Tesla: The High Cost Of Disruption

Aug. 1.14 | About: Tesla Motors (TSLA)


Tesla's Q2 earnings report showed deepening losses as Tesla prepares for Model X production.

This was to be expected, and investors seem to be taking the loss in stride.

Tesla's Gigafactory has become lower risk due to the partnership with Panasonic.

Tesla is the wave of the future, but the road ahead may be bumpy for investors.

In February I wrote "Tesla, the Exuberance of Disruption" in which I extolled the virtues of Tesla's (NASDAQ:TSLA) disruptive electric-car technology, and pointed out that disruptive companies such as Tesla often have valuations beyond any rational financial basis. I also pointed out that the ramp-up of Model X production would probably push Tesla into deeper losses, which might present buying opportunities.

Debt Concerns

Now, at mid-year, that's basically what we're seeing, except for the buying opportunities. In the reaction to the current earnings report, released on Thursday, there has been no big after-hours sell-off, despite a net GAAP loss of $62 million, 24% worse than the $50 million loss of Q1.

Should investors be worried? No. Should they be concerned? Yes, but mildly. Here are the reasons:

1) Tesla's debt load. Tesla increased its long-term debt by 55% compared to Q1 to $2.36 billion. Much of this is intended to finance the Gigafactory. As a result, Tesla's interest cost nearly tripled compared to Q1 to $31.2 million from $11.8 million.

Tesla's operating loss actually decreased compared to Q1 by 35% to $28.7 million. It was the interest expense that pushed the net loss higher.

2) Revenue grew to $768 million by 24% compared to Q1. Investors can take some comfort in this and the fact that Model S production continues to expand. Q2 deliveries increased by 17% compared to Q1 to 7579 vehicles. Concerns that Tesla was saturating demand for the Model S appear to have been unfounded. As Musk pointed out in the conference call, Tesla is doing nothing by way of marketing to spur demand. Tesla can't afford to do that, he said, because that would negatively impact customer wait times.

On the conference call, Musk stated that Tesla plans to produce 1000/cars per week by the end of Q3 and 2000 cars per week by the end of 2015, when the Model X will be in full production. So it appears that Tesla can quickly grow into its debt. Model S production of 12000 cars per quarter would be about a 50% increase over the current level, and commensurate with the increase in interest cost.

3) The Panasonic (OTCPK:PCRFY) agreement. Another factor that should mitigate concern about Tesla's debt is the recently announced agreement to share the cost of the Gigafactory with Panasonic, Tesla's current battery provider. Musk indicated that Panasonic, Tesla and other partners would split the $4 billion-$5 billion cost of the factory. Tesla's share would be about 40%-50%, Panasonic's about 30%, with other partners and state subsidies making up the rest.

Gigafactory Risk Reduction

In my article "Tesla's Gigafactory: A Risk Assessment", I put the overall risk at moderate. Based on what Musk had to say about the Gigafactory on the conference call, I would have to drop the risk level down to low. This is because Tesla is taking a very conservative approach to the factory, and because Panasonic will be involved. When asked about whether the batteries would use the same electrodes and chemistry as the current Panasonic batteries, the answer was a definite No. On the other hand, Tesla only expects a 15% improvement in storage capacity from the new batteries, indicating that the cells are not radically different. Also, Musk stated that the batteries would be cylindrical, with optimized dimensions not too different from the current Panasonic cells.

Musk made clear that the planned 30% cost reduction in battery packs is due to economies of scale and co-location. Gigafactory scale enables the creation of specialized machines for more efficient battery production that would be too costly for a smaller facility, according to Musk. The manufacture of precursor materials by Panasonic's partners, Panasonic's manufacturing, and Tesla's cell packaging will all be located inside the Gigafactory.

Tesla appears to be well aware of the potential for greatly increasing energy storage density that I discuss in my Gigafactory article, but they see that as further in the future, roughly 10 years away. Musk said that he sees the Gigafactory as a way to get to that future, that they wouldn't be able to achieve otherwise. I interpret that to mean that Tesla believes they need to get the necessary experience of manufacturing batteries on the scale of the Gigafactory before they tackle the more experimental, but very promising Lithium battery technologies. These technologies have been demonstrated in a laboratory setting to produce 3-4 times the storage capacity of conventional Lithium batteries.

Model X Appeal

As a car buff, and the owner of an Acura MDX, the most environmentally-responsible SUV I could buy at the time, I just salivate at the prospect of the Model X. With its electronically governed twin electric motors, the potential for real-time traction and stability control of the Model X is almost mind-boggling. That, and the fact that performance version will do 0-60 in under 5 seconds. Musk believes that Tesla will be able to sell roughly equal numbers of Models X and S, perhaps a little more of X. I believe him.

In fact, I expect that the X will handily outsell the S, assuming that it's comparably priced. That is a big assumption, however, given the twin drivetrains, and the added complexity of coordinating the two drive systems.

A Caution for Fans

As the reader may have guessed by now, I'm an unrepentant Tesla fan. I can't help it. I just know this is the future. Fuel cells? Come on. People really don't want to turn their cars into Hindenbergs. Gasoline is bad enough.

Musk was asked about the apparent move by the automobile industry in the direction of fuel cell technology. Musk allowed that at Tesla they were "confused" by the interest. I'm not. Hydrogen fuel cells are just a stalking horse put forward by the auto industry to buy time. One sees this behavior time and again in incumbent industries in the throes of disruption. They see the future coming, but the logic of the bottom line dictates that they maximize the investment they've made in their existing technology. Therefore, they delay and dissemble.

This probably will slow down the adoption of battery-powered cars, although how much is difficult to say. Which brings me to my caution. It's a caution I've repeated often in the past. Just because a company has great technology doesn't mean it's a good investment. This is especially true of very disruptive companies like Tesla. The fans swarm the stock, and the valuation goes through the roof.

I can't bring myself to say they're wrong, but Tesla does have an uphill battle ahead of it with a very entrenched and well-funded industry. Tesla is on a path to do so many things that haven't been done before: create a new automobile company, make electric vehicles a mass market item, build a huge battery factory, and change an entire industry.

Tesla's advantage is the advantage of all disruptors: they're skating to where the puck will be. The incumbents know where the puck will be as well, but they've decided they can make more money (in the near term) by standing still, or worse, by trying to block their adversary.

With an agenda that daring and ambitious, Tesla is bound to stumble occasionally. That means pullbacks and price corrections, and heartburn for Tesla investors. However, I still believe that such setbacks will be temporary and constitute buying opportunities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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