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Is Tesla on Sale or in Trouble?

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Last Friday, electric automaker Tesla (TSLA - Free Report) announced 3,000 employee layoffs in an attempt to lower costs, even as they attempt to increase production of the mass-market Model 3.

In a letter to employees, Tesla CEO Elon Musk pointed out that although the company had made great strides in terms of the number of vehicles it is able to produce and deliver, the high prices of its cars keeps them out of reach for most consumers.

Musk predicted that the company would be able to post a second consecutive profitable quarter due to continued shipment of higher priced Model 3 variants – including to Europe and Asia for the first time – but that future sales and profitability growth hinged on the company’s ability to produce lower-cost vehicles for a wider audience.

The CEO said that audited results would probably show a profit, “but less than Q3,” - when the company earned $2.90/share, blowing away estimates of a small loss for the period. The Zacks Consensus Estimate for Q4 earnings is $2.13/share – consistent with Musk’s prognostications.

TSLA is currently a Zacks Rank #3 (Hold).

The Model 3 was originally introduced with an expected base price of $35,000, but most of the cars that have been delivered so far have been long-range versions that start at $49,000 - and sold for an average price of about $60,000 during Q3. Recently, Tesla has made the mid-range level Model 3 available, starting at $44,000, but none of the $35,000 cars have yet been sold and Musk himself has admitted that the company is not currently able to turn a profit on the lowest price Model 3s.

In the letter, Musk targeted May of 2019 for the first sale of $35,000 cars to all markets. He’s racing against the clock in the US due to the impeding expiration of the federal tax credit for Tesla vehicles. Through 2018, buyers of all Tesla cars received a $7,500 tax credit. In the first two quarters of 2019, the credit is reduced to $3,750, then halved again – to $1,875 - during the second half of the year before being eliminated altogether in 2020.

Especially in the lower price ranges, the federal tax credit is a significant component of the final price consumers pay for a Tesla.

Investors were not pleased with the concept of layoffs or the indications that earnings would be lower and the shares traded sharply lower, shedding 14% since closing at $347.31/share on Thursday before the announcement.

The reaction was so severe that two very positive developments for Tesla went largely ignored - the groundbreaking for a Gigafactory in China that will produce batteries and Model 3 autos, possibly within a year, and European “homologation” of the Model 3, approving the vehicle for sale throughout the continent. The first Model 3s left the West Coast of the US for Europe on a cargo ship last week and European customers anxiously awaiting cars they ordered have been tracking the vessel’s progress on an internet app.

All of the 14,000 orders taken so far in Europe are for the higher-priced variants of the Model 3, a bullish sign for Q1 2019 revenues.

The extreme selloff on the layoff news seems overdone, though Tesla still trades at a 12M forward P/E ratio of 52X. For reference, mature competitors in the industry like General Motors (GM - Free Report) , Ford (F - Free Report) , Toyota (TM - Free Report) and Volkswagen (VWAGY - Free Report) all trade at single-digit multiples.

The rich multiple highlights the fact that Tesla remains under constant pressure to produce revenue and profit growth in order to deserve its share price. The bull case is that Tesla will be able to continue its growth trajectory for the foreseeable future which will translate into rising share prices, but this past week has been an indication that the markets are likely to be unforgiving of any missteps along the way.

For investors who still believe in Tesla’s long-term prospects, recent declines offer an opportunity to purchase shares at a steep discount to where they have traded recently, but be aware that more volatility most likely lies ahead, especially around the earnings release and conference call next week.

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