Tesla Stock a Buy After Earnings? What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Tesla (NASDAQ: TSLA) stock slumped after last week's earnings report, which featured a 64% jump in the rate of vehicle production coupled with a much wider-than-expected loss ($1.33 per share, adjusted). A cynic might almost come to the conclusion that the more cars Tesla sells, the more money it loses...

And yet, stockbroker Evercore ISI is anything but a cynic. The opposite, really. After reviewing Tesla's earnings report last week, Evercore returned to the market this morning with a surprising announcement: It's reinstatingits coverage of Tesla stock -- and rating it outperform.

Here are three things you need to know about that.

Tesla's Model 3 is primed for production. Image source: Tesla.

1. What Evercore said

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In a note covered on StreetInsider.com this morning, Evercore writes that while it's still hard to stick an accurate valuation on the stock (seeing as Tesla has no profits to hang a P/E ratio on, for example), Evercore is still optimistic.

The analyst sees diminishing risks that the rollout of Tesla's new Model 3 sedan will be a bust. In fact, assuming the rollout goes well, and projecting Tesla's recent "3-year forward market multiples" into the future, Evercore thinks it's reasonable to assume this valuation will hold steady as Tesla ramps production on its newest electro-buggy.

2. Meet the Model 3

So what is it that makes Evercore confident that the Model 3 will be a success? In its fiscal Q1 2017 earnings reportlast week, Tesla confirmed that "Model 3 vehicle development is nearly complete" and "on plan to start production in July." Tesla expects to achieve production of "5,000 vehicles per week at some point in 2017, and ... 10,000 vehicles per week at some point in 2018."

"[A]t some point" leaves a lot of wiggle room for investors trying to plot the volume of Model 3 sales going forward. A best-case scenario of 5,000 Model 3s produced right out of the gate starting July 1 might yield as many as 135,000 Model 3ssold by year end, for example. Or in the worst case, hitting 5,000 vehicles in the final week of 2017 might imply production of only a few tens of thousands.

Similarly, Elon Musk's 10,000-car production goal "at some point" in 2018 could, in theory, imply production of more than 500,000 Model 3s that year. But even in the worst case, hitting 5,000 cars in 2017 and continuing at that rate through most of 2018 implies well in excess of 250,000 Model 3s rolling off the production line next year -- a massive achievement.

Which way things go won't be known for another couple of months, however. Musk says he expects to give investors "guidance on vehicle deliveries for the second half of this year after we have started Model 3 production in July."

3. What comes after the Model 3

Be that as it may, Evercore is not waiting for the good news to restart its buy rating on Tesla -- it's going ahead and placing its bet today. Here's why:

According to the analyst, once Tesla gets Model 3 production up and running, and Tesla finds its production rhythm, the premium valuation on the company's products will enable Tesla stock to earn "an EBIT margin range of c12 to 15% ... in the long-term, once growth normalizes and [selling, general, and administrative expense] and [research and development expense] ratios approach industry average." That's as compared to operating profit margins of just 2.3% at Ford (NYSE: F) today, 6.1% at General Motors (NYSE: GM), or even 7.8% at Toyota(NYSE: TM).

Simply put, Evercore believes "Tesla has the potential to achieve margins which are double those of US peers today." And in Evercore's view, this means Tesla stock is not only worth a buy rating, but worth a price target of $330 a share.

But does that argument make sense?

The most important thing: Valuing Tesla

Let's consider: Here's how the three other car companies named above look at today's prices, compared to analyst estimates for their earnings "3-year[s] forward" (using data provided by S&P Global Market Intelligence).

  • GM is projected to earn $6.05 per share in 2020, and costs $34.19 today.
  • Ford should earn $1.94 per share in 2020. Ford stock costs $11.16 per share today.
  • And Toyota has projected 2020 earnings of $7.51 per share, and a $110.26 stock price today.

Their "3-year forward market multiples," as Evercore might put it, are therefore 5.6, 5.8, and 14.7, respectively. By comparison, Tesla's $311.60 share price today is 64.3 times the $4.84 in per-share profit that most analysts expect Tesla to earn in 2020. At Evercore's $330 target price, Tesla's "3-year forward market multipl[e]" would be 68.2.

So here's the question investors must ask themselves: Assume it turns out to be true, as Evercore argues, that Tesla will one day earn operating profits twice those of what Toyota (for example) churns out. Does it make sense to pay more than four times Toyota's market multiple to own a stock only twice as profitable as Toyota? Does it make sense to pay more than 10 times the valuation of General Motors to own Tesla stock only twice as profitable as GM?

Maybe it does if Tesla is also growing much faster than Toyota or GM. I'm not arguing the contrary. But to justify Tesla's stock price, you have to assume that: 1. that Tesla does grow as fast as Evercore thinks it will, 2. Tesla rolls out its Model 3 on time and in large volume, and 3. Tesla achieves a profit margin not only twice what its rivals produce -- but that it achieves profits, period, which is something Tesla hasn't done in the past.

Like I said, I'm not saying it's not possible Evercore is right. But it does seem to be making an awful lot of assumptions on faith.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Ford and Tesla. The Motley Fool has a disclosure policy.