25 low growth v 14 high growth).
• 4 of the 9 top gainers had relatively low margins (AMZN, NFLX, TSLA, MZOR).

These points suggest that high revenue growth, not high margins, has been the key to high returns for tech stocks at least over the 5-year time period studied.

In response to the third point, @strangecosmos raised the question of whether there might be some quirk in accounting treatment of these companies that masked high margins:

I wonder how much this an artifact of differences in accounting and/or different stages of growth. For example, is the cost of producing original content and licensing outside content included in Netflix's cost of goods sold? That would imply Netflix could double its subscribers and possibly double its gross margin. This is an important difference between software companies like Netflix and hardware companies like Apple. If Apple doubles the number of people who buy the iPhone, the gross margin doesn't double.

As noted above (post 23), I believe the answer to the specific example given (NFLX) is clearly "no" since NFLX amortizes its content costs, which if anything would tend to stretch out its costs over a longer period of time. In fact, its free cash flow is strongly negative (even more so than Tesla's historic cash flows) to the tune of $3-$4B/year.

@strangecosmos then raised the question of whether because content was a fixed cost NFLX could simply "double its subscribers and possibly double its gross margins." That has not been the case to date, and there is no reason to believe that will change. To grow its subscriber base, every year NFLX has to massively invest in content, and those investments have grown rapidly over the years as content providers raise their prices, competition grows in the space and NFLX needs to expand its offerings to attract new subscribers. So while an individual content purchase is a "fixed cost" in an accounting sense (apologies for any confusion about that), NFLX has no choice but to continue to make huge investments in content. It cannot just wave a magic wand and double subscribers (and margins) without continually investing in content.

How Much Will Content Costs Impact Netflix's Cash Flows?
Netflix exec says 85 percent of new spending will go towards original content
Netflix puts content above costs but is the policy sustainable?

Circling back to the original point in post 20, the bottom line is that according to Loup's data, high returns for tech stocks have been driven by high revenue growth, not by high margins. Out of 14 high growth companies, 9 were at the very top of the list for investor returns. High growth is a sign that you are disrupting an industry, which is certainly the case with NFLX, AMZN and TSLA.

Tesla is growing at roughly double the rate of the fastest growing large tech companies and has been able to maintain these insane growth rates over long periods of time. Hopefully at some point once Tesla is earning a profit and the bankwuptcy narrative and other drama subside a bit investors will focus again on Tesla's ludicrous growth and long-term potential.

 

[strangecosmos]

I don’t think you can deconflate growth and margins so easily. Part of being a high-growth company is often investing heavily in growth — things like R&D, sales, entering new markets, launching new products, etc. — that can lead to a lower gross margin, operating margin, and net margin (depending where on the income statement different costs are accounted for). These low margins are a temporary phenomenon that will end at some point.

It is widely believed by Amazon shareholders that Amazon’s low margins are a deliberate result of its choice to pursue fast growth. The implicit assumption is that at some point in the distant future, Amazon could reach a steady state or slow growth phase where its margins would shoot up because it’s no longer pursuing long-term growth at the cost of near-term profit.

Netflix and AWS are software as a service businesses, which traditionally have very high margins. You can run a software as a service business at low margins, or even at a loss, to grow as fast as possible. But at some point once you’ve achieved enough economies of scale you can decide to start bringing in high profits.

New original content at Netflix helps drive subscriber growth, but fundamentally new original content is a fixed cost. There is no reason the costs of original content have to rise linearly along with subscriber growth. Similarly, Facebook had to hire more engineers to work on more features as it grew, but revenue from user growth greatly outstripped expense growth.

It makes intuitive sense that companies that grow revenue faster also grow share price faster. (Although apparently over the long run value stocks outperform growth stocks.) However, I think it mischaracterizes Netflix and Amazon to say they are low-margin companies. I mean, Tesla has a negative net margin, implying that the value of the stock is $0. That analysis is too simple. Software as a service is a high-margin business, even though you can run it at a loss for a long time as a deliberate growth strategy. Netflix and AWS are both software as a service businesses.

So, the thesis that faster growth leads to higher returns may be true. It makes intuitive sense to me, although apparently it isn’t actually true historically.

It may also be true that whether a company is low-margin or high-margin doesn’t matter, as long as it’s growing fast. Maybe. But Netflix and Amazon aren’t good examples companies that can be expected to have low margins over the long run.

 

[EinSV]

While both NFLX and AMZN can be expected to improve margins over time, investors have been fine with low margins to date, and AMZN has been public for 21 years and NFLX for 16. This is an important point. NFLX and AMZN, like Tesla, could have adopted a different approach and accepted reduced growth to improve profitability. But Loup's data suggests that tech companies that are profitable but slower growing generated lower shareholder returns than higher growth companies -- even those with relatively low margins like NFLX and AMZN.

A few clarifications. Netflix isn't software as a service -- it does not sell software. https://www.quora.com/Is-Netflix-SaaS Netflix is a video on demand/content delivery company, or as it calls itself "the world's leading internet entertainment service." As a company in the entertainment business, it has had to continually make massive investments in content, leading to massive negative free cash flow (this year negative $3B-$4B). While investors undoubtedly expect margins to improve over time, Netflix cannot simply sit on a library of aging content and expect subscribers to join and cash to roll in. It must continually invest heavily in new, fresh content that is more appealing than the competition. And with strong competitors in the fray (including Amazon) predicting huge margin growth into Google/Facebook territory is very speculative.

As far as Amazon, in 2017 AWS made up only 10% of Amazon's revenues -- 90% of its revenues were from low margin businesses, primarily online commerce (and now even brick-and-mortar, with the Whole Foods merger). Its operating margins as a company are very low -- on the order of 3-4%.

Given its massive, low margin online commerce business, AMZN as a company may never enjoy the 25-50% operating margins some software companies achieve. But investors don't seem to care, nor should they. Profits can be generated not just by high margins, but by high revenues with more modest margins. For example, Walmart currently has $500B in revenue per year. If AMZN's retail business overtakes that and operating margins increase above traditional retail as they have the potential to do, that relatively low margin business can generate extremely high profits. Combined with AWS and other high margin businesses built off the low margin backbone, AMZN has the potential to generate massive profits even if its company-wide margins remain well below Google, Facebook, etc.

The bottom line is that prospects for long-term profitability certainly factor into it (no one wants a perennial money loser) but it is hard to make the case that very high Facebook or Google-like margins or even expectations of margins like that are a necessary part of the equation. In any case, Tesla enjoys very high gross margins by automotive industry standards, and has predicted Model 3 gross margins in the high 20s. Operating costs are increasing at a much lower rate than revenues, which over time should lead to increased operating profits (unless investments in growth are increased, which is also fine). Looking further into the future, Model Y, Semi and Pickup should be highly profitable as Tesla's battery costs drop, manufacturing automation and efficiency increases and Tesla continues to reduce operating expenses as a portion of revenue. Tesla also has high margin, software focused businesses like grid services and (more speculative) Tesla Network to add into the mix. Plus, Tesla, like Amazon, is highly innovative and will likely create new products or entire businesses that few expect, just as it has in the past.

All while (hopefully) continuing to grow roughly twice as fast as Netflix and Amazon -- two of the most amazing growth companies around.

 

[lklundin]

A lot of people use electricity.

And a lot of people rely on transportation of people and goods...

I am still holding on to all my TSLA shares.

 

[EinSV]

Fun facts (plus mild speculation) for Q3:

2018 $6.9B revenue (projected)
2017 $2.9B revenue
2016 $2.3B revenue
2015 $937M

Q3 Growth rate (annualized):
2017-2018: 138%
2016-2018: 74%
2015-2018: 95%

And projecting for Q3/4:

Annual growth rate ($21.6B revenue -- luvb2b Q3/4 projections plus actual Q1/2):
2017-2018: 83% ($11.8B -->$21.6B)
2016-2018: 75% ($7B-->$21.6B)
2015-2018: 75% ($4B-->$21.6B)

Why aren't we hearing about this?

FUD is blinding people to the most impressive growth story of a generation.

 

[strangecosmos]

EinSV, the main point to appreciate with Netflix is its economies of scale. Economies of scale are at their highest when a product or service has a near-zero marginal cost, as is the case with software or digital entertainment. (It costs almost nothing to “produce” a webpage load or a video stream.) If your marginal cost is nearly zero, that means your net margin is limited only by your fixed costs.

That means if Netflix can increase its customer base 10x while increasing fixed costs 2x, its net margin will increase 5x. It could go from a 10% net margin currently to a 50% net margin. Just by growing subscribers.

The amount that Netflix can increase its net margin is entirely a question of how much it will need to increase its fixed costs to achieve subscriber growth. On one hand, Netflix is benefitting from a societal transition away from broadcasting toward the Internet. It also arguably benefits from a network effect to some degree — audience attracts content which attracts audience.

On the other hand, subscriber growth is partially a function of the amount of new original content available to watch. Plus Amazon, HBO, Disney, Apple, YouTube, and others are building out streaming services, potentially limiting Netflix’s long-term growth potential.

Netflix pessimists would argue that the cost of the content required to sustain subscriber growth at the rate required to justify Netflix’s valuation will, in the long-term, be greater than the revenue Netflix will bring in from those subscribers. So, Netflix’s valuation will inevitably collapse. Netflix might just end up going bankrupt.

But Netflix optimists would argue that at some point Netflix will achieve escape velocity: subscriber revenue growth will begin to far outstrip growth in content costs, and massive positive free cash flow will materialize. In the optimistic scenario, Netflix’s net margin and free cash flow margin can improve dramatically.

The amount of net margin and free cash flow margin improvement that is possible for Netflix is beyond what would be possible for a car manufacturing company like Tesla without the use of software or AI (which have near-zero marginal cost), since raw material costs and labour costs mean that cars have a very high marginal cost.

So, that’s why Netflix is not a good example or at least not an uncontroversial example of a low-margin business, and not a good analogy for Tesla — unless you’re specifically talking about software or AI, i.e. Autopilot or the Tesla Network or the Alien Dreadnought.

 

[strangecosmos]

Amazon is a bit of an outlier with regard to companies in general. When I think of Amazon, I think of Galileo Russell’s idea that Amazon has helped convince the stock market that what has intrinsic value is not earnings, but earnings power. Not cash flow, but ability to generate cash flow. If true, this means one of two things:

1. Amazon is being valued on the expectation that at some future point it will generate much higher earnings and cash flow than it is currently. (And in so doing, quite possibly achieve much higher net margin and cash flow margin.)

2. The intrinsic value of Amazon has reached a new layer of abstraction, beyond any actual future earnings or cash flow. Today, we don’t need companies to pay dividends or do stock buybacks to ascribe to them intrinsic value. We just need the assurance that they could do so, either now or someday in the future. We can delay any actual dividends or stock buybacks indefinitely. So, maybe Amazon will never have to actually generate enough earnings or cash flow to justify its valuation at a normal multiple. Maybe the assurance that it could do so will satisfy the stock market indefinitely.

This complicates any discussion of Amazon’s long-term margins. So does the fact that Amazon is involved in so many different businesses: retail, grocery, meal kits, AWS, video streaming, Kindle, Audible, Echo, Ring, and a little-understood, nascent healthcare business.

 

[EinSV]

I think it would be useful to get re-oriented. The Loup report cited in the OP concluded that five year returns for 14 high growth tech stocks "was 485% vs. the non-growth return of 116%, a more than 4x difference." There's Still No Such Thing as a Value Stock in Tech | Loup Ventures

And as spelled out earlier in the thread, the top 9 tech stocks with the highest 5-year returns for shareholders were in the high growth group, with annual revenue growth above 20%. Not one was in the lower growth group. Also striking is that the majority of the high growth group companies -- 9 of 14 -- were clumped at the very top on the list of companies with the best returns. And a 10th -- Google -- generated healthy returns that were much higher than the average of the lower growth group (197% v. 116%).

These are striking numbers showing a very strong correlation of high growth to high returns in tech (regardless of margins).

We seem to be going in circles on Netflix but I basically agree with these comments about Amazon:

1. Amazon is being valued on the expectation that at some future point it will generate much higher earnings and cash flow than it is currently. (And in so doing, quite possibly achieve much higher net margin and cash flow margin.)

2. The intrinsic value of Amazon has reached a new layer of abstraction, beyond any actual future earnings or cash flow. Today, we don’t need companies to pay dividends or do stock buybacks to ascribe to them intrinsic value. We just need the assurance that they could do so, either now or someday in the future. We can delay any actual dividends or stock buybacks indefinitely.

I think this is a good summary of how the market looks at Amazon -- investors are willing to forego higher earnings in the short term in favor of more growth, banking on much higher earnings and cash flow in the long-term.

I believe the same has been true for Tesla in the past and can be in the future, especially if Tesla, like Amazon, can begin generating positive cash flow and at least a modest profit on a regular basis. The combination of high growth, modest profits and high future profit and cash flow potential seems to be very attractive to investors.

luvb2b's model projects that Tesla will have operating margins of about 5.5% as early as next quarter (Q4 2018). q2-q4 2018 financial projections ($396M operating income/$7.083B revenue).

That is with estimated Model 3 margins at 22% compared to over 25% Tesla has forecast by late 2019, and without the continued improvements in operational efficiency that should come as Tesla scales. If Tesla can generate significant positive margins even while growing at an insane rate of 75% or more annualized -- almost triple Amazon's historical growth rate -- investors should stand up and take notice (whether they do or not is anyone's guess). This is especially so given Tesla's product pipeline and record of innovation.

Using the estimates earlier in this thread (which assume growth settles back into the 50% range) Tesla could be generating $130 billion or more in revenue by 2023 if it executes on its product roadmap. If it can generate 10% operating margins while still growing rapidly, that could result in earnings of about $10 billion/year after taxes and interest. Assuming growth is expected to slow to the 25% range after 2023, a PE of 25-40 would be reasonable. That could result in a valuation of $250-$400 billion. And the valuation could be even higher if Tesla can continue to grow faster than 25%, or investors continue to apply the growth premium you describe, recognizing that due to investments in growth Tesla's earnings continue to understate its future earning potential. For example, according to ycharts, Amazon currently has a P/E of 150 (TTM) and Netflix has a P/E of 160 (TTM).

 

[strangecosmos]

I think this is a good summary of how the market looks at Amazon -- investors are willing to forego higher earnings in the short term in favor of more growth, banking on much higher earnings and cash flow in the long-term.

I believe the same has been true for Tesla in the past and can be in the future, especially if Tesla, like Amazon, can begin generating positive cash flow and at least a modest profit on a regular basis. The combination of high growth, modest profits and high future profit and cash flow potential seems to be very attractive to investors.

Amazon intentionally ran at a negative net margin for years to accelerate growth. Investors weren’t valuing Amazon on the basis of it being a negative net margin company — it would be worth $0.

Similarly, just because Netflix’s net margin is currently 10% doesn’t mean that investors are valuing it on the basis of being a 10% net margin company. Like Amazon, Netflix’s investors might be expecting a much higher net margin in the future.

Tesla’s factories have fixed costs that make it unprofitable to produce 1,000 Model 3s per week, profitable to produce 5,000 per week, and more profitable to produce 10,000 per week. Similarly, Netflix’s content is a fixed cost. The more subscribers it has, the more profitable it is. More subscribers, higher margin. The more units that are sold (cars/subscriptions), the more units that fixed costs are spread across — resulting in more profit per unit.

If Netflix increases the amount it spends annually on new original content by $0, its subscriber base will probably still grow just due to more people hearing about it, more places getting high-speed Internet, etc. So margin will probably increase automatically.

Alternatively, Netflix can double its spending on original content, potentially reducing its net margin — by as such as 50% if no new subscribers join. But if instead it quadruples its subscriber base (and therefore revenue), then it just doubled its net margin!

Reed Hastings himself says: “There are scale economies in companies like Netflix. Those merit investing forward to get to scale.”

And interestingly also: “There have been a lot of businesses like Amazon that have scale economics, that succeed outside Silicon Valley.“

 

[EinSV]

With Tesla's Q3 earnings report out, it's time for an update.

Tesla's revenues for the quarter came in at $6.8B, a staggering 70% increase from Q2 and 134% increase from Q3 2017. Although most Wall Street analysts were wildly off the mark, the revenue number should not have been a surprise -- luvb2b's final update nailed it at $6.8B.

Conservatively assuming revenues increase modestly from $6.8B to $7.0B in Q4, with higher Model 3 volume offset by lower average sales prices, would result in the following annualized growth over the past two years.

1 Year: 80% ($11.8B -->$21.2B)
2 Year: 74% ($7B-->$21.2B)

In 2019 revenue growth will likely moderate a bit back to the 50-60% range as Model 3 production ramps at a slower rate, and lower priced Model 3 versions become part of the mix, before exploding again in 2020-21 with the introduction of the Model Y, ramping of the China Gigafactory, projected annual tripling of storage installations (by MWh), ramping of solar roof production and potentially the beginning of Semi production.

There were a few aspects of the report that stood out to me as demonstrating the financial strength of Tesla's business model over the long-term:

• massive cash flow -- ~$1.4B in operating cash flow and ~$800M in free cash flow
• unexpectedly high operating margins -- 6.1% -- leading to significant profits
• a 5% reduction in operating expenses (excluding one-time items) despite an increase of 70% in revenues, a vivid demonstration of operating leverage and the power of Tesla to improve profitability as the business scales

Tesla's ability to achieve such strong cash flow and profitability while growing at astonishing rates is truly remarkable and surprising to most -- Tesla's operating margins and profitability are running well ahead of what virtually anyone expected. While operating margins may fluctuate somewhat, it is worth noting that Amazon did not reach operating margins over 6% until this year -- 21 years after going public.

In an earlier post, I laid out where Tesla might be in 2023 if it successfully implements its product roadmap:

700K Model 3 @$45K $31.5B
1M Model Y @$45K $45B
300K pickup @$50K $15B
100K S/X @$100K $10B
100K Semi @$165K $16.5B
200K solar roof @$40K $8B
5K Roadster at $225K $1.1B
Storage $6B

Total: $133B

This is without factoring in any revenue for Tesla Network, which may or may not be up and running by then.

Tesla expects Model 3 gross margins to increase to 25% or higher next year, and similar or better margins seem likely for its automotive business as a whole through 2023. If Tesla can continue to reduce operating expenses as a percentage of revenue, as also seems likely, operating margins will grow even faster than gross margins.

As noted above, if Tesla can generate 10% operating margins, that could result in earnings of about $10 billion/year after taxes and interest, off $133 billion in revenue. Using a P/E of 25-40 (assuming growth is expected to slow to "merely" 25%/year after 2023) would result in a valuation of $250-$400 billion.

And the valuation could be even higher if Tesla can continue to grow faster than 25% after 2023, or investors apply Netflix or Amazon-like P/Es recognizing the long-term potential of a growth juggernaut with a highly profitable business model.

Also, Tesla's ability to generate 6.1% operating margins in its first quarter as a high volume car company, in the midst of breakneck growth and a chaotic ordering and delivery process, suggests it may be able to generate operating margins well in excess of 10% even while in ludicrous growth mode. This could support even higher valuations.

In addition to demonstrating that Tesla has a profitable business model even while growing at a breakneck pace, the Q3 report also should help alleviate unfounded fears about Tesla's viability, as it shows the bankwuptcy narrative is a sham. Once the clouds have time to clear and more investors begin to focus on Tesla's competitive advantages and business model, they may start recognizing Tesla's incredible potential for growth and profitability.

 

[electracity]

In 2019 revenue growth will likely moderate a bit back to the 50-60% range as Model 3 production ramps at a slower rate, and lower priced Model 3 versions become part of the mix, before exploding again in 2020-21 with the introduction of the Model Y, ramping of the China Gigafactory, projected annual tripling of storage installations (by MWh) and ramping of solar roof production.

I think you have that backwards. Tesla will double unit volume in 2019 and improve production efficiency. Then they hit the stall with little capability to increase production in 2020 and 2021.

The model Y will compete for production with the model 3 until substantial capacity is added after 2021. Tesla still probably hasn't decided how to use the model Y. They can increase revenue and margins in Fremont by supplanting low price/margin model 3 with high price/margin model Y. Or they can wait to launch the model Y.

I'm assuming they will start in China with assembling the model 3 as they do in Europe (Tilburg?). Then add bits as they build their organization in China.

 

[EinSV]

I think you have that backwards. Tesla will double unit volume in 2019 and improve production efficiency. Then they hit the stall with little capability to increase production in 2020 and 2021.

The model Y will compete for production with the model 3 until substantial capacity is added after 2021. Tesla still probably hasn't decided how to use the model Y. They can increase revenue and margins in Fremont by supplanting low price/margin model 3 with high price/margin model Y. Or they can wait to launch the model Y.

I'm assuming they will start in China with assembling the model 3 as they do in Europe (Tilburg?). Then add bits as they build their organization in China.

Mmm, don't think so. On the Q3 ER call, Elon estimated Model 3 production of 7-10k/week in Fremont plus 5-8k/week in China. He also said they planned to start doing partial Model 3 production in China by the end of 2019. It may Tilburg-ish initially (I'm not sure) but the point is to add capacity (5-8K/week) as well as address tariff issues. Elon's estimate on the call for total Model 3 production was 500K-1M/year -- I used 700K/year as an estimate which will likely prove to be too low.

Elon also said on the call that Tesla had already approved a Model Y prototype for production and confirmed again that they plan to have Model Y in volume production in 2020. CUVs are more popular than sedans so Elon's rough estimate of 1M Model Ys/year sounds right to me.

It is unclear whether Model Y will be produced at a new U.S. factory or the Gigafactory, but Elon has already made clear it won't be at Fremont since it's too crowded. Tesla also has said Model Y will be produced at its factory in China, but there no reason to believe that will hamper the 5-8K/week Model 3 production in China that Elon estimated.

So Model Y should be in volume production in 2020, while Model 3 production is ramping up in China. Semi production may begin at about the same time as Model Y, we'll see. Add in storage and solar roof ramps and 2020-21 should bring more explosive growth.

 

[30seconds]

Looks to me that with these free cash flows Tesla will be able to build China w/o any additional investment.

They still need / want a European GF, which as free cash flow grows (from ramping Fremont production to 7k/ week) can also be financed internally. Maybe that gets announced mid next year