Other than politics, Tesla (TSLA) ranks among the top triggers of emotionally charged discussions among the investment community. It’s no surprise that some respected authors charged out of the gate with theories on how the numbers didn’t add up after Tesla showed a profit during the latest quarter. It’s hard to know who is right, but we believe it’s not all doom and gloom for Tesla. In fact, Tesla may just be on the verge of realizing its promised (claimed) potential.
It’s no secret that Elon Musk’s lofty plans have not always seen the light of day, but maybe the disconnect has been more of a timing issue than anything else. Let’s start by looking at some numbers provided in the latest quarterly report.
At first glance, there’s plenty to not like about the report. For instance, YOY top-line growth looks horrendous. But that discounts a couple of points. First, the tax credit for EV vehicles was cut in half at the beginning of 2019 and then again in July. Second, Tesla has been on a kind of a honeymoon phase since the massive hype and excitement surrounding the introduction of the Model S. There’s invariably a period of adjustment at the end of the honeymoon when the sugar high subsides and the true prospects of the company begin to emerge.
This phenomenon as it relates to the introduction of a new technology is more generally known as the hype cycle or alternatively the hype cycle plus market adoption cycle. The latter provides a more detailed examination by combining the Gartner Hype Cycle with the Technology Adoption Cycle.
For simplicity let’s just use the Gartner Hype Cycle, which describes the evolution of a new technology introduction in five steps. Below are the steps:
Each Hype Cycle drills down into the five key phases of a technology’s life cycle.
- Innovation Trigger: A potential technology breakthrough kicks things off. Early proof-of-concept stories and media interest trigger significant publicity. Often no usable products exist and commercial viability is unproven.
- Peak of Inflated Expectations: Early publicity produces a number of success stories — often accompanied by scores of failures. Some companies take action, many do not.
- Trough of Disillusionment: Interest wanes as experiments and implementations fail to deliver. Producers of the technology shake out or fail. Investments continue only if the surviving providers improve their products to the satisfaction of early adopters.
- Slope of Enlightenment: More instances of how the technology can benefit the enterprise start to crystallize and become more widely understood. Second- and third-generation products appear from technology providers. More enterprises fund pilots, conservative companies remain cautious.
- Plateau of Productivity: Mainstream adoption starts to take off. Criteria for assessing provider viability are more clearly defined. The technology’s broad market applicability and relevance are clearly paying off.
Do the first three steps seem applicable to Tesla’s journey so far? We think they do. The question is whether or not Tesla will prove to be one of the “surviving providers” of solar and EV technologies. An important determining factor in the success of a new technology is adoption. Therefore, the number of deliveries is a good metric to consider when evaluating Tesla’s long-term prognosis.
Source: Company PR
Compare the total deliveries line since mid-2017 to the graphical representation of the Hype Cycle below.
In terms of deliveries, Tesla appears to be doing fine. The Trough of Disillusionment is shallow and brief, and the ensuing Slope of Enlightenment may already be underway. This bodes well for Tesla considering it had to additionally cope with the end of the tax breaks which in all likelihood only exasperated the severity of the trough.
It’s true that the ASPs are dropping, and the revenue is not keeping up with the deliveries, but that’s exactly what should be happening. Wide adoption doesn’t happen on expensive products. The cars must be within reach and be competitive with gasoline cars to offer a compelling value. The prices should in fact be coming down and if the profits go up at the same time, it is only icing on the cake.
Other than some obvious creative accounting, Q3 results point to the possibility that Tesla has successfully traversed the trough and is on its way toward the Slope of Enlightenment.
Let’s address the creative accounting for a moment. The company reported a net profit of $143M for Q3 vs a loss of $408M for Q2. That’s a differential of $551M. The breakdown is shown below:
The notable items in favor of Q3 were the “Total Cost of Revenue,” “Operating Expense” and “Other Income/Expense.”
Total Cost of Revenue
There are several factors that contributed to the $317M savings in the total cost of revenue but the lion’s share or $251M belonged to savings realized from the total automotive cost of revenues. There was a total of 95,356 and 97,186 vehicles delivered during Q2 and Q3, respectively. Total cost of automotive revenue for Q2 and Q3 were $4360M and $4131M, respectively. That means the average vehicle cost $45,723 and $42,506 during Q2 and Q3. That’s a $3,217 cost savings per vehicle in Q3. This calculation may be off but that is not the main point. The important thing is that each vehicle cost considerably less to build in Q3. More on that later as it has been examined in other articles and will be an important part of the remainder of this article.
Operating Expense Reduction
There was a $158M reduction in operating expense compared to the previous quarter. The operating expense had three parts:
Source: Company PR
The cost of Research and Development was $10M higher in Q3. Cost of selling, general and administrative was $51M lower in Q3 and there was no restructuring fee in Q3 vs. $117M in Q2.
Regarding the “Selling, General and Administrative” line item the following excerpt from the 10-Q is relevant:
SG&A expenses decreased $134 million, or 18%, in the three months ended September 30, 2019, as compared to the three months ended September 30, 2018. The decrease was primarily due to a $103 million decrease in employee and labor related expenses from decreased headcount and cost efficiency initiatives, and a $25 million decrease in marketing expenses.
And regarding the Operating Expense Tesla had the following to say:
Likewise, we expect operating expenses as a percentage of revenue to continue to decrease in the future as we focus on increasing operational efficiency and process automation, as well as from increases in expected overall revenues from our expanding sales. In particular, our efforts to scale down and optimize our cost structure relative to the size of our business have already manifested in total operating expenses decreasing from $3.4 billion to $3.1 billion during the nine month periods ended September 30, 2018 and 2019, respectively, including restructuring and other charges. Meanwhile, our total revenues increased from $14.2 billion to $17.2 billion, respectively, during such periods.
It’s difficult to confirm or reject the validity of these statements, but it certainly makes sense that as the process matures operational efficiencies are improved.
Regarding the extra $117M restructuring fee, it’s something that does need to be considered when comparing QOQ performances. That said, it would be a stretch to suspect shady practices if no restructuring expense is incurred. Having such expense is actually considered a one-time fee and not the other way around.
Source: Company PR
The above table shows the restructuring expenses since 2Q18 in millions of dollars. Note that restructuring expense above $100M has been rare. Before 2Q18, restructuring expense was not even included in the report as a line item.
Other Income (Expense)
Q3 showed a net positive of $126 listed as Other Income (Expense). Here’s what the 10-Q had to say about other income (expense):
Other income (expense), net, consists primarily of foreign exchange gains and losses related to our foreign currency-denominated monetary assets and liabilities and changes in the fair values of our fixed-for-floating interest rate swaps. We expect our foreign exchange gains and losses will vary depending upon movements in the underlying exchange rates.
Other income (expense), net, increased by $62 million, or 270%, in the three months ended September 30, 2019 as compared to the three months ended September 30, 2018. Other income (expense), net, increased by $34 million, or 94%, in the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. These changes were primarily due to favorable fluctuations in foreign currency exchange rates, partially offset by losses from interest rate swaps related to our debt facilities when compared to the prior period.
It certainly seems like the gains from Other Income during Q3 will not be consistently repeatable and the results should be adjusted accordingly before any comparison against other quarters is attempted.
Total Automotive Cost of Revenues
The reduction in automotive cost of revenue is another area that has raised accounting suspicions, but we believe there could be a legitimate explanation for at least a good portion of these savings.
For example it was reported that Roth Capital lowered Tesla to a Sell saying that Tesla’s 10-Q indicates that the gross margin gain in Q3 was driven by one-time items such as warranty adjustments.
After examining the 10-Q we are not exactly clear what one-time warranty adjustment Roth Capital is referring to but perhaps it’s related to the provision for warranty as reported in this Reuters article:
In the filing, Tesla also said it had a provision for warranty of $138 million in the third quarter versus $187 million last year.
To gain more clarity on this issue, let’s examine how Tesla has allocated the provision for warranty throughout the last several quarters. The table below shows this information since 3Q17 when Tesla first began delivering the Model 3.
Source: Company Filings
It’s obvious that Tesla overshot the estimates when the Model 3 volume spiked during 3Q18. The following quarter the allocation was decreased even though the deliveries were markedly higher. The allocation for 2Q19 seems to have been a little high as well, leading to an adjustment lower for 3Q19. Creative accounting doesn’t appear to have played a role here. The point the Reuters article makes is well taken -revenues are certainly lower YOY, but the two periods belong to two different steps in the Hype Cycle. 3Q18 was near the top of the Peak of Inflated Expectations and 3Q19 was just barely past the Trough of Disillusionment. Giving due consideration to the Hype Cycle, a more appropriate comparison would be QOQ.
The QOQ comparison reveals a net reduction of $15M between Q2 and Q3 in warranty provisions. There’s still $302M in reduced cost of production between the two quarters.
We believe that the cost reduction is mostly related to the evolution of new technologies. This is the stage when costs are reduced rapidly as the processes are relatively new and largely inefficient with ample room for improvements. As years go by and more efficiency is squeezed out of the processes, the pace of cost reductions will naturally slow down.
Notable among the production costs is the cost of battery packs. Battery costs are rapidly approaching an inflection point where EVs become cost competitive with gasoline-powered vehicles. This is a very significant milestone and may be far closer than we expect. In fact, the inflection point may have already been reached and it may only be a matter of clearing out the old inventory to start using cost competitive battery packs.
Remember the point about how much efficiency can be squeezed out of new vs. mature technologies? If the point of even cost competitiveness has already been reached, how long will the gas-powered vehicles be able to compete on the total cost of ownership before they are blown out of the water?
So, what exactly is this inflection point? According to this blog published on Green Energy Consumer Alliance website, it is $100/kWh:
Experts estimate that battery costs need to drop down to $100 per kilowatt-hour in order for EVs to be price competitive with combustion-engine vehicles.
Here is more from the same blog:
In 2010, when electric cars were first introduced into the mass-market, lithium-ion battery packs cost about $1,000 per kilowatt-hour of storage.
Volkswagen (OTCPK:VLKAF) recently announced that it has reached the $100/kWh milestone. It’s hard to imagine that Tesla is far behind (if at all). Tesla already has stated that they will have $100/kWh battery cells this year and battery packs next year. Given VW’s announcement, Tesla’s claim seems perfectly reasonable.
One last issue worth addressing pertains to the questions surrounding the income claimed from the Smart Summons feature that was introduced just before the end of the quarter. Perhaps including the $30M income for a feature that was released four short days prior to the end of the quarter was a bit of a stretch. But whether or not the move was justified it’s rather immaterial. The small amount can be counted toward Q3 or Q4 earnings and it wouldn’t really change the equation.
Risks are always present, especially with adoption of new technologies. Obvious among them is the competition. We previously believed that as a new car company Tesla would not stand a chance against the deep-pocketed incumbents with years of manufacturing and refinement experience. We thought that all the incumbents had to do is to wait it out and let Tesla bear the grunt of the technology introduction before they move in and collect the rewards.
This brings us to the next risk factor and that’s the lack of a moat. For Tesla to succeed, EVs need all-around adoption. All-around adoption will not happen on proprietary platforms. This will prevent Tesla from having any kind of a significant moat.
Another risk is the limits on the raw material supplies for batteries. The adoption of EVs is bound to put significant pressure on the supply of these materials. This is especially true for lithium as the dominant material for the current technology.
Tesla’s latest ER made it very easy for bulls and bears to selectively concentrate on the aspects of the report that confirmed their previous biases. We believe the ER was positive and changed our previous slightly bearish leaning stance into cautiously bullish. YOY comparison based on the same criteria used for established technologies is not the best approach for Tesla. QOQ comparison provides better cues about Tesla’s prospects. There are however some items that need special consideration. For instance, Q2 had an unusually large restructuring expense of $117M. There also was a net positive of $126M related to other income (expenses) between Q2 and Q3 and $30 income attributable to possible premature accounting of the Smart Summons feature. These would have to be removed from the total $551M earnings delta before comparing the performance between the quarters. But the results are still impressive even considering these adjustments. Furthermore, whereas the large positive income form “Other Income (Expenses)” category is unlikely to be repeated often, zero or small restructuring expense and income from Smart Summons feature can be expected to be repeatable in the future.
Regarding risks, competition seems to be asleep at the wheel right now. As mentioned before, we previously thought time is on the side of the competition since they are already established companies that could simply wait for Tesla to burn itself out. Now we believe time is against the competition. The longer they wait, the bigger Tesla’s first mover advantage will become. Electric cars are more electric than cars. Tesla is not moving into gasoline car companies’ home territory. They will be moving into Tesla’s home turf and the slower they move the better Tesla’s chances of becoming a dominant player will be.
The lack of a moat is a real issue and it will be interesting to see how Tesla will address it.
Regarding raw material shortage for batteries, it will likely be addressed by new industries that are being created to extract Lithium from the raw material more efficiently and to build new types of batteries such as lithium-silicon and solid state lithium batteries that make more efficient use of the existing materials. Even Tesla itself is making headways in battery technology and even announced a battery that can last a million miles recently.
Market should not treat new and mature technologies in the same light and indeed it doesn’t do so. Perhaps that is partly the source of the disconnect between the bulls and the bears.
The latest results raise the possibility of accelerating efficiencies in manufacturing electric vehicles that could have significant ramifications in the near future. This supposition would of course need to be confirmed but the indications are promising.
We normally don’t like sky-high valuations. Not because Tesla doesn’t deserve it but because high valuation makes the stock more susceptible to large swings. For that reason, we are neutral on the stock. That does not diminish our belief that Tesla may just be on the brink of something great.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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