More Broken Promises from Tesla

David Trainer  |

“I’m optimistic about being profitable in Q1 and for all quarters going forward.”

-Elon Musk, January 31, 2019

Just six months ago, Elon Musk made the bold prediction that Tesla would be profitable in all quarters going forward. Instead, Tesla has recorded a $689 million operating loss through the first half of 2019. Musk now says he feels “pretty confident” about breaking even in Q3 and returning to profitability in Q4. Given his track record of missed predictions – see the constant revisions to the Model 3 production targets – investors should place no stock in this claim.

More alarming than Elon’s failed promises is the fact that Tesla’s Q2 results show the company has dramatically scaled back its investments in new production capacity, self-driving research, and other technological innovation. This decrease in investment helps produce positive cash flow in the short-term, but it further decreases the chances of the company justifying its valuation over the long-term. Tesla (TSLA) is back in the Danger Zone.

Steady Decline in Gross Margins

One of the primary bull cases for Tesla revolves around the potential for economies of scale. As the company increases its production, bulls argue, it will become more efficient and produce cars at a lower price, thereby increasing its margins.

Instead, as Figure 1 shows, the opposite has happened. Tesla’s gross margins have steadily declined, from 28% in 2014 to just 18% over the trailing twelve months (TTM).

Figure 1: Tesla Gross Margins: 2014-TTM

Image Source: New Constructs, LLC

Sources: New Constructs, LLC, and company filings

Part of this decline can be attributed to the shift from the higher-priced Model S and Model X to the Model 3. However, it’s not as if the Model 3 is a cheap car. According the company’s Q2 investor letter, the average selling price for the Model 3 is ~$50,000.

For comparison, the average selling price for General Motors (GM) in North America last year was ~$38,000. Even with a lower average selling price, it managed to earn the same gross margin of 18%. Tesla’s margins have fallen to the level of its mass-market competitors despite the fact that it still sells high-end vehicles.

Magnitude of Decreased Investment is Alarming

In an attempt to distract investors from its disappointing margins, Tesla instead focused on its free cash flow in the latest quarter. The top bullet point of its investor letter highlighted the company’s $5 billion in cash on hand and $614 million in operating cash flow minus capex in Q2.

However, this cash flow is the result of short-term gimmicks that will put the company in a worse position over the long-term. Tesla ran down its inventory by ~$500 million last quarter, increased its deferred revenue by ~$150 million, and further diluted shareholders by spending ~$210 million on employee stock compensation. These factors produce the illusion of operating cash flows despite the company’s lack of real cash flows.

At the same time, Tesla dramatically reduced its capital expenditure, from $610 million in 2Q18 to just $250 million in 2Q19, a 59% decrease year over year. Tesla’s capex last quarter represented less than half of its depreciation, amortization, and impairment of $579 million. As Figure 2 shows, Tesla’s net investment over the TTM period has fallen to -$680 million.

Figure 2: Tesla Capex Minus Depreciation, Amortization, and Impairment: 2014-TTM

Click to enlarge

Image Source: New Constructs, LLC

Sources: New Constructs, LLC, and company filings

Meanwhile, here’s a short list of the major projects Tesla claims to be working on and which require significant capex:

  • Expanding the Supercharger network, which has long been held up as a key competitive advantage
  • Expanding service locations and mobile service fleet to address customer complaints
  • Building the Shanghai Gigafactory, which is supposed to begin producing Model 3’s by the end of the year
  • Preparing for Model Y production in its Fremont plant, which is supposed to launch next fall
  • Continuing to ramp up production to hit targeted deliveries of 360-400 thousand in 2019 (currently on pace for 317 thousand deliveries for the year)
  • Developing the Tesla Semi (although any mention of this project was dropped from the Q2 investor letter)

How can Tesla possibly complete this many projects while investing significantly below its rate of depreciation and amortization? According to the company:

“We continue to find opportunities to improve capital efficiency and shift cash outflows to future periods.”

“Shift cash outflows to future periods” suggests that Tesla is kicking the can down the road. Tesla will likely face huge capital costs in the near future, fail to meet its timeline for these projects, or (most likely) both.

Tesla’s reduced capital spending appears to be a response to the liquidity concerns that many analysts expressed earlier this year. Since 2011, Tesla has burned through ~$24 billion in negative free cash flow. The sell-side concern over the company’s cash position effectively signaled that Wall Street wasn’t willing to subsidize Elon Musk’s money-losing business any more.

As a result, Musk needs to start showing a level of capital discipline he hasn’t had in the past. Unfortunately, this reduced capital spending is incompatible with the lofty goals Tesla needs to hit in order to justify its valuation.

Falling Behind in Self-Driving

In addition to decreasing its capex, Tesla minimized its losses in Q2 by significantly decreasing its research and development spending. The company spent $324 million on R&D in Q2, down 16% year-over-year. TTM spending on R&D has dropped to $1.4 billion, slightly below 2017 levels.

Meanwhile, General Motors (GM) continues to ramp up its R&D spending. GM spent $7.8 billion on R&D in 2018, more than 5 times as much as Tesla, as shown in Figure 3.

Figure 3: R&D Spending: TSLA vs. GM: 2015-TTM

Click to enlarge

Image Source: New Constructs, LLC

Sources: New Constructs, LLC, and company filings

The size of GM’s R&D spending advantage means that GM is starting to catch Tesla in terms of EVs – besides the Chevy Bolt, it’s working on an electric crossover, pickup, and premium EV’s under the Cadillac brand. In addition, GM continues to widen its lead in self-driving, where it already ranks far ahead of Tesla according to research provider Navigant’s 2019 Automated Driving Leaderboard, seen in Figure 4.

Figure 4: Tesla Is Back of the Pack in Self-Driving

Click to enlarge

Image Source: New Constructs, LLC

Sources: Navigant Research

Elon Musk continues to promise “full self-driving” by the end of the year, but most third-party researchers agree that fully autonomous vehicles are still years away for all firms.

Musk’s unrealistic timeframes appear to be contributing to some turmoil in the company’s self-driving unit. Musk is “upset that some team members have told him they can’t meet the timelines he has set for developing the technology,” according to The Information’s Amir Efrati. This frustration led to several senior engineers leaving the company earlier this year, according to Efrati’s report.

Constant Turnover Raises Red Flags

These self-driving engineers are far from the only senior employees to leave Tesla over the past two years. Business Insider put together a handy list of all the senior executives that left the company since the beginning of 2018, including:

  • The CFO
  • Multiple Chief Accounting Officers
  • The Senior Director of Production and Vice President of Production
  • The heads of manufacturing engineering, equipment engineering, Autopilot engineering, and field performance engineering

Overall, more than 30 high-level employees have left the company since the start of 2018. Most recently, on the company’s Q2 earnings call, JB Straubel, the co-founder and CTO who reportedly invented most of the company’s key technologies, announced that he would be stepping down from his position.

Combined with the decrease in capex and R&D, this constant turnover makes it hard to believe that Tesla will be able to hit all its stated goals. It appears that Musk just keeps spinning his wheels, cycling through people in the hopes he will eventually find someone that can meet his unrealistic expectations.

Valuation Remains Risky

After the negative reaction to Q2 earnings, TSLA is down 27% in 2019. Even more astounding, the stock is now essentially flat over the past five years, while the S&P 500 is up 57%. Despite all the talk of TSLA as a “momentum” stock, it has delivered no gains to investors since the summer of 2014.

While the stock price has been flat over the past five years, TSLA’s valuation has increased significantly. Share dilution through employee stock compensation and acquisitions has increased the total share count by 38%. In addition, total debt has increased from $2.6 billion in 2014 to $13.4 billion currently. As a result, Tesla’s enterprise value has increased by 61% since 2014. Our reverse discounted cash flow (DCF) model quantifies just how high the expectations still are for this company.

In order to justify its current valuation of $235/share, TSLA must achieve 4% NOPAT margins – similar to GM or Ford (F) – and grow revenue by 30% compounded annually for seven years. See the math behind this dynamic DCF scenario.

In the above scenario, TSLA would earn $133 billion in revenue in year 7. For comparison, Ford earned $160 billion in revenue last year, and GM earned $147 billion. TSLA’s valuation still implies it will achieve the scale and profitability of a major, mass-market automaker.

We don’t see that scenario as being particularly plausible. Maybe, TSLA could someday achieve those margins by focusing on higher-priced models, but growth is already slowing, and their reduced investment should lead to even slower growth going forward. If TSLA earns 4% margins and grows revenue by 13% compounded annually for 10 years, the stock is worth just $82/share today – a 65% downside to the current stock price. See the math behind this dynamic DCF scenario.

What Noise Traders Miss With TSLA

These days, fewer investors pay attention to fundamentals and the red flags buried in financial filings. Instead, due to the proliferation of noise traders, the focus tends toward technical trading tends while high-quality fundamental research is overlooked. Here’s a quick summary for noise traders when analyzing TSLA:

  • Reported free cash flow is an illusion created by decreasing inventory, paying employees with stock, and underinvesting in the business
  • Gross margins continue to decline even as the business scales
  • Claims about production gains, self-driving technology, and new products deserve serious skepticism
  • Valuation still implies that the company can supplant traditional automakers

Catalyst: More Missed Promises to Come

Investors already recognize the serious problems with Tesla, as evidenced by the 27% decline in the stock YTD. We expect the stock to continue to fall over the rest of the year and into 2020, as Tesla continues to miss its targets as a result of underinvestment, constant turnover in the executive ranks, and unrealistic promises.

The focus will be on production and deliveries in the second half of 2019. Despite its disappointing Q2 results, Tesla reiterated its guidance for 360-400 thousand deliveries on the year. In order to achieve this goal, the company must deliver over 100 thousand vehicles in each of the next two quarters, a number it has never achieved. Wedbush analyst Daniel Ives described hitting this target as “an Everest-like uphill battle.”

We will not be surprised to see the Shanghai Gigafactory run behind schedule and fail to start production this year. We’re not sure if any investors still put stock in Musk’s self-driving promises, but we think it is very likely Tesla will also come up short on this front.

No Capital Return

Tesla has never offered a dividend in its history as a public company. This lack of capital return should come as no surprise, since the company typically fails to generate positive cash flow. Since 2011, Tesla has hemorrhaged -$24 billion (61% of market cap) in free cash flow.

Tesla also does not buy back any stock, nor does it have any immediate plans to do so.

Insider Trading and Short Interest

Insider activity has been minimal over the past 12 months, with 190 thousand shares purchased and 357 thousand shares sold for a net effect of 168 thousand shares sold. These sales represent less than 1% of shares outstanding.

There are currently 41 million shares sold short, which equates to 24% of shares outstanding and 5 days to cover. The number of shares sold short has increased by 62% since the beginning of the year. Tesla’s ongoing struggles seem to be attracting more shorts to the stock.

Critical Details Found in Financial Filings by Our Robo-Analyst Technology

As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings. Below are specifics on the adjustments we make based on Robo-Analyst[1] findings in Tesla’s 2018 10-K:

Income Statement: we made $1.3 billion of adjustments, with a net effect of removing $1 billion in non-operating expense (5% of revenue). We removed $133 million in non-operating income and $1.2 billion in non-operating expenses. You can see all the adjustments made to TSLA’s income statement here.

Balance Sheet: we made $7.9 billion of adjustments to calculate invested capital with a net increase of $2.7 billion. You can see all the adjustments made to TSLA’s balance sheet here.

Valuation: we made $17.9 billion of adjustments with a net effect of decreasing shareholder value by $15.8 billion. You can see all the adjustments made to TSLA’s valuation here.

Unattractive Funds That Hold TSLA

The following funds receive our Unattractive-or-worse rating and allocate significantly to Tesla.

  1. Baron Partners Fund (BPTIX) – 13.7% allocation and Unattractive rating
  2. ARK Innovation ETF (ARKK) – 10.3% allocation and Very Unattractive rating
  3. ARK Web x.0 ETF (ARKW) – 9.4% allocation and Unattractive rating
  4. American Beacon ARK Transformational Innovation Fund (ADNCX) – 9% allocation and Very Unattractive rating

This article originally published on July 29, 2019.

Disclosure: David Trainer, Kyle Guske II, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

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[1] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: Disclosure: David Trainer, Kyle Guske II, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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