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In late April I published an article titled "Tesla Q1 Earnings, An Epic April Fool's Prank" that carefully dissected Tesla Motors' (NASDAQ:TSLA) claim it would report a GAAP and non-GAAP profit in the first quarter and explained where the earnings would come from. The article drew over 14,000 page views and over 600 mostly hostile comments from readers, but was kinder to Tesla than the reports it ultimately filed with the SEC.

In late May I published a follow-on article titled "The Dark Side of Tesla s Masterful Short Squeeze" that examined Tesla's first quarter earnings report and discussed the likely future impact of lease accounting and a saturated market for ZEV credits. The second article drew another 14,000 page views and another 800 mostly hostile comments from readers, but was once again quite accurate in its description of the adverse revenue and income statement impacts from Tesla's recently announced lease equivalent financing program.

On Wednesday of this week Tesla reported its second quarter results. It beat guidance and expectations on the number cars delivered and average sales price per car, and significantly improved gross margin on its core business of making and selling cars without regard to the profitability of its 100% margin side business of creating and selling ZEV and other regulatory credits.

The following table highlights Tesla's accomplishments as a start-up manufacturing company over the last 12 months.


(Click to enlarge)

These are impressive numbers that add a ton of credibility to management's claim that Tesla will approach a 25% gross margin by Q4, excluding ZEV credits but including other regulatory credits.

While I'm quite impressed with the accomplishments of Tesla's manufacturing team, I believe their reported non-GAAP earnings for Q2 are the worst kind of distortion; a fairy tale that pretends Tesla was in the same business during Q1 and Q2.

The business of making and selling cars is pretty straightforward. When Tesla sells a car to a cash customer it receives a check for the entire purchase price and that's the end of the story.

The business of making cars and leasing them to customers is very different because the lender who writes a check for the purchase price is relying on the customer's credit for a little over half the loan amount and relying on Tesla's credit for the balance.

When Tesla delivers a car to a finance customer, it receives a check for the entire purchase price from the bank and sets up two liability accounts on its balance sheet to reflect the substance of the transaction. The balance sheet accounting for a hypothetical $100,000 Model S breaks down as follows:

Debit

Credit

Cash

$100,000

Liability - Deferred revenue

$50,715

Liability - Other long-term liabilities

$49,285

The deferred revenue liability represents the amount the customer will pay the bank during the lease term. The other long-term liability represents the amount Tesla will be required to pay the bank when the three-year old Model S is sold at the end of the lease term. If Tesla receives less than $49,285 from the sale of the three-year old Model S after accounting for the cost of selling the used car, it will suffer a loss on the trade.

In a cash sale 100% of the resale value risk lies with the customer. In a financed sale 100% of the resale value risk lies with Tesla. Pretending the two are somehow equivalent is dishonest.

Tesla fundamentally changed its business model the moment it started offering a lease finance equivalent to customers. Unfortunately, the non-GAAP reporting methodology Tesla used in its Q2 shareholders letter pretends that a lease is the same as a sale and compresses everything into the current quarter. It shows the amounts the customer is required to pay as non-GAAP revenue and it also shows the amounts that Tesla is required to pay as non-GAAP revenue.

It's the corporate equivalent of taking out a second mortgage on your home and calling the refinance check income.

In its shareholder letter Tesla reported a GAAP loss of $30.5 million and a non-GAAP profit of $26.3 million. The difference between the two numbers came from:

  • $21.0 million in stock compensation and non-cash loan costs;
  • $16.4 million in one-time costs related to their DOE loan repayment; and
  • $19.3 million in adjustments related to lease accounting.

The first two adjustments are very typical and don't strike me as problematic. The third adjustment that pretends Tesla was in another business and magically transforms debt to revenue is a very grim fairy tale.

I understand that Tesla has become a cult stock over the last couple years. But like most cult members, Tesla acolytes share a couple of dogmatic beliefs that are logically inconsistent and mutually exclusive.

When Tesla talks about the resale value of a used Model S it's happy to promise customers that the $100,000 car they buy today will have a market value of at least $49,000 in 2016. They're so confident that they put the promise in writing for the bank and billionaire Elon Musk threw in his personal guarantee for good measure.

In my experience, banks don't require personal guarantees from executives unless they have grave reservations about a company's ability to pay when the note comes due.

When Tesla talks about its future product development plans, it can barely contain the evangelical zeal over a planned Gen3 vehicle that will offer slightly less performance and opulence than the Model S, but be available to customers for a price in the $35,000 range.

While I personally think the promise of the Gen3 Tesla will prove elusive because it will require major improvements in battery and other EV technologies over the next three years, the more important question is "What will happen to the resale value of a three-year old Model S if it has to compete in the market against a spiffy new Gen3 Tesla that can be had for $35,000, or for that matter $50,000?" Frankly I can't imagine a market where the successful launch of an affordable Gen3 Tesla won't trash the resale value of today's $100,000 Model S.

So my question for Tesla longs is "What do you want to believe?" Do you want to believe the planned Gen3 Tesla will destroy the residual value of today's Model S and make a cruel joke of Tesla's earnings reports or would you rather believe Tesla will remain a niche manufacturer of luxury goods that retain a high resale value because no competitive products even come close?

I earned my undergraduate degree in accounting before going on to law school so balance sheet analysis is part of my DNA. In its letter to stockholders, Tesla reported cash, working capital and stockholders equity that were all clustered in the $5.25 to $6.25 per share range. When I compare the hard financial statement values with yesterday's closing price of $153.50, I can't avoid the conclusion that the current stock price is 4% substance and 96% blue sky.

I've written about my proprietary blue sky to book value, or BS to book, ratio in other articles and am once again happy to report that Tesla's BS to book ratio is high enough to make all the other market darlings blush over their feeble performance. The following table summarizes the BS to book ratio for several companies I frequently see mentioned as Tesla peers.

Symbol

Market Cap (billions)

Book Value(billions)

BS to Book

TSLA

$17.73

$0.67

25.34

Amazon (NASDAQ:AMZN)

$135.12

$8.73

14.47

Netflix (NASDAQ:NFLX)

$14.75

$1.11

12.35

Green Mtn Coffee Roasters (NASDAQ:GMCR)

$11.41

$2.39

3.78

Apple (NASDAQ:AAPL)

$418.83

$118.20

2.54

Over the next year Tesla is unlikely to see significant revenue growth. While quarterly deliveries may ramp into the 6,000-unit range, increased sales will probably be attributable to an increased take rate for the Tesla financing option. In that scenario GAAP revenues will fall by 12.5% as ZEV credits disappear and fall further if take rates on Tesla financing increase as management expects they will. On a non-fairy tale basis, Tesla's GAAP and non-GAAP earnings will slowly increase. With each passing quarter, however, Tesla will be loading another $150 to $200 million of debt on its balance sheet that's only 50% offset by corresponding customer promises to pay.

I've never shorted a stock and I'm not about to start now, but I'm convinced the downside risk in owning Tesla's stock at prices approaching $155 per share is an order of magnitude greater than the upside potential.

Source: Tesla's Non-GAAP Fairy Tale