Tesla's Painful Journey Into The Valley Of Death

Nov. 7.13 | About: Tesla Motors (TSLA)

On Tuesday of this week Tesla Motors (NASDAQ:TSLA) reported third quarter results. It beat guidance on the number vehicles delivered, benefited from higher average selling prices and significantly boosted gross margin on its core business of making and selling cars without regard to its 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 five quarters.

Click to enlarge
(Click to enlarge)

These very are impressive results. While I was skeptical about management's claim that Tesla would approach a 25% gross margin in Q4, excluding ZEV credits but including other regulatory credits, I've become a believer, at least over the short term.

Tesla's balance sheet at September 30th was very strong with $795 million in cash and $564 million of stockholders' equity. While there's no way to predict with certainty, I expect the year-end numbers to be even stronger because I think there's a good chance that the substantial bulk of $600 million in subordinated convertible notes that Tesla sold in May were converted into common stock during the recent price spike. My reasoning is simple. Debt instruments like the Tesla convertibles are perennial favorites of bond fund managers who want safety and security with a reasonable yield and a good upside. Bond fund managers are generally more risk averse than equity investors and when one has an opportunity to book gains of 30% or more over a period of a few months, the temptation to take the gain and eliminate the market risk is almost irresistible. Accordingly I won't be surprised to see a billion dollars on the stockholders equity line at year-end. If the note conversions happened as quickly as I think they should have, there should be subsequent event disclosure to that effect in Tesla's upcoming Form 10-Q.

While I'm impressed with Tesla's manufacturing accomplishments and its balance sheet, I continue to believe its reported non-GAAP earnings are a fairy tale; hypothetical information about a company engaged in a different business. Since I discussed the glaring irregularities in Tesla's non-GAAP reporting in an earlier article, Tesla's Non-GAAP Fairy Tale, I'll simply offer the following table which shows what Tesla's non-GAAP results would have been if they used conventional non-GAAP adjustments instead of ignoring the realities of lease accounting.

Click to enlarge
(Click to enlarge)

On balance, I thought Tesla reported a fine Q3 performance, but their Q3 conference call was far more interesting than the financial results because it provided so much color on issues that I've been discussing for years. After listening to the call several times, I can't resist the temptation to share an old favorite story:

"A billionaire is called in for a follow-up visit after his annual physical and the doctor tells him that a CT Scan identified an inoperable tumor. When the doctor tells his patient that he only has four years to live the billionaire asks, "What are my options Doc?" After thinking for a minute the doctor replies, "You could go out and build a giga-factory for lithium-ion batteries. It won't give you a longer life, but the next four years will feel like an eternity."

From my perspective the most intriguing aspect of the conference call was Tesla's demolition of the urban legend that lithium-ion batteries are fungible commodities like their lead-acid cousins.

Most investors know that liberal government support and overly enthusiastic assumptions about market demand for plug-in vehicles resulted in a massive capacity glut in the lithium-ion battery industry and huge losses for companies that received almost $2 billion of battery manufacturing grants in 2009. What isn't widely understood is that lithium-ion batteries come in a variety of cell architectures and chemistries, and devices that are designed to use a particular architecture and chemistry cannot readily accommodate substitutions.

It doesn't matter that there are about 660 M&Ms in a one-pound bag if a particular consumer can only eat the blue ones because of food dye allergies.

In connection with its recently concluded contract negotiations with Panasonic (OTCPK:PCRFY), Tesla made a big show of trotting out Samsung (OTC:SSNLF) and LG Chem as stalking horse suppliers because they're the only companies with enough capacity to satisfy Tesla's anticipated needs. While the markets assumed that Tesla could mix and match 18650 cells from all three companies and play one off against the other, the reality is that Panasonic was the only game in town because 18650 cells from the other two companies use different chemistries and offer different cycle-life, energy, performance and safety profiles. While it was possible that Tesla might choose one of the other battery manufacturers for its upcoming Model X line, there was no meaningful chance that an alternative battery supplier would be used for the Model S because a change of that magnitude would require Tesla to redesign its products to accommodate the substitution before beginning an entirely new testing and validation process.

I have previously written about the gargantuan battery constraints Tesla will face if its business model is successful. I've also discussed the likelihood that its recent contract extension with Panasonic resulted in a better price to Panasonic that will either reduce Tesla's profit margins or increase the cost of its products. But even I was shocked by the open way that Tesla's CEO and Chief Product Architect Elon Musk described Tesla's need for a giga-factory to produce lithium-ion cells for its planned third-generation EV. He basically said that Panasonic can make enough 18650 cells for the Model S and the Model X, but all the lithium-ion battery manufacturing capacity in the world won't be enough for the GenIII. To launch that vehicle and pursue Tesla's quixotic quest to build the perfect EV for the common man, somebody will have to splash out tens of billions to build a giga-factory with a production capacity that's on par with total global production capacity for all lithium-ion battery cells of all architectures and chemistries.

In a way, Tesla's decision to pursue plans for a battery giga-factory was predictable. Henry Ford learned early that a manufacturer can't buy a single component that represents a quarter to a third of its total product cost without creating an overpriced product. By the time Panasonic marks up its cells by a third to cover manufacturing costs, overhead and profit and Tesla tacks on another third to cover manufacturing costs, overhead and profit, cells that cost Panasonic $250 per kWh to make end up costing the final consumer $423 per kWh at the cell level and closer to $630 per kWh at the pack level.

The unanswered question on my mind is "who in heavens name is going to be willing to finance a giga-factory for Tesla?" Once again, my thought process is simple and is based on several hard business realities, including:

  • Battery factories are designed and built for a specific form factor and chemistry and they can't easily adapt to changes in either set of specifications, which means that once Tesla builds a giga-factory it will be locked into a particular form factor and battery chemistry for many years and it will be unable to respond quickly to future technological change;
  • The global supply chain for the foils, separators, electrolytes, cathode materials, anode materials and other essential lithium-ion battery components has not expanded as quickly as cell manufacturing capacity, which means that a giga-factory that would double global lithium-ion battery manufacturing capacity would have to include equipment to make all the required components from commercially available raw materials;
  • While Tesla has done an admirable job of building high performance toys for the 1%, its business model of manufacturing electric cars for the masses is unproven;
  • Battery factories are only efficient if they operate at their rated capacity and plants that build cells for one purpose have a tough time finding willing customers for capacity that isn't fully absorbed by their primary customer; and
  • Despite the "wish upon a star" arguments of EV advocates, battery-dominant electric vehicles are not good for the environment, energy efficient or sustainable on a planet where seven billion people are struggling to earn a fair share of the available resources.

While I expect Tesla to finish the year with about a billion dollars in equity, I can't imagine a rational financier making a multibillion dollar bet that showmanship and hype can overcome economic and environmental reality in the long term.

Tesla's stock was a spectacular performer over the last year, rocketing from a 52-week low of $29.85 to a 52-week high of $194.50. That being said, the ongoing price collapse is pretty solid evidence that Tesla's hype cycle has run its course and the stock has seen its Peak of Inflated Expectations. Unless I'm gravely mistaken, Tesla is just beginning a long and painful journey into the depths of the valley of death where there will be no sustainable price recovery until the market comes to grips with the harsh reality that there will be no third-generation Tesla because there aren't enough blue M&Ms in the lithium-ion battery world to make that dream a reality.

Since I expect Tesla to finish the year with about $1 billion in stockholders' equity, or roughly $8 per share, a market bottom in the $25 range won't surprise me. I've represented small public companies for over three decades and learned firsthand that stock prices behave like pendulums and over the long-term they swing from extreme overvaluation to extreme undervaluation. It's a ton of fun for long investors when the pendulum is moving in their favor. It's far less fun when the music stops and momentum sharply reverses course.

Click to enlarge
(Click to enlarge)

Frankly I'm amazed that it took this long for Tesla to hit the Peak of Inflated Expectations since I've been cautioning my readers about the hype cycle since Tesla's stock price was in the low $30s. I guess that just goes to show that I'm great at identifying bubble stocks but my crystal ball isn't very good at predicting when a bubble will burst.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am a former director of Axion Power International (NASDAQ:AXPW) and hold a substantial long position in its common stock. I currently serve as executive vice president of ePower Engine Systems, a privately held company that's developing an engine-dominant series hybrid drivetrain for heavy trucking.