Tesla (TSLA) has been a modest part of my portfolio along with other innovative companies -- Apple (AAPL), Michael Kors (KORS), and Chipotle Mexican Grill (CMG) -- for years. In September 2012 I cashed out my entire Apple position right before the iPhone 5 launch at $694, mainly because I realized Apple wasn't the ever-innovative company it had been, but rather one only delivering incrementally updated products. Meanwhile, I was building the first version of the Tesla pricing model shown below. After seeing the results of this model, I added all my profits from the Apple investment to my existing Tesla position.
I admit Tesla was a very high-risk investment back then, but its incredible upside potential and my risk-tolerant young age supported this individual strategy. Since Tesla had numerous risks, I built the original pricing model with three modes: conservative, realistic, and optimistic. I also made minor updates to it following major announcements, but these changes didn't affect the results significantly. Meanwhile, there were (and still are) numerous analysts' reports from highly respected investment banks trashing Tesla, as well as hundreds of negative articles written all over the webosphere claiming that Tesla will run out of cash in Q1, go bankrupt soon, etc. There were also hundreds of baseless, irrational, and -- in my opinion -- mostly politically motivated macroeconomic doom and gloom claims.
Despite these claims, and as I predicted, Tesla progressed flawlessly into 2013 and mitigated the majority of its risks one by one. The U.S. economy also continued its slow recovery while the markets kept reaching all-time highs. However, if you adjust these numbers for inflation (historical P/E ratios, etc.) they weren't and still aren't as "bubbly" as they were claimed to be. My other investments, Michael Kors and Chipotle Mexican Grill, have been doing great as well, but they are now simply dwarfed by Tesla's ~500%-plus profits.
I began advising my friends to invest in Tesla in Q4 2012 because I felt the majority of the risks were mitigated, and let's just say that the ones who did are very happy. I also ended up writing two full analyses on Tesla, suggesting it as a strong buy for long-term investors, and even shared conservative and realistic versions of my pricing model. Meanwhile, the market has been extremely generous to Tesla, as evidenced by its share price already surpassing two of my 2013 year end price targets: conservative at $73, realistic at $161, and optimistic at $215. These price targets don't sound crazy now, but they definitely did back when Tesla was trading in high $20s.
I am re-presenting the same "realistic" version from my second article since the underlying numbers -- such as deliveries, gross margin, ZEV decrease, etc. -- are still on track for 2013 year end. In addition, there haven't been any strategy changes, mistakes, or viable product announcements from competitors, and supercharger network expansion, global store/service station openings, etc. are all progressing as I estimated. I strongly believe my investment advice is still valid and am maintaining my long position.
The one factor this model lacks, however, is "lease accounting." I believe it won't be accurate to estimate the percentage of customers that will lease Tesla's current and future products in many different countries as similar leasing programs are introduced around the world. That brings me to the second part of my article; why reconciled non-GAAP numbers are crucial for long-term investors.
Feel free to ask me any questions on the model, and plug in your own P/E if you disagree with my estimates of the market's pricing in the long term.
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Tesla Introduces Leasing Program on April 2, 2013
Tesla partnered with Wells Fargo and U.S. Bank to provide leasing option to its customers in Q2. Although the program was great, the way it was marketed was the first major mistake I had seen from the company (hence the title of my first article). Thankfully, the ever-humble Musk and his team listened to negative but fair feedback and improved the program on May 3.
Regardless, the leasing program was great news. It made the Model S more affordable and less risky for many potential buyers, which led to higher sales that were cheered by investors. Already, more than 30% of customers have opted to lease their cars in Q2 and the company expects the rate to increase going forward. This all sounds good, but now Tesla investors have a "high-class problem," especially the ones that do their own homework. GAAP (generally accepted accounting principles) dictates that all public companies spread the recognition of revenue and cost for leased purchases over the term covered by the resale value guarantee. In Tesla's case, the guaranteed resale value is approximately 50% of the base vehicle (60Kwh version) selling price and 43% of vehicle options (including upgrade to 85Kwh battery), and the term is 36 to 39 months. The resale amount is specified at the time of delivery and is forecast to be higher than any high-volume premium sedan brand (Audi, BMW, Mercedes, Jaguar, Lexus, etc.).
So, how do you compare quarterly or annual results with previous ones to track progress? How do you estimate the percentage of customers who will lease the car going forward? What about this percentage in different countries if/when Tesla introduces similar programs? If customer sentiment stays as positive as today and they don't sell their cars, how will new investors react to the "GAAP revenue/profit jump" starting in Q3 2016?
For this very reason, Tesla notified investors about the effects of lease accounting in all of its statements, and in addition provided deferred revenue and profit figures to reconcile. With these reconciliations, Tesla investors can easily track the company's progress and check on its earlier stated targets, such as 25% gross margin (excluding ZEVs) by Q4 2013.
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Circled in red: Deferred revenue and profits due to lease accounting, obviously none in Q1. Also highlighted in yellow: One-time fee that GAAP-loving, profit-hawking shorts like to simply ignore.
As expected, negative and ignorant articles ensued. Some compared Q2 revenue and profit results directly with Q1, ignoring lease accounting, and claimed Tesla's figures declined by 20%-30%. These people would fail Accounting 101 at a community college. Others claimed Tesla's accounting practices to be deceitful with titles like "Beating Estimates Thanks to Some Fun With Accounting," "Profit Or Not?", "Non-GAAP Fairy Tale," and many more.
So what was Tesla supposed to do? Ignore lease accounting effects and only provide GAAP-dictated results? Where do the hundreds of millions of dollars of annual cash received go, then?
Facts do not cease to exist because they are ignored -- Aldous Huxley
Let's look at a single purchase so we can clearly see the effects of lease accounting on an individual product basis. Let's say a customer named Johann Bitterson test drives a Model S 60Kwh and says, "This is Car 2.0, well beyond anything I've ever driven" and purchases it. He decides to lease it via U.S. Bank since he is still doubtful about the future of the company. Although U.S. Bank wires the full $73,070 amount to Tesla Motors, only about $3,000 of this can be represented in each of the next 12 quarterly reports. Between the 36th and 39th month, Johann has the option to sell the car back to Tesla at the guaranteed value or keep it if he's satisfied.
Under lease accounting, only ~$3K revenue is recognized on first 12 quarters, ~4% of the cash Tesla receives (Model S 60 Kwh, supercharger enabled).
In my opinion, increasing positive factors such as the "Car of the Year" award by Motor Trend, "Highest Rated Car" by Consumer Reports, "Safest Car Tested" by NHTSA, progressive improvement of the car via wireless updates, expanding of the free-to-use supercharger network, extremely low maintenance, and superior service program, $2,000-plus annual electricity vs. gas savings compared to its peers, and many others greatly diminish the risk of significant percentage of lessers selling their cars back to Tesla. After all, if somebody believes a significant percentage of Model S lessers will switch back to comparable BMW, Porsche, Audi, etc. ICEVs after driving it for three years, they shouldn't be invested in Tesla.
Now, let's look at Tesla's Q1 and Q2 GAAP results to see the complete impact: deliveries up by 250 cars, ZEVs down by $17 million. This all sounds good. But wait: Revenues down by $144 million/28%? Sell, sell, sell! Well, only if you like to compare apples to bananas by ignoring lease accounting. Obviously, sensible investors will look at non-GAAP figures as well to track actual progress. I should also note that there's a positive but misleading figure in GAAP numbers -- gross margin is significantly higher since Tesla can recognize 100% of credits, but only a small percentage of revenue and costs.
Lease accounting effects from Tesla's current and future products in different markets will distort GAAP figures significantly for many years. Estimating the percentage of customers opting for leasing instead of buying will only get more difficult as Tesla introduces leasing programs partnered with banks in Canada (Musk mentioned negotiations with Scotia Bank are under way), EU, Asia, and the rest of the world. This is why the reconciled and audited non-GAAP figures are crucial.
Both new and existing investors should carefully examine the non-GAAP figures as much as, if not more than, GAAP figures to track the company's true progress. Any report or article with quarter-over-quarter or year-over-year comparisons should be scrutinized carefully as it will be misleading if lease accounting is ignored. I am long Tesla and still suggest it as a buy for long-term investors -- but not for the short term.