I can see in your eyes
That you're tired of the talk
You're tired of the lies
Every time you let a day pass you by
A part of you dies
Take a chance, win or lose
Don't ever give up on the life that you choose
You've gotta hit 'em like a freight train comin'
You drop the pedal with the motor runnin'
Right here right now
Yesterday's gone, tomorrow's always in doubt
Right here, Right Now -- KISS
I doubt that this will come as much of a surprise even to the most bullish Tesla Motors, Inc. (TSLA) investor. The irony of incorporating lyrics from KISS, a band which has made a very nice living on hype and theatrics, shouldn't be lost when relating to Tesla. Co-founder, Elon Musk, an inventor and entrepreneur who isn't shy about hyping his cool electric vehicle into a $21 Billion valuation, said the following after Q1's positive free cash flow claim:
So we don't have any plans right now to raise funding. Essentially, we're-we expect to be-or we were positive cash flow in Q1, and we expect to be relatively sort of neutral in cash flow in Q2. But, yes, it's always possible that we could be opportunistic about raising a round. But there's no-we've spent no time on that at all. So if we were to do a round, it would be the reasons that you mentioned, which is to ensure that if there was some unexpected supply interruption, some sort of force majeure event.
Just 7 days later, "fueled" by the May 8, 2013 TSLA announcement claiming its first quarterly "profit" and free cash flow profit, it announced a $830M offering, led by Musk. Since then, TSLA stock has rocketed to $173.15 "right here, right now."
Clearly, a $0.12 profit, real or otherwise, isn't a justification for a $21B valuation. "Yesterday's gone," but I believe we need to look closely under the hood of the Q1 filing to understand the true "profit" picture, and more importantly, the margins for forecasting future earnings. We will also analyze the free cash flow claim which may confirm that "tomorrow's always in doubt."
Let's start with the easy items. TSLA included a $10.7M non-cash gain from the cancellation of equity warrants and $6.4M in currency gains in Q1. The cancellation of warrants is a one-time, non-operating event that shouldn't be considered when evaluating the profitability of TSLA. Currency gains are unpredictable and could be negative in the future, so it's prudent to remove them when considering the profitability and future margins of the business. The reported GAAP profit was $11.3M, so eliminating just these two items shows that TSLA would have lost $5.8M on a GAAP basis. But that is merely the beginning.
Sales of "Zero Emission Vehicle" (ZEV) credits accounted for $68M of TSLA revenue and gross profit for Q1. For Q1, the company stated that it sold ZEV credits on one-half of cars sold in Q1; however, expect that figure to drop to one-sixth for the remainder of 2013 and eventually to zero (the credits are finite in number and only available for a fixed period of time). This is very important to understand because it speaks to the true operating margin of TSLA. These ZEV credits contribute 100% to gross margin. Removing the unsustainable effects of the ZEV credits changes the operating margin from management's reported 17.1% to 5.7%!
Additionally, management made changes to depreciation schedules on equipment and lengthened the depreciable life on machinery from that it used in previous years. The estimated effect of these favorable changes for Q1 was close to $18M. Adding this cosmetic change to our gross margin calculation reduces the true margin to 2.8%.
And it gets worse. Contrast this 2.8% or 5.7% margin, depending on what you think about the depreciation change, with Elon Musk's statement that he expects a 25% gross margin on the high-end vehicles. It makes sense that margins will improve over time as TSLA gains efficiencies and experience, but the level of efficiencies needed would be off the charts.
The final concern I would like to raise in regards to TSLA's sustainability of earnings is the warranty reserves. TSLA is accruing warranty reserves at 2.6% of sales which is in line with automotive giant General Motors (GM). For several reasons, this is an alarming low accrual provision for TSLA. The first is that TSLA utilizes new and unproven technology. Secondly, the warranty of the Model S is one year plus 12,000 additional miles to domestic peers. Lastly, the battery warranty extends out eight years. The current impact to earnings is sort of an immaterial $2.2M based on proper warranty assumptions, but if the company is successful in ramping up sales and production, this could become severely understated.
The sum of all these parts is that the true sustainable earnings picture for Q1 2013 was -$91.7M, not including any potential change to warranty provisions. Even worse, the free cash flow, reported as +$6.8M, is estimated to truly be -$76.3M after accounting for reductions in inventory of $30.9M, increases in A/P and liabilities of $41.5M, and reduced CapEx spending of $10.7M. The worst is that this figure is likely to be affected more severely when you consider the effects of reduced ZEV credits. TSLA is likely to continue to burn cash in excess of $100M per quarter.
The secondary offering was rushed out seven days after the Q1 earnings announcement by Goldman Sachs (GS). Goldman's own analysts have provided gloomy forecasts on TSLA's share price targets. I believe even their "worst case" scenario of $58 is too optimistic because the analyst assumed a 14.1% margin. The true margin may be closer to 6% yielding a valuation target of $20/share.
Q2 was more of the same for TSLA as the company switched to a non-GAAP reporting method (and again to Non-GAAP v.2) which are not reflective of economic reality and very unusual. The larger of the two EPS figures adds back "deferred gross profit due to lease accounting" which is equivalent to counting your chickens before they hatch (at least that is how we referred to it during my days in Texas). This method also removes non-recurring/non-cash losses and expenses but not similar gains and losses and further uses basic EPS share count, which excludes the dilutive effect of convertible debt. As in Q1, TSLA recognized unsustainable (by their own admission) revenues from ZEV and other regulatory credits into "automobile sales" for Q2. The effect in Q2 is $51.5M in ZEV credits and $17.9M in regulatory credits. Removing these from sales gives a total of $332.1M in sales to end customers. A far cry from the headline sales figure of $552M.
Gross Margin showed slight improvement in Q2 but nothing near the headline figure of 24.8%. Excluding the unsustainable ZEV credits drops the gross margin to 12.6% but that is just the beginning (again). If we also remove the other regulatory credits, the gross margin drops to a meager 9.3%, and if we undo management's new adjustment for stock-based compensation, we are down to 9.1%. Unfortunately for fans of TSLA's stock, this is still too high as we need to consider the aforementioned low warranty accrual which, in our opinion, is overstated by another $3.1M. Additionally, Q2 benefited from changes to how depreciation was measured (discussed above).
Keep in mind that the company touted these non-GAAP "profits" under two methods (the first $0.22 and the second $0.05), while the GAAP accounting method produced a LOSS of $0.26 per share.
The only good news I see for TSLA is that it builds a great car. The bad news is that its accounting isn't great, and its ability to transform the great car into a great company appears suspect at best. Analysts are expecting $0.11 per share profit for Q3 and $534.6M in sales. It is anybody's guess on which of the methods of accounting they expect TSLA to use to reach these figures. Suffice to say, it unlikely will be GAAP-based to reach these figures.
In light of the many reasons discussed above, TSLA shares appear to be grossly overvalued right here, right now. My recommendation is to join the 31.7% short interest holders and short TSLA at $173.15.
Sell SHORT TSLA at the market, October 25, 2013