Great Magic Trick Tesla; Now Do It Again
Tesla surprises with strong Q3 results, the period CEO Elon musk said the company was close to "death." Huh?
Tesla Motors (TSLA US) “faced a severe threat of death due to the Model 3 production ramp” and was “weeks away from death” at one point over the past year, according to CEO Elon Musk in an interview with Axios on HBO that aired on Sunday. Recalling his emotional interview with the New York Times, Musk described the struggle to save the company as “very painful,” saying "it hurts my brain and my heart.”
Remarkably, he didn’t even mention Tesla’s triumphant third quarter results which exceeded expectations with reported revenue, profit, and free cash flow much stronger versus Bond Angle and market consensus estimates. Tesla stock rallied on the news and was seen trading at $348 as of Wednesday, up 22% versus the end of October when earnings were announced.
Still, investors should probably remain wary about the quality of Tesla’s results, especially its prospects for the fourth quarter and throughout 2019.
Why? Because, Musk continues to reveal in troubling ways that there's more to Tesla's story, and often much more to be concerned about, versus what is publicly known at any given time.
Indeed, as it turned out Tesla’s impressive third quarter results were significantly enhanced by aggressive sales, accounting, and cash flow maneuvers. Otherwise, it looks like results may have fallen short of market estimates as well as Musk's ambitious guidance as I projected.
If so, there’s a good chance Tesla still isn’t ready to generate sustainable profitability and cash flow every quarter going forward as Musk projects.
This doesn’t bode well for fourth quarter performance which may be similarly pressured.
Keep Your Eye On the Ball
Tesla reported $6.82 billion in consolidated revenue for the third quarter versus $2.98 billion last year. This was driven mostly by auto segment revenue up 158% to $6.1 billion on deliveries up 220% to 83,775.
Auto segment gross margin was reported at 25.8% (up 750 bps y/y), and at 25.5% (up 680 bps y/y) excluding the boost from $52.3 million in reported sales of Zero Emission Vehicle Credits (ZEV) and $21 million in stock-based compensation expense (SBC) which Tesla adds back for adjusted results.
From there:
Higher gross profit plus surprising declines in consolidated SG&A and R&D expenses produced $920 million in GAAP EBITDA, an increase of $1.05 billion versus last year. Adjusted EBITDA was $1.04 billion, up $1.07 billion y/y after also adding back $26 million in unusual charges and $205 million in SBC.
Adjusted net income also was reported up $1.04 billion to $516 million ($312 million plus $205 million in SBC), Tesla’s first quarterly profit since the modest $22 million for the third quarter of 2016—and it’s only had three profitable quarters in its 15-year history.
Net income plus the add-back of noncash expenses and unusual charges accounted for most of reported cash from operations which swelled to nearly $1.4 billion versus $300 million consumed last year. As a result, Tesla reported $881 million in free cash flow after capex versus $1.05 billion burned last year.
Ending available cash was $2.97 billion, down versus $3.53 billion last year but up versus $2.2 billion in the second quarter, indicating potentially enough to retire $440 million in debt maturing in the fourth quarter and still leave at least $2.3 billion left in cash at year-end as required by Tesla’s credit facility ($1.9 billion for 2019 debt due plus $400 million cushion).
Tesla expects to generate positive GAAP net income and free cash flow “for all quarters going forward,” seemingly in one fell swoop to address the company’s most serious concerns about ongoing liquidity ahead of hefty cash obligations from maturing debt plus burgeoning capex necessary to meet its growing project list.
So Why All the Drama?
Such dramatic strength in reported results, versus both year/year and even notably improved second quarter results, should have been apparent to Tesla management early enough in the quarter to inspire enthusiasm and bolster confidence. Instead, as I noted in “Musk and Weird Q3 Developments Are Driving Investors to Telsa's Rivals” on 10/11/18, we observed:
CEO Elon Musk was so desperate to escape public scrutiny from market analysts and short-sellers that he impulsively launched his disastrous buyout scheme (See my report Tesla Take-Private Plan: Shoot First, Answer Questions Later (If at All) on 8/15/18 and Tesla’s Take-Private Plan: Never Mind on 8/26/18) just ahead of Tesla announcing its strongest, most profitable quarter ever.
Musk exhibits petulant to bizarre to combative behavior, from tweeting about unbearable pressure and even potential failure of the company if he’s not working day and night (similar to what he just told Axios) to picking fights with a hero to dare a lawsuit, to smoking pot on the air (complicating his SpaceX contracts with the US Air Force and Nasa), to insulting the SEC even as he is being convicted of securities fraud for his bogus take-private plan for Tesla, fined, and ordered to step down as its Chairman.
Several high-profile executives in finance, accounting, and global supply management abruptly left Tesla, accelerating a troubling exodus over the previous year; e.g. Chief Accounting Officer Dave Morton left after less than a month, abandoning a $10 million sign-on bonus.
Musk implied missed guidance as of the last weekend of the quarter, warning that Tesla was “very close” but still not profitable—even though the company was about to report adjusted net income up more than $1 billion both sequentially and year/year to $516 million.
A deep dive into Tesla's 10-Q shows Musk and Tesla's skittish management may have had good reason to be so concerned. Underlying performance in the quarter was more complicated--and much weaker--versus the story told by the reported numbers.
And now Musk has admitted to the world in the Axios interview that the company was “weeks away from death:”
Musk: Well I mean Tesla really faced this severe threat of death due to the Model 3 production ramp.
Essentially the company was bleeding money like crazy and just if we didn’t solve these problems in a very short period of time,we would die and it was extremely difficult to solve them.
Axios: How close to death did you come?
Musk: Within single digit weeks.
Really? This is exactly what many investors were worried about. What did Tesla’s banks and long-suffering suppliers think about this? Did they even know?
And more to the point, how far would Musk go to save his company from death’s door?
Far as you can see
Tesla used aggressive sales, accounting, and cash management maneuvers which significantly increased reported revenue, profit, and cash flow, effectively overstating the strength of core performance trends.
Most of the increase reported in consolidated revenue was driven by the $3.8 billion jump in auto segment revenue, which was significantly boosted in several ways.
For example, and it’s not clear why, but Tesla was only forthcoming in its earnings release about $52.3 million it generated with ZEV credit sales. The 10-Q reported another $137.2 million generated from the sale of greenhouse-gas (GHG) emissions credits, for a total contribution of $189.5 million reported in auto sales versus just $20 million in such credits sold in the third quarter last year.
Tesla also has benefited all year from new revenue-recognition rules adopted January 1st (ASC 606) related to vehicles leased with resale value guarantees. The effect is to transfer revenue to Auto Sales from Leased Sales—conveniently also at lower cost versus previously reported which then boosts gross margin.
Interestingly, Tesla does not adjust previous year figures for comparison purposes—so I did. This quarter the net boost to auto segment revenue from ASC 606 adjustments was $229.6 million versus last year, including a whopping $479 million added to auto sales offset by just $249 million removed from leasing revenue. By the way, Tesla can reap this year/year boost only one more time with the fourth quarter—2019 numbers will be apples to apples comparisons.
Contributions from regulatory credit sales plus new revenue recognition rules generated $419 million in additional auto segment revenue (sales plus leasing) as reported, accounting for 11% of the increase versus the same quarter last year.
These contributed a sizable $670 million specifically to $5.88 billion reported just in auto sales—a boost accounting for 18% of the reported y/y increase or $7,980 per car delivered.
Remember, average price per car already is in precipitous decline just with the addition of lower-priced Model 3s to the mix which comprised 67% of total deliveries. These contributions made the difference between $70,168 per car using reported sales, down 12% y/y, and $62,188 per car delivered using sales excluding the contributions—down 21% y/y.
Expected average price erosion on mix as Model 3 sales continue to dominate overall revenue seemed to be exacerbated by indications of additional pricing pressure and perhaps even fading demand—indicating that sales stability remains elusive:
Tesla admitted to notable sales and margin pressure owing to tariffs in China which have made its cars dramatically less competitive, and projected an associated $50 million hit to gross margin in the fourth quarter.
What happened to the backlog? After more than a year of steady updates on Tesla’s swelling Model 3 order backlog when it couldn’t make cars fast enough to meet demand, management suddenly dropped the conversation.
There was no update on the current status of more than 420 thousand reservations as of the second quarter for the Model 3, much less how many are now orders versus cancellations. Given Tesla’s persisting problems meeting its production targets, we would expect the company to continue to boast about a strong order backlog if it exists.
Instead, significant shortfalls in production targets apparently didn’t hurt sales—there were plenty of cars left over. Indeed Tesla actually had sufficient available inventory to hold an increasing number of flash sales, some even on a first-come, first-served basis which offered almost immediate delivery. Quick delivery was further encouraged by increasing sales discounts. Fire sales can move inventory, but only if the price discounts are fat enough—pricing power that’s much harder to claw back.
Everything’s on sale! The accelerating sales push crashed into the last weekend of the quarter, which reportedly was responsible for one of Tesla’s partner banks being identified as an “entity” comprising more than 10% of accounts receivable at quarter-end because, according to Tesla, it couldn’t complete the paperwork on car loans in time to remit cash before the quarter closed.
This implies at least $115.5 million in sales via just this one bank, perhaps 1500-2000 in cars or nearly 10% of total cars Tesla sold in the US in September, were possibly sold the last business day—and very likely at a significant discount given Tesla's urgency to drive sales.
That’s not all. That large “entity” cited above only explained part of the surprising $585 million jump in accounts receivable versus the second quarter, which nearly doubled it to an unprecedented $1.16 billion. Excluding the $115.5 million noted above still leaves $469.5 million unexplained.
Cagey Tesla blamed this increase on the quarter closing on the weekend—but that’s actually happened every other quarter over the past year without blowing up accounts receivable. And Tesla only explained the bank customer cited above when pressed for days after results were first reported. Mystery: Unsolved.
Going with the idea that Tesla takes every opportunity to boast about good news as well as to conceal bad news, there’s a good chance the explanation would make Tesla look bad. A large fleet sale, for example, might be good news to boast about and would easily explain a large bump in accounts receivable, but no such deal has surfaced. Instead, Tesla was uncomfortable about admitting it had $115.5 million in cash still tied up in loan processing on a significant number of cars sold presumably during the last hours of the quarter.
If it also had another $300-$400 million or so in loans still in processing with several other banks for the same reason, this could mean Tesla potentially sold 10-20% or more of its quarterly deliveries in the closing days and hours of the quarter—and yes, at sizable discounts.
Frantically selling so many cars so late in the quarter definitely could trigger high drama and intense pressure fairly early in the quarter and going forward as severe underperformance began to take shape that threatened profitability, cash flow, and already pressured liquidity.
This which would explain:
Tesla’s “delivery hell” Musk complained about over the last two weeks of the quarter when: 1) Tesla pulled out extra employees and even Tesla owners to help get cars delivered and 2) Musk reported buying extra carriers to handle the rush to deliver cars—a claim quickly disputed by trucking industry execs.
Why Tesla might employ aggressive accounting and other strategies to juice reported results—perhaps so much so seasoned execs decided they had to leave rather than play ball.
Why Tesla reportedly went after its own suppliers, looking for more discounts, substantial extensions on already overdue payables, and even cash back on existing contracts (which the company denies).
Why Musk worried the company still wasn’t profitable as of the last weekend of the quarter.
Why Musk worried the company was “bleeding money like crazy” and “going bankrupt” and even “weeks away from death.”
Why Musk became alarmingly irrational and even irresponsible, as noted above, to the detriment of the company as well as its employees, suppliers, creditors, customers, and investors.
Relax. We Still Made Money (in a way)
Auto Segment Gross Profit was up 264% to $1.54 billion, with the 25.8% margin up 750 bps. However, this also was boosted by emissions credit sales ($189.5 million) plus advantageous cost adjustments with the new revenue recognition rules as cited above (net benefit $88.4 million) plus related write-downs to inventory ($26.2 million).
Otherwise comparable gross profit was $305 million lower versus reported at $1.27 billion, with the margin actually 350 bps lower at 22.4%. Adding back $21 million in SBC as Tesla prefers nudges it to $1.29 billion in gross profit and 22.7% in margin--still well below the reported number.
Tesla also reduced warranty expense per car to just $2,242 versus $2,911 for the second quarter, $2,371 for the first quarter, and $2,302 for the third quarter last year. This savings added another $56 million to gross profit versus the second quarter calculation, or added $5 million using the number from last year—which may seem logical given that the cheaper Model 3 comprised 67% of cars delivered.
However, Tesla boosted the warranty provision per car in the second quarter when the Model 3 contribution jumped to 45% versus 27% in the first quarter.
Plus the Model 3 is logging a troubling increase in flaws and defects and service issues (including problems with cold weather) that are driving up repair costs.
So it seems premature, to say the least, to dial back warranty reserves—this reduction seemed aimed to boost profit for this critical and particularly troubled quarter.
Tesla nudged gross margin a bit more via moving $72.8 million in cars in finished inventory into PPE to be used as loaner cars no longer for sale.
Note that the near $400 million in boosts identified here in gross profit came from unusual, non-recurring, or inordinately low-balled assessments, not sustainable or core underlying performance. Even more troubling, Tesla needed this and more—reported pretax earnings was just $271 million and GAAP net income (excluding minority interest) was just $312 million.
Austerity governed overhead costs. SG&A and R&D both declined versus the second quarter and were only modestly higher versus last year, remarkable and seemingly illogical even given the massive boost in revenue.
Tesla did initiate meaningful layoffs in the second quarter, but it also has lost a number of high-level executives at a time when the bench already is light versus the increased management support which seems warranted. SG&A fell to just 10.7% of consolidated revenue versus 19% in the second quarter and 22% last year. I estimate this generated $100-200 million in savings this quarter that will be hard to preserve.
R&D seems almost tragically underserved, coming in at just $350 million—a meager 5% of revenue. That was down 5% versus the second quarter and up just 5% versus last year when revenue was less than $3 billion. The ideal spend might reasonably be $120-300 million higher, 7-9% or more of revenue, given Tesla’s hefty and growing to-do list. Since last year Tesla has launched the Model 3, but Model X and S are aging with no replacements on deck. Still waiting in development are the Model Y, the Roadster, the pick-up, and the semi-truck, not to mention significant committed capex for existing Gigafactories and the new Gigafactory supposedly about to be developed in China.
Tesla’s more aggressive rivals have serious competition rolling out now and almost continuously over the next year and beyond—it’s early lead is evaporating.
In the end, the $400 million or so boost to gross profit from unusual items plus $300-500 million in savings from unsustainably low SG&A and R&D accounted for most all the $1 billion boost in GAAP EBITDA of $920 million (13.5% margin), versus negative $135 million last year. Adjusted EBITDA excluding SBC and unusual charges was $1.04 billion, a likely fleeting 15.2% margin.
Without these enhancements, Tesla likely would have generated another significant loss of $500 million or more, even after adding back SBC as it prefers for adjusted net income. That would eliminate free cash flow, as cash flow from operations would have mostly evaporated and thus fail to cover even sharply reduced capex of $510 million.
So much for Tesla’s miracle third quarter.
What To Expect for the Fourth Quarter
With insufficient earnings contribution to generate cash, we have to look at the balance sheet to determine how Tesla managed to increase available cash by $731 million to $2.97 billion. Interestingly, Inventory did not generate cash despite the massive increase in cars delivered, which only modestly exceeded cars produced.
Instead Tesla again generated cash mostly by stretching payables--which increased by $566 million versus the second quarter--and by borrowing another $163 million in debt and capital leases.
This is an increasingly risky strategy Tesla can’t continue—it’s suppliers can and will shut it down if it doesn’t improve its payment performance.
Inventory behavior may indicate Tesla’s workaround strategy for that. Not only has it moved existing inventory cars into PPE for loaner cars, there’s a good chance it also might be using other cars for scrap; e.g. some of the dust-laden cars that have been photographed parked in desert lots over extended periods could be expensively damaged (batteries ruined, for example) and so could be stripped for parts more cheaply versus being repaired.
It also appears that sales are not suffering from Tesla’s persistent inability to sustain even 5,000 weekly production levels of the Model 3, so perhaps demand has begun to fade as I have projected—another potential reason inventory is not shrinking.
Indeed Bloomberg’s Model 3 Production Tracker shows weekly production has declined steadily since the peak at the end of October and is down 6% to just 4,311.
Building less works in a pinch to preserve cash, but it’s not an optimistic solution for a supposedly high growth company to generate cash.
That $585 million jump in accounts receivable should have been collected shortly into the fourth quarter, however. If so, that is sufficient to retire the $440 million in debt maturing in the quarter, potentially preserving enough cash as needed on the books at year-end.
The Pressure on Operations Should Continue
Don’t expect a repeat of third quarter reported profit margins. Tesla has been cutting prices liberally for all versions of all models of its new and used cars, in the US and overseas.
Price reductions for China were recently announced at 12-26%, which likely will increase the already forecasted impact to gross margin. There’s also a good chance that wider coverage of disturbing problems surfacing with Model 3 could drive more customers to increasingly comparable and more reliable rivals.
Now midpoint through the quarter, disappointing sales trends already are apparent. InsideEVs.com reported that Tesla marked its largest sequential declines in US sales for the year in October for Model 3 (down 20%), Model S (down 64%), and Model X (down 69%), with international sales coming in even weaker.
This deficit for Models S+X will be even harder to make up versus particularly strong sales in December last year.
Weaker pricing and fading volumes could further exacerbate margins already pressured to match burnished numbers logged in the third quarter.
If so, I expect Tesla will try again to salvage profitability by trying to boost emissions credit sales and continuing to hold direct costs inordinately low—especially R&D.
This plus Tesla’s troubling underspend in capex (now roughly even with depreciation as of the third quarter) puts Tesla at even further disadvantage at the start of the new year when it really needs to reap dividends from growth investment, not starve it.
My full year projections for 2018 and 2019
I estimate fourth quarter deliveries up roughly 7% versus the third quarter to nearly 90,000, including 62,000 Model 3s, with lower average pricing near $65,500.
This indicates auto sales revenue at $5.7 billion (down 4% sequentially, up 135% y/y) with reported GAAP gross margin at 24.6% versus 25.8% sequentially and 18.9% y/y.
I estimate consolidated revenue at $6.55 billion (down 4% sequentially, up 99% y/y), $945 million in adjusted EBITDA (14.4% margin versus 1.1% last year), and near $180-240 million in reported net income.
This indicates leverage improved to 5.7x versus 24.8x sequentially on $11.34 billion in debt, which assumes $440 million in debt retired during the quarter.
2019 May Make 2018 Look Like a Frolic
Market and economic conditions are clearly becoming less favorable for car buyers, and the competitive environment will likely become much more challenging for Tesla in the US and abroad through next year. Nevertheless, there’s a good chance Tesla can successfully expand market share via increased Model 3 availability overseas as planned, albeit at less favorable pricing. I expect potentially accelerating erosion in sales and profits from Models S and X, however. Tesla should be able to offset some, though not all, pricing and mix erosion via slowly improving operating efficiency sufficient to generate better visibility into sales and profit trends, as well as increasingly reliable cash generating capacity.
That said, Tesla may continue to struggle to generate significant cash flow to fund increasing capex it needs for its burgeoning project load (I estimated at least $3 billion in capex for 2019) plus $1.7 billion due in maturing debt and possibly several hundred million in legal settlements.
I’ve already projected that Tesla likely could get its banks to waive covenants it may breach and it probably can refinance near term debt with unsecured senior notes—though this likely will result in higher interest costs and fees and potentially new covenant restrictions. All mostly because of Musk’s past shenanigans and broad and very reasonable concern investors harbor over what disturbing stunt he might pull next or, even worse, what kind of trouble may be brewing that hasn't come out yet.
The wild card and perhaps biggest obstacle in Tesla’s future, still, is Elon Musk. The main lesson learned over the past year is that Musk will be Musk and no one in the company or on the Board will stop him, even if he blows up the stock as well as the company in the process. Now, however, Musk has dulled both Tesla’s coveted mystique as well as its market advantage as it starts 2019 with all models now several years old.
The consequences of Musk’s actions to date remain palpable. Indeed, even after reporting its strongest quarter ever Tesla stock still hasn’t rallied back to the $360 level it needs to attain by December 1st and hold through February 28th so investors can be repaid in stock instead of precious cash when its $920 million convertible bond issue matures on March 1st. If it can’t do this the company’s liquidity remains constrained by obligations to repay that debt in cash (likely borrowed at higher cost) plus retain that cash until then with a $400 million cushion on the balance sheet to comply with its credit facility. Another $728 million in debt matures later in the year, including $566 million in convertible notes due November 1st.
An increasingly challenging market environment means more stress ahead for Tesla and for Musk—and we’ve seen how well he handles stress (it hurts his brain and his heart).
This plus persisting weakness in Tesla's underlying operating performance and its aggressive financial reporting keeps me wary of Tesla’s bonds through at least another quarter despite underlying improvement apparent in its credit quality.
Maintain “Underperform” on TSLA 5.3% Senior Notes due 2025, up nearly 3 points over the past month to 86.5 (7.9% ytw; 491 bps). That’s a paltry 86 bps per turn of leverage—hardly adequate compensation for such a volatile issuer. Given Tesla's persistently uncertainty we could see 3-5 points additional downside from here.
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