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Tesla: A Classic Case of Building Economies of Scale to Achieve Profitability

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Tesla's financials are a mess: total future debt obligations exceeding $10 billion, of which nearly $2.5 billion will hit maturity between now and the end of next year in 2019; a staggering debt/equity ratio of 2.4X; GAAP net losses in virtually every quarter since their 2010 IPO; and an accumulated deficit since inception of nearly $5 billion.

Tesla reported $2.7 billion in cash on hand and burned through roughly $1.05 billion in cash (operating cash outflow plus capex) during the quarter ended March 2018. If this pace of cash burn continues, the company could run out of reserves midway through the fourth quarter of this year.

Further exacerbating the situation is the onslaught of serious competition. GM, BMW, Volkswagen, Porsche, Jaguar, Nissan, and Mercedes-Benz have all announced plans for committing billions to the development of mass market electric vehicles. Some are already available for customers such as the Chevrolet Bolt and Nissan Leaf, and many more are set to hit the market within the next 12-24 months.

Mounting debt alongside mounting cash burn and oncoming competition is typically a recipe for financial ruin. And yet, in spite all of this widely known, widely reported and publicly available information, Tesla's shares have remained virtually flat to slightly lower YTD.

What do Tesla investors see that could possibly outweigh all of the above red flags and possibility of financial insolvency?

The story appears to be a special situation that doesn't present itself very often.

According to Elon Musk's Master Plan, the idea is simple:

1) Create a low volume car, which would necessarily be expensive
2) Use that money to develop a medium volume car at a lower price
3) Use that money to create an affordable, high volume car

While the idea is simple, the execution is complex: building economies of scale, which necessarily requires massive upfront capital investments and R&D. To that effect, Tesla has invested over $5 billion in combined capex and R&D since 2016, primarily to build capacity to manufacture up to a million cars annually, much of which is planned to be automated through a network of sophisticated robotics.

Tesla acquired German robotics firm Grohmann Engineering in 2016 primarily to advance this objective, with the machinery having just recently been disassembled at its German headquarters, shipped to Tesla's Gigafactory in Nevada, and reassembled there in an effort to boost the company's production rate of the Model 3 electric sedan.

Despite the company's struggles and repeated missed deadlines to hit production targets, investors still seem to be focused on the long term opportunity Tesla is uniquely positioned to potentially realize a windfall from: the growing adoption of EVs by worldwide consumers.

With battery capacity now powerful enough to compete with gas cars, charging infrastructure rapidly expanding, and more affordable vehicles now hitting the market; EVs are quickly becoming more viable to replace their internal combustion engine counterparts. Data from global EV sales tracking database at EV-Volumes.com shows it:



Furthermore, a recent survey by AAA found that 20% of Americans reported their next car will be an EV, up from 15% a year ago. Various fundamental reasons for this paradigm shift lend support to this - EVs are now capable of traveling over 200 miles on a single charge, have lower overall cost of ownership, instant torque, and nimbler handling.

Tesla in particular, however, has a major competitive advantage: the widespread Tesla Supercharger network, which allows for long distance travel. With EV sales in the United States as a percentage of overall auto sales still only at 0.05%, according to Consumer Reports, the potential for continued growth is significant. As such, even with oncoming competition from legacy automakers with hundreds of years of combined experience in mass production, the rapidly growing pie could suggest Tesla has an opportunity to significantly grow revenues even if its market share dominance of EVs begins to wane.

Tesla's strong brand equity, as Consumer Reports shows, first-mover advantage and its proprietary coast-to-coast high-speed charging network all suggest the Palo Alto-based carmarker is uniquely positioned for growth in an overall growing industry.


Debt Risk and Production Tied at the Hip

A major concern for Tesla is its mounting debt. From the recently filed SEC Form 10Q:



Tesla exited the March 2018 quarter with $10.4 billion in total debt, with nearly a quarter of that amount coming due over the next 18 months. However, Tesla's debt relative to total capital or 2018 EBITDA looks quite reasonable compared to a peer group mix of automakers, industrials and tech companies like Boeing, GM and Amazon:



While its true all of these companies are profitable and Tesla isn't (more on this later), what's of greater importance to bondholders is EBITDA, which represents cash operating income available to service the debt. When standardizing debt to expected 2018 EBITDA, Tesla is indeed on the high end but less so than GM and Ford:



Tesla could stand to reduce its balance sheet leverage, and there's a pathway to do it: increasing Model 3 production. If Tesla successfully resolves the production bottlenecks and can begin scaling revenues, EBITDA could continue to accelerate. Analysts polled by Zacks currently estimate this to occur, expecting EBITDA to climb from $2.015 billion in 2018 to $3.47 billion in 2019, led primarily by a production ramp of the Model 3:



Source: Zacks Investment Research Inc. | EPSSurprise.com


The pathway to reducing the degree of leverage risk is thus clear: achieve Model 3 production targets on time. Leaked internal emails this week suggest the company is currently on the cusp of hitting 3500 cars produced this week, according to Electrek. A VIN registration tracking methodology maintained by Bloomberg also suggest Tesla is on track of hitting similar production rates in the coming weeks.


Scaling Revenues Relative to Operating Expenses

Tesla's 10Q for the March 2018 quarter states:

"We expect operating expenses to grow in 2018 as compared to 2017, although operating expenses should decrease significantly as a percentage of revenue due to the significant increase in expected revenue in 2018 and as we focus on increasing operational efficiency."

Indeed, since mid-2016, SG&A expense relative to total revenues have been on the decline from a peak of 25%, even as revenue has dramatically increased:




This trend of increasing revenues faster than operating expenses is encouraging, and suggests that the pathway to profitability lies in Tesla's ability to scale production. This is a classic case of economies of scale: operating income is negative even when gross profit is positive due to large, up-front fixed costs, but that there is a production level at which total revenue equals total variable cost plus total fixed costs. The gross profit of each unit produced thereafter flows directly to the bottom line profit, before taxes are applied. We can take a practical exercise to visualize this:



Selling, general and administrative costs, R&D expense, and interest expense totaled $1.24 billion in the March 2018 quarter. Holding those costs steady for this exercise, this represents our fixed costs going forward. Variable costs primarily involve cost of goods sold, which is roughly 75% for Model X and S sales, and varies for Model 3 based on unit production.

We assume negative gross margins on the Model 3, consistent with management's commentary, up to 20,000 units, which then gradually scales up to a maximum 22% gross margin at 60,000 units and beyond. We also assume a steady state of Model S and X production at 25,000 units per quarter, average selling price (ASP) of $100,000, and an average selling price of the Model 3 of $52,500.

Given these assumptions, the point at which total revenues surpass total expenses is 59,000 Model 3 units per quarter, which roughly translates to about 4,916 weekly Model 3 unit production, assuming a 12-week quarter. This lines up with management's commentary that a 5000/week Model 3 production run rate will result in positive GAAP net income.

The purpose of this exercise isn't to forecast Tesla's production or earnings, but to understand why Tesla is posting widening net losses despite rapidly increasing revenue, and where the pathway to profitability likely lies. Because Tesla has allocated the full costs of production up front, operating income will appear negative up until they reach the production threshold, and each unit sold thereafter will accrue directly to the bottom line.


Cash Flows vs Profits

Operating cash flow is typically higher than net income for most companies due to various non-cash expenses being added back. If OCF is below net income for a sustained period, it could suggest the company is manipulating or aggressively recognizing revenues on the income statement without actually collecting the cash. A quick look at the spread between Tesla's operating cash flow and GAAP net income, calculated quarterly based on rolling 4-quarter totals shows the following:



Although operating cash flow has been negative for Tesla, it's important to see OCF in a significantly better position than GAAP net income. Even if Tesla comes close to GAAP breakeven with Model 3 production, we should see significant operating cash inflow in 2018 given this trend, which would go a long way in reducing Tesla's cash burn.


Capital Raises to Fund OpEx Not the Same as CapEx

This, however, does not mean Tesla will halt its cash burn. Management has guided $3 billion in capex needs this year in preparation for Semi truck and Model Y compact SUV products, as well as a possible Gigafactory in China. Tesla would need to generate quarterly operating cash flow of at least $750 million ($3 billion over four quarters) to arrest its cash burn. That would require Model 3 production exceeding 6000 units per week, sustained. While it's possible to achieve, it's not likely in 2018. As such, further capital raises are highly likely.

As we saw in the revenues vs total cost curve exercise above, it's entirely feasible that Tesla can fund all its operations (before capex) through just Model S, X, and 3 sales. This would suggest that a growing portion of gross profit from future products such as the Tesla Semi, Model Y and Tesla Energy division would accrue directly to the bottom line, before taxes, leading to exponential earnings growth.

Capital markets understand the difference between raising capital for the sake of funding operating expenses versus pursuing growth opportunities. If Tesla can prove its economies of scale business model can be GAAP (and non-GAAP) profitable, it's difficult to imagine capital markets unwilling to finance its growth capex projects. The growing mass-market adoption of EVs, Tesla's strong brand equity, competitive advantages in the global Supercharging network and best-in-class unit battery costs per kWh, and consumer cost economics being competitive with gas and diesel all point to significant opportunities for Tesla.

However, in order to even be in a position to capitalize on this, Tesla needs to successfully scale the Model 3. The critical importance of hitting the 5000/week production target cannot be overstated for Tesla's future as a going concern.




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