Friday was a day of unfortunate delays for Elon Musk, the CEO of Tesla Motors (NASDAQ:TSLA). He had two critical items on his To-Do List - launch the SpaceX Dragon Capsule and file Tesla's Form 10-K for last year.
Neither went according to plan. The Dragon will have a late rendezvous with the space station and the Form 10-K will suffer a similar fate.
While it's rare for a large accelerated filer like Tesla to miss an SEC filing deadline, there can be any number of reasons including clerical errors and even technical glitches with the SEC's Edgar system. If it was a simple clerical error or technical glitch, Tesla's annual report will be on file at the SEC before the market opens on Monday.
However, if Tesla requests a 15-day extension by submitting a Form 12b-25 Notification of Late Filing, the most likely reason will be unresolved audit issues. Prudent investors should carefully monitor the situation as it develops.
Tesla released its fourth quarter and year-end financial results on February 20th, together with year-end balance sheet data. While most analysts, pundits and advocates focused on Tesla's Q4 income statement, I focused instead on its balance sheet, which was released in a non-traditional format that blurs distinctions between current and non-current assets and liabilities.
After working my way through Tesla's balance sheet data and its prior SEC filings in an effort to estimate its year-end working capital position, I was surprised to calculate a $23 million working capital deficit at year-end. The figures were far worse than the $3 million working capital surplus J.P. Morgan forecast in mid-December. It's simply not adequate for a money losing company that plans to manufacture and sell $1.5 billion of products this year.
Since then I've been waiting patiently and quietly to see whether the auditor's report in Tesla's Form 10-K will include the dreaded going concern paragraph you frequently see in micro-caps:
"The accompanying financial statements have been prepared assuming that ABC Company will continue as a going concern. As discussed in Note X to the financial statements, ABC Company has suffered recurring operating losses, negative cash flows from operating activities, recurring working capital deficits and adverse key financial ratios that raise substantial doubt about the company's ability to continue as a going concern. Management's plans in regard to these matters are also describe in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty."
Tesla's balance sheet at September 30th was very fragile with a working capital deficit of $101.2 million and an equity deficit of $27.9 million. When Tesla raised $222.1 million of fresh equity in early October the market breathed easier. Five months later, it looks like Tesla is back in the fiscal ditch with a surging working capital deficit and rapidly shrinking equity. Just last week, the Maxim Group released a "Company Update" that forecasts a working capital deficit of $61.8 million by the end of this month.
Tesla's year-end cash of $201.9 million looks pretty solid until you consider its other accounts.
A huge chunk of Tesla's cash came from increases in accounts payable and accrued liabilities, which surged from $190.5 million to $343.2 million during the quarter. While vendors who make automotive parts usually offer reasonable credit, they do want to be paid promptly so they can pay their own bills. Tesla's suppliers can't be thrilled by its decision to hold onto $152.6 million of cash for year-end window dressing.
There was also a $109 million increase in inventory to $268.6 million, which includes 350 cars that were built in Q4 but not delivered to customers. At planned production rates it will take substantially all of Q1 to turn roughly $245 million of parts inventories into finished goods and then convert the finished goods into cash.
While there's no way to know whether Tesla is meeting creditor expectations, Mr. Musk did offer a tantalizing insight into his supplier relationships in a recent Investors Business Daily interview:
"When we finally figured out what was wrong at the Czech factory and sent the payment for the tires and said please put them on a plane, they put them on a boat instead."
While he offered the example to demonstrate the complexity of a global supply chain, it clearly suggests that all is not sweetness and light. If this was not a one-off event and key suppliers are demanding payment before parts are shipped, the next few months could get pretty rocky.
The most surprising entry on Tesla's year-end balance sheet was a reservation payments balance of $138.8 million, a $500,000 increase from Q3.
Tesla reportedly delivered 2,400 cars in Q4. It's my understanding that the deliveries included 1,000 Signature Editions that required $40,000 deposits and 1,400 other vehicles that required $5,000 deposits. It's also my understanding that Tesla booked 4,200 new reservations during the quarter that each required $5,000 deposits. If my understanding of the deliveries and reservations is accurate, the reservation deposits on Tesla's year-end balance sheet should have fallen by $26 million. The only reasonable explanation is that additional deposits from existing reservation holders who wanted to avoid a pending price increase offset the cash drain.
It was a cute trick, but a trick that can only happen once.
If we assume for the sake of simplicity that Tesla has received an average deposit of $10,000 on each car it will deliver this quarter, its Q1 cash flow calculations will start with small non-GAAP income, and then deduct a $45 million cash drain for reservations credited to revenue. As near as I can tell, that's the biggest reason the Maxim Group expects Tesla's working capital deficit to explode to $61.8 million by the end of this month.
I'm also troubled by Tesla's decision to slash quarterly R&D spending by $10 million during a period when R&D should presumably be increasing to set the stage for a Model X launch next year and a Gen 3 launch a year later.
Under the circumstances I have to believe the last couple weeks at Tesla have included several brutally frank discussions with the auditors over the need for a going concern paragraph.
Last week, Mr. Musk told IBD, "We don't think there's a need to do any fundraising." But those comforting words ring hollow when I recall Tesla's July conference call when Mr. Musk told investors:
"I do want to emphasize that our cash flow projections require no funding raise at all. If we do not raise any funding, we can reach cash flow positive with decent margin. That's not to say that there isn't some merit in raising a little bit [of] funding maybe, just to increase the cushion. That's something that we're debating internally, and something that we may do. But I do want to emphasize it's not something we have to do."
Tesla needs a few hundred million dollars of additional working capital if it wants to be viewed as a credible manufacturing enterprise. I know it, Mr. Musk knows it and so do his auditors.
"The auditor has a responsibility to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited."
Unlike CEOs who can engage in "Disneyland forecasting" where wishes come true if you only believe hard enough, an auditor's work is based on objectively verifiable evidence that focuses on a number of complex business issues including:
- Negative trends-for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, adverse key financial ratios.
- Other indications of possible financial difficulties-for example, default on loan or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets.
- Internal matters-for example, work stoppages or other labor difficulties, substantial dependence on the success of a particular project, uneconomic long-term commitments, need to significantly revise operations.
Optimistic assumptions about reservation conversions and sales on other continents won't cut it. Auditors need substantial credible evidence. While I've never represented a company as big as Tesla, I've never won the argument when the auditors believed a going concern paragraph was appropriate.
I've heard all about Tesla's plans to manufacture and sell 4,500 cars this quarter and generate a small non-GAAP profit (profit before the ugly truth). What many fail to grasp is that Tesla's practice of front-loading cash through reservation deposits has set up a perfect storm for breakeven non-GAAP income while cash resources go swirling down the drain.
While a going concern paragraph isn't normally a big deal for a micro-cap company, it can be a major problem for a mid-cap like Tesla that's sporting a $4 billion market capitalization and trading at 31.5 times book value. EV fans may not care about trivialities like balance sheets, but vendors, lenders and institutional investors do care.
I am not predicting that Tesla will be saddled with a going concern paragraph in its annual report. Nevertheless, I see a substantial risk of a qualified audit opinion. I believe everybody but the short sellers has ignored that risk.