Why Tesla's Big Drop Could Be Your Big Opportunity

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Tesla Motors has been one of the most volatile stocks in the market this year. Recently, Tesla stock has dropped more than 35% from its yearly high, despite a solid earnings report that confirmed the company's long-term growth trajectory.

However, Tesla has a solid technology lead in the electric vehicle market. Moreover, there's no indication that Tesla owners (or prospective owners) are worried about the car's safety, despite a few recent vehicle fires. Indeed, the Model S has the best safety rating of any car ever tested! Tesla's recent drop therefore makes the stock more attractive for investors who believe in the company's long-term potential but missed out earlier this year.

No longer priced for perfection

Just two months ago, Tesla was priced for perfection. To justify its valuation, Tesla not only needed to maintain its momentum in the luxury car market, but it also needed its 3rd generation "affordable car" -- which is expected to go into production in 2017 with a $35,000 price tag -- to be a huge success.

Tesla may be able to create a sustainable competitive advantage through its purchasing scale in the battery market, as well as the close association of its brand with EVs. However, two of the top global automakers -- General Motors and Volkswagen -- have shown a keen interest in becoming major players in the EV market. They already have big scale advantages in purchasing and distribution.

As a result, I think it would be rash to invest in Tesla on the assumption that it will dominate a large market of affordable EVs, while earning a healthy margin in the process. However, at the current market price, Tesla doesn't need such a high level of success in the mainstream market to generate a good return for investors.

The promise of the high-end

Instead, most of Tesla's valuation today can be accounted for by its prospects within the luxury market (and to a lesser extent, powertrain development for other EV makers). That's a much more comfortable situation for investors, since Tesla has already demonstrated this year that it can build highly successful luxury vehicles.

Tesla's Model S has been a huge success, with demand outstripping supply (Photo: Tesla Motors)

This year, Tesla will deliver around 21,500 Model S vehicles . Tesla's sales have been held back entirely by supply constraints (particularly for battery cells) rather than demand. In fact, Tesla recently stated that U.S. demand has already hit 20,000 vehicles per year, and international sales are just ramping up. The company expects Model S demand to exceed 40,000 units per year by the end of 2014, with supply roughly catching up to demand by that point .

In late 2014, Tesla will introduce a second model to its lineup: the Model X crossover. The Model X hasn't gone on sale yet, so it's impossible to be sure of the demand, but given the global popularity of SUVs today, it would not be surprising for it to equal Model S demand . (Especially as a zero-emission SUV!)

The Model X crossover is expected to go into production late next year (Photo: Tesla Motors)

By 2016, when manufacturing of both models has fully ramped up, Tesla could be selling 80,000-100,000 luxury vehicles annually. The company is already well on the way to hitting its 25% gross margin (excluding ZEV regulatory credits) target in the current quarter. Increasing the production rate could push gross margin even higher: perhaps to 30%.

Assuming an average selling price of $90,000-$100,000 -- below recent ASPs -- Tesla could be generating $2 billion-$3 billion in gross profit from its two luxury cars by 2016. That's up from an annual run rate of just over $500 million last quarter ! Even if operating expenses double between now and then, it would still put Tesla on track for pre-tax earnings of around $1 billion in 2016.

Foolish wrap

Even at Tesla's current valuation, it will need to produce growth beyond the 2016 scenario I laid out in order to pay off for investors. (Tesla is currently valued at around 20-30 times its hypothetical 2016 after-tax earnings.) However, whereas Tesla's peak valuation implied a near-certainty that Tesla would be selling hundreds of thousands of "affordable cars" before the end of the decade, today's valuation does not require five to 10 years of flawless execution.

Tesla is certainly not a "safe" investment for risk-averse investors. But for long-term investors who are willing to accept significant risk in return for a big growth opportunity, Tesla is starting to look good again.

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The article Why Tesla's Big Drop Could Be Your Big Opportunity originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends General Motors and Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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