Tesla Motors: The Apple of Automakers

BOSTON ( TheStreet) -- Tesla Motors ( TSLA), a pure-play electric-car company, is an emerging power among automakers, a newcomer to an innovation-starved industry.

Tesla, named after Serbian inventor Nikola Tesla, was incorporated in 2003 and unveiled its first car, the Roadster, in 2007. With a base price around $110,000, the Roadster is in a premium bracket, comparable to gas-powered sport vehicles such as those offered by Mercedes and Porsche. Tesla is growing rapidly, but it faces material risk.

Tesla went public on the Nasdaq last June, and its stock has since fallen 2.1%. Already, it has been dogged by recalls. In May of 2009, it sent technicians to the homes of 345 Roadster owners to tighten hub flange bolts. Then, in October, it recalled an estimated 439 cars to remove an auxiliary cable, part of a back-up power system, that presented a fire risk if it chafed a nearby carbon-fiber panel. Relative to the recall woes of major brands, such as Toyota ( TM), Tesla's were relatively insignificant. They haven't damaged sales, either. Roadster's unit tally has passed 1,500. The sports car is churning asphalt in 30 countries.

Tesla's first derivative, the Roadster Sport, is also gaining popularity, helped by positive reviews. Its zero-to-60-miles-per-hour acceleration of 3.7 seconds has legitimized the franchise as a competitor to established sports brands. However, two tenths of a second costs an extra $20,000. The Sport is priced above its predecessor, commanding roughly $130,000. The Model S, which is still in development, is a sedan, tentatively priced at around $57,000 and designed to poach market share from BMW, Audi and the like. Tesla reported in December that it has already booked more than 3,000 Model S reservations ahead of the release.

Tesla will disclose fourth-quarter results on February 15. During the third quarter, its net loss narrowed 9%, sequentially, to less than $35 million, or 38 cents a share, as revenue grew 10% to $31 million. Yet, automotive sales declined marginally as development-services revenue surged 78%, quarter-over-quarter, to $7.9 million, buoying the top line. From an investor's perspective, development services, which now encompasses partnerships with Toyota to develop a powertrain system for an electric RAV4 and battery design for the Daimler A-Class, is the preferable growth venue. The development-services unit's quarterly gross margin expanded from 58% to 68%, sequentially, assisted by new deals and improved pricing.

By comparison, the automotive gross margin inched up from 15% to 17%. Thus, the company's total gross margin expansion, from 22% to 30%, was primarily a result of the development-services division. However, Tesla's core mission is to build cars, not outsource its product-design and expertise to industry laggards, and it's remaining loyal to this tenet. Having just purchased a $42 million manufacturing facility in Fremont, California from United Motors Manufacturing, Tesla's production timeline for the Model S is intact. At peak capacity, when utilized by United, the facility was assembling 400,000 vehicles annually.

Tesla's strategy, commencing with a premium model, though seemingly contradictory to mass-market appeal, is a tech-industry tactic. Silicon Valley-based Tesla likens its Roadster to a first-mover product, and initial buyers are "innovators." Sleek design and limited production are likely to garner brand cachet. Thus, Tesla is employing a step-down marketing technique. The Model S, at roughly half the price of the Roadster and with greater production potential, will appeal to a broader demographic of "early adopters." Tesla's next model, codenamed BlueStar, is, purportedly, a crossover that will be priced at $30,000 to target "early majority" electric-car buyers.

This strategy, called "crossing the chasm", is derived from the Everett-Rogers diffusion of innovations theory. Smart-phone and tablet-computer designer Apple ( AAPL) has repeatedly implemented it, flawlessly. It is unlikely that Tesla will enjoy comparable success. But, so far, the company's performance is praiseworthy. U.S. automotive behemoths GM ( GM) and Ford ( F), despite solid progress since the recession, are still lagging behind rookie Tesla in key respects. Neither of the old-line automakers has an all-electric vehicle. The Chevrolet Volt, a plug-in hybrid, utilizes a battery similar to Tesla's. GM Vice Chairman Robert Lutz has credited Tesla as Volt's muse.

Other companies, including Toyota and Panasonic, which builds Tesla's highest energy-density lithium ion cells, have made equity investments in the company. Toyota owns 3.2% of shares outstanding and Panasonic controls 1.5%. Toyota invested $50 million into Tesla, immediately following the company's initial public offering, underwritten by Goldman Sachs, Morgan Stanley, JPMorgan ( JPM) and Deutsche Bank, three of which now cover its stock. Deutsche rates the shares "hold." Goldman ranks them "neutral." JPMorgan ranks Tesla "overweight", forecasting that its stock will advance 29% to $30 during 2011.

JPMorgan believes that "the investing community (and the majority of the automotive industry) is substantially underrating Tesla's potential, not just on electric vehicle powertrain technology (where converts arguably have been made of Toyota and Daimler) but more broadly on its ability to deliver world-class non-powertrain-related vehicle engineering and to eventually grow into a full-line premium carmaker with atypical cost competitiveness." The research team just visited Tesla's new production facility and met with management, which confirmed the bank's bullish view. JPMorgan's $30 target was derived from a discounted cash flow model.

However, several of the bank's assumptions are notably cautious. For example, it forecasts a terminal operating margin of just over 8%, standard for German luxury carmakers, whereas Tesla management forecasts a stable mid-teens operating margin over the long run. If management hits its projection, a higher share price is warranted. JPMorgan forecasts a loss of $1.88 a share in 2011, a loss of $1.46 a share in 2012 and a profit of $1.51 a share in 2013. Still, there may be material upside if demand for the S Model exceeds expectations. A video of the S Alpha version, operating in real-world conditions, was released online in January. The video received 85,000 hits in a matter of hours.

Ultimately, Tesla's success depends upon brand perception with global consumers. Environmentally conscientious, tech-savvy customers have propelled one company, Apple, to the rank of sector hegemon. It seems that Tesla is striving to be the Apple of auto, even modeling its showrooms in the likeness of Apple stores. But, risks abound. Although Tesla's the first mover in the electric-car space, many other first movers failed to achieve lead market share because of competitive pressures. The company's distribution network is far behind established peers and its capital limits marketing potential until cash flow ramps up. Nevertheless, Tesla's unlikely ascent is accelerating.

-- Written by Jake Lynch in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.