Tesla Earnings Watch: Follow the Gross Margin Percent

Tesla Earnings Watch: Follow the Gross Margin Percent

It's always a challenge to pinpoint a proper valuation for a young, rapidly growing company such as Tesla . How do you place a value on a company with a history of net losses, an expectation of forward profit but at unknown levels, and a stock price that's already up a gazillion percent? With Tesla sporting around a $20 billion market cap already, it's going to take a series of milestone accomplishments to justify an even higher valuation. The first one up is the percentage of profit Tesla makes on each car sale before overhead, which is also known as gross profit margin.

Entering a low-margin industry
A natural concern with Tesla or any car company is its profit margin. General Motors and Ford both have long histories of paper-thin profit margins.

General Motors reported 2012 sales of $152.3 billion, quite a large chunk of change. Yet with all of its economies of scale, decades of manufacturing experience, and marketing might, it tends to average only 12% in gross profit margin. This means that for every $1 in sales that General Motors makes, it only has 12 pennies left for overhead and advertising.

Ford's gross profit margin is a bit better at an average around 15%, but then it has high selling, general, and administrative costs, or SG&A. Both General Motors and Ford have quite significant S&A costs, which run anywhere from 5% to 10%, depending on the quarter. It's an extremely cost-intensive industry.

Now compare Tesla. For the first and second quarter of 2013, it averaged 9% gross profit margin without including zero-emission, or ZEV, credits. This is similar to the margins for General Motors and Ford and it is part of the reason why many comparisons suggest that Tesla is overvalued.

Expanding margins
The gross profit margin story, excluding ZEV credits, is nothing short of impressive. In the first quarter, it was only 5%. In the second quarter, it jumped 8% to 13%. In the conference call, CEO Elon Musk predicted another 6% jump to 19% for the third quarter. For the fourth quarter, the target is 25%. After that, Tesla is "cautiously optimistic" about further margin expansion.

In the conference call, Musk stated,

... the things that affect the gross margin, in order for them to, the fourth quarter really needs to be in place, we are essentially in place about a month before the fourth quarter, otherwise the parts that go into the car will not contain the [cost savings] that are necessary. So, essentially things needs to be in place next month and so that's not very far away. That's why we felt confident enough to reaffirm the 25% gross margin guidance [excluding ZEV credits] for the fourth quarter.

Musk seems very sure of himself, based on the inherent visibility the operation affords. In order for Tesla to eventually justify a higher market cap than $20 billion, one of the keys it is going to need is a sustainable strong profit margin well above others in the industry. Tesla will obviously also need much larger production, larger sales, and manageable overhead, but evidence of those things is still several quarters away.

Foolish final thoughts
Pay close attention to the gross profit margins, excluding ZEV credits, in the upcoming earnings announcement. Take note if the 19% target is indeed hit, missed, or exceeded. Pay attention to fourth-quarter and beyond guidance. If Tesla has hit or exceeded 19% in margins and continues its strong guidance, then it could be a whole new ballgame. It would mean that comparative ratios for General Motors and Ford can be thrown out the window.

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The article Tesla Earnings Watch: Follow the Gross Margin Percent originally appeared on Fool.com.

Nickey Friedman has no position in any stocks mentioned. The Motley Fool recommends General Motors. It recommends and owns shares of Ford and 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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Originally published