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Over the last few weeks electric vehicle aficianados have been beside themselves with glee over reports that Tesla Motors (NASDAQ:TSLA) will report a net profit on both a GAAP and non-GAAP basis for the first quarter of 2013. Since the news broke on March 31st, the stock has gapped up from $37.89 to an all-time high of $52.92.

Few commenters and even fewer investors understand that Tesla's Q1 income guidance is little more than an epic April Fools prank, an aberration attributable to the confluence of non-recurring factors that will leave Tesla solidly in the red for the next two years.

The two big drivers of Tesla's Q1 earnings will be:

  • A one-time non-cash gain of $11 million arising from the reversal of a derivative warrant liability associated with the acceleration of Tesla's DOE loan; and
  • An estimated $20 million in ZEV credits that have already saturated the market for 2013 and beyond, and effectively destroyed the value of future ZEV credits.

When Tesla borrowed $465 million under the Department of Energy's ATVM loan program, it issued a warrant that gave the government a right to buy up to 3.1 million shares of common stock at a price of roughly $8 per share. In accordance with GAAP, it recognized an operating expense for the fair market value of the warrant and booked a related long-term liability. When Tesla amended the terms of its ATVM loan in early March, the acceleration of its payment schedule reduced the estimated value of the DOE's warrant by $11. That reduction of an estimated future liability will be reported as non-recurring income in Q1. Without the warrant liability reversal, there would be no first quarter GAAP net income.

A more troubling dynamic is the role of ZEV credits in Tesla's past, current and future operating results.

During 2012, Tesla received $40.5 million from the sale of ZEV and GHG credits to automakers. In an April 18th research note Morgan Stanley estimated that Tesla's ZEV credits for Q1 would be over $20 million, but fall in future quarters.

Something about the two numbers didn't add up for me. During 2012, Tesla delivered about 2,950 vehicles and received roughly $13,725 per unit in additional revenue from sales of ZEV and GHG credits. In Q1, however, Tesla delivered 4,750 vehicles and Morgan Stanley thinks they'll only receive $4,200 per unit in ZEV and GHG credits. It was enough to make me ask, "Why are Tesla's expected ZEV and GHG credit values cratering?

I found the answer in a 2010 report from the Natural Resources Defense Council titled, "The Zero Emission Vehicle Program, An Analysis of Industry s Ability to Meet the Standards," which used this graph to forecast annual demand for ZEV credits and the available supply of credits over time.


(Click to enlarge)

While the NRDC did not assign a specific number to aggregate national demand for ZEV credits during the 2012 to 2014 time frame, an eyeball estimate of 50,000 credits per year is pretty close. Through the end of 2012, the graph projected that aggregate demand for ZEV credits would exceed available supplies, creating a robust sellers market. From 2013 onward, the graph projected that supply would exceed demand by a modest to wide margin, creating an anemic buyers market.

While Tesla was the primary beneficiary of the seller's market that existed in 2012, the benefits beyond Q1 of 2013 will most likely be limited to non-existent.

The most important thing to understand about ZEV credits is that the number of credits per car varies with battery pack size. The following table from the NRDC report summarizes the five credit classes that existed in 2010.

Credit Tier

Expected Technology

Credits

Type III

BEV ≥200mi

4

Type II

BEV ≥100mi

3

Type I.5

BEV 75-99mi

2.5

Type I

BEV 50-74mi

2

Type 0

BEV < 50

1

Based on the NRDC table, it appears that every car Tesla delivers generates a minimum of four ZEV credits. While I've been told that Tesla earns five ZEV credits when it sells a Model S with an 85 kWh battery pack, I haven't found definitive regulatory confirmation of that number. So I classify it as credible rumor rather than absolute fact.

In the first quarter of 2013, automakers other than Tesla sold a total of 13,063 plug-in vehicles that generated something on the order of 30,000 ZEV credits. The 4,750 cars sold by Tesla increased the available supply of ZEV credits by 20,000. Unless there's been a massive surge in ZEV requirements over the last two years, the ZEV credit market for 2013 is already saturated and the ZEV credit revenue that reduced Tesla's 2012 loss by $40.5 million and will turn a large Q1 operating loss into an insignificant GAAP profit will fall to approximately zero in Q2.

When you eliminate the combined impact of the warrant liability reversal and the non-recurring ZEV credit sales, Tesla's Q1 net loss from recurring business activity will be about $30 million, as opposed to the anticipated GAAP net income of roughly $2 million.

April Fools!

In its recent research note, Morgan Stanley predicted that Tesla would report a net loss of $108 million for 2013 followed by a net loss of $43 million for 2014. Investors who are buying Tesla stock for an eye-watering 39.4 times book value are in for a very rude awakening.

Source: Tesla's Q1 Earnings, An Epic April Fools Prank